- The Rise and Fall and Rise of Blue Chip: Fiduciary Duty Trumps Waiver in Latest First Department Decision
- September 21, 2011 | Author: Peter A. Mahler
- Law Firm: Farrell Fritz, P.C. - New York Office
Toward the close of its 2010-11 term, the New York Court of Appeals (the state's highest court) issued a pair of decisions in the Centro and Arfa cases that cast a dark cloud over a line of precedent established by the Manhattan-based Appellate Division, First Department, that had refused to enforce releases or fiduciary waivers given by sellers of interests in closely held businesses who later brought suit against the purchasers/controlling owners for concealing material information affecting the buy-out price, such as an impending deal to sell the company assets to a third party at a much higher valuation.
The best known of the First Department cases, Blue Chip Emerald v. Allied Partners, 299 AD2d 278 (2002), and its progeny including Littman v. Magee, 54 AD3d 14 (2008), broadly suggested that a fiduciary can never contractually relieve itself of its duty of full disclosure by withholding material information the non-controlling owner needs in making its decision to enter into the buy-out agreement. In Centro and Arfa, however, the Court of Appeals expressly disagreed with the First Department cases insofar as they would preclude a sophisticated party from giving a release or waiver in favor of its fiduciary as part of a transaction where the party understands that the fiduciary is acting in its own self-interest and the release or waiver is knowingly entered into.
Anyone who thought Blue Chip was down for the count would be mistaken. Last week, over a vigorous two-judge dissent, a three-judge majority in Pappas v. Tzolis, 2011 NY Slip Op 06455 (1st Dept Sept. 15, 2011), unabashedly wielded Blue Chip to salvage a lawsuit brought by two owners of a realty company who, after selling their LLC membership interests to the third member under an agreement containing a fiduciary waiver, brought suit claiming the buyer intentionally concealed from them an impending deal to sell the company's sole asset to an outside buyer at a spectactularly higher valuation.
The Lower Court's Ruling
My March 2010 post about the trial court's decision in Pappas throwing out the complaint gives a full recital of the underlying facts. In brief, the three parties formed a member-managed Delaware LLC to hold a long-term net lease on a Manhattan commercial property, which they then subleased to one of the members, Tzolis, who subsequently stopped paying rent and then proposed that he acquire the other two members' interests. The deal was made for $1.5 million. Six months later, Tzolis as sole LLC member transfered the lease to a developer for $17.5 million. The two former members then brought suit against Tzolis for breach of fiduciary duty, fraud and other claims based on his alleged nondisclosure at the time of the buy-out of his concurrent negotiations with the developer who acquired the lease.
The trial court dismissed the complaint based primarily on the "Other Activities" provision in the LLC's operating agreement that authorized any member to "engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members." The judge held that the provision eliminated Tzolis's alleged fiduciary duty of disclosure, as authorized under Section 18-1101(c) of Delaware's LLC Act as well as under New York law to the extent made applicable under the LLC agreement's choice-of-law provision.
The judge also accepted Tzolis's argument that the parties' intent to eliminate fiduciary duty under this provision was re-affirmed by a "Certificate" signed by the selling members as part of the buy-out agreement, stating that the sellers had performed their own due diligence, had engaged their own legal counsel, were not relying on any representation by Tzolis outside those made in the agreement, and that "each of the undersigned sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned sellers in connection with [the sales of their interests]."
The Majority Opinion
Last week's appellate decision reversed the lower court and reinstated the complaint's central claims for fiduciary breach and fraud. (It's interesting to note that two of the three judges in the majority, Justices Saxe and Acosta, were on the panel that decided the Littman v. Magee case that, along with Blue Chip, came under attack in Centro and Arfa.)
The majority starts its analysis stating that, as the party seeking dismissal, Tzolis had the procedural burden of "clearly" establishing that the Other Activities provision "eliminated the particular fiduciary duty that plaintiffs contend he breached." The majority readily finds that, while the provision may have permitted Tzolis to pursue for his own benefit a competitive business opportunity unrelated to the LLC,
the provision does not "clearly" permit Tzolis to engage in behavior such as that alleged here, which was to surreptitiously engineer the lucrative sale of the sole asset owned by [the LLC], without informing his fellow owners of that entity.
The majority reaches the same conclusion under substantive Delaware law holding that "'unless the LLC agreement in a manager-managed LLC explicity . . . restricts or eliminates traditional fiduciary duties, managers owe those duties to . . . [the LLC's] members'" (quoting Kelly v. Blum, 2010 WL 629850, *10 (Del Ch 2010).
The majority devotes the greater part of its analysis to the effect of the Certificate's statements disclaiming plaintiffs' reliance on any representations by Tzolis and that Tzolis owed them no fiduciary duty. Stating that "[t]his Court addressed that very issue in Blue Chip . . . a case with very similar facts," the majority concludes that "we are compelled to act with the same uncompromising rigidity here as in Blue Chip." Notwithstanding the Certificate's disclaimers, Tzolis "had an overriding duty to disclose his dealings with [the developer] to plaintiffs before they assigned their interests in [the LLC] to him."
Arguably the most critical part of the majority's opininon is its treatment of the Court of Appeals' recent Centro and Arfa decisions in which, as noted above, the higher court seemingly gutted Blue Chip. Here's how the majority distinguishes the cases and narrows their import as regards the effect of the Certificate:
. . . Centro is distinguishable. In that case, the plaintiffs alleged that the defendants, their co-fiduciaries, induced them to sell their interest in a telecommunications company by misrepresenting the value of the enterprise. The Court of Appeals, in affirming the dismissal of the plaintiffs' fraud claim, noted that the "plaintiffs knew that defendants had not supplied them with the financial information necessary to properly value [their interest], and that they were entitled to that information . . . In short, this is an instance where plaintiffs have been so lax in protecting themselves that they cannot fairly ask for the law's protection'" (2011 Slip Op at *7, quoting DDJ Mgt., LLC v Rhone Group L.L.C., 15 NY3d 147, 154 ). The Court further noted that the plaintiff "ha[d] actual knowledge that its fiduciary [was] not being entirely forthright" (id.). In contrast, defendants here have made no showing that plaintiffs had any reason to suspect Tzolis of deceit or that they had the independent ability to discover facts that would have deterred them from selling their interests in [the LLC] to him.
The majority dismisses as "irrelevant" Centro's (and impliedly Arfa's) explicit disagreement with Blue Chip. In both of those cases, the majority says, prior to entering into the agreements including releases, the relationships between the co-owners had deteriorated to the point that, in Centro's words, "the fiduciary relationship is no longer one of unquestioning trust." The majority contrasts the facts in Pappas, where there is
no evidence that plaintiffs and Tzolis were not still in a relationship of unquestioning trust at the time of the transaction at issue, other than employing the circular logic that they must not have had such a relationship given that plaintiffs were willing to execute the certificate.
Finally, the majority also distinguishes the "exceedingly broad" releases given in Centro and Arfa that, unlike the language used in the Certificate, extinguished the defendants' liability "in all manner of actions . . . whatsoever . . . whether past, present or future . . . resulting from the ownership of membership interests in the entity . . .."
The first sentence of the dissent, written by Justice Helen Freedman and joined by Justice David Friedman, plainly states its thesis: "I would affirm the dismissal of the complaint in its entirety, because contractual disclaimers by plaintiffs preclude the causes of action that the majority has reinstated." (It's again interesting to note that Justice David Friedman wrote both of the First Department opinions upheld by the Court of Appeals in Centro and Arfa, while Justice Helen Freedman voted with the majority in Centro.)
It's unclear the extent to which the dissenters rest their position on the Other Activities provision in the LLC's operating agreement. All they say is that the provision "anticipated competing interests among the LLC members"; that it "afforded Tzolis latitude to pursue his individual business interests for his own gain regardless if his co-members' interests"; and that the restriction or elimination of fiduciary duty is permitted under Delaware law. The dissent does not directly lock horns with the majority's distinction between competitive activities involving business opportunities outside the LLC versus those involving the LLC's sole asset, and thus whether the provision standing alone eliminated the fiduciary duty of disclosure allegedly breached by Tzolis.
What is clear is the dissenters' reliance on the Certificate as an insuperable, contractual barrier to the plaintiffs' claims. Justice Freedman writes:
In this case, plaintiffs were business partners of Tzolis who affirmed at the closing and in connection with the assignments that they were represented by counsel and had performed their own due diligence in connection with the transaction. Their acknowledgment in the closing certificate that Tzolis was not acting as their fiduciary and that they were not relying on any representations by him beyond those contained in the closing documents, constituted fair notice that plaintiffs were engaging in an arm's-length business transaction with Tzolis, that they should not place their "unquestioning trust" in him, and that in exchange for their immediate and certain twentyfold return on their investment, they were forgoing the possibility of future greater profit.
The dissent calls "unpersuasive" the majority's attempt to distinguish Centro. Here's what Justice Freedman says:
It is immaterial that instead of signing a general release plaintiffs executed a certificate disclaiming Tzolis's fiduciary duty and his earlier representations. The disclaimer was tantamount to a release from all claims against Tzolis in connection with the assignment that were premised on his fiduciary duty to plaintiffs.
Lastly, Justice Freedman also challenges the majority's contention that Tzolis made no showing that plaintiffs lacked "unquestioning trust" in him, writing as follows:
The face of the closing certificate, however, indicates otherwise. In consideration of Tzolis's purchase, plaintiffs were presented with, and with the advice of counsel signed, an explicit acknowledgment that Tzolis was not their fiduciary and that they should not rely on his earlier representations. Even if plaintiffs had the right to place their trust in Tzolis before they signed the certificate, that right necessarily ended when they executed it. Accordingly, the breach of fiduciary duty claim is barred.
Next Stop, Court of Appeals?
Under New York appellate rules, a two-judge dissent gives the losing party a right of appeal to the Court of Appeals when the decision "finally determines the action" which does not appear to be the case here. I would nonetheless think there's a more than decent chance that either the Appellate Division or Court of Appeals would grant discretionary leave to appeal. We bystanders can only hope Tzolis pursues further appeal.
The wavering fortunes of Blue Chip reflect a fascinating tug-of-war between two schools of thought. On the one hand, there are what I'll call the judicial interventionists who believe it is the purpose and duty of the courts to use their powers of equity to enforce common law norms of behavior among business partners who owe each other, as Judge Cardozo put it in Meinhard v. Salmon, the "punctilio of an honor the most sensitive." On the other hand there are the contractarians who posit that the parties by and large are free to order their business relations as they see fit and that judicial policing should not extend beyond enforcement of the parties' agreements. The Delaware LLC Act, with its express invocation of the freedom-of-contract principle and its express authorization to eliminate fiduciary duty, creates an optimal vehicle for the latter school.
Of course, the New York Court of Appeals is not a debating society and, should the Pappas case come before it, it is likely to examine closely the facts alleged in the complaint and the precise language used in the parties' agreements to fashion a ruling that resolves the particular dispute on the narrowest possible grounds. As I see it, that narrow issue will be whether, under the analysis advanced in Centro and Arfa, Tzolis's reliance on the Certificate as a fiduciary waiver must be accompanied by extrinsic evidence of an already deteriorated relationship and loss of trust between the bargaining business partners, or whether the "mere" presence in the Certificate of disclaimers and a fiduciary waiver itself evidences the selling members' actual or constructive knowledge and acceptance of the risk that Tzolis was withholding material information concerning the value of the LLC's asset.