What’s in a Name? - (PART II)

How Opening a Restaurant in New York Can Constitute Unfair Competition with a Foreign Restaurant with No U.S.  Branches

This is a follow up article to last week’s blog post .

In view of the New York Court of Appeal’s decision, the Second Circuit upheld the District Court’s award of summary judgment in favor of the Bukhara Grill, including the unfair competition claim under New York law. Having agreed with the District Court that ITC adduced enough evidence of deliberate copying to satisfy that element of this claim, the Second Circuit focused on the sufficiency of ITC’s showing of secondary meaning.

ITC’s original argument was that proof of secondary meaning was not required “when a New York unfair competition claim is based on intentional copying.” Recognizing that the New York Court of Appeals ruled otherwise, ITC then made the argument that the District Court had erred in applying a stricter standard to its secondary meaning analysis than the Court of Appeals had identified and erroneously concluded that ITC could not establish secondary meaning. ITC submitted that if it had had the benefit of the New York Court of Appeals’ decision, it would have submitted evidence substantial enough to withstand summary judgment.

The Second Circuit made clear that for purposes of determining secondary meaning “in the New York market” both the District Court and the New York Court of Appeals were referring to the same market, that is potential customers for Bukhara Grill’s New York restaurant. “We do not understand the Court of Appeals to have limited the relevant market to persons who had already eaten in Bukhara Grill’s restaurants, nor do we understand the district court to have expanded the relevant market to every New Yorker, whether or not inclined to eat in restaurants generally or Indian restaurants in particular.” ITC Ltd. v. Punchgini, Inc., 373 F. Supp. 2d at 288.

In any event, the Second Circuit held that ITC failed to provide sufficient evidence to create a genuine issue of material fact on whether the Bukhara mark and trade dress used by the Bukhara Grill calls to mind ITC’s goodwill for the Grill’s’ potential customers or that the Grill’s’ customers primarily associate the Bukhara mark and trade dress with ITC.

The Second Circuit also found that the District Court did not hold ITC to an unduly strict standard of secondary meaning, but instead considered the evidence in light of the following six factors traditionally recognized as relevant to secondary meaning:

(1)   advertising expenditures

ITC was found not to have provided any evidence that it had advertised its foreign “Bukhara” restaurants in the United States.

(2)   consumer studies linking the mark to a source

ITC was found to have failed to make any attempt to show any name recognition or goodwill through consumer studies. The Second Circuit also observed the lack of evidence of any actual overlap between customers of Bukhara Grill’s restaurant and ITC’s Bukhara “aside from ITC’s own inadmissible speculation.”  The Court noted that, as a result, a reasonable fact-finder could not conclude that potential customers of Bukhara Grill’s restaurant would primarily associate the Bukhara mark with ITC, especially given that numerous restaurants, with no affiliation to ITC, use the name “Bukhara” in Virginia Washington, Massachusetts and around the world.

(3)   unsolicited media coverage of the product

The Second Circuit observed that ITC’s evidence of goodwill came wholly from foreign media sources – ITC did not include any evidence that would permit an inference that such media reports or sources had reached the relevant consumer market in New York.

(4)   sales success

The Second Circuit did not discuss this factor, as ITC did not have any sale successes to consider.

(5)   attempts to plagiarize the mark

Responding to ITC’s argument that the District Court did not consider the public statement and advertisements which stated or implied a connection with ITC, the Second Circuit observed that the District Court plainly did consider this evidence in concluding that Bukhara Grill had intentionally copied ITC’s mark and trade dress, but found that intentional copying alone was not be enough to demonstrate the necessary “secondary meaning” where the “copying” at issue is prohibited based on the application of the “famous marks” doctrine for marks that have acquired a “secondary meaning.” The Court found this reasoning to be consistent with the New York Court of Appeals’ opinion that a famous foreign mark holder must show more than copying in order to pursue a claim for unfair competition under New York state law. “ITC cannot satisfy this burden simply by pointing to evidence of obvious similarities between defendants' Bukhara Grill and ITC's own Bukhara restaurant, because such evidence is no proof that defendants' potential customers were even aware of the existence of ITC's Bukhara.” id., 164.

(6)   length and exclusivity of the mark’s use

The Court rejected the exclusivity argument by finding that a reasonable fact-finder could not conclude that potential customers of Bukhara Grill’s restaurant would primarily associate the Bukhara mark with ITC, especially given that numerous restaurants, with no affiliation to ITC, use the name “Bukhara” in Virginia Washington, Massachusetts and around the world.  The Second Circuit noted that ITC had produced no evidence that the goodwill that had been generated by ITC’s former New York and Chicago locations had not endured long enough for defendants’ potential customers to “primarily associate” defendants’ Bukhara restaurant with ITC’s former restaurants.

Conclusion

Taking into account that the evidence failed as a matter of law to raise a triable question of fact on the issue of secondary meaning necessary to establish a New York common law unfair competition claim, the Second Circuit affirmed the District Court’s grant of summary judgment in all respects.

Food for Thought

Under these decisions, it would appear to be perfectly legal for a New York restauranteur to deliberately copy a restaurant that he saw in, say, Mumbai, including taking its name, so long as the Indian restaurant had it acquired “secondary meaning” in the New York market. Does this seem right?

What’s in a Name? - (PART I)

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How Opening a Restaurant in New York Can Constitute Unfair Competition with a Restaurant with No U.S. Operations

Bukhara is an ancient city on the Silk Road in Uzbekistan.  It has an interesting Central Asian cuisine and quite a few émigrés in New York City.  If a few Bukharan-Americans were to open a restaurant in the New York named after their city of origin, under what circumstances could they be held liable for unfair competition to a restaurant in India named Bukhara, with no branches in the United States?

Remarkably, a case similar to this one has already found its way to both the Second Circuit and the New York Court of Appeals. A restaurant in New York named “Bukhara Grill” was sued in Federal Court for unfair competition and related claims by ITC, the owner of an Indian chain of restaurants named “Bukhara,” based in New Delhi.  ITC, at one point, had a branch in New York and had filed a trademark application for the name “Bukhara,” but the New York branch had shut down.  It had no current operations in North America. 

When ITC’s branch in New York closed, three of its employees opened their own restaurant and called it Bukhara Grill.  As one of them explained, there was “no restaurant Bukhara in New York, and we just thought we [would] take the name.” (ITC Ltd. v Punchgini, Inc., 482 F3d 135, 144 [2d Cir 2007]).  And, as they would later note, there were at least 20 other restaurants around the world named “Bukhara.”  But Bukhara Grill bore similarities to ITC’s Bukhara aside from name, including menu, decoration and waiters’ dress.

Shortly after the Bukhara Grill opened, ITC’s counsel sent a letter to one of the owners, relying on the “famous marks” doctrine (see below) and accusing him of “passing off [his] new business [i.e., Bukhara Grill] as that of” ITC, “piggy[]back[ing] on the tremendous reputation” of ITC's Bukhara restaurants, and “partak[ing] of the fame, goodwill and custom earned by [ITC], by the mere adoption of the identical name.”  ITC Ltd. v. Punchgini, Inc., 9 N.Y.3d 467, 473 (2007).

The famous mark’s doctrine holds that a trademark owner not currently using a mark in the U.S. can nevertheless stop any infringing use in the U.S. if the mark at issue is famous or has acquired “secondary meaning” within the U.S. “Secondary meaning” is a term of art referencing a trademark’s ability to ‘identify the source of the product rather than the product itself ’ ITC Ltd. v. Punchgini, Inc., 518 F.3d 159, 161. When secondary meaning attaches, a mark that a business would not have initially been able to register may achieve trademark status. The mark may be subject to registration at some point in the future after sufficient use has been made to prove secondary meaning under trademark law.

ITC’s counsel demanded that the new restaurant cease using the name Bukhara and acknowledge ITC’s exclusive rights to the Bukhara mark; he also demanded an accounting of its sales and profits and remittance of any such profits, as well as estimated damages and attorneys’ fees.

Bukhara Grill’s counsel responded by stating that Bukhara had abandoned the tradename in the United States two years earlier, so it had no rights to it.

Ultimately, ITC filed suit in the United States District Court for the Southern District of New York, alleging trademark infringement under section 32 (1) (a) of the Lanham Act (codified at 15 USC § 1114 [1] [a]); unfair competition and false advertising under sections 43 (a) and 44 (h) of the Lanham Act (codified at 15 USC § 1125 [a]; § 1126 [h]); and parallel claims under New York common law. Bukhara Grill defended by claiming “abandonment” and filed a counterclaim seeking cancellation of the mark's registration on that ground.

After discovery, both sides moved for summary judgment. The District Court ruled that ITC could not pursue a trademark infringement claim because it had abandoned the mark for restaurants in the United States. It also rejected ITC’s unfair competition claims under section 43 (a) of the Lanham Act and New York common law. 

The Second Circuit affirmed the District Court’s award of summary judgment on Bukhara’s infringement, unfair competition and false advertising claims under federal law. It rejected the use of the famous marks doctrine under federal law, but was uncertain whether it applied under New York common law. Thus, it certified the following two questions to the New York Court of Appeals: (1) “Does New York common law permit the owner of a famous mark or trade dress to assert property rights therein by virtue of the owner's prior use of the mark or dress in a foreign country?”; (2) “If so, how famous must a foreign mark be to permit a foreign mark owner to bring a claim for unfair competition?” (482 F3d at 167.)

The New York Court of Appeals responded by stating: “We have long recognized two theories of common-law unfair competition: palming off and misappropriation.  “Palming off”--that is, the sale of the goods of one manufacturer as those of another --was the first   theory of unfair competition endorsed by New York courts, and has been extended . . . to situations where the parties are not even in competition.”  ITC Ltd. v. Punchgini, Inc., 9 N.Y.3d at 476-477. Misappropriation rests on the principle “that one may not misappropriate the results of the skill, expenditures and labors of a competitor.” Id. The Court of Appeals stated that New York courts decided cases such as this one on a “misappropriation” theory and that there is no separate “famous mark or trade dress” theory in New York. 

Under New York law, “[a]n unfair competition claim involving misappropriation usually concerns the taking and use of the plaintiff's property to compete against the plaintiff's own use of the same property.” The term “commercial advantage” has been used interchangeably with “property” within the meaning of the misappropriation theory. . . . for certain kinds of businesses (particularly cachet goods/services with highly mobile clienteles), goodwill can, and does, cross state and national boundary lines.

Accordingly, while we answer “Yes” to the first certified question, we are not thereby recognizing the famous or well-known marks doctrine, or any other new theory of liability under the New York law of unfair competition. Instead, we simply reaffirm that when a business, through renown in New York, possesses goodwill constituting property or a commercial advantage in this state, that goodwill is protected from misappropriation under New York unfair competition law. This is so whether the business is domestic or foreign.”

The Court followed this by answering the second question, stating that “protection from misappropriation of a famous foreign mark presupposes the existence of actual goodwill in New York. If a foreign plaintiff has no goodwill in this state to appropriate, there can be no viable claim for unfair competition under a theory of misappropriation. At the very least, a plaintiff's mark, when used in New York, must call to mind its goodwill. . . Thus, at a minimum, consumers of the good or service provided under a certain mark by a defendant in New York must primarily associate the mark with the foreign plaintiff.” (9 N.Y.3d at 479). 

Thus, to prevail on an unfair competition theory, under New York law, the Plaintiff would have to show that defendants appropriated (i.e., deliberately copied), its mark or dress for their New York restaurant. If it makes that showing, it would then have to establish that the relevant consumer market for New York's Bukhara restaurant primarily associates the Bukhara mark or dress with those Bukhara restaurants owned and operated by Plaintiff  (9 N.Y.3d at 480). In short, to pursue an unfair competition claim, Plaintiff must adduce proof of both deliberate copying and “secondary meaning”. 

The case went back to the Second Circuit, which we will discuss further in another blog post next week. Where the Court concentrated on what constitutes “secondary meaning”.

How Good is a “No Oral Waivers” Clause?

Not very, if your actions could be construed as an oral waiver

Many, probably most, contracts contain provisions that prohibit oral waivers of any of their terms.  Language, such as that the paragraph below, is often included in a contract, to prevent a party from claiming that the other side orally agreed to waive a particular term or requirement of the contract: 

Waiver. No waiver of any provision of this Agreement or any rights or obligations of either party hereunder shall be effective, except pursuant to written instrument signed by the party or parties waiving compliance.

Most people assume that this unambiguous provision, which contains no exceptions, is fully enforceable and precludes a claim of waiver.  But, that it is not quite the case.  Oral waivers are permitted if the court determines that the parties acted in a manner consistent with a waiver, such as not enforcing a contract provision.

In Kamco Supply Corp. v On the Right Track, LLC, Kamco agreed to purchase annual and monthly minimum volumes of products from defendants.  It never came close to achieving these minimum volumes, but the parties kept working together under the contract anyway, until one day, the defendants declared Kamco in default for failing to purchase the minimum quantities mandated.

The Supreme Court held that the minimum requirements provisions had been waived, notwithstanding a “no waiver” clause in the contract.  As for the “no oral waiver” clause, the court held that it was not dispositive, as “[t]he factual question of whether waiver occurred may be determined by consideration of words or conduct.”

The Appellate Division, Second Department affirmed, explaining:

The general principles relating to the law of waiver and estoppel in New York are well known. Once a contract is formed, the parties may of course change their agreement by another agreement, by course of performance, or by conduct amounting to a waiver or estoppel.  Thus, [c]ontractual rights maybe waived if they are knowingly, voluntarily and intentionally abandoned, and [s]uch abandonment may be established by affirmative conduct or by failure to act so as to evince an intent not to claim a purported advantage. As the intentional relinquishment of a known right, a waiver should not be lightly presumed. Similarly, a party’s reluctance to terminate a contract upon a breach and its attempts to encourage the breaching party to adhere to its obligations under the contract do not necessarily constitute a waiver of the innocent party’s rights in the future.  
A waiver, however, maybe proved by undisputed acts or language so inconsistent with [the party’s] purpose to stand upon his [or her] rights as to leave no opportunity for a reasonable inference to the contrary.” (internal citations and quotation marks omitted).

Waiver and election of remedies

In the Kamco case, the Second Department also explained the “interplay” between the concept of waiver and the doctrine of election of remedies:  

Under the election of remedies doctrine, “when a party materially breaches a contract, the non-breaching party must choose between two options: it can elect to terminate the contract or continue it. If the non-breaching party chooses to continue to perform or accept performance, it loses its right to terminate the contract based on the prior breach.”
“[A]n election of remedies is merely a species of waiver. Thus, a party that continues to perform or accept performance despite the failure of a condition precedent established for its benefit may be said—provided that such party’s intent is clearly expressed—either to have elected to affirm the contract despite the failure of the condition, or to have waived the satisfaction of the condition. Whether viewed as an election or as a waiver, the result is the same: the party is barred from terminating the contract based on the failure of the condition precedent and may be held liable if it subsequently fails to perform.”
 “However, in the case of a waiver that is deemed broad enough to apply prospectively to an executory obligation, the effect of such a waiver would arguably be broader than that of a mere election. Whereas an election to continue the performance of a contract despite the occurrence of a material breach would bar the right to terminate the contract based on that breach it would not preclude an action based on a subsequent breach. By contrast, a prospective waiver of the breached provision would . . . serve to bar an action based on a subsequent breach of that provision.”

The Appellate Division noted that determining whether a waiver occurred, notwithstanding a “no waiver” clause is very difficult, especially when it comes to “relational contracts” – those where there are repeated occasions for performance over the course of months or years, and “particularly when trying to gauge whether a waiver relates only to a contemporaneous or past obligation, or applies prospectively to executory obligations as well.”  It continued, by stating: 

In approaching this question, it is useful to recall that the roots of waiver lie firmly in equity, and are “designed to prevent the waiving party from lulling the other party into a belief that strict compliance with a contractual duty will not be required and then either suing for noncompliance or demanding compliance for the purpose of avoiding the transaction. (internal citations and quotation marks omitted). 

The Appellate Division concluded that after months of waiving the minimum purchase requirements and after having concluded that Kamco could never meet them going forward, defendants’ waivers of past performance morphed into a waiver of future performance.  As for the “no waiver" clause, it stated:

Finally, we agree with the Supreme Court that, under the facts presented, the agreements’ no-oral-waiver provision . . . does not compel a different result. As explained above, the Kamco parties’ persistent and repeated failure to meet minimum purchase requirements, coupled with [defendants’] continued acceptance of such conduct without any reservation or protest until a few weeks before the expiration of the agreements by which time it was, of course, too late to insist upon strict compliance with the terms of the agreements), equitably estops [defendants] from invoking the benefit of the no-oral waiver provision (internal citations and quotation marks omitted).

Lessons Learned

The Kamco case illustrates that parties to a contract should not rely on a “no waiver” clause when confronted by a default or variance in performance by the other party.  It is critical, in addressing such defaults or variances, to be clear and explicit as to whether a waiver is intended, and if so what the extent of the waiver is.  If the intent is to waive one failure to perform, but not future ones, this needs to be explicitly stated. Otherwise, a court, down the road, may conclude the opposite. 

PUFFERY AND OTHER DEFENSES TO FRAUDULENT MISREPRESENTATION CLAIMS

-          “This investment is foolproof.”

-          “This is a great investment opportunity."

-          “You have nothing to worry about."

-          “The investment is fully guaranteed.”

-          “Your loan will be fully repaid with 16% interest in no longer than a year."

-          “I will sell my own property to ensure that you are paid back.”

The potential investor believed he couldn’t have received any more positive assurances that the investment would be successful and so he proceeded with the investment.  When the investment tanked, the investor sued for fraudulent misrepresentation.

In Scola v. Boivin, a 2016 case decided by New York Supreme Court Justice O. Peter Sherwood on facts similar to those above, the investor lost.  None of these statements were deemed to be actionable.  The first three statements were deemed to be pure “puffery” or nonactionable expressions of opinion or future value. The next two were deemed to be true statements – the loan was guaranteed and the note did provide that the loan would be fully repaid with 16% interest within one year. The last statement – which was disputed by the defendant - was deemed to be an unenforceable promise and barred by the statute of frauds. 

So, what would the investor have had to show to succeed on a claim of fraudulent misrepresentation?   As the Scola decision noted the elements of such a claim are “a misrepresentation or a material omission of fact which was false and known to be false by defendant, made for the purpose of inducing the other party to rely upon it, justifiable reliance of the other party on the misrepresentation or material omission, and injury.”  Another way of saying this is that to constitute actionable fraud, the false representation relied upon must relate to a past or existing fact or something equivalent thereto, as distinguished from a mere estimate or expression of opinion.

This rule does not completely relieve someone who limits himself to expressions of future fact from liability for fraud.  It has been held that an expression or prediction as to some future event, known by the author to be false or made despite the anticipation that the event will not occur, is deemed a statement of a material existing fact, sufficient to support a fraud action.  See Green v. Beer, a 2009 Southern District of New York case. 

In the same vein, financial projections have been held not to be mere opinions when they were made “knowing that they were false and unreasonable and that they were not based on [the company’s] actual financial condition.” See CPC Int’l Inc. v. McKesson Corp., a 1987 New York Court of Appeals case, which held that projections of expected financial performance constitute “material existing [facts], sufficient to support a fraud action.”

 

Statements that are recklessly made, i.e., where the maker didn’t know whether the statement was true or false, and was indifferent to whether it was true or false or to the injury which might ensue, may also be the basis for a fraudulent misrepresentation action. 

In the Scola case, the investor argued that the statement that the investment was “foolproof” was made recklessly. But, the Court rejected this argument, holding that it was not a representation of fact, but rather puffery.  The Court relied, at least in part, on Longo v Butler Equities II, L.P., in which the First Department determined that the “alleged misrepresentations that the target company was seriously Undervalued and could be profitably broken up, and that partnership investors would be 'in and out' in not more than one year, can only be understood as nonactionable expressions of opinion, mere puffing.”

So, what is the rationale behind the rule that statements that are mere “puffing” are not actionable?  These statements are deemed to be “nothing more than a recommendation of the [speaker’s] wares. It is common knowledge that dealers are wont to put the best side out, and extol their goods. The public is so familiar with dealer’s ‘talk’ that it is generally regarded as a mere expression of opinion, and, where the parties deal on equal terms, is not relied upon to any great extent.” Koch v Greenberg, affirmed by the Federal Second Circuit, which cited Bareham & McFarland, Inc. v Kane, a 1930 Fourth Department case.

Promoter’s Liability for Breach of Fiduciary Duties

The Roni LLC v. Arfa Saga

Can promoters of limited liability companies be held liable for a breach of fiduciary duties that occurred prior to the formation of the LLC?

In Roni v. Arfa, investors in various real estate owning LLCs sued the promoters of those LLCs for not disclosing that they had received “commissions” from the sellers of the properties of up to 15%.  The investors argued that these commissions inflated the purchase prices by millions of dollars. The promoters moved to dismiss, contending that they had no duty to disclose these payments since they could not be held to be fiduciaries prior to the formation of the LLCs. 

The case quickly devolved into one in which the key issue was whether the promoters had fiduciary duties to the investors before the LLCs were formed and the investors had put up their money.  If the transactions were at an “arm’s length” – as the promoters argued - between sophisticated parties, there would be no fiduciary duty, and the promoters would have no obligation to disclose this fact.

The Supreme Court (New York’s trial level court) determined that the promoters did have fiduciary duties, and the promoters appealed this decision.

The Appellate Division Decision

The New York Appellate Division, First Department ruled that the LLC promoters had a fiduciary duty and denied the motion to dismiss, by analogizing to the rule in effect for corporations. The First Department stated:

Both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders. By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members. The fiduciary duty includes the obligation to disclose fully any interests of the promoter that might affect the company and its members, including profits that the promoter makes from organizing the company.

Under this ruling, LLC promoters were found to have pre-formation fiduciary duties to investors merely by virtue of their status as organizers of the LLC.  The First Department granted the promoters leave to appeal to the Court of Appeals the following certified question: “Was the order of [the First Department], which affirmed the order of [the] Supreme Court, properly made?”

The New York Court of Appeals’ Decision

In its decision issued in December 2011, the New York Court of Appeals answered the certified question affirmatively, but did so without following the Appellate Division’s bright line rule that promoters are fiduciaries.  Instead, the Court of Appeals held that a fact-specific inquiry was necessary in order to determine whether a fiduciary relationship existed, noting:  

A fiduciary relationship arises "between two persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relation". Put differently, "[a] fiduciary relation exists when confidence is reposed on one side and there is resulting superiority and influence on the other."

Applying this test, the Court of Appeals concluded that the investors had sufficiently alleged the existence of a fiduciary relationship between the LLC promoters and themselves. The Court reasoned as follows:

Here, plaintiffs assert that the promoter defendants planned the business venture, organized the limited liability companies, solicited their involvement and exercised control over the invested funds. We agree with plaintiffs that the promoters of  a limited liability company are in the best position to disclose material facts to investors and can reveal those facts more efficiently than individual investors, who would otherwise incur expense investigating what the promoters already know.  In addition, the complaint alleges that the promoter defendants represented to the foreign investors that they had "particular experience and expertise" in the New York real estate market. Although the promoter defendants describe plaintiffs as "sophisticated prospective investors," the complaint paints a different picture, stating that they were "overseas investors who had little or limited knowledge of New York real estate or United States laws, customs or business practices with respect to real estate or investments." Moreover, plaintiffs contend that the promoters defendants assumed a position of trust and confidence, in part, by "playing upon the cultural identities and friendship" of plaintiffs. Accepting the totality of these allegations to be true, as we must at this early stage of the litigation, the complaint adequately pleads a fiduciary relationship. 

The Subsequent New York Supreme Court Decision

The case was sent back to Supreme Court Justice Charles E. Ramos for further proceedings, and after discovery, both the investors and the promoters moved for summary judgment. The Supreme Court – now looking at the additional facts that had been adduced in discovery - determined factually that each of the defendants had conducted themselves in manner that made them promoters. The Court applied the Appellate Division’s definition of a “promoter” as one who “plans the business venture, organizes the LLCs, and solicits investors to invest” and relied on its decision that promoters are, by virtue of their status, fiduciaries. 

In its decision, the Supreme Court rejected the promoters’ argument that the Court of Appeals had rejected the Appellate Division ruling imposing fiduciary duties on promoters by virtue of their status as promoters. Instead, it stated that the Appellate Division’s test and the Court of Appeal’s test were both valid.  Some parties can acquire fiduciary duties merely by their status (i.e, attorneys, brokers) and others by having superior knowledge and expertise that is relied on by the other party. 

The Open Question

This series of decisions left open the question as to why the Court of Appeals avoided the Appellate Divisions bright line test – promoters have fiduciary duties – in favor of a more nuanced test.  Although the Court of Appeals did not formally reject the Appellate Division’s test, it appeared to leave open the possibility that a promoter might in certain circumstances not have fiduciary duties (i.e., where the investors were very sophisticated and did not rely on the promoter’s superior knowledge and expertise).

We will have to wait and see.  

Schroeder v. Pinterest Inc.

A COLLECTION OF LEGAL PRINCIPLES RELATING TO STOLEN INTELLECTUAL PROPERTY INVOLVING SOCIAL MEDIA WEBSITES

Were the ideas and functionality behind the Pinterest social media website stolen? A case alleging just that is making its way through the New York court system. In Schroeder v. Pinterest Inc., the New York Appellate Division First Department addressed multiple issues relating to a lawsuit claiming theft of ideas and work product that led to the development of the popular website Pinterest.com. 

Pinterest is “a content sharing service that allows members to ‘pin’ images, videos and other objects in their pinboard.” In the Pinterest case, an internet entrepreneur is claiming that the former Chairman and Chief Executive Officer of two companies he founded with former classmates stole their website concept, designs, and business plan, and gave them to a different group of developers who used them to create the immensely popular social media website Pinterest.com.  

Case Background – In 2005, Plaintiff Schroeder, then a Columbia Law School student, came up with the idea of developing “a social network bulletin board where users could share their physical location with friends over the [i]nternet.” He taught himself how to program and spent many hours developing the site. He brought two of his classmates into the project to help him. Together they formed Rendezvoo, LLC, a limited liability company, in order to develop the website. Rendezvoo’s operating agreement mandated that all three members owed each other fiduciary duties and “were expressly prohibited from unilaterally taking any corporate opportunities.” Rendezvoo’s website application was released to the public in 2006, and in a second version, was expanded to allow users to share their interests as well as their physical locations.

Seeking to raise additional capital for website development, the three developers were introduced to early stage investor and self-proclaimed “entrepreneur mentor,” Brian Cohen. After learning about their business model and business plan, Cohen accepted their offer to become Chairman and Chief Executive Officer of Rendezvoo. He was also given an 18% equity interest in Rendezvoo. Although never formally memorialized, Cohen agreed to be bound by Rendezvoo’s operating agreement restricting the misappropriation of company ideas and work product.

In 2007, at Cohen’s urging, the four Rendezvoo principals took down the Rendezvoo website and began developing a new site with a narrower focus than Rendezvoo. The new site, named Skoopwire, would focus exclusively on providing early access to new products and services. The four Rendezvoo principals founded Skoop Media Associates, Inc. to develop the new website. Skoop Media’s website, Skoopwire.com, was “a direct-to-customer news wire connecting businesses to bloggers, sophisticated customers and journalists wanting easy access to information about new products and services before they were covered in the mainstream media.” 

The business relationship between the three original developers and Cohen quickly soured. According to the complaint, Cohen sought more equity and when he did not get it, he deadlocked the project “so he could steal the core ideas for himself and freeze out Schroeder from reaping any benefits.” By early 2008, the parties began to contemplate liquidating and dissolving Skoop Media, but they never formally proceeded to do so. Schroder attempted to have the shareholders sign an agreement to protect the Rendezvoo or Skoopwire concepts, but nobody signed it. In mid-2008, Cohen “abandoned” his positions with both companies. The Skoopwire website was never released to the public. Both Rendezvoo and Skoop Media were never dissolved.

In 2009, Cohen met the future founders of Pinterest.com at a business school competition. In March of 2010, Pinterest.com was launched. “The website allows users to pull images from elsewhere on the [i]nternet and generate pins which are compiled into various topic boards.” Users then “have the ability to view the most popular pins on the site as well as the board that other users have created.”  

Upon viewing Pinterest.com, Schroeder noticed it was virtually identical to the second version of the Rendezvoo website. Schroeder noticed key features which bore clear similarities to their previous work including “the ability for users to post their interests for their friends and other users of the site to see.” In 2012, Schroder read an article in which Cohen “bragged about being Pinterest’s ‘first investor,’” and described how he met Pinterest’s founders in 2009, shortly after he allegedly deadlocked the Rendezvoo and Skoopwire projects. Plaintiffs allege that, in this article, Cohen falsely stated that he did not know where the concept of "pinning on Boards" came from, and claimed that the Pinterest website "came out of nowhere." The complaint further alleges that Pinterest’s founders knew that the ideas given to them by Cohen were not his own.

In June 2013, Schroeder, Rendezvoo and Skoop Media sued Cohen, his company, New York Angels and Pinterest, and in September, the Cohen defendants and Pinterest separately moved to dismiss the complaint.

In July 2014, Judge Melvin L. Schweitzer granted Cohen’s motion and dismissed the breach of fiduciary duty, misappropriation and unjust enrichment claims. The court, however, denied dismissal of the causes of action for misappropriation of skills and expenditures, and promissory estoppel. This appeal followed.

The Court analyzed each of the plaintiffs’ claims for legal sufficiency and ruled as follows:

Breach of Fiduciary Duties – The Appellate Division held that the Plaintiffs had properly stated a claim for breach of fiduciary duties, and reversed the lower court’s dismissal of this claim. The complaint alleges that Cohen, as Chairman and Chief Executive Officer of both Rendezvoo and Skoop Media, owed fiduciary duties to both companies and to Schroeder, a fellow shareholder and member. Additionally, the complaint alleges that Cohen breached those duties by intentionally deadlocking the Rendezvoo and Skoopwire projects, stealing the proprietary ideas, technology and business plans underlying their sites, and providing this information to Pinterest.

Cohen argued that the fiduciary duty claim was not viable because he was no longer affiliated with Rendezvoo or Skoop Media by 2009, when he allegedly gave Pinterest the confidential information. He cited cases holding that a director who resigned or was terminated no longer owed fiduciary duties to the company. 

The Court ruled that the complaint sufficiently alleged that Cohen was still an officer of Rendezvoo and Skoop Media at the time of the alleged breach. Plaintiffs claimed that the breaches began when Cohen deadlocked the two companies while they were still active. The Court noted that there was no allegation in the complaint that Cohen ever resigned his positions, or relinquished his ownership interests in either entity, implying that Cohen was never relieved of his fiduciary duties.

The Court added that even if Cohen had resigned from both companies before giving the information to the Pinterest entrepreneurs, he could still be held liable if Plaintiffs could show that his breaches “were founded on information acquired during the fiduciary relationship."

The Court dismissed the aiding and abetting breach of fiduciary duties claim against Pinterest, stating that an essential element of such a claim is that the defendant knew that the party it was aiding was under such a duty and the complaint did not allege that Pinterest knew of Cohen’s prior relationship with Plaintiffs.

Unjust Enrichment - The Court upheld the dismissal of the unjust enrichment claim against Pinterest on the grounds that the complaint did not allege a “sufficiently close relationship” between plaintiffs and Pinterest necessary to sustain such a claim; in fact, the Court noted, it did not allege any relationship between them.

Misappropriation of Trade Secrets – The Court upheld the misappropriation of trade secrets claim against Cohen, but dismissed this claim against Pinterest.

Regarding Cohen, the Court held that Plaintiffs had sufficiently alleged that Plaintiffs (1) possessed a trade secret, and (2) Cohen used that trade secret in breach of an agreement, confidential relationship or duty. The Complaint alleged that Cohen had “exposed” valuable confidential and proprietary technology and business plans by providing them to Pinterest. Cohen made these improper disclosures in violation of his executive positions with Rendezvoo and Skoop Media as well as his agreement to be bound by Rendezvoo’s confidentiality agreement.

Nevertheless, the Court noted the trade secrets claim was limited to only confidential information – essentially excluding any features contained in Rendezvoo’s website application that was made publicly available – because a trade secrets claim, by definition, excludes information in the public domain.

Regarding Pinterest, the Court stated that the Complaint contained no allegations that Pinterest had breached an agreement or confidential relationship with or duty to Plaintiffs, nor did it allege that Pinterest acquired the information by improper means. Merely obtaining the information from Cohen without knowledge that he had improperly taken it is insufficient to hold Pinterest liable for trade secret misappropriation.

Misappropriation of Ideas – The Court upheld the misappropriation of ideas claim against Cohen, but dismissed it against Pinterest. The Court held that the Complaint alleged (1) a legal relationship between Plaintiffs and Cohen, and (2) the idea allegedly taken was “novel and concrete.” The legal relationship between Plaintiffs and Pinterest was lacking and thus this claim had to be dismissed.

Misappropriation of Skills and Expenditures – The Court upheld this claim against Cohen, but dismissed it against Pinterest. The Complaint properly alleged that Cohen had (1) misappropriated Plaintiffs’ labor, skills, expenditures, or goodwill, and (2) displayed some element of bad faith in doing so. Bad faith can be established by demonstrating “fraud, deception, or an abuse of a fiduciary or confidential relationship.” The Complaint alleged that Cohen misappropriated years of Schroeder’s work that was used to develop the Rendezvoo and Skoopwire websites. In addition, bad faith was shown on Cohen’s part by his disclosure of confidential and propriety information while he was a fiduciary of Rendezvoo and Skoop Media, as well as his violation of Rendezvoo’s operating agreement.

Promissory Estoppel – The Court held that the Complaint did not allege a viable promissory estoppel claim against Cohen based on his July 1, 2008 email stating that he had "absolutely NO interest in PROFITING from [Schroeder’s] specific design work on Skoopwire." The Court noted that the elements of such a claim are: (1) a promise that is sufficiently clear and unambiguous, (2) reasonable reliance on the promise by a party, and (3) injury caused by the reliance, and held that the Complaint was deficient because it did not allege that Schroeder had relied to his detriment on this promise.

Misappropriation of Ideas

New York law recognizes a cause of action for misappropriation of ideas, but it is not an easy claim to establish.  This cause of action requires proof of two elements: (1) a legal relationship between the parties in the form of a fiduciary relationship, express contract, implied contract, or quasi-contract; and (2) an idea that is novel and concrete. 

The idea must be truly novel.  An idea that is merely “a variation on a basic theme” already in the public domain is not novel.

Under New York law, as applied by its Federal courts, there are two separate types of misappropriation of ideas cases – non-contract and contract based claims.  Where the claim is not based on a contract, the idea at issue must be original and novel in absolute terms.  This is so because unoriginal, known ideas have no value as property, and the law does not protect against the use of that which is free and available to all.  Claims based upon a contract or quasi-contract require only a showing that the disclosed idea was novel to the buyer.  

Novelty is generally a fact issue, but sometimes an idea may be so unoriginal or lacking in novelty generally that the court can determine that as a matter of law, the buyer is deemed to have had knowledge of the idea.  In such cases, neither a property-based nor a contract-based claim exists.

Under New York law, as applied in State courts, absolute novelty is requisite for both contract and non-contract based claims.  However, the novelty of an idea need not be demonstrated in order to establish a claim for breach of contract where, subsequent to disclosure of the idea, the parties entered into a contract for use of the idea.  The reasoning is that the buyer, by entering into a contract, has demonstrated its agreement that the idea has value.  Thus, a contract based claim can proceed even if the idea lacks novelty. 

The mere formation of a contract in a submission-of-idea case does not necessarily mean that the contract has been breached by the defendant upon his use of the idea.  Under New York law, in order to recover for breach of contract in a submission-of-idea case, a plaintiff must demonstrate some nexus or causal connection between his or her disclosure and the defendant’s use of the idea. In essence, where there is an independent source for the idea used by the defendant, there may be no breach of contract claim.  

 

Personal Liability for Corporate Debts

The “Two Signature” Rule

It is black letter law that one who signs an agreement in his or her corporate capacity is not personally liable. It is therefore remarkable how much litigation there is involving the issue of whether an individual signing for the corporation has also personally obligated himself under the agreement.[1]

 

The general rule laid out by the New York Court of Appeals in 1961 in Salzman Sign Co. v. Beck is that a corporate representative will not be liable for a corporation’s debts unless there is a manifestation “clear and explicit of the [representative]’s intention to substitute or superadd his personal liability for, or to, that of his principal.”[2]

 

In Salzman, the defendant corporate president signed a printed form contract on behalf of the corporation, which contained the following provision in the middle of the contract (paragraph 5):

 

Where the Purchaser is a corporation, in consideration of extending credit to it, the officer or officers signing on behalf of such corporation, hereby personally guarantee the payments hereinabove provided for.[3]

 

Even though the contract explicitly stated that the president was personally liable, the Court ruled that he was not. It based its decision on the fact that notwithstanding this clause, there was no “clear and explicit” evidence that he had intended to become personally liable. It ruled that individual liability would not be shown unless the president had signed twice – once for the corporation and once personally.[4]

 

From a policy standpoint, the Court of Appeals’ decision was based on its concern with preventing unwary corporate representatives from unwittingly becoming liable for corporate contracts that contained hidden or nondescript personal liability clauses. The Court explained:

 

In modern times most commercial business is done between corporations, everyone in business knows that an individual stockholder or officer is not liable for his corporation's engagements unless he signs individually, and where individual responsibility is demanded the nearly universal practice is that the officer signs twice -- once as an officer and again as an individual. There is great danger in allowing a single sentence in a long contract to bind individually a person who signs only as a corporate officer. In many situations the signing officer holds little or no stock and if the language of the agreement makes him individually liable his estate may be stuck for a long obligation it never dreamed of assuming.[5]

 

From this decision arose the “double signature” rule – which provides that an individual signing for a corporation cannot be held personally liable unless he or she signs the contract twice.[6]

 

The double signature rule can be overcome only where there is clear and explicit evidence that the corporate representative intended to bind him or herself personally so that what is before the court is “not a situation wherein the plaintiff attempted to trap an unwary corporate officer into making an unintended assumption of personal liability by inserting an obscure clause in the midst of a lengthy and complex contract.”[7] At the same time, it is clear that the inclusion of a single sentence purporting to bind an agent personally is insufficient to establish such intent.[8]

 

A separate, but related, issue which is often litigated is whether the individual is personally liable where the signature line does not indicate that the individual was signing in a representative capacity. Even then, the individual can be held not personally liable if the contract, interpreted as a whole, indicates that the intended party was the corporation.  Significantly, it has been held that “the presence or absence of a reference to corporate office above or below a person’s signature on an instrument does not necessarily determine the capacity in which the person signed the instrument.”[9]

 

Thus, it has been held that officers of a professional corporation, who signed an office lease without any indication that they were signing in their representative capacities, were not personally liable because the context of the lease indicated that the “tenant” was intended to be the professional corporation and not themselves individually.[10]  

 

 


 

[1] E.g. Georgia Malone & Co., Inc. v. Reider, 86 A.D.3d 406, 408 (N.Y. App. Div. 1st Dep’t 2011).

[2] Salzman Sign Co. v. Beck, 10 N.Y.2d 63, 67 (N.Y. 1961) (citation and internal quotation marks omitted).

[3] Id. at 65.

[4] Id. at 66-67.

[5] Id. at 67.

[6] Id.

[7] See Florence Corp. v. Penguin Constr. Corp., 227 A.D.2d 442, 443 (N.Y. App. Div. 2d Dep’t 1996) (collecting cases).

[8] Herman v. Ness Apparel Co., 305 A.D.2d 217, 218 (N.Y. App. Div. 1st Dep’t 2003). 

[9] 150 Broadway N.Y. Assocs., L.P. v. Bodner, 14 A.D.3d 1, 7 (N.Y. App. Div. 1st Dep’t 2004) (citing PNC Capital Recovery v. Mech. Parking Sys., 283 A.D.2d 268, 270-271 (N.Y. App. Div. 1st Dep’t 2001)).

[10] See id. at 7-8. 

Misappropriation of Corporate Opportunities

Corporate directors as well as employees owe fiduciary duties to the corporation not only to safeguard presently owned business assets, but also “business opportunities.” Since corporate fiduciaries and employees “owe their undivided and unqualified loyalty to the corporation,”[1] they “cannot, without consent, divert and exploit for their own benefit any opportunity that should be deemed an asset of the corporation.”[2]  They “may not assume and engage in the promotion of personal interests which are incompatible with the superior interests of their corporation.”[3] This rule applies to other types of business entities, such as limited liability companies and partnerships. The duty not to divert prospective business opportunities may extend even to those opportunities that the corporation is financially unable or otherwise unwilling to undertake.

What is a Corporate Opportunity?

What prospective venture is considered to be a corporate opportunity? Frequently, New York courts utilize the “tangible expectancy test” which evaluates whether the corporation has an “interest” or “tangible expectancy” in the opportunity.[4] However, a “tangible expectancy” is not so easy to define. It has been described as “something much less tenable than ownership, but…more certain than a desire or hope.” Another test utilized in New York is the “line of business test” which assesses whether the opportunity is “the same as or is ‘necessary’ for, or ‘essential’ to, the line of business of the corporation.”[5] Courts have also considered whether, at the beginning of the fiduciary relationship or employment, there was a pre-existing understanding that the fiduciary or employee would pursue ventures in fields related to corporate business.

Some Examples:

A classic theft of corporate opportunity claim is a situation where a corporate officer or director transfers corporate assets to a new corporation that operates in the same business, in order to avoid sharing profits with business partners. In Howard v. Carr, the Third Department affirmed a trial court judgment against a defendant corporate president who took all of the corporation’s “employees, sales associates and customers” and “converted its assets” into a new corporation in order to “avoid sharing profits and proceeds” with his business partner.[6] Similarly, in Greenberg v. Greenberg, the Fourth Department granted a plaintiff shareholder’s motion for summary judgment on a diversion of corporate opportunity claim where it was demonstrated that defendant had:

[U]nilaterally discontinued the business of [the old corporation] after incorporating [the new corporation]; that he appropriated the fixtures and tools of [the old corporation] for use by [the new corporation]; that [the old corporation] occupies the same space that [the new corporation] occupied; and that [the new corporation] does business using the same employees, the identical phone number, and like stationery as that used by [the old corporation].[7]

The diversion of corporate opportunity doctrine also precludes the operation of a competitor business. In Soho Snacks Inc. v. Frangioudakis, the First Department reversed a trial court’s grant of a motion to dismiss by defendant corporate officers and directors who allegedly operated two food cart businesses in lower Manhattan. Those businesses were Soho Snacks Inc. (original corporation) and Unlimited Nuts Inc. (new corporation). A cognizable misappropriation of corporate opportunity claim was found because the defendant corporate officers and directors operated Unlimited Nuts on the same premises as Soho Snacks, thereby diverting prospective business away from Soho Snacks as the original corporation.

Finally, a theft of corporate opportunity extends to unrealized business ventures owed to the corporation. In Yu Han Young v. Chiu, the Second Department affirmed a trial court judgment which held that a defendant who was a corporate officer in two different real estate corporations had misappropriated a corporate opportunity when she established a competing entity and secretly purchased a commercial property in which the old corporations had a “tangible expectancy.”[8] Along the similar lines, in Appell v. L.A.G. Corp., the Supreme Court granted a plaintiff’s motion for summary judgment against his defendant business partners who excluded him from joining in a new, profitable real estate venture.

Thus, the “corporate opportunity doctrine” requires that corporate directors and employees not only secure existing assets and business, but also ensure that prospective opportunities are shared first with the corporation.

Footnotes:

[1] Howard v. Carr, 222 A.D.2d 843, 845 (N.Y. App. Div. 3d Dep’t 1995).

[2] Alexander & Alexander v. Fritzen, 147 A.D.2d 241, 246 (N.Y. App. Div. 1st Dep’t 1989)

[3] Yu Han Young v. Chiu, 49 A.D.3d 535 (N.Y. App. Div. 2d Dep’t 2008) (citing Foley v. D’Agostino, 21 A.D.2d 60, 66 (N.Y. App. Div. 1st Dep’t 1964); see Schachter v. Kulik, 96 A.D.2d 1038, 1039 (N.Y. App. Div. 2d Dep’t 1983).

[4] Id. (citations omitted).

[5] Id. at 248.

[6] Howard, 222 A.D.2d at 845.

[7] Greenberg v. Greenberg, 614 N.Y.S.2d 825, 827 (N.Y. App. Div. 4th Dep’t 1994).

[8] Yu Han Young, 49 A.D.3d 535, 536 (citations omitted).  

“Faithless Servants” Beware – Part II

Illustrative Cases


In Phansalkar v. Andersen Weinroth & Co, L.P., Phansalkar, an investment banker and employee of Anderson Weinroth & Co., was found in breach of his duties of loyalty and good faith to his employer, for failing to disclose his receipt of various benefits (i.e. stock options, stock shares, fees, and business opportunities), which he had received from other companies in consideration for serving on their boards. Under the terms of his employment contract, such benefits belonged to the defendant’s employer. 

At first, the Federal District Court limited the employee’s forfeiture to compensation directly derived from transactions in which the employee breached his duties, and declined to apply the Faithless Servant Doctrine to profits made on stock options offered to the defendant by his employer. However, on appeal, the Second Circuit held that the employee must forfeit all compensation he received after the date of his first breach of duty—the clawback could not be limited to certain transactions since he was paid a general salary and not specific amounts for specific tasks. Furthermore, the Second Circuit held that the employee must forfeit any profits and interest generated by the stock options, despite investing his own capital, because they were offered to him in connection with his employment as compensation.  The Court explained that:   “When an employer makes an investment opportunity available to an employee to reward him for his work and to give him an incentive to continue working for the employer, that opportunity and any benefit realized should be subject to forfeiture like any other form of compensation. The fact that an employee must use his own capital to take advantage of such an opportunity does not require a different conclusion.”  

And in Consolidated Edison Co. v. Zebler, Zebler, an employee of Con Edison, was found to have accepted bribes in a kickback scheme over a 26-month period, in exchange for providing favorable treatment to a construction contractor, including approving inflated invoices that overcharged his employer and expediting payments to the contractor. Despite the employee’s argument that only his compensation directly related to the kickback scheme should be forfeited, the Court held that, the “faithless servant doctrine strictly requires salaried employees, such as Mr. Zebler, to forfeit 100% of their compensation… this requirement is consistent with the policy rationale behind the forfeiture rule, which is to prevent breaches of fiduciary duty by removing from agents and trustees all inducements to attempt dealing for their own benefit in matters which they have undertaken for others, or to which their agency or trust relates… Accordingly, as a salaried employee not paid on a task-by-task basis, Mr. Zebler must forfeit all of [his salary] received during the 26-month period of his disloyalty, even though he claims to be acting disloyal only 15% of the time.”   The Faithless Servant Doctrine is intended to be a deterrent against employee and fiduciary disloyalty, even in cases where no actual damages are incurred or crimes committed, and as such serves as a useful common law tool for employers and principals applicable to a wide range of contexts and circumstances. 

Contrasting New York’s Faithless Servant Doctrine with the Mandatory Victims Restitution Act 18 USCS § 3663A, a criminal statute under which Consolidated Edison also sought restitution, the Court noted: “The faithless servant doctrine does not consider criminal culpability, nor does it require the Court to value the loss of honest services. Under the faithless servant doctrine, the act of being disloyal to one's employer is itself sufficient grounds for disgorging all compensation received during the period of disloyalty, and does not depend on actual harm to the employer.”  

 

“Faithless Servants” Beware – Part I

The Evolution of the Faithless Servant Doctrine

The “Faithless Servant Doctrine” is unusual in that it goes against the general common law principle that the purpose of damages is to make the injured party whole.  It is one of the few examples in our common law in which damages are not measured in this manner.     

The Doctrine provides that when an employee seriously breaches his terms of employment or a fiduciary seriously breaches her fiduciary duties, he or she can be forced to forfeit their compensation – both prospectively and retrospectively. The theory behind the Doctrine is simply that one who has acted unfaithfully in an employment context should not be entitled to his or her compensation. In other words, a condition of payment of compensation is that the employee or fiduciary will faithfully perform his job.

New York is among a minority of states that have developed this Doctrine through judge-made common law.  It serves as a powerful tool for employers and principals to recover compensation paid or due to employees, or fiduciaries who have breached their employment contract or fiduciary duties.

First adopted by New York courts in the 19th century, the  Faithless Servant Doctrine has sometimes been criticized for its potentially ”draconian” results and has been limited and tempered somewhat by New York courts over time.  Originally, an employee or fiduciary that seriously breached his employment agreement or her fiduciary duty could have any outstanding compensation withheld and even the entirety of their prior compensation forcibly returned to the employer or principal. In other states, this protection is sometimes incorporated into employment contracts by a “clawback” provision. However, in New York, Alabama, Michigan, South Carolina, Kansas, Florida, Massachusetts, and Oregon state common law already provides some degree of “clawback” protection to most employer/employee and principal/fiduciary relationships where the compensated party acts wrongfully and in bad faith in the course of their duties.

The U.S. Court of Appeals for the Second Circuit, whose jurisdiction includes New York, has used two different tests in applying the Faithless Servant Doctrine under New York law. The first standard requires that the defendant violate his employment contract through misconduct or “unfaithfulness.” The second requires only that the defendant act adversely to his employer in any part of a transaction, or alternatively, omit to disclose any interest which would naturally influence his conduct in dealing with the subject of his employment. New York state courts have followed the Second Circuit’s lead, but vary which of these tests they apply –since as a common law doctrine, the courts have no concrete statutory text to reference.

The Faithless Servant Doctrine can be applied to a company’s employees and fiduciaries at any level, from the bottom up to board members, executive officers, and general partners. Some of the most common circumstances under which the Faithless Servant Doctrine is applied include when a fiduciary or employee:

  • embezzles or steals money from the company
  • diverts a business opportunity from the company
  • engages the company in a self-dealing transaction
  • commits any kind of fraud in connection with the company, or
  • steals trade secrets or clients from a company – especially in conjunction with a demonstrated decrease in productivity and intentions to launch a competing business.

In New York, the Faithless Servant Doctrine can be applied and enforced even if the plaintiff employer or principal was not actually harmed by the defendant’s wrongdoing.

The Faithless Servant Doctrine is not limited to only direct payments of capital. Rather, any stock options or other investment opportunities offered to the defendant in connection with his employment may also have their profits, plus interest, subject to clawback via the Doctrine. This rule applies even where the defendant used his own capital to invest. Even retirement funds, pensions, and other benefits can be subject to the Faithless Servant Doctrine.

Depending on the severity of the wrongdoing, even a single instance of misconduct or unfaithfulness can be enough to warrant application of the Faithless Servant Doctrine.

The modern trend in the application of the Faithless Servant Doctrine has  limited the clawback power to only the period of employment during which the wrongdoing occurred. In cases where the defendant was paid on a task-by-task or commission basis, the clawback is sometimes limited only to the specific tasks or sales which were directly related to or affected by the wrongdoing. Tasks and sales totally insulated and disconnected from the defendant’s wrongdoing are often out of reach of the modern Faithless Servant Doctrine under New York law.

 

“Self-Dealing” Is it ever permissible?

“Self-dealing” is a legal concept which is applied to a transaction in which a fiduciary (such as a trustee, general partner, controlling shareholder, director, or officer) derives a personal benefit from a transaction with or involving the entity to which he owes the fiduciary duty. In re Nat'l Auto Credit S'Holders Litig., 2003 Del. Ch. LEXIS 5, 30 (Del. Ch. Jan. 10, 2003), (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)).

The Accounting Remedy – II

Statutory Provisions under New York Law

As discussed in our last Blog post, the right to an accounting exists under common law and, in some instances, according to statute

The accounting remedy is codified in New York Partnership Law § 44 and New York Business Corporation Law § 720.  Section 44 of the Partnership Law provides that:

            Any partner shall have the right to a formal account as to partnership affairs:

1. If he is wrongfully excluded from the partnership business or possession of its property by his copartners,

2. If the right exists under the terms of any agreement,

3. As provided by section forty-three[1],

4. Whenever other circumstances render it just and reasonable.

The “Equitable Accounting” Remedy

The right to an accounting has its basis both in common law and in statute. 

The law related to common law “equitable accountings” has evolved and changed over the years, and this evolution affords courts much flexibility to achieve just results.  But, the law is still subject to conflicting opinions and inconsistent rules of law.  As New York Supreme Court Justice Judith J. Gische stated after analyzing the law relating to equitable accountings:

“The body of law on equitable accountings is conflicting and muddled.” - Evans v. Perl, 2009 N.Y. Slip. Op. 31413, 2009 WL 1905169 (N.Y. Sup. Ct. June 23, 2009).

Rights of Limited Partners in the Face of a General Partner’s Self-Dealing

Limited partnerships have in large measure been replaced by limited liability companies as the passive investment vehicles of choice.  But, they are still relevant because they are still sometimes used and there are many legacy limited partnerships that are still in existence.

On the surface, it appears limited partners have very few rights and protections.  They are not allowed to participate in management or to second guess the general partner’s actions.  However, while the law requires that they stay passive insofar as management is concerned, it does afford them a number of protections to assure that their financial interests are not abused.

"A limited partner is not in the hopeless position where he must only suffer in silence when an alleged wrong occurs. He has a right of full and free access to information contained in the partnership books, and of all things affecting the partnership, as well as a right to formal accounting." Millard v Newmark & Co., 24 AD2d 333, 336 (lst Dep' t, 1966).