At first glance it might appear as if the New York Court of Appeals struck a major blow to LLC minority member rights in their November 2012 ruling Pappas v. Tzolis. After all, the New York high court held that a majority member owed no duty to disclose to his fellow members that upon buying out their equity interests, he planned to immediately flip for $17.5 million the interests he had acquired from them for $1.5 million.
However, implicit in the opinion is the recognition that if business partners have a relationship based on mutual trust, a partner may not be free to cheat his partner out of financial gains by failing to disclose material facts.
Pappas v. Tzolis involved a Limited Liability Corporation (“LLC”) formed by three parties in January 2006 to acquire a long-term leasehold interest in a Lower Manhattan building. Steve Pappas and Steve Tzolis each contributed $50,000 to this project with Constantine Ifantopoulos contributing another $25,000. Trouble plagued this LLC from the start. Tzolis sought to sublease the property to another company he owned, and according to Pappas and Ifantopoulos, they had to go along with this because Tzolis had blocked efforts to sublease to other entities. Further, Tzolis would not cooperate in the development of the property and his company neglected to pay the $20,000 monthly rent on the sublease.
In January 2007, Tzolis bought out Pappas and Ifantopoulos for $1 million and $500,000, respectively. This seemed like a very good deal to the sellers since these amounts represented a return of twenty times their initial investment in just one year. However, eight months later, they learned that Tzolis had turned around and assigned the sublease to another company, Extell Development Company (“Extell”), for $17.5 million.
Naturally upset about missing out on this windfall, Pappas and Ifantopoulos alleged that Tzolis committed fraud and breached his fiduciary duties by not disclosing that he had negotiated the assignment to Extell even before he had offered to buy Pappas’ and Ifantopoulos’s interests.
Here they ran into a problem. Pappas and Ifantopoulos had waived away their fiduciary duty claims in the LLC Operating Agreement and the documentation of the sale of their membership interests. The Operating Agreement contained a provision that allowed LLC members 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.” Likewise, a certificate signed by each seller at the closing of the sale stated that each had retained his own counsel, conducted his own due diligence on the value of the lease, was not relying on any representations by Tzolis and that “Steve Tzolis ha[d] no fiduciary duty to the  Sellers in connection with [the] assignments.”
Pappas and Ifantopoulos attempted to counter this language by claiming that their fiduciary duty waiver was inoperative and that Tzolis continued to have a duty of disclosure to them while they remained members of their LLC.
The New York Court of Appeals did not see it their way and held that their fiduciary duty waiver precluded any claims against Tzolis. In reaching this conclusion, New York’s highest court relied on three-part test it articulated in its 2011 decision, Centro Empresarial Cempresa S.A. v. América Móvil, S.A.B. de C.V., to determine when a voluntary fiduciary duty release would be valid: As the Court of Appeals noted, in that case it had determined that “[a] sophisticated principal is able to release its fiduciary from claims — at least where . . . the fiduciary relationship is no longer one of unquestioning trust — so long as the principal understands that the fiduciary is acting in its own interest and the release is knowingly entered into.” Of course, this all assumes that the fiduciary release itself was not procured by fraud.
In Pappas, the Court was careful to point out that the relationship among the members was not built on trust. From the beginning, there had been tension between the parties that should have put Pappas and Ifantopoulos on notice that they could not rely on Tzolis to protect their interests. Further, the Court emphasized that the fact that Tzolis was offering them a return on investment that was 20 times what they had paid just one year earlier should have triggered some sort of reaction that the deal might be too good to be true and that there might be more value in the leasehold than they had previously thought.
Thus, the decision in Pappas is fact specific and a different result might be produced if given a different fact pattern. But, the fact pattern in Pappas is not an isolated incident. Wouldn’t the fact that a majority partner is offering to buy out the minority partners, while not selling his own interest, put the minority partners on notice that something is up? In these circumstances, it would be difficult for a sophisticated minority partner to later claim that he was duped; merely the fact of the offer – with different consequences for him and the majority - should have been put him on guard.
So, what lessons can minority partners faced with a buyout offer the majority partner learn from this case:
1. Do your own investigation of the fair value of the entity.
2. Try to obtain representations from the majority owner regarding all offers, negotiations or discussions that might reflect on that value.
3. If you are going to rely on representations of the majority equity owner, get them in writing and make sure they survive the closing.
4. Make sure you do not unknowingly waive any of your rights in the closing documentation.
5. If you do decide to sell, go in with your eyes wide open and do not expect to be able to bring a lawsuit if it turns out later that the buyer received a windfall by failing to disclose what he was really up to.