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.  

Fiduciary Duties in LLCs and Limited Partnerships

It has long been a truism that partners in joint endeavors owe each other certain responsibilities to look out for one another. Justice Benjamin N. Cardozo stated the proposition as follows:

Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.

Meinhard v Salmon, 249 NY 458 (1928). Although Justice Cardozo elucidated this rule over 90 years ago, it still rings true today. In Birnbaum v Birnbaum, the court reaffirmed this strong duty stating:

This is a sensitive and ‘inflexible’ rule of fidelity, barring not only blatant self-dealing, but also requiring avoidance of situations in which a fiduciary's personal interest possibly conflicts with the interest of those owed a fiduciary duty (Matter of Ryan, 291 N.Y. 376, 407). Included within this rule's broad scope is every situation in which a fiduciary, who is bound to single-mindedly pursue the interests of those to whom a duty of loyalty is owed, deals with a person "in such close relation [to the fiduciary] * * * that possible advantage to such other person might * * * consciously or unconsciously" influence the fiduciary's judgment.

LLC and Limited Partnership Dissolution: When is it “not reasonably practicable to carry on the business in conformity with the [entity agreement]”?

The New York and Delaware LLC and Limited Partnership Acts both provide that an LLC or limited partnership may be dissolved “whenever it is not reasonably practicable to carry on the business in conformity with the [LLC articles of organization, operating agreement or limited partnership agreement].” [1] This is the standard, but what does it mean?

When can an LLC member or limited partner seek dissolution, with some reasonable basis to believe that he will be successful?  These situations arise fairly frequently and there are no clear-cut rules.  Many courts have noted the dearth of case law which explicitly define the standard of what it means for it not to be “reasonably practicable” to carry on the business in conformity with the entity’s governing documents.[2]

The starting point for a “reasonably practicable” analysis is always what these documents say.  The documents take on great significance and small differences in their language can be decisive.  For example, entity documents with broad “purpose” clauses are likely to give the managers much greater latitude as to what they can do and make them more impervious to efforts to cause dissolution.  On the other hand, if the entitiy’s stated purpose  includes generating “cash flow” or “profits,” a failure to do so is much more likely to lead to dissolution that if the documents are silent on this point.

Limitations on Majority Rule in the Management of Business Entities

The general rule in the corporate governance of business entities -- including corporations, limited liability companies and partnerships -- is that absent an agreement or statutory requirement to the contrary, majority rule governs.  Indeed, majority equity owners often assume that they can do pretty much anything they want with regard to the business entity. 

However, this is an erroneous assumption.  Over the years, many legal principles have evolved which limit the freedom of the majority  to do as they wish.