Pre-formation fiduciary duties in LLCs: another NY problem

Larry Ribstein —  21 June 2010

I have often complained (e.g., here) of the troubling lawlessness of NY LLC law, a problem that may be affecting the use of LLCs in that state and thereby NY’s business environment.

A recent example is Roni LLC v Arfa. Investors in a real estate deal sued the promoters for breach of fiduciary duty by failing to disclose their commissions from the property sellers and mortgage brokers, which plaintiffs claim inflated the price the LLCs paid for the properties.

The court held that the parties’ arms-length pre-formation business relationship alone did not support a fiduciary relationship.

This is probably consistent with partnership law. Bromberg & Ribstein §6.06(b) discusses the basic problem (footnotes with extensive citations omitted):

There is a question as to the extent to which people negotiating to be partners have a duty to make affirmative disclosures to their prospective partners. It may be difficult to distinguish at least the initial negotiations concerning the terms of the partnership from any other arm’s-length dealings in which the parties have no reason to expect complete candor.

Note, however, that a duty to disclose may be based on the general duty to refrain from false representations, since non-disclosure may make a statement misleading.

U.P.A. §21(1) provides for a fiduciary duty in transactions connected with the formation of the partnership. However, as discussed in Bromberg & Ribstein, this probably only recognizes a duty where the partnership relationship has already been formed, but the business is in the process of formation. RUPA §403(c) clarifies the issue by providing for disclosure by “[e]ach partner and the partnership” to “a partner,” thus excluding a duty to one who is not yet a partner. R.U.P.A. §404 provides that partners have duties of loyalty and care in the conduct and winding up of the partnership but not in the “formation” of the partnership.

Despite all this, the court denied the promoter defendants’ motion to dismiss based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them.” The court applied by analogy old corporate cases holding that “both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders.” The court said:

“By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members (see generally Limited Liability Company Law § 203[a][iii]). 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. * * * Accordingly, plaintiffs stated a cause of action for breach of fiduciary duty by alleging that the promoter defendants failed to reveal that they would receive commissions from sellers and mortgage brokers in addition to their other, disclosed, profit from the venture. * * *

The court’s reliance on NY LLC Act §203 is questionable. That section merely provides for formation of the LLC, not for any duties of the organizers. RULLCA §409-410 do not provide for pre-formation duties to those who are not members, and I’m not aware of any LLC case law on the issue (see Ribstein & Keatinge, §9:5).

There is no reason to think that the old corporate promoter cases were a better source of law on this issue than uncorporation law (see generally, Rise of the Uncorporation
as to the uncorporate nature of LLCs). Indeed, it’s not even clear the old corporate cases are still good law for corporations. The uncertainties resulting from stretching the duty to disclose to the pre-formation period have now been replaced by federal disclosure law under Securities Act of 1933, which also applies to at least some LLCs.

The case may have been correctly decided because it’s possible the complaint alleged a misrepresentation which would be actionable without implying a fiduciary duty. But the court’s reasoning using hoary old corporate promoter cases to create a pre-formation fiduciary duty to disclose in LLC cases promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.

It seems they only way NY business people involved in business formation can avoid this problem is simply to avoid New York.

Larry Ribstein

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Professor of Law, University of Illinois College of Law