The tangled duty to tell the whole truth

Larry Ribstein —  18 September 2011

A recent NY App. Div case, Pappas v. Tzolis, presents a tangled web that illustrates the current state of the LLC contracting architecture in the U.S. I previously discussed the lower court opinion in this case, concluding that ” any appeal of this judgment should be interesting.” (See also Peter Mahler.) I was right about that.

The complaint alleges that Tzolis and plaintiffs formed an LLC (Vrahos) for the sole purpose of entering into a long-term lease.  Tzolis got a sublease on the property in exchange for advancing the LLC’s $1.2 million security deposit and additional payments. Tzolis later took over the lease so he could extinguish the sublease.  The plaintiff members assigned him their interests, receiving a payment that was 20 times what they invested about a year earlier.  Six months thereafter Tzolis assigned the lease to a third party for $17.5 million.  The complaint alleges he was negotiating this sale at the time of buying out the plaintiffs.  Plaintiffs sue on various theories essentially based Tzolis’s breach of fiduciary duty in failing to disclose these negotiations.

At this point the case gets complicated.

To begin with, the LLC operating agreement, in a section titled “Other Activities of Members,” provided that “[a]ny Member may 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 title of this section was “other activities.”

Given the title and the reference to “competition with the LLC, this section seems to refer only to dealings outside the LLC rather than a buyout of co-members’ interest without disclosing negotiations to sell the LLC’s only property. The title’s reference to “other activities” clarifies this intent.  Except that the agreement elsewhere says that “headings. . . shall be given no effect in the interpretation of this Agreement.” If the heading has no effect, should the section be limited to outside dealings as it implies, or extended to “investments of any nature whatsoever,” including an “investment” in another member’s interest, as it says?

Confused yet?  Ok, let’s add another layer.  At the time of the assignment the parties signed a handwritten “certificate,” which included the following language:

[E]ach of the undersigned Sellers, in connection with their respective assignments to Steve Tzolis of their membership interests in Vrahos LLC, has performed their own due diligence in connection with such assignments. Each of the undersigned Sellers has engaged its own legal counsel, and is not relying on any representation by Steve Tzolis or any of his agents or representatives, except as set forth in the assignments & other documents delivered to the undersigned Sellers today. Further, each of the undersigned Sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned Sellers in connection with such assignments.

Still not confused?  The LLC was formed in Delaware, which normally means Delaware law applies.  But the operating agreement provided that it was governed by NY law.

How should a court untangle this mess?  Let’s start with what law applies.  As I discussed regarding the lower court opinion in this case, referring to the choice-of-law analysis in The Law Market, incorporating in Delaware indicates the parties’ intent to apply Delaware law notwithstanding a contrary choice of law clause.  This intent is supported by Kobayashi and my paper presenting data indicating that LLCs choose Delaware in order to get the advantages of Delaware’s legal infrastructure.  On the other hand, the parties arguably were focusing on choice of law more in the choice of law clause (NY) than in the state of organization (Delaware).

Both courts in this case concluded that a choice between the two states was unnecessary because both states reached the same result.  The problem is that that same result was different in the two opinions — dismissal of the complaint below, reversed above.

The lower court relied on Delaware’s freedom-of-contract provision, and said that “under New York law, parties are free to contract as they wish, so long as the terms of their contract are neither unlawful, nor in violation of public policy.” But as I noted in my post on the lower court opinion, NY has no equivalent to Delaware’s freedom of contract provision.

If the only relevant contract provision here were the operating agreement, the defendant should lose.  As discussed in my earlier post, even Delaware requires fiduciary opt-outs to be clear, which this was not.  The Appellate Division appropriately cited Kelly v. Blum on that point (which I discussed here).

But does the handwritten certificate have the requisite clarity? There the plaintiffs explicitly disclaimed they were owed any fiduciary duty in connection with the specific transaction at issue.  The lower court didn’t make much of this, saying that the defendant didn’t claim it was a waiver, but that it just evidenced and certified the non-existence of any fiduciary duties defendant might have owed.  This strategy may have been intended to head off the argument that any release of duties in the certificate was invalid because of defendant’s preexisting fiduciary duty.

The Appellate Division didn’t buy this strategy.  Having held that Tzolis owed a duty under the agreement, the court held that the certificate couldn’t override it.

The court relied on Blue Chip Emerald v Allied Partners 299 A.D.2d 278, 750 N.Y.S.2d 291 (1st Dep’t 2002). This is part of a line of cases discussed in Ribstein & Keatinge, §9:5, n.51 involving non-enforcement of seemingly clear fraud waivers. For other cases along the same lines see Kronenberg v. Katz, 872 A.2d 568 (Del. Ch. 2004); Salm v. Feldstein, 20 A.D.3d 469, 799 N.Y.S.2d 104, 106 (2d Dep’t 2005). Also, a non-LLC case, Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006) (criticized here) refused to insulate a seller from liability for intentional misrepresentations despite a clear and comprehensive contract that covered precisely these claims because “the public policy of this State will not permit” a contract that would insulate a seller who deliberately lied or knew that the company had made false representations.

But there are cases upholding fraud waivers.  See DIRECTV Group, Inc. v. Darlene Investments, LLC, 2006 WL 2773024 (S.D. N.Y. 2006), applying Delaware law, and two recent NY Court of Appeals cases: Centro Empresarial Cempresa S.A. v. America Movil and Arfa v. Zamir. Centro emphasized that the release was broad, the fiduciary relationship was “no longer one of unquestioning trust,” and the plaintiff understood that the fiduciary was acting in its own interest. Arfa relied on the facts that plaintiffs were sophisticated and there was distrust between the parties. In these circumstances the courts held that plaintiff could not simply rely on defendant, but had a duty to investigate further. See Peter Mahler’s excellent discussion of these NY cases.

A vigorous dissent in Pappas by Justice Freedman, joined by Justice Friedman, relied on Centros.  The dissent acknowledged that while the operating agreement did not eliminate Tzolis’s fiduciary duties, the certificate notified plaintiffs that they shouldn’t place “unquestioning trust” in Tzolis, and therefore “was tantamount to a release” of fiduciary duty claims.  Moreover,

Tzolis’s substantial offer to plaintiffs should have alerted them to the fact that some deal was in the offing. Pappas and Ifantapoulos did not ask Tzolis why he was offering them 20 times more than what they had invested in Vrahos one year earlier; their lack of due diligence is unreasonable as a matter of law and fatal to plaintiffs’ claim.

Obviously this tangled mess in a substantial deal where the parties clearly could afford sophisticated advice suggests that something is amiss somewhere in the system.

Does the problem lie in the statute?  The parties easily could have taken advantage of Delaware’s broad freedom of contract provision and entered into a clear fiduciary opt-out, which would seem appropriate in the sort of limited joint venture involved in this case.  Instead they deliberately complicated their choice of law to use NY law which lacks such a provision.

But Abry indicates that Delaware law is no panacea.  Is NY clearer, given Centros?  The problem is that it is one thing to say that the parties’ relationship has broken down into clear distrust, as in Centros, and another to derive that distrust from the certificate alone, which is itself subject to the incomplete waiver of fiduciary duties in the initial agreements.

Abry suggests that once the parties agree to fiduciary duties because they failed to opt out, these duties may preclude them from ever opting out.  At that point the best they can hope for is a judicial determination that the fiduciary duty did not result in liability for particular conduct.  That could be based on actual distrust (Centros) or other circumstantial evidence (the high buyout price in a rapidly rising market).

Which raises a final question:  was there even a breach of fiduciary duty in this case?  What difference should it make whether defendant had an offer in hand?  The plaintiffs had reason to know the lease value was rising rapidly.

The basic problem is that this case has been decided on a motion to dismiss, and therefore on the complaint’s allegations.  Issues about what plaintiffs knew, when did they know it, and what did defendant have to tell them are for trial.

The answer here is to let the parties, via a clear agreement, opt out of liability for intentional nondisclosures.  A clear opt out should prevent the need for a trial.  Why can’t at least sophisticated parties agree to fend for themselves in determining what price they should get for their property? Under such a rule it would be up to the lawyers to help the parties clarify their intentions, as the lawyers arguably did here.  But given the incomplete statutory protection in NY and the unclear cases in both NY and Delaware there was an inadequate legal framework for such an agreement.

Update: Read Peter Mahler’s through analysis of the case.

Larry Ribstein

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Professor of Law, University of Illinois College of Law