A Deal's a Deal - Federal Court Says That Exercising Buyout Option in New York LLC Without Advance Notice Is Not a Breach of Fiduciary Duty
Are fiduciary duties relevant when an LLC member has an option under its operating agreement to buy out another member for a fair-market-value price? For example, must the member give advance warning before exercising its option even if not required by the agreement? One of two members in a New York LLC whose interest was purchased under such an option apparently felt it had been misled and damaged by the other’s silence regarding its intention to exercise the option, in LJL 33rd Street Associates, LLC v. Pitcairn Properties Inc., 725 F.3d 184 (2d Cir. July 31, 2013). The court said no breach of fiduciary duties had occurred – the contract ruled.
Background. LJL 33rd Street Associates (LJL) and Pitcairn Properties Inc. (Pitcairn) were the two members of 35-39 West 33rd Street Associates, LLC, a New York LLC (the Company). The Company owned a high-rise luxury apartment complex in Manhattan (the Property). LJL owned 50.01% of the Company, and Pitcairn owned 49.99% and managed the Property.
The Company’s operating agreement gave LJL the option of purchasing Pitcairn’s interest in the Company for its fair market value if Salah Mekkawy ceased to be employed by Pitcairn. Mekkawy was initially the CEO of Pitcairn, but by 2010 his duties had been reduced and he was no longer involved in managing the Property.
In October 2010 the parties discussed Mekkawy’s employment, but LJL’s purchase option was never mentioned. First, Mekkawy told LJL, but not Pitcairn, that he would be leaving Pitcairn. Pitcairn was at the same time considering terminating Mekkawy, and its CEO met with LJL to discuss the termination. LJL indicated at the meeting that it was unhappy with Mekkawy and would not object to his departure from Pitcairn, and that LJL was satisfied with Pitcairn’s management of the Property. Several days later Pitcairn informed LJL that it had terminated Mekkawy’s employment.
During the discussions LJL never mentioned its purchase option and Pitcairn never asked about it. Five days after receiving Pitcairn’s notice of Mekkawy’s termination, LJL formally exercised its purchase option.
The Company’s operating agreement defined the option’s purchase price as the fair market value of the Property (FMV) less the Company’s liabilities, and called for arbitration to determine the FMV if the parties could not agree.
LJL and Pitcairn could not agree on the FMV, and Pitcairn proposed selling the Property or offering it for sale in order to determine its true market price. LJL refused and initiated arbitration. After a hearing the arbitrator entered an award determining the FMV of the Property, but the arbitrator declined to determine the purchase price.
LJL petitioned the New York Supreme Court to confirm the arbitrator’s determination of the FMV and to vacate the arbitrator’s refusal to determine the purchase price. Pitcairn removed the case to federal court and asserted claims that LJL had breached its fiduciary duties and the implied covenant of good faith and fair dealing. Pitcairn also claimed that LJL was estopped from exercising its purchase option because it had misled Pitcairn to believe that it would not exercise its option if Mekkawy were fired.
The district court sustained the arbitrator’s refusal to determine the purchase price on the grounds that the arbitration agreement did not extend to arbitration of the purchase price, and dismissed Pitcairn’s claims of breach of fiduciary duty and the implied covenant of good faith and fair dealing. Pitcairn appealed.
The Court of Appeals. The Court of Appeals first dealt with LJL’s contention that the arbitrator was required by the operating agreement to determine the purchase price for Pitcairn’s member interest, as well as the Property’s FMV. The court pointed out that although the operating agreement expressly provided for arbitration of the FMV, it had no provisions for determining the purchase price. Id. at 192. LJL argued that the purchase price was arbitrable because it was inextricably tied up with the merits of the dispute over the FMV, citing prior case law. The court disagreed, finding the two issues to be analytically distinct. But, said the court, even if the arbitrator had discretion to determine the purchase price, it was not an abuse of his discretion to decline to do so. Id. at 193.
Pitcairn claimed that LJL violated its fiduciary duties by not disclosing its intent to exercise its purchase option, but the court gave short shrift to that argument. The court recited the following facts: (a) LJL’s purchase option was a contract right to purchase Pitcairn’s member interest for a price based on the Property’s FMV; (b) Pitcairn did not contend that LJL ever made false representations about Mekkawy or stated that it would not exercise its option if he were terminated; and (c) Pitcairn never asked whether LJL intended to exercise its option or requested that LJL waive its option. After reciting the facts, the court concluded with no further analysis that LJL had not breached its fiduciary duties as claimed by Pitcairn. Id. at 195.
Pitcairn also claimed that LJL had a fiduciary duty to market the Property to a third party or to seek other offers, to help determine its FMV. The court said no, pointing out that the parties’ operating agreement contemplated a specific arbitration procedure to determine the Property’s FMV, and that no language in the agreement required LJL to participate in what the court characterized as “an illusory auction, deceiving potential purchasers into bidding for a property that was in fact not for sale, for the purpose of helping Pitcairn obtain evidence of value.” Id.
Pitcairn invoked the implied covenant of good faith and fair dealing, but the court found there to be no breach by LJL of the implied covenant. “The mere fact of LJL’s decision to exercise its contractual right, absent bad faith conduct, cannot be deemed a breach of its duty to deal with Pitcairn in good faith.” Id. at 196.
The upshot was that the arbitrator’s determination of the FMV of the Property and his refusal to determine the purchase price of Pitcairn’s member interest were upheld, and Pitcairn’s claims for breach of fiduciary duty and breach of the implied covenant of good faith and fair dealing were rejected.
Comment. LJL 33rd Street is a classic case of sandbagging. (For non-poker players, sandbagging is checking to a raise, sometimes pejoratively called lying in the weeds. In a round of betting, before the bets open, a player can check, meaning that he doesn’t bet but also doesn’t drop out. If someone else opens the betting, the player who checked can then call the bet to stay in the game, or he can raise the bet. It’s sandbagging when a player raises the bet after having checked. It’s viewed askance by some, because checking on the first round can be viewed as implying that one’s hand is weak, while the subsequent raise likely shows to the contrary. Sandbagging is within the rules of the game, unless house rules, such as in a friendly home game, bar it.)
I suspect Pitcairn felt it had been sandbagged by LJL. During their meeting in October, LJL told Pitcairn that it was comfortable with Pitcairn’s management of the Property. That would seem to imply that LJL had no desire to change the status quo, but shortly thereafter LJL exercised its option to buy out Pitcairn, within days of Mekkawy’s termination.
Pitcairn apparently drew the inference from LJL’s assurances about its satisfaction with Pitcairn’s management that LJL would not exercise its option, but Pitcairn had the ability to directly address its doubts or questions by simply asking LJL whether it planned to exercise the option if Mekkawy were terminated. That, coupled with the fact that LJL never made any statements about its option, appears to be the major reason why the court rejected Pitcairn’s claims of breach of fiduciary duty and breach of the implied covenant of good faith and fair dealing.
Prior Montana Case. I recently blogged about Gordon v. Kuzara, a Montana Supreme Court decision that refused to enforce an LLC agreement’s arbitration clause in a dissolution dispute, here. One member sued for judicial dissolution of the LLC, and the other member responded with a motion to compel arbitration based on an arbitration clause in the LLC’s operating agreement. The court in Gordon refused to require arbitration because the arbitration clause required arbitration only for disputes challenging the operating agreement, any activity under the operating agreement, or any interpretation of the operating agreement. The petitioner in Gordon sought dissolution under Montana’s LLC Act – a statutory remedy – which was not covered by the arbitration clause.
Georgia Rejects Arbitration. Now we have an eerily similar case from Georgia, handed down three weeks before Gordon. Simmons Family Props., LLLP v. Shelton, No. A10A1495, 2010 Ga. App. LEXIS 1116 (Ga. Ct. App. Nov. 30, 2010). Two of the LLC’s three members filed a petition for dissolution under Ga. Code § 14-11-603(a), which provides for court-ordered dissolution using the familiar standard, “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or a written operating agreement.”
The other member filed a motion to stay the petition and to compel arbitration, relying on the following language from the LLC’s operating agreement:
“Any dispute, controversy or claim arising out of or in connection with, or relating to this Agreement or any breach or alleged breach hereof shall, upon the request of any party involved, be submitted to, and settled by, arbitration ….”
Simmons Family, 2010 Ga. App. LEXIS 1116, at *4.
The court pointed out that the dissolution remedy requested under Georgia’s LLC Act is an independent legal mechanism and that the LLC’s operating agreement did not govern dissolution procedures under Section 14-11-603. The mode of dissolution involved therefore did not “arise out of, in connection with or relate to the terms of the operating agreement or any alleged breach thereof.” Id. at *5-6. The court therefore rejected the motion to compel arbitration.
As I suggested in my previous blog on Gordon v. Kuzara, the arbitration clause would have covered a petition for a statutory dissolution if it had included a reference to the interpretation or enforcement of rights under the state’s LLC Act.
Prior Attorneys’ Fees Case from Idaho. A similar result obtained in an Idaho case where attorneys’ fees were sought in a dissolution petition. Last year I blogged about Henderson v. Henderson Investment Properties, LLC, in which an attorneys’ fees clause in an LLC operating agreement was not enforced in an Idaho judicial dissolution case, here. The attorneys’ fees clause only applied to actions to enforce the LLC agreement, and the dissolution petition was for a statutory remedy, independent of the LLC’s operating agreement.
Dysfunctional Boilerplate. In all three of these cases it’s a fair assumption that when the members put their operating agreement together, they expected the arbitration clause or the attorneys’ fees to apply to a petition for a court-ordered, statutory dissolution. In each case their expectations were dashed. Why? Because the attorney that drafted their operating agreement almost certainly relied on a form or an agreement from a prior deal.
The arbitration clause or attorneys’ fees clause may have been old and may have been frequently used in the past by the lawyer, or it may have come from a form book. But when put to the test it was inadequate. As Kenneth Adams points out in his blog on contract drafting: “If a particular bit of contract prose has been reused year after year after year, that’s no guarantee of reliability. Instead, it likely means that no one has subjected it to real scrutiny and that you probably could poke holes in it.”
Contract boilerplate is not necessarily “tried and true.” Think about that clause before reusing it.
“Most people can't think, most of the remainder won't think, the small fraction who do think mostly can't do it very well. The extremely tiny fraction who think regularly, accurately, creatively, and without self-delusion – in the long run, these are the only people who count.” Robert A. Heinlein
Arbitration of contract disputes is not generally required unless the parties agree to arbitration in their contract. LLC founders will therefore often include mandatory arbitration clauses in their LLC agreement. These are intended to require all disputes about the LLC to be arbitrated instead of being tried in court.
Montana Arbitration Clause. Arbitration clauses are usually enforceable. The Montana Supreme Court, however, recently refused in a case of first impression in Montana to enforce an LLC agreement’s arbitration clause. Gordon v. Kuzara, 2010 MT 275, 358 Mont. 432 (December 21, 2010). The plaintiff in Gordon sought judicial dissolution of the LLC, and the defendant filed a motion to compel arbitration based on the arbitration clause in the parties’ LLC agreement. Peter Mahler has nicely described the case and the court’s reasoning in his New York Business Divorce blog.
The gist of the court’s holding was that arbitration was not mandatory because the arbitration language in the LLC agreement did not cover a request for judicial dissolution. The contract said that arbitration was mandatory if any member was “challenging this agreement, any activity conducted pursuant to this agreement, or any interpretation of the terms of this agreement.” Gordon, 358 Mont. at 432.
That language is broad, but the dissolution petition was not based on a right granted by the LLC agreement. The LLC agreement had no provision requiring judicial dissolution, and the request for a dissolution order was instead based on the statutory remedy under the Montana LLC Act. Mont. Code Ann. § 35-8-902. Although the petitioner cited examples of conduct by the other member to show that the LLC was no longer economically feasible, the court concluded that the request for dissolution was based on the statutory remedy, not the LLC agreement. Gordon, 358 Mont. at 437.
Idaho Attorneys’ Fees. Arbitration is not the only contractual dispute resolution procedure that can turn out to be unavailable when dissolution is sought. Last year I posted about a case in Idaho, Henderson v. Henderson Investment Properties, LLC, where an attorneys’ fees clause in an LLC agreement was not enforced.
The trial court awarded attorneys’ fees in Henderson based on the LLC agreement’s attorneys’ fees clause, which covered actions brought to enforce any provision of the LLC agreement. The Idaho Supreme Court reversed the trial court’s award because the plaintiff did not seek to enforce the LLC agreement, but instead sought judicial dissolution, a statutory remedy.
Drafting Lessons. Both the Montana case and the Idaho case involved contractual clauses that were not enforced because they were not written broadly enough to encompass a petition for the LLC’s dissolution. One case involved a clause requiring arbitration, the other involved a clause requiring the loser to pay the winner’s attorneys’ fees.
In my post on the Henderson case I discussed how the attorneys’ fees clause could have been written to cover a dispute over dissolution, by adding language along the lines of “or to interpret or enforce any rights under the [State] Limited Liability Company Act.” The attorneys’ fees clause would then apply to either a dispute over the terms of the LLC agreement or to a dissolution petition. The broader language I suggest should have changed the result in Gordon, as well.
Another approach would be to add an express reference to dissolution in the attorneys’ fees clause or arbitration clause, as suggested by Peter Mahler in his post. That would remove all doubts about whether dissolution is covered, but would not extend to disputes over other statutorily granted rights that often are not referred to in the LLC agreement. For example, LLC statutes usually require that certain documents and records be provided to members on request.