New York High Court Punts on Fiduciary Duties of LLC Promoters
Last month New York’s highest court, the Court of Appeals, affirmed a 2010 ruling by the Appellate Division that LLC promoters were fiduciaries of the investors they solicited, prior to the LLC’s formation, to become members. Roni LLC v. Arfa, 2011 WL 6338906 (N.Y. Dec. 20, 2011). The top court’s ruling was a surprisingly short memorandum opinion, given the significance of the issue presented.
The Appellate Division had applied the corporate rule on pre-formation activities to LLCs. “It is well settled 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…. By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members.” Roni LLC v. Arfa, 74 A.D.3d 442, 444 (N.Y. App. Div. 2010). I wrote about the Appellate Division’s ruling here, and about last month’s oral argument before the Court of Appeals, here.
The Appellate Division’s ruling had also garnered attention from New York lawyer Peter Mahler, here and here, and from the late Professor Larry Ribstein, who passed away recently, here. Professor Ribstein also filed an amicus brief on the case with the Court of Appeals. The major criticisms of the 2010 ruling have been that the rule of the old corporate cases is no longer necessary because of the disclosure requirements of the federal and state securities laws, and that the corporate rule should not be applied to LLCs because their contractual nature distinguishes them from corporations.
The Court of Appeals put off the question, however, whether mere status as a pre-formation LLC promoter is adequate to create a fiduciary relationship. “Based on the foregoing analysis, we need not decide the question of whether the promoter defendants’ status as organizers of the limited liability companies, standing alone, was sufficient to allege a fiduciary relationship.” Roni LLC v. Arfa, 2011 WL 6338906, at *4 n.2.
The court instead began by citing prior case law to the effect that a fiduciary relationship exists “when confidence is reposed on one side and there is resulting superiority and influence on the other,” id. at *2. The court then reviewed the complaint’s allegations that (1) the promoters planned the business venture, organized the LLC, and controlled the invested funds; (2) the promoters were in the best position to disclose material facts to the investors; (3) the promoters represented to the foreign investors that they had particular experience and expertise in the New York real estate market; and (4) the promoters played upon the cultural identities and friendship of the investors. The court found that the complaint’s allegations showed confidence by the investors and resulting superiority and influence by the promoters, and therefore adequately pled a fiduciary relationship. Id. at *3.
The Court of Appeals ignored the Appellate Division’s holding that the complaint’s allegations are inadequate to establish a fiduciary relationship, which suggests that the Court of Appeals went out of its way to affirm without ruling on the “LLC-promoter-status-equals-a-fiduciary” issue. But if so, it’s slightly puzzling that the court also saw no distinction between LLCs and corporations for the issues in this case:
Certainly there are differences between limited liability companies and traditional corporations, but the distinctions are not relevant to the allegations in this case: a potential exists regardless of corporate form for “conscienceless promoters [to] accumulate property at a low price under a well-devised scheme to unload it upon others at a high price.
Id. at *4 n.1.
Although the court’s opinion leaves open the “LLC-promoter-status-equals-fiduciary” issue, I suspect that most plaintiff’s attorneys will conclude that the court left them with enough to work with when pleading pre-formation fiduciary duty claims against LLC promoters. For one thing, the first three of the four factual points in Roni referred to by the court and summarized above are likely to apply to most promoter situations.
Texas Court Rejects Claim by Unpaid Creditor That Two LLC Organizers Were Liable as General Partners
LLC organizers sometimes refer to themselves loosely as “partners” during the preliminary stages of a development project, before they get around to forming their limited liability company, but those words can come back to haunt them. Say, for example, that during the pre-formation phase, one of the organizers signs a contract in his own name, intending that the LLC carry out the contract. The LLC is formed, but then the project doesn’t go forward, the parties fall out, and the organizer that signed the contract can’t pay. In that case the creditor on the contract may seek payment from both the contract signer and the other organizer, on the theory that the organizers were partners and therefore were both liable.
The Lawsuit. That scenario played out in Lentz Engineering, L.C. v. Brown, No. 14-10-00610-CV, 2011 Tex. App. LEXIS 7723 (Tex. App. Sept. 27, 2011). William Wilkins and Alden Brown were planning to purchase and develop a real estate project. Wilkins entered into a contract to purchase the property, and Brown and Wilkins met with an attorney in February 2005 and agreed to form a Texas LLC to carry out the development. In March Brown gave Wilkins $400,000 to purchase the property, and Wilkins acquired the real estate in April. One day later, the attorney filed articles of organization for the LLC, which identified Brown and Wilkins as the LLC’s managers.
During the summer Brown became suspicious of Wilkin’s conduct and attempted to recover his money and obtain title to the property. Meanwhile, Wilkins entered into a contract in his own name with Lentz Engineering for engineering services. Lentz performed its work under the contract but was not paid.
Lentz then sued both Wilkins and Brown for breach of contract. Lentz’s theory was that Wilkins was directly liable on the contract, and that Brown was liable because he was partners with Wilkins and was therefore fully liable for the debts of the partnership. Wilkins defaulted on the lawsuit but Brown defended on the ground that he and Wilkins were not partners.
Judicial Admission. Brown’s first difficulty was self-inflicted. Lentz contended that Brown had judicially admitted in a motion for summary judgment that a partnership existed between Brown and Wilkins. For example, Brown’s motion stated: “Although Wilkins and Brown entered into a partnership to acquire the Manvel property, that partnership was not formed until March 2005.” Brown also made other, similar statements in his motion. Id. at *4-5.
The court dismissed the “judicial admission” contention, because Brown had taken a contrary position in other pleadings and even in the same summary judgment motion. To be considered a judicial admission, a party’s statement must be clear, deliberate, and unequivocal, and Brown’s contradictory statements didn’t satisfy that standard.
Partnership Formation. The court then considered the main argument, i.e., whether Brown and Wilkins had formed a partnership. The Texas statute’s definition of a general partnership is similar to that of most states: an association of two or more persons to carry on a business for profit as owners, regardless of whether the persons intend to create a partnership or whether the association is actually called a “partnership.” Tex. Bus. Orgs. Code Ann. § 152.051(b).
Facts and Circumstances. Whether a partnership exists depends on all the facts and circumstances. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *9. The factors considered in determining if a partnership has been created include:
(a) sharing of profits of the business;
(b) sharing of losses or liability for claims;
(c) contributing or agreeing to contribute money or property to the business;
(d) participating in control of the business; and
(e) expressing an intent to be partners in the business.
Tex. Bus. Orgs. Code Ann. § 152.052. Note that the first three factors – sharing profits, losses, and contributions – are present in almost every LLC. The fourth factor, participating in control, is present in all member-managed LLCs and in some manager-managed LLCs. Only the last factor, expressing an intent to be partners, is not present in an LLC.
The court found uncontroverted evidence of only two of the factors, splitting profits and participating in control of the business. There was contradictory evidence about expressions of intent to be partners. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *12-14.
Going the other way, both Wilkins and Brown expressed their intent to form an LLC, they opened a bank account in the name of the LLC, and the Certificate of Organization for the LLC was filed before the date on which Wilkins signed the contract with Lentz Engineering. Id.
The relative timing of filing the Certificate of Organization and signing the contract seems to have carried extra weight with the court:
Although courts have held promoters of a company may be liable on contracts made by other promoters prior to formation of the company as if the promoters were partners, Lentz has not cited any authority to suggest that liability should be imposed on one promoter because of another promoter's conduct after the formation of the company.
Id. at *15. The court concluded that the evidence did not conclusively establish the existence of a partnership and that the trial court’s finding of no partnership was not against the great weight and preponderance of the evidence. The trial court’s ruling in favor of Brown was affirmed.
Lessons Learned. The substantial overlap between an LLC and the five factors listed in the Texas statute is a little scary. New business organizers who refer to each other as partners, before the LLC is created, may rue the day they used that terminology. They may have already discussed and agreed on the first four factors, and if they introduce each other as partners, the stage is set. If one partner signs a contract before the LLC is formed, and then things fall apart and the LLC is not formed, the organizers may find that as partners they are all jointly and severally liable on the contract.
How to avoid this outcome? Expunge the word “partners” from any description of the organizers. One of the great benefits of LLCs is their limited liability; don’t open the door to personal liability by calling yourselves partners.
Organizers should strive to form the LLC early. Any contracts should not be signed until after the LLC is formed, and then they should be signed in the name of the LLC.
New York Addresses Fiduciary Duties of LLC Organizers
The New York Appellate Division recently applied the fiduciary rules for corporate organizers to the organizers of LLCs, and found the LLC organizers to be fiduciaries of the investors they solicited to become members. Roni LLC v. Arfa, No. 1758, 601224/07, 2010 N.Y. App. Div. LEXIS 4613 (June 3, 2010).
The defendants were the promoters and organizers of several New York LLCs. The organizers entered into real estate purchase agreements, and then assigned the agreements to the LLCs after their formation. The organizers, who were the initial members of the LLCs, solicited outside investors to purchase member interests in the LLCs. The investors’ funds were then used by the LLCs to purchase the real properties.
Subsequently the investors sued the organizers, claiming that the organizers concealed brokerage commissions they received from property sellers and mortgage brokers. The investors alleged that the undisclosed commissions inflated the purchase prices of the real estate by at least $6.5 million.
The investors asserted claims for waste, breach of fiduciary duty, actual fraud, constructive fraud and an accounting. The organizers moved to dismiss for failure to state a cause of action and for failure to plead actual fraud and breach of fiduciary duty with specificity. The trial court denied the motion and upheld all claims, other than the claim for waste. The organizers appealed the dismissal of the motion, contending that the investors had not alleged adequate facts to establish that the organizers were their fiduciaries.
The key to the court’s decision was its extension of the corporate rule to LLCs. The court noted that “[i]t is well settled 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.” Id. at **5. From there it was a short jump to LLCs: “By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members.” Id. at **5-6. As fiduciaries, the organizers were obligated to fully disclose the organizers’ interests that might affect the LLC and its members, including the organizers’ profits from organizing the LLC. Id. at **6. The court held that the investors had therefore stated a cause of action by alleging that the defendant organizers had failed to disclose the commissions they received from sellers and mortgage brokers, which inflated the purchase prices of the LLCs’ real estate. Id.
The organizers also defended on grounds that the investors had failed to allege that the undisclosed commissions were material, that the investors justifiably relied on the organizers’ silence, and that the investors were damaged. The court made short work of those defenses. Damages had been alleged, said the court. And because the case was an appeal of the trial court’s denial of the plaintiffs’ motion to dismiss, the issues of materiality and reliance could not be resolved as a matter of law, but would have to be resolved at trial. Id. at **7-8.
The Roni court’s resolution of the fiduciary duties of LLC organizers is an example of legal reasoning by analogy. The court looked at the rule that applied to organizers of corporations, and apparently deciding that LLCs are similar enough to corporations, applied the corporate rule to LLCs.
As the law of LLCs develops, state courts are frequently called upon to decide novel LLC issues. In doing so the courts often look to the law applicable in the analogous corporate context. Examples that I have written on previously include New York (de facto corporations, here), Colorado (creditors’ claims against directors, here), Oregon (requirements for derivative suits, here), and Michigan (officer liability for corporate torts, here).
The Roni court did not explain the principles underlying the corporate rule that it relied upon, but simply applied it “[b]y extension.” Id. at **5-6. The court’s implicit recognition of a close analogy between corporations and LLCs was presumably based on the entity nature of each and the similar roles played by the organizers of each type of entity.
