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.
Fiduciary Duties of LLC Organizers Argued Before New York's Highest Court
Last year the New York Appellate Division ruled that LLC organizers are fiduciaries of the investors they solicit to be members, and that as such they have a duty to disclose their self-dealing. Roni LLC v. Arfa, 903 N.Y.S.2d 352 (App. Div. 2010). I reported on the case, here.
The Roni decision was critiqued by New York lawyer Peter Mahler, who blogs on New York business law, here, and by law professor Larry Ribstein, here. To oversimplify a bit, the gist of the criticism is that the rule of the old corporate cases, on which the Roni court relied, (a) has been made unnecessary by the disclosure rules of federal and state securities laws, and (b) should not apply to LLCs because the contractual nature of the relationship between LLC members allows them to allocate risks and define duties inter se, which is not characteristic of corporations.
Roni has since been appealed to New York’s highest court, the New York Court of Appeals. Oral arguments in the case were heard by the court on November 15, 2011, and yesterday Peter Mahler blogged on the briefing and the oral arguments, here. His article is a fascinating review of the oral arguments before the high court. The judges’ questions apparently ranged widely from “Why should LLCs be treated differently?” to concerns over line-drawing and the reach of the Roni rule articulated by the Appellate Division.
So now we wait for the high court’s decision, which Peter Mahler predicts will likely be in the early months of next year. One can hope, if the Appellate Division ruling is upheld, that the court will provide some guidance on the scope of the Roni duty to disclose.
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.
