Three-member LLC’s sole asset is long-term commercial lease. 40% Member A buys out 60% Members B and C for $1.5 million. Six months later, Member A sells lease to third party for $17.5 million. Members B and C bring damages suit against Member A for breach of fiduciary duty of disclosure, alleging that Member A secretly was negotiating sale of lease when he bought out Members B and C. Member A defends suit based on express waiver of fiduciary duty in buy-out agreement and on operating agreement’s provision permitting members to engage in competitive business ventures. Who wins?

That’s the question confronting the New York Court of Appeals, the state’s highest court, in Pappas v. Tzolis, No. 193. Earlier this month, the Court of Appeals heard oral argument of the defendant member’s appeal from a split decision by the Manhattan-based Appellate Division, First Department, permitting the complaining members’ lawsuit to proceed after it had been dismissed by the trial court.

The Pappas appeal presents the latest chapter in the ongoing, doctrinal clash of two, fundamentally different notions of the relations and duties among co-owners/fiduciaries of closely held business entities when they enter into buy-out agreements and otherwise formally reconstitute ownership and management rights. The outcome in Pappas also may mark the dénouement of a running debate between the Court of Appeals and the First Department, in which the inferior appellate court more often than not has come down on the side of fiduciary enforcement notwithstanding contractual outs, while the superior court in recent decisions has shown a greater willingness to enforce releases and other contractual waivers of fiduciary duty negotiated by sophisticated business partners with the assistance of counsel.

Some Background Reading

I’ve previously published a number of posts on the lower court decisions in Pappas and on other key decisions that may influence the outcome in Pappas:

  • Read here my June 2008 report on the First Department’s Littman v. Magee decision which, drawing upon that court’s 2002 ruling in the Blue Chip Emerald case, enforced the purchasing LLC member’s fiduciary duty of disclosure of an impending third-party buyout notwithstanding a general release given by the selling members.
  • Read here my March 2010 report of the Pappas trial court’s decision dismissing the complaint, primarily based on the provision in the LLC’s operating agreement permitting competitive business ventures, which the judge interpreted as eliminating the fiduciary relationship that would otherwise be owed by the members to each other.
  • Read here my June 2011 report of the Court of Appeals’ decisions in the Centro and Arfa cases in which the Court held that contractual releases negotiated at arm’s-length by sophisticated parties and their counsel mandated dismissal of fiduciary breach claims arising from buy-out agreements among co-owners, and in which the Court explicitly criticized the First Department’s Blue Chip Emerald and Littman decisions as “misapprehend[ing] our case law.”
  • Read here my September 2011 report of the First Department’s 3-2 decision reinstating the complaint in Pappas where, notwithstanding the Court of Appeals’ criticism of Blue Chip Emerald three months earlier, the majority explicitly relied on that case and distinguished Centro on the ground that there, unlike in Pappas, the fiduciary relationship between buyer and seller was “no longer one of unquestioning trust” due to pre-existing disputes and accusations of non-disclosure.

I’m also fortunate to be able to offer readers copies of the briefs filed with the Court of Appeals in Pappas, courtesy of E. Leo Milonas and Frederick A. Brodie of Pillsbury Winthrop Shaw Pittman LLP, the appellate counsel for defendant Steve Tzolis:

  • Read here Tzolis’ opening brief.
  • Read here Pappas’ opposition brief.
  • Read here Tzolis’ reply brief.

The Oral Argument in Pappas

The Pappas appeal was argued on October 11, 2012, before the seven judges of the Court of Appeals which happened to be holding session that week not in its usual Albany setting, but in the Appellate Division, First Department’s beautiful courtroom located at Madison Avenue and 25th Street in Manhattan. You can watch here a video recording of the argument which lasted 20 minutes and featured attorneys E. Leo Milonas and Carl E. Person arguing for the appellants and respondents, respectively.

Following are some highlights of the oral argument, with the minute and second marks noted in parentheses for those who’d like to watch the actual exchanges:

  • After some initial colloquy concerning the circumstances surrounding, and attorney participation in, the preparation and execution of the handwritten certificate containing the waiver of fiduciary duty, Judge Smith inquired whether the selling members suffered any harm in view of the fact that Tzolis alone held the sublease to the LLC’s property, the term of which was virtually co-extensive with the LLC’s lease, and could have assigned the sublease to a third party and thereby reaped all the “upside” for himself. Mr. Milonas clarified that the LLC’s operating agreement required the other member’s consent for an assignment of the sublease. (2:00 – 4:00)
  • Judges Graffeo and Read asked Mr. Milonas to define the extent of the fiduciary duty owed by Tzolis and whether it was waived. Mr. Milonas answered that, as the trial court had found, the fiduciary duty was waived in the operating agreement’s provision permitting the members to engage in competitive business ventures as well as in the waiver certificate given as part of the buy-out transaction. When pressed, Mr. Milonas agreed that Tzolis had a fiduciary duty of disclosure under the operating agreement at least until the waiver certificate was executed. (4:10 – 5:10)
  • Chief Judge Lippman and Judges Ciparick and Smith asked Mr. Milonas a series of questions regarding whether the selling members had any reason to distrust Tzolis at the time of the buy-out that would have put them under a duty to inquire of Tzolis whether he had an outside offer for the LLC’s asset, particularly in light of the $1.5 million they were receiving for their 60% membership interest which was multiple times their investment. Mr. Milonas said there was not a “loving relationship” between Tzolis and the other two members and that the buy-out transaction was conducted at arm’s length. (6:00 – 7:45)
  • Judge Smith asked Mr. Milonas whether, in the absence of the waiver, it would be a breach for one partner to buy out another without disclosing that he had a higher, outside offer for the partnership’s property. Mr. Milonas agreed but insisted that those were not the facts in Pappas and that parties should be free to enter into contracts so long as they don’t violate public policy. (8:35 – 9:30)
  • Chief Judge Lippman asked Mr. Milonas whether the facts in Pappas were different than Centro, where it was “clearer” that the selling shareholders had reason to know that the buyer-controlling shareholder had not been forthright about the company’s financial condition and prospects. Mr. Milonas answered that the members in Pappas had been at odds from the beginning about different things; that the buy-out was done on an “as is” basis with an express fiduciary waiver and without any representations; and that the facts supporting waiver of fiduciary duty in Pappas were “stronger” than those in Centro. (9:30 – 10:15)
  • Upon beginning his argument Mr. Person was quickly met by Chief Judge Lippman’s questions whether the case is any different from Centro, and what meaning attached to the certificate of fiduciary waiver given by his clients in the buy-out. Mr. Person responded that the pre-buy-out differences among the members were ordinary business disputes and that his clients signed the waiver certificate because they had no reason to believe that Tzolis had engaged in any wrongdoing. (10:30 – 11:50)
  • Judge Read and Chief Judge Lippman questioned Mr. Person whether his clients had reason to be suspicious of Tzolis given the large premium he was paying them for their membership interests. Mr. Person replied that none of them had invested money, and that the value was in the long-term lease. (11:50 – 12:25)
  • Mr. Person argued that the certificate of waiver, even assuming it was effective at the time it was executed by his clients, had lapsed as a result of a delay in the closing of the buy-out transaction. Judge Smith and Chief Judge Lippman followed up with a number of questions, most of which sounded skeptical of the point. (14:50 – 18:10)

So now we wait for the Court of Appeals to render its decision. Quite possibly the outcome will pivot on the judges’ conclusion that Pappas either can or cannot be distinguished from Centro in terms of whether the selling members had a continuing relationship of unquestioned trust with Tzolis at the time of the buy-out transaction, or had reason to suspect that he had another deal in the offing.

I have one minor disappointment to share, namely, the fact that neither in the briefs nor at argument did counsel or the judges address the complex choice of law issue arising from the subject LLC’s status as a Delaware LLC whose operating agreement provides that it is governed by New York law. Read here the late Professor Larry Ribstein’s commentary on that aspect of the Pappas case.