“Intentional” Breach of Fiduciary Duty Defeats Operating Agreement’s Exculpatory Clause
June 07, 2021
Last week, Peter Mahler blogged about a recent decision holding that a minority shareholder’s claim against its majority co-owners for breach of fiduciary duty in connection with a sale of the business to a third party overcame for pleading purposes a broad general release delivered by the minority shareholder as part of the deal documents. In that case, Shilpa Saketh Realty, Inc. v Vidiyala, 191 AD3d 512 [1st Dept 2021], the court reversed dismissal and reinstated the plaintiff’s claims.
This week, we consider a variation on the theme of fiduciary duty claims overcoming contractual provisions limiting or eliminating those very duties, this time in the context of a so-called “exculpatory” clause in an LLC operating agreement and an appeal from a post-trial judgment of dismissal.
Reminiscent of Shilpa, in John v Varughese, 2021 NY Slip Op 03026 [2d Dept May 12, 2021], the appeals court partially modified dismissal of the minority member’s derivative complaint and directed entry of a money judgment in the company’s favor on one narrow aspect of its fiduciary duty claim, notwithstanding the existence of the operating agreement’s exculpatory clause. Before we get to particular facts of Varughese, though, let’s take a look at the law of LLC operating agreement exculpatory clauses.
Section 417’s Exculpatory Provision
Exculpatory provisions in operating agreements, insulating managers or members from claims of misconduct in connection with their official duties, are authorized by Section 417 (a) of the Limited Liability Company Law (the “LLC Law”), which provides that an operating agreement “may set forth a provision eliminating or limiting the personal liability of managers” except for four categories of serious misconduct:
- “bad faith”
- “intentional misconduct”
- “a knowing violation of the law,” or
- the manager or member “personally gained in fact a financial profit or other advantage to which he or she was not legally entitled.”
Cases applying these important exceptions are rare: before Varughese, there were just three New York appellate decisions applying the exculpatory language of LLC Law 417 (a).
The TIC Holdings Case
In the first case, TIC Holdings, LLC v HR Software Acquisitions Group, Inc., 301 AD2d 414 [1st Dept 2003], an LLC sued its member and former manager for breach of fiduciary duty, misappropriation of business opportunity, and tortious interference with prospective business advantage for allegedly “scaring off” potential investors while the company was in “financial straits” to attempt to buy the company for themselves at a “low price.”
The Court affirmed denial of the defendants’ motion for summary judgment for indemnification under the operating agreement, holding that “the complaint sufficiently alleges intentional wrongdoing and bad faith to render the cited exculpatory and indemnification provisions ineffective under both longstanding general common-law principles and the specific governing statutes,” Sections 417 and 420 of the LLC Law.
The Kagan Case
In Kagan v HMC-New York, Inc., 94 AD3d 67 [1st Dept 2012], a member of two financial investment firm LLCs sued the managers for breach of the implied covenant of good faith and fair dealing. The Court held that, “as a matter of public policy and longstanding general common-law principles an LLC operating agreement may not limit liability for tortious conduct . . . But, there is no tortious conduct alleged in this case.”
The Court ruled that plaintiff’s claim for breach of the covenant of good faith and fair dealing – traditionally viewed as “arising in contract” – did not fall within Section 417 (a)’s four exceptions “limited only to specific tortious acts — intentional misconduct, a knowing violation of the law, gross negligence and self-dealing; none of which the plaintiff alleges against them.”
Ironically, under Delaware law, the only kind of claim for which LLCs “may not limit or eliminate liability” of managers or members is the type of claim Kagan held insufficient to establish personal liability in New York: “bad faith violation of the implied contractual covenant of good faith and fair dealing.” In this post, Peter Mahler gave full treatment to Kagan‘s exculpatory clause holding.
The Howard Case
In Howard v Pooler, 184 AD3d 1160 [4th Dept 2020], a minority member of a real estate development firm sued the majority member. The Court affirmed entry of a money judgment in plaintiff’s favor following a bench trial on his claims for breach of fiduciary duty and breach of the implied covenant of good faith and fair dealing, crediting the lower court’s finding of Pooler’s “lack of good faith” adhering to his duties under the operating agreement. The Court also ruled that defendant was not shielded from personal liability by the operating agreement’s exculpatory clause “inasmuch as the court found that defendant acted in bad faith.”
One might argue that Kagan and Howard‘s seemingly conflicting holdings about whether breach of the implied covenant of good faith and fair dealing is sufficient to overcome Section 417 (a)’s personal liability shield (Kagan ruling “no” but Howard ruling “yes”) presents a leaveworthy issue for the Court of Appeals (though the Appellate Division in Howard later denied leave to appeal).
Last year, I wrote about a different aspect of Howard: the potential for a plaintiff alleging breach of fiduciary duty to recover disgorgement of profits, and, when pled derivatively, attorneys’ fees.
The Varughese Case
Finally getting to the subject of this week’s article, in Varughese, the plaintiff, John, owned 35% of the membership interests of Duchess Gardens, an LLC which owned a retail strip mall in Wappinger Falls, New York. The defendant, Varughese, owned 8% of the membership interests and served as its managing member.
According to the complaint, Varughese ignored written notices from the LLC’s insurance carrier requiring remediation of recommendations from a loss control inspection during the underwriting process, resulting in the carrier’s cancellation of Duchess Gardens’ fire insurance policy. Months after the policy’s cancellation, a large fire destroyed several units in the strip mall resulting in an uninsured loss exceeding $1 million. After the fire, Duchess Gardens was unable to pay its mortgage, resulting in a foreclosure lawsuit. According to the complaint, Varughese concealed these facts from his co-members until long after they occurred. The complaint alleged five causes of action: (i) gross negligence, (ii) breach of fiduciary duty, (iii) waste, (iv) misrepresentation, and (v) accounting.
The Bench Trial, Post-Trial Findings, and Judgment
The parties proceeded to a bench trial before Nassau County Commercial Division Justice Timothy S. Driscoll, each side acknowledging in their post-trial memoranda (you can read here and here) the following exculpatory clause in the operating agreement:
. . . Each manager’s liability to this Company or its members for damages for any breach of duty in such capacity is eliminated, except if . . . his acts or omissions were in bad faith or involved intentional misconduct or a knowing violation of law or that he personally gained in fact a financial profit or other advantage to which he was not legally entitled . . .
In post-trial findings of fact and conclusions of law, the Court held that John failed to prove gross negligence:
Plaintiff’s central allegation . . . was the fact that the liability insurance on the property lapsed, and thus there was no insurance at the time of the fire. While the insurance lapse showed that Defendant may not have paid great attention to detail, . . . the credible evidence showed that Defendant and his property manager, Crumpton, frequently communicated about the need to undertake various remedial measures at the property to satisfy the insurance company to keep coverage in place. Those remedial measures were in fact completed prior to the fire. Moreover, defendant continued to ensure that premiums for insurance were paid.
The Court specifically found that it “credits [Varughese]’s testimony that he believed the insurance was still in effect” and ruled that Varughese’s “belief, while erroneous, does not demonstrate the fundamental lack of care or concern necessary to constitute gross negligence.”
The Court also held that John failed to prove breach of fiduciary duty because there was no “actionable misconduct” by Varughese. “Such a claim for misconduct must rely on more than mere negligence,” the Court ruled, because “the Company’s Operating Agreement exculpates any manager for negligence,” and John failed to establish conduct that overcame the exculpatory language of the operating agreement.
The Court did not explicitly address a narrow aspect of the fiduciary duty claim, on which John focused at page 9 of his post-trial memorandum: an assertion that Varughese had “taken $50,000 of Company funds for himself by surreptitiously writing a check for that amount” and using it in part to pay personal legal fees.
In the resulting judgment, the Court dismissed John’s complaint.
John appealed the judgment. In the resulting decision, the Court explained that because of the operating agreement’s exculpatory clause, Varughese “may be held liable only for an intentional or bad faith breach of fiduciary duty, or an act from which he personally gained a financial profit or other advantage to which he was not legally entitled.” Concerning the claim of misrepresentation, the Court ruled that under “the operative exculpatory clause in the company’s operating agreement,” Varughese “may be held liable only for an intentional act of misrepresentation or concealment.”
As to Varughese’s alleged misconduct regarding the company’s lapse in fire insurance, the Court ruled that those actions “did not rise to the level of an intentional or willful breach of fiduciary duty, nor an intentional waste of the company’s assets,” did not satisfy the elements of intentional misrepresentation, and were time barred to the extent pled as a claim for gross negligence.
But, the Court concluded: “The trial evidence showed that the defendant intentionally breached a fiduciary duty to the company by transferring the sum of $50,000 from the company’s funds to another entity in which he had an interest, without authority and without any benefit to the company” and “defendant’s use of those funds for his own attorney’s fees was not authorized by the company’s operating agreement.” On this aspect of the complaint, the court reversed and directed entry of judgment in John’s favor derivatively on behalf of Duchess Gardens.
Comments on Varughese
Varughese is important precedent for LLC owners and practitioners litigating the circumstances in which a claim for breach of fiduciary duty may overcome an operating agreement’s exculpatory clause, the terms of which mirror (as they usually do) the statutory language of LLC Law 417 (a). Varughese also coined a new term in New York jurisprudence: the “intentional or bad faith breach of fiduciary duty.”
One suspects business divorce practitioners will see complaints deploying this phrase where the applicable operating agreement contains an exculpatory clause and the plaintiff hopes to overcome it. If asked to venture a definition of an “intentional or bad faith breach of fiduciary duty,” I would describe it as an egregious case of misappropriation or self-dealing by a member or manager for which the company received no financial benefit. We look forward to more cases like Varughese exploring the legal standards of LLC Law 417 (a).