The Duty to Disclose Third-Party Offers Amidst Buy-Out Negotiations, Revisited
January 11, 2021
In 2011 and 2012, the New York Court of Appeals decided a series of difficult cases addressing the circumstances under which a contractual waiver or release included in a buyout or other agreement between co-owners of closely held firms provides insulation from subsequent claims for breach of fiduciary duty or fraud based on an alleged failure to disclose vital information concerning the firm’s financial condition or the existence of a third-party offer to purchase the firm’s assets at a significantly higher value.
The upshot of the three cases — Centro Empresarial v America Movil, Arfa v Zamir, and Pappas v Tzolis — is that it depends not only on the particular language of the waiver or release but also on the sophistication of the complaining party and whether, at the time of the transaction, the complaining party had reason to distrust the other party such that it could not reasonably rely on the latter’s representations. Centro in particular rejected any categorical rule that the non-controlling owner may “blindly trust” the alleged fiduciary’s representations or that the controlling owner owes a non-releasable fiduciary duty to disclose to the co-owner all material information bearing on the transaction. In all three cases, which you can read about in my prior posts here and here, the complaining parties lost their claims.
I’m inclined to believe that the cumulative impact of the Centro-Arfa-Pappas trilogy is responsible for the relative dearth of reported decisions by New York courts over the last eight years involving claims of the sort, and that lawyers representing business owners on both sides of buyouts and other transactions between co-owners have applied the trilogy’s lessons in negotiating and documenting agreements.
Until recently, I encountered only three post-2012 published decisions involving buyout-related lawsuits alleging breach of a fiduciary duty of disclosure, one decided in 2013 and two in 2015. In two of them, the court threw out the claims (read here and here). In the third, the court denied a pre-answer motion to dismiss (read here).
Now there’s a fourth, Bak v Rostek, 2020 NY Slip Op 33142(U) [Sup Ct Kings County Sept. 25, 2020], in which a 47.5% member of a single-asset realty-holding LLC sold his membership interest to the other 52.5% member for around $900,000 based on a $1.9 million valuation assigned by the buying member. One month later, the buying member sold the LLC’s property to a third-party buyer for $2.9 million. After learning of the sale, the 47.5% member sued the other member for damages equal to the delta between what he received in the buyout and 47.5% of the net proceeds from the $2.9 million sale, arguing primarily that the defendant breached fiduciary duty by failing to disclose third-party offers that were tendered shortly before the buyout.
In 2010, the plaintiff Adam Bak and the defendant Krzysztof Rostek, as 47.5% members each, and non-party Bogdan Chmielewski as 5% member, formed 1059 Manhattan Avenue LLC to purchase a property in Brooklyn’s Greenpoint section for development and construction of a mixed use condominium project.
The Operating Agreement named Rostek Managing Member with typically broad and exclusive authority over all decisions concerning the LLC’s business affairs save certain major decisions reserved for approval by a majority of the membership interests including a sale of the property. The Operating Agreement also imposed on the Managing Member duties of good faith and care mirroring the statutory duties set forth in section 409 (a) of the LLC Law.
By 2012, the project met with unanticipated construction problems and was not fully financed. In early 2012, Rostek purchased Chmielewski’s 5% interest for approximately $98,000, representing a small return on his approximately $89,000 investment. Bak, who had invested about $820,000 in the project, not long afterward began discussions with Rostek about buying out Bak’s 47.5% interest.
In late July 2012, they entered into a buyout agreement for Rostek’s purchase of Bak’s interest for a little over $900,000 paid in full upon execution of the agreement. The buyout agreement included a provision in which Bak acknowledged that upon receipt of payment, he “shall have no right, claim, and/or interest of any kind in any profits, distributions, dividends, or other equity stemming from [the LLC]” and that Bak “waived” any claim for amounts beyond the buyout payment “that would otherwise be due” on account of Bak’s “past or present interest in [the LLC].”
Another provision recited that the agreement followed “careful discussion and negotiation” and that its terms “are hereby accepted by each party as fair and reasonable . . . and each party agrees never to assert to the contrary.” The agreement also included a provision stating that Bak “has declined to be represented by any attorney in this matter” despite being advised to retain an attorney of his choice. The agreement did not include a release of either party.
Sometime afterward, Bak learned that Rostek sold the LLC’s realty to a third party for $2.9 million in a deal that closed in late August 2012, i.e., a month after Bak’s buyout.
Bak’s Lawsuit and Rostek’s Dismissal Motion
Bak filed suit against Rostek in July 2015, likely timed to fall just within the three-year statute of limitations for a breach of fiduciary duty claim seeking money damages. His complaint alleged that the price for his buyout was based on a Rostek’s $1.9 million valuation; that Bak relied on Rostek as the LLC’s managing member to keep him fully informed of all material facts related to the property, including its market value and any offers to purchase the property; that Rostek failed to disclose to Bak the upcoming sale of the property for $2,900,000; and that had Bak known of the upcoming sale, which would have netted him an additional $470,000 for his 47.5% share, he would not have sold his interest to Rostek at the price he did.
In addition to fiduciary breach, Bak’s complaint asserted claims for fraud, unjust enrichment, negligent misrepresentation, gross negligence, fraud, and money had and received.
The case appears to have gotten bogged down in discovery over the next several years. In early 2020, Bak’s counsel filed a post-discovery note of issue certifying the case as trial-ready.
In June 2020, Rostek filed a motion for summary judgment seeking dismissal of the action in its entirety. Rostek admitted receiving a number of offers from prospective buyers of the property and a proposed buyer-signed contract for a $2.7 million sale while simultaneously negotiating with Bak. Nonetheless, in his opening brief (read here), Rostek argued that Bak’s claim for fiduciary breach should be dismissed because any fiduciary relationship terminated upon Bak’s buyout in July 2012, a month before the property sale to the third-party.
Alternatively, Rostek contended that Bak went ahead with the buyout knowing of several third-party offers and proposed contracts that “fell through”; that Bak chose not to obtain his own valuation of the property; and that the ultimate third-party buyer of the property did not make an offer until after Bak’s buyout in late July 2012. Rostek also argued that Bak’s claim was barred by the buyout agreement’s provision waiving claims for any additional amounts due Bak for his “past or present interest” in the LLC.
Bak opposed Rostek’s motion, contending that prior to his buyout Rostek never told him about his receipt of multiple offers for the property or about the buyer-signed contract for $2.7 million that he rejected in favor of the later-received $2.9 million offer. Bak’s brief (read here) argued that Rostek had an affirmative duty to disclose the pre-buyout offers and proposed contract, and that his failure to do so breached his fiduciary duty.
The Court’s Decision
In a decision by Brooklyn Commercial Division Justice Leon Ruchelsman, the court rejected Rostek’s argument that there existed no fiduciary relationship or duty as a matter of law, writing that
there has been evidence submitted that at the time the plaintiff and defendant were negotiating the buyout the defendant was negotiating to sell the property to others for more than was evaluated between plaintiff and defendant. Surely there are questions whether defendant owed the plaintiff a fiduciary responsibility to inform him of those negotiations. The fact that the actual transaction occurred after the buyout, does not absolve the defendant of his duty to the plaintiff of such vital and profitable information.
Justice Ruchelsman likewise was unpersuaded by Rostek’s assertion that Bak never inquired concerning the property’s valuation or its “true worth” and instead “merely adopted the representations of the defendant and was satisfied with the profit he was promised.” Even if true, the court explained,
the defendant still maintained a duty to inform the plaintiff of the negotiations that were underway that would have yielded plaintiff far greater profits. The plaintiff’s apparent indifference to the valuation of the property does not absolve the defendant from his fiduciary duty to the plaintiff as a member.
Rather than resulting in a waiver, Justice Ruchelsman added, Bak’s alleged reliance on Rostek’s $1.9 million valuation “supports the existence of a breach of fiduciary duty and does not absolve the defendant in any manner.”
Based on those findings, the court denied Rostek’s motion to dismiss Bak’s claim for breach of fiduciary duty as well as the claims for negligent misrepresentation and unjust enrichment. The court did, however, dismiss Bak’s fraud and gross negligence claims.
It’s a shame that neither in the court’s decision nor the parties’ briefs is there any mention of any of the leading Court of Appeals’ decisions mentioned at the top of this post. I would have liked to read the parties’ and the court’s treatment of the analyses employed in the Centro-Arfa-Pappas trilogy, namely:
- whether Bak’s claim for breach of fiduciary duty fell within the buyout agreement’s express provisions stating that Bak “waived” any claim for amounts “that would otherwise be due” on account of Bak’s “past or present interest in [the LLC] and that Bak “shall have no right, claim, and/or interest of any kind in any profits, distributions, dividends, or other equity stemming from [the LLC],” and that the agreement’s terms “are hereby accepted by each party as fair and reasonable . . . and each party agrees never to assert to the contrary” ;
- whether Bak’s reliance on Rostek’s valuation in the context of a buyout negotiation is the type of “blind trust” that, without more, was rejected as a categorical basis for alleging fiduciary breach in a buyout or other transaction between co-owners of a closely held firm;
- whether there was any deterioration in the relationship between Bak and Rostek such that Bak had reason not to rely on Rostek’s valuation of the property;
- whether Bak’s sophistication or lack thereof in real estate matters was or should have been a factor in the court’s analysis; and
- whether Bak’s lack of legal representation in the buyout transaction, and the express acknowledgement in the buyout agreement that he was advised to obtain his own counsel, was considered a plus or a minus to his claim.
I’m also intrigued by the absence of any formal release given by Bak in Rostek’s favor, as I would normally expect to see in a buyout transaction of the sort. The release’s omission is all the more intriguing given that, when Rostek bought out Chmielewski’s 5% interest, the buyout agreement included the seller’s general release of Rostek. Had Bak released Rostek, I imagine that would have been Rostek’s #1 defense.
Another intriguing difference between the two agreements is the inclusion in Chmielewski’s buyout of a side agreement giving him 5% of the profit on any sale of the property within six months of the agreement. Bak’s buyout agreement had no similar price-protection provision a/k/a jerk insurance.
Neither side has filed a notice of appeal from the decision, so it looks like the case will proceed to a bench trial at some point down the road. When that will be, given the strains on the court system during the COVID pandemic, is anyone’s guess.