The Farro Litigation: The Rest of the Story
January 25, 2021
In last week’s New York Business Divorce, Peter Mahler wrote about an important new decision with far-reaching implications for New York LLC owners. In Farro v Schochet, ___ AD3d___, 2021 NY Slip Op 00150 [2d Dept Jan 13. 2021], Peter and I persuaded a Brooklyn appeals court to rule, based upon Sections 1002 (f) and (g) of the Limited Liability Company Law, that a limited liability company member forced out of a business in a lawful cash-out a/k/a “squeeze-out” or “freeze-out” merger lacks (with limited exceptions) any legal right to attack the validity of the merger, or to have it set aside or rescinded, including based upon alleged grounds of “illegality” or “fraud.”
The Farro merger holding conclusively distinguishes – and places in a different category entirely – LLC mergers from corporation mergers. The latter preserves for dissenting shareholders a post-merger right under Section 623 (k) of the Business Corporation Law (the “BCL”) to maintain an “appropriate action” (construed by the courts to mean one for “equitable relief”) to challenge a merger based upon alleged “unlawful” or “fraudulent” conduct.
After Farro, it is clear that BCL 623 (k)’s “illegality” of “fraud” exception to the post-merger, exclusive remedy of a “fair value” appraisal proceeding does not apply to LLC mergers, and that a fair value appraisal proceeding is the one and only legal remedy available to an LLC owner forced out of the business in an LLC merger that otherwise complies with the merger statutes and the operating agreement (if any).
Although last week’s article addressed the appeals court’s merger holdings in Farro in quite some detail, the article tells only part of the story. In fact, the Farro decision was one of four related opinions the appeals court issued that day. In this article, I’ll do my best to tell the rest of the story, focusing on two of those other decisions. In the first, which I’ll call the “Counterclaims Appeal,” the appeals court affirmed in its entirety the lower court’s decision denying Farro’s motion to dismiss our clients’ counterclaims. In the second, which I’ll call the “Direct Claims Appeal”, the appeals court affirmed in its entirety the lower court’s decision denying Farro’s motion to dismiss our clients’ claims in a separate lawsuit they brought against Farro.
The Counterclaims Appeal
After Farro sued LMEG and his former co-members, Wilhelm and Schochet, they filed ten counterclaims against him, counts one through seven brought on behalf of LMEG for breach of fiduciary duty / faithless servant, fraud, negligent misrepresentation, conversion, unjust enrichment, declaratory judgment, and accounting, and the remaining counts brought on behalf of Schochet for fraud, negligent misrepresentation, and constructive fraudulent conveyance under Debtor and Creditor Law 273.
The claims LMEG asserted all originated from Wilhelm and Schochet’s alleged discovery, post-Farro’s expulsion from the business via the merger, that Farro allegedly engaged in misappropriation from the company by causing the business to repay personal loans Farro had taken from his friends and family members as if they were debts of the company, allegedly pocketing the loan proceeds and saddling the LLC with the debt. The claims Schochet asserted all originated from Farro’s alleged representations to Schochet in late-2011, as a material inducement to Schochet becoming a member of LMEG, that the LLC’s inventory value exceeded $10 million, when in fact the inventory value was allegedly less than $2 million. All of the claims were rooted in allegations of fraud, particularly that Farro had allegedly taken careful steps to conceal his loan misappropriation activity from LMEG, Wilhelm, and Schochet by manipulating the company’s financial records of which he had exclusive control at the time of the fraud.
In the Counterclaims Appeal, Farro v Schochet, ___ AD3d ___, 2021 NY Slip Op 00152 [2d Dept Jan. 13, 2021], the Court ruled:
- Farro could not rely upon the doctrine of ratification for dismissal of LMEG’s counterclaims predicated upon Farro’s loan misappropriation because an act of ratification can only be accomplished with “full knowledge of the material facts relating to the transaction,” which “must be clearly established and may not be inferred from doubtful or equivocal acts or language.” The Court ruled that the countercomplaint sufficiently pled Farro “actively concealed” his conduct by falsifying LMEG’s financial records, so LMEG and its members raised, at a minimum, an issue of fact as to their knowledge of Farro’s activity.
- The countercomplaint was timely under the statute of limitations to “the extent that the counterclaims seek damages based upon conduct occurring after October 2010,” less than six years before Farro filed his original complaint. The Court relied upon the statute of limitations’ “relation back” provision, CPLR 203 (d), which provides that a “defense or counterclaim is not barred if it was not barred at the time the claims asserted in the complaint were interposed.” The Court further held that all of the counterclaims, including the first counterclaim for breach of fiduciary, were governed by a six-year statute of limitations because they were replete with “allegations of fraud.”
- The countercomplaint alleged with sufficient particularity the claims for breach of fiduciary duty, fraud, and misrepresentation. The Court ruled that the facts alleged were “sufficient to permit a reasonable inference of the alleged conduct,” “particularly since they alleged that the operative facts are peculiarly within the knowledge of the party alleged to have committed the fraud.”
The Direct Claims Appeal
Weeks after Farro scuttled the sale of LMEG to a private equity firm by filing his initial lawsuit challenging for the first time ever the membership interest in the business Schochet acquired in 2011, LMEG, Wilhelm, and Schochet filed a separate lawsuit against Farro. The lawsuit revolved about alleged breaches by Farro on two separate occasions of oral agreements and fiduciary duties to sell the business to private equity firms TZP Capital Partners and Ridgemont Equity Partners.
In the Direct Claims Appeal, LMEG Wireless, LLC v Farro, ___ AD3d ___, 2021 NY Slip Op 00164 [2d Dept Jan 13., 2021], the Court ruled:
- LMEG, Wilhelm, and Schochet’s claims for breach of oral agreements to sell LMEG to third-party private equity firms were not unenforceable under the so-called “doctrine of definiteness.” “Contrary to [Farro’s] assertion,” the Court wrote, “an agreement to accept a reasonable offer is not necessarily unenforceable; instead, a party may agree to be bound to a contract even where a material term is left open,” and here, “[t]here were objective criteria, such as whether an offer comported with the company’s value as established by an analysis of its financial records, which could be used to determine whether a given offer was ‘reasonable.’”
- The claims for breach of fiduciary duty were timely under the statute of limitations. The Court ruled that although the fiduciary duty claims “do not allege fraud” and “seek only monetary damages, not equitable relief,” so “a three-year limitations period applied, nonetheless, “most of the acts of which the plaintiffs complain occurred between December 2014 and March of 2016, and the complaint was filed in November 2016, [so] these causes of action are timely.”
- The claims for breach of fiduciary duty sufficiently pled the essential elements, including that Farro “was a manager of LMEG Wireless until he was removed from that position in May 2016, [so] he owed a fiduciary duty to the plaintiffs.”
- The claim for accounting sufficiently alleged that LMEG, Wilhelm, and Schochet “demanded an accounting from [Farro] which he refused to provide” and that Farro “as a manager of LMEG Wireless during the period in question, owed a fiduciary duty to them,” giving rise to a legal duty to account.
As a result of these holdings, Farro instantaneously transformed from plaintiff to defendant, his pleading dismissed in full, now forced to defend himself on multiple fronts, including against ten counterclaims in the Farro case, ten direct claims in the LMEG case, and an appraisal proceeding recently commenced by the company to determine the fair value of Farro’s former interest in the LLC.