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Keep Your Friends Close, But Your Fiduciaries Closer

That’s Sun Tzu by way of Michael Corleone by way – it seems – of the New York Court of Appeals.  New York’s highest court recently held in Pappas v Tzolis, 20 N.Y.3d 228 (N.Y. November 27, 2012) that partners in LLCs can, by agreement, free themselves of fiduciary duties toward each other and, therefore, will not later be heard to complain of breaches of those duties.

Pappas dealt with one member’s buyout of the others’ LLC membership interests for $1.5 million.  The LLC’s single asset was a long-term lease on a building in Lower Manhattan.  In consummating the buyout, the members executed certificates confirming that they had each performed their own due diligence and releasing each other from any fiduciary duties that may have been owed to each other.  Several months after the buyout, the remaining member of the LLC turned around and assigned the lease to a third party for $17.5 million.  It was discovered after the fact that this member had been negotiating the lease assignment with the third party before he bought out his partners.  The former members sued their partner for, among other things, breach of fiduciary duty in failing to disclose his negotiation of the lease assignment to the third party.

In ruling that the members had contracted away the fiduciary duty that would have otherwise been imposed under such circumstances, the Court reasoned that where the relationship among sophisticated businessmen is no longer one of trust, the principal cannot reasonably rely on the fiduciary’s representations without engaging in a heightened degree of diligence.  Pappas, 20 N.Y.3d 228, *5 (“The test, in essence, is whether, given the nature of the parties’ relationship at the time of the release, the principal is aware of information about the fiduciary that would make reliance on the fiduciary unreasonable.”).  The Court concluded that because the relationship among the parties had become antagonistic, the members selling their LLC interests could have and should have uncovered their partner’s activities.

We can only imagine what Sun Tzu would make of this ruling, but the Godfather would almost certainly say that “it’s all out war, we go to the mattresses.”

Michael C. McCabe, Jr.