Notwithstanding that the pictured snow globe is the only snow I’ve seen in my neck of the woods this balmy winter, I’m pleased to present my annual Winter Case Notes collection of recent court decisions of interest.
This year’s collection features a relatively rare example of a court awarding punitive damages against a company controller for breach of fiduciary duty; a decision denying enforcement of allegedly promised “equity” in an LLC; and a decision dismissing untimely fraud claims against co-members of a realty holding LLC.
Shareholder Derivative Action Yields $1 Million Punitive Damages Award Against Company Controller
Clients complaining of fiduciary breaches by their business partners often ask whether they can recover punitive damages. I usually answer yes but add, it’s a high bar to get them and the success rate is low. Here’s one of the success stories.
In 2019, Reggie Middleton, the founder/CEO of a fintech company named Veritaseum, Inc., got into hot water with the SEC which accused him of raising millions of dollars through an initial coin offering without registering with the SEC while misleading investors to attract more funds with false information. The SEC action culminated with a settlement agreement requiring Middleton to pay disgorgement and prejudgment interest over $8 million plus a civil penalty of $1 million.
Middleton’s legal troubles did not end there. Shortly before the settlement’s announcement, a Veritaseum shareholder filed a derivative action in New York Supreme Court alleging that Middleton caused patents belonging to the company to be transferred to himself personally and used by other companies owned and controlled by him in breach of his fiduciary duty of loyalty.
In her post-trial decision last December in Hall v Middleton, Manhattan Commercial Division Justice Jennifer G. Schecter rejected Middleton’s contention that he had the right to personally own the patents as “nothing more than revisionist history proffered in an attempt to steal the Company’s primary assets for himself” in breach of his duty of loyalty to the company.
To remedy the breach the court not surprisingly ordered Middleton to transfer the patents to the company. What caught my eye was the court’s handling of the plaintiff’s derivative damages claims. On the one hand, Justice Schecter denied compensatory damages, finding that the plaintiff offered no evidence of comparable license fees or royalties to support a compensatory damages award and failed “to prove that Middleton and his other companies further profited from the patents or other assets and opportunities of the Company.”
On the other hand, Justice Schecter matched the SEC’s $1 million penalty with her own award of $1 million in punitive damages against Middleton for breach of fiduciary duty, offering this modernized version of Judge Cardozo’s “punctilio of honor the most sensitive”:
Middleton claimed that there is no need for trust in cryptocurrency transactions because they are “unbreakable promises.” While that may be true on the blockchain, there is tremendous need for trust and fidelity among fiduciaries. Where, as here, that trust is flagrantly violated, there must be real consequences to ensure that it doesn’t happen again. Anything short of significant punitive damages would further, not thwart, duplicity.
The judgment entered by the court also awarded the plaintiff $450,000 to reimburse his attorney’s fees as authorized by Business Corporation Law § 626(e), payable by the company presumably out of the $1 million punitive damages.
Court Rejects Claim of “Equity Interest” in LLC
Is there such a thing as an “equity interest” in an LLC distinct from a “membership interest”? Not according to the Appellate Division, First Department’s decision last week in Srivatsa v Rosetta Holdings LLC.
To put that in context, the case involves the plaintiff’s effort to enforce the defendants’ alleged oral agreement to give him a one-sixth ownership interest in a options market-making business spun off from Barclays after he left his job at Barclays to help transition the business from Barclays to the new firm known as Rosetta, organized as a Delaware LLC. Rosetta’s 2018 operating agreement named one of the defendants as the 100% member. A 2020 “Contribution Agreement” to which the plaintiff and others were signatories also acknowledged the defendant’s 100% ownership at that time.
The lower court, in another decision by Justice Schecter, dismissed the plaintiff’s claim for breach of contract. The Appellate Division’s decision last week affirmed the order of dismissal, finding that the Contribution Agreement at most reflected an unenforceable agreement to agree as to the LLC’s future membership.
For me, the appellate decision’s most interesting part is the court’s description and rejection of the plaintiff’s “central claim” that he “was granted an ‘equity interest’ entirely distinct from a ‘membership interest’ in Rosetta.” First, the court noted that the claim “does not appear in the complaint” and contradicts certain allegations in the complaint and in the plaintiff’s submissions to the motion court.
Second, the court disagreed with the plaintiff’s reliance on the operating agreement’s separate references to “Interest Holders” and “Members,” and on Delaware LLC Act § 18-702(d)’s reference to the assignee of an LLC interest who has no liability as an LLC member. As the court explained:
Plaintiff neither alleges nor attests that defendants agreed he would be an “Interest Holder” in Rosetta. Furthermore, plaintiff’s assertion that his status as a nonmember equity stakeholder in Rosetta was a status he could enjoy indefinitely is contradicted by section 18-702(d) of the LLC Act which, like the Amended and Restated Contribution Agreement, expressly concerns only an interim period before and “until” an assignee of an LLC interest “becomes a member.”
Although not mentioned in the court’s decision, Rosetta’s operating agreement defines “Interest Holder” to mean “any Person who holds an Interest, whether as a Member or as an unadmitted assignee of a Member.” The plaintiff apparently nowhere alleged that he was an “unadmitted assignee of a Member.”
Court Dismisses Untimely Fraud Claim Against LLC Members
Sometimes it pays to bring an action to obtain company books and records to investigate potential misconduct by business partners before filing an action asserting claims against them. Here’s an example where that strategy backfired when the court dismissed fraud claims as untimely.
In Lazar v Mor, decided last week by the Appellate Division, First Department, three LLCs in 2012 acquired several residential properties in Manhattan. Each LLC had four members, two of whom — the defendants — allegedly handled all aspects of the property acquisitions, financing, banking and tax reporting start to finish, as well as the resale of all the properties in December 2015.
In September 2016, the two plaintiffs noticed that the LLCs’ draft 2015 tax returns zeroed out hundreds of thousands of dollars of debt owed to the LLCs by the defendants. Their complaint alleges that by March 2017, when they met with the companies’ tax accountant, the plaintiffs “had serious concerns regarding the true sources of the capital contributions that Defendants had purportedly made to the LLCs.”
After further prolonged, informal efforts to get to the bottom, in October 2018 plaintiffs filed suit to obtain the LLCs’ books-and-records, which the court ordered defendants to produce in December 2018. The subsequent production allegedly omitted key records including closing statements and bank records, and in general raised more questions.
In August 2019, the plaintiffs filed a new lawsuit against defendants asserting claims for breach of fiduciary duty, breach of contract, unjust enrichment, and conversion. In the months that followed they obtained by subpoena closing statements for the property acquisitions in 2012, allegedly showing that the collective purchase prices for the properties was about $2 million lower than defendants had represented to the plaintiffs at the time.
Based on the subpoenaed records, in January 2020, plaintiffs filed an amended complaint adding several fraud claims alleging that by inflating the purchase prices of the properties the defendants induced plaintiffs to make additional capital contributions that in turn allowed defendants to falsify their own, inflated contributions.
Under New York law, the statute of limitations for fraud is the longer of six years from when the fraud occurred or two years from when the fraud was discovered or could have been discovered with reasonable diligence a/k/a the fraud-discovery rule.
The defendants moved to dismiss the amended complaint on various grounds. The motion targeted the fraud claims as time barred, arguing that even with the benefit of the fraud-discovery rule, by the time plaintiffs met with the tax accountant in March 2017, which was more than two years before they filed the lawsuit, the plaintiffs were on inquiry notice of the fraud that allegedly took place in 2012. Defendants also argued that the purchase prices for all the LLC properties were readily verifiable by plaintiffs long before then through an online search of the City of New York Finance Department’s Automated City Register Information System (ACRIS).
In a January 2022 decision by Manhattan Commercial Division Justice Andrea Masley, the lower court accepted defendants’ arguments and dismissed the fraud claims as time-barred. In its decision last week affirming Justice Masley’s dismissal order, the Appellate Division explained:
This action was commenced more than six years after the alleged frauds in 2012. Accordingly, plaintiffs’ fraud-based claims would be timely only if they were brought within two years of when plaintiffs discovered the fraud or could have discovered it with reasonable diligence (CPLR 213). Plaintiffs had serious concerns by March 2017 regarding defendants’ fraudulent conduct in connection with the purchase of the properties, including with respect to their capital contributions. Thus, they were on inquiry notice of defendants’ alleged fraud and misrepresentations with respect to those transactions, including the purchase prices paid for the properties more than two years before they commenced the action. Although plaintiffs allege that defendants refused to provide requested information and documents, the purchase price information was publicly available through an online search of the City of New York’s Automated City Register Information System since the time of the real estate purchases. Thus, reasonable diligence would have revealed the actual purchase prices of the properties more than two years before this action was commenced. [Citations omitted.]
Over the years I’ve encountered a number of non-professional real estate investors unfamiliar with the ACRIS database on which one can easily find documentation of all deed conveyances, mortgages, and other recorded real estate transactions in New York City, including real estate transfer tax records showing purchase prices. A five-minute ACRIS search any time prior to 2018 would have saved the Lazar plaintiffs a lot of trouble and, in all likelihood, would have prompted them to file a fraud lawsuit within the six-year statute of limitations in lieu of their books-and-records proceeding.