Two LLC Sponsors Have No “Fiduciary” Claim Against the Third Because They Signed Contract Disclaiming Reliance on the Third’s Representation

The agreements in this case — there were several — strike us as eccentric by any standard. But agreements they were, and their collective contents are at the root of this action by two of the signers (Ps) against the third (D), interposing several claims against D. The salient one is breach of fiduciary duty.

A limited liability company was formed to lease a Manhattan building. The original investments in the LLC were $50,000 for D and $50,000 and $25,000 respectively for the plaintiffs. D later bought out the two plaintiffs’ interests in the LLC for $1 million and $500,000. A handsome profit for them. About a year after that, D made a handsomer deal for himself that enabled him to assign the lease to a company for $17,500,000. That’s what brought the lawsuit. Plaintiffs claim that when D bought them out he had already “surreptitiously negotiated” the bigger deal.

The circumstances of the arrival of that $17,500,000 lease would lead any observer to suspect chicanery of some kind, built at least in some measure on a charge of breach of fiduciary duty by D against the two plaintiffs. But the key thing to the Court in this case, Pappas v. Tzolis, 20 N.Y.3d 228, …. N.Y.S.2d …. (Nov. 27, 2012), is that the plaintiffs, when they agreed to D’s buy-out, were already on such notice as would impel them to make further inquiry. “The need to use care to reach an independent assessment” of what the value of the lease would be at that point, says the Court, “should have been obvious to plaintiffs, given that [D] offered to buy [and in fact bought] their interests for 20 times what they had paid for them just a year earlier”.

Breach of fiduciary duty was indeed a major part of the plaintiffs’ claims, but the Court holds that they forfeited it by signing — at the time of the buyout — an agreement with D reciting that D “has no fiduciary duty” to plaintiffs. Both sides were “sophisticated entities”, the Court finds; their relationship was not one of trust and hence the plaintiffs could not “reasonably rely on the fiduciary without making additional inquiry”.

The test to be applied, holds the Court in an opinion by Judge Pigott, 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 finds the plaintiffs’ purported reliance in this case unreasonable because “plaintiffs were sophisticated businessmen represented by counsel” and “at the time of the buyout, the relationship between the parties was not one of trust”.

What can really stand some investigation in cases like this is the meaning of “sophisticated” and the significance of being advised by “counsel”. Isn’t one being “sophisticated” enough when he sells a year-old investment for some 20 times its worth? If the law says that such an increase in value by itself puts you on notice that there may be even more that’s being concealed, does it put counsel to the burden of warning about it? And in this context what kind of counsel are we talking about? Legal counsel? Financial counsel? Psychiatric counsel?

In the face of the law’s misgivings about sophistication, the guileless may be licking their chops. This deserves looking into.

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Pappas is only the latest example of the crushing label of “sophistication”. We’ve had many cases over the years in which a party’s excuse for its conduct has been rejected on the basis that the party was “sophisticated”. Once considered a compliment, and elsewhere perhaps still, in judicial decisions “sophisticated” has become a handy epithet indicating that whatever the party did, it should have known better. Instead of its historic flattery as an honorific, it now comes on to warn the honoree that it’s about to lose its case.

Outside the courthouse a party hearing himself described as “sophisticated” might puff up with pride and pleasure. Even strut a bit. Inside, however, the word produces apprehension.

The Pappas case, above, is just the latest entry. It has a host of precedents.

In Wallace (1995, Digest 434), for example, the loss emanated from the terms of what was described as an instrument drawn “between sophisticated, counseled business people negotiating at arm’s length”. And in Chemical Bank v. Meltzer (1999, Digest 474), a bank got bamboozled after being found “a sophisticated creditor”.

We can easily turn to more recent examples, such as JMD Holding (2005, Digest 547), where the bamboozling went to “sophisticated and well represented business people”. And EBC (2005, Digest 549), where the shaft went to parties a dissent described as “sophisticated” and “counseled”.

Then, in Deutsche Bank (2006, Digest 559), a “sophisticated institutional trader” was held subject to New York longarm jurisdiction after entering the state electronically. (Serves it right. You won’t find an unsophisticated person sneaking into New York through the cyberspace.)

There are so many more illustrations, and in so many other contexts. In Hoffend (2006, Digest 562), for example, “a sophisticated commercial entity” was faulted and did not get the insurance coverage it said it bargained for. And in Madison (2006, Digest 566), sophisticated parties with counsel lost out on a guaranty issue in a lease dispute.

When the meek have at last inherited the earth, they’re likely to find huge tracts already inhabited by the simple-minded.

Any message? Sure. If you’re on the last lap of an appeal, be sure you wash off all signs of sophistication along the way. The Court has this hound dog up there — nothin’ but a hound dog — but he can sniff out a sophisticate at 1500 yards.