Appellate Ruling Puts Pappas v. Tzolis to the Test

Farrell Fritz, P.C.
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The New York Court of Appeals’ 2012 opinion in Pappas v Tzolis, decided in the wake and spirit of that court’s rulings the year before in the Centro Empresarial v America Movil and Arfa v Zamir cases, raised the bar for claims of fraud and breach of fiduciary duty brought by non-controlling shareholders and LLC members in connection with buyout transactions. In so doing, the Centro-Arfa-Pappas trilogy rejected a line of cases decided by the Appellate Division, First Department, which seemingly held that a fiduciary involved in a self-interested transaction with another owner can almost never rely on a release or fiduciary waiver to avoid liability against allegations of non-disclosure and fraudulent inducement.

The plaintiffs-sellers in Pappas filed a post-buyout suit against the defendant-buyer after learning that, at the time of the buyout, he had an undisclosed deal with a third party for the sale of the company’s primary asset at a price exponentially higher than the value paid for the plaintiffs’ shares. The First Department sustained the fiduciary breach and fraud claims as pleaded.

The Court of Appeals reversed and dismissed the suit based on the buyout agreement’s explicit waiver of fiduciary duty. The Court of Appeals focused on the complaint’s allegations that the plaintiffs’ relationship with the buyer, Tzolis, “had become antagonistic to the extent that plaintiffs could no longer reasonably regard Tzolis as trustworthy” and that “reliance on Tzolis’s representations as a fiduciary would not have been reasonable.” The court’s opinion also noted that the plaintiffs were “sophisticated businessmen represented by counsel.”

A recent appeal to the First Department in Shilpa Saketh Realty, Inc. v Vidiyala put to the test that court’s application of the principles laid down by the Court of Appeals in Pappas. As best as I can tell, Shilpa is only the second post-Pappas First Department decision in which it entertained a shareholder dispute involving claims of fiduciary breach and fraud connected to a stock purchase agreement that included a fiduciary waiver and/or release.

On the prior occasion, in Malta v Gaudio, the court cited Pappas in a decision affirming the dismissal of a fiduciary breach claim as barred by a broad release provision. The court noted that the plaintiff was a “sophisticated principal represented by independent counsel” who admitted that he no longer trusted his co-owner at the time of the transaction — seemingly a slam-dunk application of Pappas.

The First Department also cited Pappas in last February’s Shilpa ruling. In contrast to Malta, however, the court in Shilpa reversed the dismissal of fraud and fiduciary breach claims notwithstanding the presence of a broad release and a fiduciary waiver-like provision in the transaction documents involving the sale of the company to a third party for $500 million. Why the different outcome? Read on.

Background

The complaint in Shilpa basically alleged that the defendant majority shareholders of InvaGen Pharmaceuticals, Inc., a Long Island-based generic pharmaceutical company, cheated the plaintiff minority shareholder out of $14.3 million in proceeds from the sale of InvaGen to a multinational pharmaceutical company.

The complaint alleged that the minority shareholder-plaintiff, Shilpa Saketh Realty, Inc., was a passive, 9% shareholder of InvaGen owned by two individuals who were young students at the time of the sale.  Allegedly, the plaintiff was not represented by outside counsel in connection with the company sale, did not participate in the negotiation or preparation of the transaction documents, and relied on one of the  defendant shareholders — allegedly a close family friend of the plaintiff’s principals — as its designated agent and attorney-in-fact to represent its interests in connection with the transaction.

Prior to consummation of the sale, the principal of InvaGen’s largest shareholder allegedly advised that $100 million of the $500 million sale price would be paid to the company’s outside distributor and that the allocation of sale proceeds to InvaGen’s shareholders, including plaintiff’s 9% share, would be reduced  proportionately.

The complaint alleged that, when it came time for the closing, it was provided only with signature pages of the closing documents and that plaintiff’s principals did not have an opportunity to read the documents before signing them.

After the closing, the plaintiff allegedly discovered there had been no payment to InvaGen’s distributor as defendants represented and that, in the definitive agreement that they had not previously seen, the defendants reduced plaintiff’s pro rata share of the sale proceeds from 9% to 6.874% with a corresponding increase in the defendants’ shares.

The complaint asserted various species of fraud claims plus breach of fiduciary duty against InvaGen’s majority shareholders and sought $14.3 million in damages.

The Lower Court Dismisses the Complaint

The defendants filed a motion to dismiss the complaint based on the “Allocated Share Schedule” included in the Stock Purchase Agreement, disclosing the 2.126% reduction in plaintiff’s share, and on the broad General Release given by plaintiff covering all claims connected to the parties’ Stock Purchase Agreement including “unknown and unsuspected Claims.” Naturally, their brief cited the Court of Appeals’ Pappas decision in support of their position.

In opposition, the plaintiff sought to invalidate the release and to distinguish Pappas on the ground defendants were fiduciaries of the plaintiff which had no reason to believe that any of the defendants were acting selfishly nor was plaintiff aware of any information that would make reliance on them unreasonable.

The Decision and Order by Manhattan Commercial Division Justice Barry R. Ostrager agreed with the  defendants and dismissed the complaint. The court found that “the broad and unambiguous terms of the Release bar plaintiff’s claims” and that plaintiff “had a duty to read what claims it was releasing” and “a duty to read the agreements.”

Justice Ostrager also noted that the plaintiff’s two principals “were either in pursuit of or had advanced degrees and were well aware that they were engaged in a multi-hundred-million-dollar transaction” and that the complaint did not allege “any time pressure, coercion, or lack of access to counsel” or that plaintiff “even requested access to the full document to read.”

In addition, Justice Ostrager wrote,

even if defendants were fiduciaries of plaintiff and even if plaintiff was unsophisticated, plaintiff’s exclusive reliance on defendants is unreasonable, because defendants’ alleged representations are contradicted by the express terms of the Transaction Documents, which plaintiff admittedly did not read. Even assuming plaintiff was not as sophisticated as the parties in [Pappas and Centro Empresarial], plaintiff’s alleged reliance on defendants does not excuse plaintiff’s failure to read the Transaction Documents.

The Appellate Court Reinstates the Complaint

Plaintiff appealed from the order dismissing its complaint to the Appellate Division, First Department. For those who want to take a closer look at the parties’ appellate arguments, the plaintiff’s opening and reply briefs are available here and here, and the defendants’ opposing brief here.

The First Department reversed Justice Ostrager’s order and reinstated the complaint. Its decision addressed the primary issue of the release’s validity in a single paragraph and cited a single case — Pappas. Here’s all it said:

Given that two of the three defendants were fiduciaries to plaintiff, and the allegations of the complaint describe united efforts rather than an adversarial or arm’s length negotiations with another party for the sale of the parties’ jointly owned company, it cannot be said as a matter of law that the release or the agreements (which plaintiff signed without reading) bar or bind plaintiff here (Pappas v Tzolis, 20 NY3d 228, 232-233 [2012]). Moreover, given that the release was not a bar to the claims, and plaintiff’s reliance on misrepresentations was not unreasonable as a matter of law, because it was excused from reading the agreements, we reject defendants’ argument that either the release, or the agreements are a defense as a matter of law.

The defendants subsequently filed with the Appellate Division a motion to reargue or, alternatively, for leave to appeal to the Court of Appeals. The motion primarily argued that the court misapprehended the effect of the Court of Appeals’ Pappas decision, contending that Pappas requires an allegation, missing from the complaint in Shilpa, of a separate fraudulent inducement to enter into the release different from that alleged with regard to the underlying fraud.

The motion also argued that the court overlooked fiduciary-waiver language in the Stock Purchase Agreement’s merger clause stating that “all parties to this Agreement specifically acknowledge that no party has any special relationship with another party that would justify any expectation beyond that of an ordinary buyer and an ordinary seller in an arm’s-length transaction.”

By order dated May 18, 2021, the Appellate Division denied the motion. As of this writing, the defendants have not filed a motion in the Court of Appeals seeking leave to appeal to that court. I expect/guess they’ll do so  later this month. The Court of Appeals grants very few such applications, but you never know what might arrest the judges’ attention.

A Difference With or Without a Distinction?

In both Pappas and the Malta case mentioned above, the complaints themselves established that the parties had an antagonistic relationship such that the courts found as a matter of law that the plaintiffs could not reasonably rely on any representations or duty to disclose on the part of the defendants as a basis for a claim of fraud or fiduciary breach. At the same time, in neither case did the transaction documents explicitly disclose that which the plaintiffs later alleged was a wrongful, self-interested act by the defendants.

Shilpa flips those two circumstances: the complaint alleges that the plaintiff had no reason to distrust the defendants yet the transaction documents expressly disclosed the reduction of the plaintiff’s allocated share of the sale proceeds and made no mention of disbursing $100 million to InvaGen’s distributor.

Justice Ostrager ruled that the plaintiff’s alleged reliance on defendants did not excuse its failure to read the transaction documents and, what’s more, that the plaintiff had an affirmative “duty to read what claims it was releasing.” The Appellate Division stated that the plaintiff was “excused from reading the agreements.” Why? The court doesn’t explain.

It’s important to keep in mind the procedural posture of the Shilpa decisions, i.e., a pre-answer motion to dismiss in which the complaint’s factual allegations, unless conclusively negated by documentary evidence, are deemed by the court to be true for purposes of the motion. The complaint’s reinstatement means, absent settlement, the litigants will take discovery likely followed by summary judgment motions and, if the court finds genuine issues of fact, a trial and potentially post-trial appeals, all of which probably will take years. However it turns out, it’s sure to be of great interest to business divorce aficionados.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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