Promoter’s Liability for Breach of Fiduciary Duties

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The Roni LLC v. Arfa Saga

Can promoters of limited liability companies be held liable for a breach of fiduciary duties that occurred prior to the formation of the LLC?

In Roni v. Arfa, investors in various real estate owning LLCs sued the promoters of those LLCs for not disclosing that they had received “commissions” from the sellers of the properties of up to 15%.  The investors argued that these commissions inflated the purchase prices by millions of dollars. The promoters moved to dismiss, contending that they had no duty to disclose these payments since they could not be held to be fiduciaries prior to the formation of the LLCs. 

The case quickly devolved into one in which the key issue was whether the promoters had fiduciary duties to the investors before the LLCs were formed and the investors had put up their money.  If the transactions were at an “arm’s length” – as the promoters argued - between sophisticated parties, there would be no fiduciary duty, and the promoters would have no obligation to disclose this fact.

The Supreme Court (New York’s trial level court) determined that the promoters did have fiduciary duties, and the promoters appealed this decision.

The Appellate Division Decision

The New York Appellate Division, First Department ruled that the LLC promoters had a fiduciary duty and denied the motion to dismiss, by analogizing to the rule in effect for corporations. The First Department stated:

Both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders. By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members. The fiduciary duty includes the obligation to disclose fully any interests of the promoter that might affect the company and its members, including profits that the promoter makes from organizing the company.

Under this ruling, LLC promoters were found to have pre-formation fiduciary duties to investors merely by virtue of their status as organizers of the LLC.  The First Department granted the promoters leave to appeal to the Court of Appeals the following certified question: “Was the order of [the First Department], which affirmed the order of [the] Supreme Court, properly made?”

The New York Court of Appeals’ Decision

In its decision issued in December 2011, the New York Court of Appeals answered the certified question affirmatively, but did so without following the Appellate Division’s bright line rule that promoters are fiduciaries.  Instead, the Court of Appeals held that a fact-specific inquiry was necessary in order to determine whether a fiduciary relationship existed, noting:  

A fiduciary relationship arises "between two persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relation". Put differently, "[a] fiduciary relation exists when confidence is reposed on one side and there is resulting superiority and influence on the other."

Applying this test, the Court of Appeals concluded that the investors had sufficiently alleged the existence of a fiduciary relationship between the LLC promoters and themselves. The Court reasoned as follows:

Here, plaintiffs assert that the promoter defendants planned the business venture, organized the limited liability companies, solicited their involvement and exercised control over the invested funds. We agree with plaintiffs that the promoters of  a limited liability company are in the best position to disclose material facts to investors and can reveal those facts more efficiently than individual investors, who would otherwise incur expense investigating what the promoters already know.  In addition, the complaint alleges that the promoter defendants represented to the foreign investors that they had "particular experience and expertise" in the New York real estate market. Although the promoter defendants describe plaintiffs as "sophisticated prospective investors," the complaint paints a different picture, stating that they were "overseas investors who had little or limited knowledge of New York real estate or United States laws, customs or business practices with respect to real estate or investments." Moreover, plaintiffs contend that the promoters defendants assumed a position of trust and confidence, in part, by "playing upon the cultural identities and friendship" of plaintiffs. Accepting the totality of these allegations to be true, as we must at this early stage of the litigation, the complaint adequately pleads a fiduciary relationship. 

The Subsequent New York Supreme Court Decision

The case was sent back to Supreme Court Justice Charles E. Ramos for further proceedings, and after discovery, both the investors and the promoters moved for summary judgment. The Supreme Court – now looking at the additional facts that had been adduced in discovery - determined factually that each of the defendants had conducted themselves in manner that made them promoters. The Court applied the Appellate Division’s definition of a “promoter” as one who “plans the business venture, organizes the LLCs, and solicits investors to invest” and relied on its decision that promoters are, by virtue of their status, fiduciaries. 

In its decision, the Supreme Court rejected the promoters’ argument that the Court of Appeals had rejected the Appellate Division ruling imposing fiduciary duties on promoters by virtue of their status as promoters. Instead, it stated that the Appellate Division’s test and the Court of Appeal’s test were both valid.  Some parties can acquire fiduciary duties merely by their status (i.e, attorneys, brokers) and others by having superior knowledge and expertise that is relied on by the other party. 

The Open Question

This series of decisions left open the question as to why the Court of Appeals avoided the Appellate Divisions bright line test – promoters have fiduciary duties – in favor of a more nuanced test.  Although the Court of Appeals did not formally reject the Appellate Division’s test, it appeared to leave open the possibility that a promoter might in certain circumstances not have fiduciary duties (i.e., where the investors were very sophisticated and did not rely on the promoter’s superior knowledge and expertise).

We will have to wait and see.  

Schroeder v. Pinterest Inc.

A COLLECTION OF LEGAL PRINCIPLES RELATING TO STOLEN INTELLECTUAL PROPERTY INVOLVING SOCIAL MEDIA WEBSITES

Were the ideas and functionality behind the Pinterest social media website stolen? A case alleging just that is making its way through the New York court system. In Schroeder v. Pinterest Inc., the New York Appellate Division First Department addressed multiple issues relating to a lawsuit claiming theft of ideas and work product that led to the development of the popular website Pinterest.com. 

Pinterest is “a content sharing service that allows members to ‘pin’ images, videos and other objects in their pinboard.” In the Pinterest case, an internet entrepreneur is claiming that the former Chairman and Chief Executive Officer of two companies he founded with former classmates stole their website concept, designs, and business plan, and gave them to a different group of developers who used them to create the immensely popular social media website Pinterest.com.  

Case Background – In 2005, Plaintiff Schroeder, then a Columbia Law School student, came up with the idea of developing “a social network bulletin board where users could share their physical location with friends over the [i]nternet.” He taught himself how to program and spent many hours developing the site. He brought two of his classmates into the project to help him. Together they formed Rendezvoo, LLC, a limited liability company, in order to develop the website. Rendezvoo’s operating agreement mandated that all three members owed each other fiduciary duties and “were expressly prohibited from unilaterally taking any corporate opportunities.” Rendezvoo’s website application was released to the public in 2006, and in a second version, was expanded to allow users to share their interests as well as their physical locations.

Seeking to raise additional capital for website development, the three developers were introduced to early stage investor and self-proclaimed “entrepreneur mentor,” Brian Cohen. After learning about their business model and business plan, Cohen accepted their offer to become Chairman and Chief Executive Officer of Rendezvoo. He was also given an 18% equity interest in Rendezvoo. Although never formally memorialized, Cohen agreed to be bound by Rendezvoo’s operating agreement restricting the misappropriation of company ideas and work product.

In 2007, at Cohen’s urging, the four Rendezvoo principals took down the Rendezvoo website and began developing a new site with a narrower focus than Rendezvoo. The new site, named Skoopwire, would focus exclusively on providing early access to new products and services. The four Rendezvoo principals founded Skoop Media Associates, Inc. to develop the new website. Skoop Media’s website, Skoopwire.com, was “a direct-to-customer news wire connecting businesses to bloggers, sophisticated customers and journalists wanting easy access to information about new products and services before they were covered in the mainstream media.” 

The business relationship between the three original developers and Cohen quickly soured. According to the complaint, Cohen sought more equity and when he did not get it, he deadlocked the project “so he could steal the core ideas for himself and freeze out Schroeder from reaping any benefits.” By early 2008, the parties began to contemplate liquidating and dissolving Skoop Media, but they never formally proceeded to do so. Schroder attempted to have the shareholders sign an agreement to protect the Rendezvoo or Skoopwire concepts, but nobody signed it. In mid-2008, Cohen “abandoned” his positions with both companies. The Skoopwire website was never released to the public. Both Rendezvoo and Skoop Media were never dissolved.

In 2009, Cohen met the future founders of Pinterest.com at a business school competition. In March of 2010, Pinterest.com was launched. “The website allows users to pull images from elsewhere on the [i]nternet and generate pins which are compiled into various topic boards.” Users then “have the ability to view the most popular pins on the site as well as the board that other users have created.”  

Upon viewing Pinterest.com, Schroeder noticed it was virtually identical to the second version of the Rendezvoo website. Schroeder noticed key features which bore clear similarities to their previous work including “the ability for users to post their interests for their friends and other users of the site to see.” In 2012, Schroder read an article in which Cohen “bragged about being Pinterest’s ‘first investor,’” and described how he met Pinterest’s founders in 2009, shortly after he allegedly deadlocked the Rendezvoo and Skoopwire projects. Plaintiffs allege that, in this article, Cohen falsely stated that he did not know where the concept of "pinning on Boards" came from, and claimed that the Pinterest website "came out of nowhere." The complaint further alleges that Pinterest’s founders knew that the ideas given to them by Cohen were not his own.

In June 2013, Schroeder, Rendezvoo and Skoop Media sued Cohen, his company, New York Angels and Pinterest, and in September, the Cohen defendants and Pinterest separately moved to dismiss the complaint.

In July 2014, Judge Melvin L. Schweitzer granted Cohen’s motion and dismissed the breach of fiduciary duty, misappropriation and unjust enrichment claims. The court, however, denied dismissal of the causes of action for misappropriation of skills and expenditures, and promissory estoppel. This appeal followed.

The Court analyzed each of the plaintiffs’ claims for legal sufficiency and ruled as follows:

Breach of Fiduciary Duties – The Appellate Division held that the Plaintiffs had properly stated a claim for breach of fiduciary duties, and reversed the lower court’s dismissal of this claim. The complaint alleges that Cohen, as Chairman and Chief Executive Officer of both Rendezvoo and Skoop Media, owed fiduciary duties to both companies and to Schroeder, a fellow shareholder and member. Additionally, the complaint alleges that Cohen breached those duties by intentionally deadlocking the Rendezvoo and Skoopwire projects, stealing the proprietary ideas, technology and business plans underlying their sites, and providing this information to Pinterest.

Cohen argued that the fiduciary duty claim was not viable because he was no longer affiliated with Rendezvoo or Skoop Media by 2009, when he allegedly gave Pinterest the confidential information. He cited cases holding that a director who resigned or was terminated no longer owed fiduciary duties to the company. 

The Court ruled that the complaint sufficiently alleged that Cohen was still an officer of Rendezvoo and Skoop Media at the time of the alleged breach. Plaintiffs claimed that the breaches began when Cohen deadlocked the two companies while they were still active. The Court noted that there was no allegation in the complaint that Cohen ever resigned his positions, or relinquished his ownership interests in either entity, implying that Cohen was never relieved of his fiduciary duties.

The Court added that even if Cohen had resigned from both companies before giving the information to the Pinterest entrepreneurs, he could still be held liable if Plaintiffs could show that his breaches “were founded on information acquired during the fiduciary relationship."

The Court dismissed the aiding and abetting breach of fiduciary duties claim against Pinterest, stating that an essential element of such a claim is that the defendant knew that the party it was aiding was under such a duty and the complaint did not allege that Pinterest knew of Cohen’s prior relationship with Plaintiffs.

Unjust Enrichment - The Court upheld the dismissal of the unjust enrichment claim against Pinterest on the grounds that the complaint did not allege a “sufficiently close relationship” between plaintiffs and Pinterest necessary to sustain such a claim; in fact, the Court noted, it did not allege any relationship between them.

Misappropriation of Trade Secrets – The Court upheld the misappropriation of trade secrets claim against Cohen, but dismissed this claim against Pinterest.

Regarding Cohen, the Court held that Plaintiffs had sufficiently alleged that Plaintiffs (1) possessed a trade secret, and (2) Cohen used that trade secret in breach of an agreement, confidential relationship or duty. The Complaint alleged that Cohen had “exposed” valuable confidential and proprietary technology and business plans by providing them to Pinterest. Cohen made these improper disclosures in violation of his executive positions with Rendezvoo and Skoop Media as well as his agreement to be bound by Rendezvoo’s confidentiality agreement.

Nevertheless, the Court noted the trade secrets claim was limited to only confidential information – essentially excluding any features contained in Rendezvoo’s website application that was made publicly available – because a trade secrets claim, by definition, excludes information in the public domain.

Regarding Pinterest, the Court stated that the Complaint contained no allegations that Pinterest had breached an agreement or confidential relationship with or duty to Plaintiffs, nor did it allege that Pinterest acquired the information by improper means. Merely obtaining the information from Cohen without knowledge that he had improperly taken it is insufficient to hold Pinterest liable for trade secret misappropriation.

Misappropriation of Ideas – The Court upheld the misappropriation of ideas claim against Cohen, but dismissed it against Pinterest. The Court held that the Complaint alleged (1) a legal relationship between Plaintiffs and Cohen, and (2) the idea allegedly taken was “novel and concrete.” The legal relationship between Plaintiffs and Pinterest was lacking and thus this claim had to be dismissed.

Misappropriation of Skills and Expenditures – The Court upheld this claim against Cohen, but dismissed it against Pinterest. The Complaint properly alleged that Cohen had (1) misappropriated Plaintiffs’ labor, skills, expenditures, or goodwill, and (2) displayed some element of bad faith in doing so. Bad faith can be established by demonstrating “fraud, deception, or an abuse of a fiduciary or confidential relationship.” The Complaint alleged that Cohen misappropriated years of Schroeder’s work that was used to develop the Rendezvoo and Skoopwire websites. In addition, bad faith was shown on Cohen’s part by his disclosure of confidential and propriety information while he was a fiduciary of Rendezvoo and Skoop Media, as well as his violation of Rendezvoo’s operating agreement.

Promissory Estoppel – The Court held that the Complaint did not allege a viable promissory estoppel claim against Cohen based on his July 1, 2008 email stating that he had "absolutely NO interest in PROFITING from [Schroeder’s] specific design work on Skoopwire." The Court noted that the elements of such a claim are: (1) a promise that is sufficiently clear and unambiguous, (2) reasonable reliance on the promise by a party, and (3) injury caused by the reliance, and held that the Complaint was deficient because it did not allege that Schroeder had relied to his detriment on this promise.