Schlam Stone & Dolan partner David Katz is quoted several times in an article published on the front page of the December 13, 2012 New York Law Journal, titled “With Nod to Delaware, N.Y. Courts Define Commercial Law.” In the article, Katz discusses the extent to which New York appeals courts have been following Delaware law in commercial disputes, including a case of first impression litigated by Schlam Stone & Dolan and decided by the Appellate Division First Department concerning whether corporate officers and directors are entitled to recover attorneys’ fees and prejudgment interest in connection with successfully vindicating their indemnification rights.
With Nod to Delaware, N.Y. Courts Define Commercial Law
by Brendan Pierson
As New York strives to become a more popular forum for commercial litigation, its courts have grappled with the legacy of its more established rival, Delaware, which has produced a large body of case law on corporate matters over several decades. A number of New York appellate decisions this year have addressed Delaware law, underscoring both where the two states’ laws are converging, and where they appear to be moving further apart.
These decisions represent a trend that has been taking shape for some time. David Katz, a partner at Schlam Stone & Dolan, said that New York courts have been looking to Delaware on corporate issues for about the last five years, and “in most cases” following Delaware’s lead when dealing with similar statutes.
The most recent such decision came from the Court of Appeals at the end of last month, and centered on the issue of whether members of a limited liability company can enter into a contract to eliminate their fiduciary duty toward the LLC and their partners.
LLCs, which combine elements of a corporation and a partnership and are meant to limit members’ individual liability, have exploded in popularity in recent years, bringing associated legal questions to light, according to Peter Mahler, a partner at Farrell Fritz.
The Court of Appeals case, Pappas v. Tzolis, 601115/09, arose from a dispute between three partners in an LLC created to lease a building in Lower Manhattan. One of the partners, Steve Tzolis, bought out the other two for a total of $1.5 million and then immediately sold his interest in the building for over $17.5 million.
The other two partners sued him for, among other things, breach of fiduciary duty, alleging that Tzolis had already been negotiating the sale when he bought them out and that he had a duty to tell them about the negotiations and potential profit.
The LLC was incorporated in Delaware, but its agreement provided that it would be governed under New York law. It also included an agreement that the partners did not have any fiduciary duty.
A long line of Delaware Chancery Court cases has held that, under Delaware law, parties can agree to free themselves of fiduciary duty. But the Appellate Division, First Department, refused to follow Delaware’s lead, citing its own precedent in Blue Chip Emerald v. Allied Partners, 299 A.D.2d 278 (2002), in which it held in a very similar case that the parties could not contract away their fiduciary duty.
Then, last month, the Court of Appeals reversed. Though it did not explicitly reference Delaware law, the decision took the same position that the Delaware Chancery Court has on the issue.
Bruce Rich, of counsel at Carter, Ledyard & Milburn, said that the decision seemed to show New York “pushing away from the fiduciary duty standard.”
By doing that, Rich said, New York could weaken one of the factors that has historically led companies to prefer doing business in Delaware rather than New York.
“A lot of practitioners say they’ll form an LLC in Delaware rather than in New York for a number of reasons,” he said. “One is that, in Delaware, it’s easier to disclaim the fiduciary duty.”
Making the matter more complicated, Delaware’s case law is itself in flux. While the Chancery Court has held that LLC members have a fiduciary duty by default unless they contract it away, the Delaware Supreme Court has not addressed the issue, and its chief justice, Myron Steele, said in a 2009 article that he believes LLC members never have a fiduciary duty unless they expressly agree to.
“That’s an example of where New York and Delaware are both wrestling with this, and are aware of the other state,” Rich said.
Mahler said he did not think the Court of Appeals’ decision in Pappas would necessarily bring New York and Delaware in line. Given the fact that Delaware law is still evolving, and the full scope of Pappas is not yet clear, Mahler said the divergence between the two states on the issue of LLC members’ fiduciary duty was still an “ongoing source of tension between the decisions in New York and the decisions in Delaware.”
“I don’t think that’s going to be resolved for some time,” he said.
Direct and Derivative Claims
An earlier pair of First Department decisions, both issued on Aug. 7, dealt with Delaware law more directly, with one explicitly adopting Delaware case law for New York and the other explicitly rejecting it.
In Yudell v. Gilbert, 600404/08, the court adopted Delaware’s standard for distinguishing between direct and derivative claims by shareholders, which was laid out in the 2004 Delaware Supreme Court case Tooley v. Donaldson, Lufkin & Jenrette, 845 A2d 1031, 1039.
The Tooley standard holds that to be a direct, rather than derivative claim, a claim “must be independent of any alleged injury to the corporation,” and the plaintiff “must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.”
Justice Karla Moskowitz, who wrote the Yudell opinion, said the Tooley standard “is consistent with New York law and has the added advantage of providing a clear and simple framework,” while New York previously “lacked a clear approach” to the issue.
The underlying lawsuit involved a dispute between stakeholders in a joint venture created to run a shopping center on Long Island, which one member alleged had been badly mismanaged. The First Department found his claims to be derivative under the Tooley standard.
Katz said the ruling did not mark a major departure for New York law.
“On the derivative front, if you look at the way New York courts were ruling, they were pretty much following Delaware law in those cases anyway,” Katz said.
“They’re happy to adopt Delaware when they think it will keep standards uniform,” said David Frydman, a partner at Gusrae Kaplan Nusbaum who represented the prevailing party in the case.
The decision, Frydman said, might make it harder to bring derivative cases in New York, and might be seen as “pro-business or pro-corporate,” but above all it would have the effect of making the legal landscape more predictable.
“It’s helpful from a standpoint of getting some certainty as to what standards are,” he said.
The second decision issued by the First Department on Aug. 7 considered and explicitly rejected Delaware case law.
The unsigned 4-1 decision in 546-552 West 146th Street LLC v. Arfa, 603041/06, dealt with whether an agreement for an LLC to indemnify its members against lawsuits covering so-called “fees on fees” — fees incurred by the members in litigating the question whether or not the companies must indemnify them under the agreement.
Delaware’s Chancery Court, interpreting language in its LLC statute similar to New York’s, ruled in 2002 in Stifel Financial v. Cochran, 809 A.2d 555, that if an indemnification provision in an LLC agreement is silent on “fees on fees,” they are covered.
But the First Department declined to follow Delaware, ruling that they are not covered when the agreement is silent. Only Justice James Catterson dissented and said the court should have followed Delaware.
Katz, who represented the losing parties in the case and is seeking leave to appeal, said he was “surprised by how little litigation there appears to be” in New York on issues of indemnification in general.
What case law there is, he said, is “very anti-indemnitee and pro-indemnitor,” but the existing cases do not deal with cases involving the principals of companies.
In Delaware, by contrast, there is a much more substantial body of case law, which is “very pro-indemnitee” compared with New York.
Katz said he is hopeful the Court of Appeals will bring New York closer to Delaware not only on fees on fees, but on indemnification issues generally.
Attorneys said that New York courts will increasingly need to engage directly with Delaware law as New York becomes a more popular forum for commercial litigation.
“I think it’s a trend,” Katz said of the recent decisions.
Mahler said the trend is the result of New York playing catch-up to Delaware, which established itself as a forum for commercial litigation decades ago.
“Delaware absolutely took the lead and has become the preferred venue to incorporate,” Mahler said, thanks to a “pro-management, very sophisticated set of business corporation laws that state has perfected over many decades.”
“From the point of view of both the bench and of a litigator or even a transactional lawyer here in New York, one of the reasons we look so carefully at Delaware law is the quality of the Delaware Chancery Court,” Mahler said. “New York courts frequently looked to decisions of the Delaware Chancery Court for guidance even in interpreting New York’s business corporation law.”
The creation of the Commercial Division 15 years ago, and the recent push to further boost its effectiveness and popularity, have changed that to some extent, Mahler said.
“It used to be that, if you had to litigate in New York, do anything you can to get into federal court,” Mahler said. “Absolutely the Commercial Division has made a difference, and I personally feel that.”
Daniel Kleinberger, a professor at William Mitchell College of Law in Minnesota who studies commercial litigation nationally, said the rise of alternative forums, including New York, has weakened the once-widespread perception that Delaware has already developed the best business laws.
“The question of Delaware’s influence is a cloudier picture than it used to be,” Kleinberger said. “It’s easier to get people to listen to arguments that Delaware is not perfect.”
Attorneys stressed, however that the tensions between the two states are ultimately resolved, businesses will be able to write contracts in order to be bound by the law they want. The problem they now face is a lack of clarity.
“It’s important to have clear rules so that companies can forecast and analyze,” Frydman said. “Even if the two states have different rules, if the rules are clear you can work around that.”