Sophisticated Party Again Fails to Do its Own Investigation

December 11, 2012

The last time we wrote on this topic, a group of plaintiffs' had their $900 million claim thrown out by a judge, essentially because the plaintiffs had stuck their head in the sand and did not investigate red flags evident in a transaction. In Pappas v. Tzolis, it was a paltry claim of just a few million that was tossed, but the underlying facts and legal principals were the same. Interestingly, it was again the selling party, the one which many believe to have less risk than the buyer, that came up holding the very short end of the stick.

The facts here are as follows: Pappas and Tzolis (and one other) formed a LLC to lease property. Tzolis personally provided the lease deposit of almost $1.2 million and was permitted to sublet the property. The parties also agreed that they had other business and could compete with the LLC or other members without notice. Trouble surfaced when Tzolis subleased the property to a company he controlled for $20,000 above the LLC's monthly payment. Unhappy with that, Pappas claimed that Tzolis prevented the LLC from leasing it directly for a higher rent, and that Tzolis was generally frustrating the lease interest of the LLC. Shortly thereafter, Tzolis bought out the other members, including Pappas. At the closing, Pappas signed a document attesting to the facts that prior to his sale of his membership interest, he had done his own due diligence using his own lawyers, and was not relying on any representation made by Tzolis or upon their relationship as co-members of the LLC. After the transaction closed, Tzolis assigned the lease interest from his entity to a third-party for $17.5 million.

Pappas sued Tzolis claiming that Tzolis had lined up this sublease before the membership interest were transferred, in violation of his fiduciary obligations to him as a member of the LLC. Had he known, argued Pappas, he would not have agreed to sell for the price that he did. The lower court threw out the case, but parts of it, including the fiduciary claim, were reinstated by the Appellate Division. The Court of Appeals, reversed the Appellate Division and threw out the case.

The court, citing to the Centro Empresarial case discussed here earlier, reiterated the rule for raising a claim of fiduciary violations in this setting. Where sophisticated parties enter into negotiations already not trusting each other or embroiled in a dispute, so that each has good reason to know that they are each acting in their own best interest, and even signing a release or waiver, they cannot come back to complain about those transactions based on the purported trust the aggrieved party had in the other.

Here, the court held that Pappas's reliance on Tzolis was unreasonable and the documents he signed controlled. His claim of fraud, that Tzolis told them he had no lessee lined up, was not only waived when Pappas signed the release and waiver, but incredible given their relationship. Pappas's remaining claims were undermined, wrote the court, because Tzolis had a right to control the leasehold and should not have been trusted by Pappas given the history and relationship among the parties.

The Silber Law Firm, LLC has successfully litigated these types of cases, and the focus on the language of the documents, in the specific context and setting in which they are executed, cannot be overstated. There are ways to minimize the risk to the parties engaged in this kind of transaction, but a hefty dose of skepticism combined with realistic due diligence is required. Sometimes the services of a forensic accountant is also something to consider, as the entity's books often tell a story that is inconsistent with what one party is being told. If you are facing a situation described in these cases, feel free to give us a call.