Last month this blog wrote about the Securities and Exchange Commission's list of exam priorities for 2017 here . Included in that list was a focus on registered representatives and employers with prior records of misconduct. This is also an exam priority for the Financial Institution's Regulatory Authority (Finra). The self regulatory organization has put in place a new exam unit that will focus on identifying high risk and recidivist brokers who pose a potential risk to investors. Based in New York, this unit is comprised of investigators, examiners, attorneys and compliance professionals who are analyzing voluminous data to detect so called rogue brokers who have been disciplined for misconduct but who still work in the industry. According to one study conducted in 2016, seven percent of financial advisers had been disciplined. The study also found that at some member firms, twenty percent of their registered representatives were part of that illustrious group. Finra reportedly has between 100 to 200 brokers in their sights and plans to review the interactions of these brokers with customers to ensure their compliance with a variety of compliance rules, including: Suitability Know-Your-Customer Outside Business Activities Private Securities Transactions Commissions and Fees The high-risk broker unit will drill down on the data to examine adviser's test scores, the number of employers he or she has had, customer complaints, reportable activities and disciplinary action taken. Finra will then combine that data with what they have gleaned from prior investigations and examinations of these brokers. Armed with this information, members of the unit will then conduct onsite exams at the firms where these brokers are employed to review their current activities. This will include an analysis of purchase and sales data, money transfers, and other activities to detect conduct such as negligence, unsuitable investment advice, excessive trading or churning, breach of fiduciary duty and the like. The onsite exams will also involve interviews with supervisors and reviews of these firm's hiring practices and supervisory systems. Finra does not intend to impose restrictions on who firms can hire. Instead, the self regulatory organization will use their findings to ascertain whether firms are aware of high risk brokers on their staffs and what steps are being taken to monitor their activities. While Finra's mission has long been to police the industry and protect the investing public, the brokerage watchdog has been pressed by Congressional lawmakers to step up their enforcement activities and confront the recidivist issue. At this juncture, it remains to be seen how effective this new unit will be in rooting out rogue brokers. In the meantime, Finra has arbitration system in place to resolve disputes between brokerage firms and customers who are often represented by experienced attorneys.

Like their larger siblings, small businesses that do business with the government, e.g. , healthcare providers who receive reimbursement from Medicare or Medicaid, government contractors or subcontractors, and nonprofit companies that receive state or federal funding, are at risk of being the subject of a whistleblower claim. Given the risks, small businesses should have whistleblower polices in place – policies that can encourage employees to report misconduct internally and minimize the risk of financial, legal, and reputational harm to the organization. Having an internal mechanism for addressing concerns about corporate/business wrongdoing, including an anti-retaliation policy, can help small businesses protect themselves from the risk of violating state and federal laws that provide protections to whistleblowers who report fraud and misconduct to the government, such as the False Claims Act (“FCA”), the Sarbanes-Oxley Act of 2002, and the whistleblower programs created under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), and ensure that if there is a violation of law or unethical activity it will be investigated and corrected. Even small companies that have no government business should develop and implement a whistleblower policy to encourage employees to bring their concerns to managers without fear of retaliation. What Is Whistleblowing? A whistleblower is a person, often a current or former employee, who reports fraud on the government with the aim of ending the wrongful conduct. The individual who reports the misconduct is called a “relator.” A whistleblower can report the fraud or misconduct a) within the company (assuming the whistleblower is an employee), b) to a government agency ( e.g. , the Securities Exchange Commission (“SEC”) or the U.S. Attorney’s Office), or c) both within and without the company. The circumstances surrounding the alleged misconduct, including the nature of the wrongdoing alleged, the relationship between the whistleblower and the company, the scope and effectiveness of any company compliance program, the desire of the whistleblower to maintain anonymity, the risk of retaliation, and the desire for a monetary reward, often dictates to whom the disclosure will be made. A business can encourage employees to report misconduct internally rather than externally by having an effective whistleblowing policy that is rooted in open communication and integrity, assuages employee fears of retaliation, and enhances employee trust in management’s ability to address the allegations or concerns. Encourage Internal Whistleblowing It is no surprise that the “tone at the top” drives the effectiveness of whistleblower policies. Indeed, the 2013 National Business Ethics Survey® (“NBES”) found that “ mployees report misdeeds 71 percent of the time when they believe top management is committed to ethics and 69 percent of the time when supervisors are committed to ethics, compared to 56 percent of the time when ethics appears to be a lower priority.” Business owners and managers, therefore, must communicate not only that illegal activity and unethical behavior will not be permitted within the company, but that internal reporting is encouraged and necessary for maintaining the integrity of the organization. The 2013 NBES survey supports this view, finding that “ ighty percent of employees report observed misconduct when ethics cultures are strong, compared to 55 percent in weak ethics cultures.” In addition, business owners and managers can encourage employees to report concerns internally by taking reports of wrongdoing seriously and responding quickly and effectively to them. By doing so, business owners and managers not only communicate to the whistleblower what action is being taken to investigate the issue, but also maintain consistency in enforcing the law or company policy and disciplining employees who are found to have violated them. Incentivizing Internal Reporting Encouraging employees to report misconduct internally can be a challenge for businesses, especially given employee fears of retaliation, distrust of management’s ability to investigate and correct problems, and the financial rewards available to whistleblowers under the FCA and SEC/CFTC whistleblower programs . To address these challenges, some businesses provide monetary and non-monetary incentives for employees to report illegal or unethical activities internally rather than to the government. The 2011NBES found that “72 percent of employees who agreed their companies reward ethical conduct did report; but far fewer employees (57 percent) who do not see ethics rewarded choose to report.” What to Include in the Whistleblower Policy Business owners should adopt comprehensive whistleblower policies. Such policies should accomplish, at least, the following: Set the “tone at the top” – build a culture that encourages employees to raise concerns or complaints about wrongful conduct internally. Review company policies, codes of conduct and agreements to ensure that they do not contain language that discourages employees from whistleblowing internally or to the government. (This Blog has repeatedly reported on the SEC’s efforts to enforce Dodd-Frank’s prohibition against such language. Here . Here . Here . Here .) Encourage employees to report the alleged wrongdoing through hotlines, to compliance and/or human resource departments (if any), or directly to their supervisors or the owner(s) of the company. Guarantee the whistleblower’s anonymity. After receiving a report of wrongdoing, the business should promptly and thoroughly investigate the matter and explain the findings to the employee, even if the investigation proves there was no wrongdoing. Have an attorney perform the investigation of the alleged wrongdoing so that employees can be assured that any information that is shared is privileged and will not be used against them. Protect the whistleblower from retaliation. Periodically evaluate the effectiveness of the policy. Takeaway: An effective whistleblower policy protects both the company and its employees. It increases the probability that the company will learn about existing or potential problems before law enforcement officials or regulators. Additionally, it sends a strong message about the company’s commitment to lawful and ethical behavior and fosters a culture of accountability and employee empowerment.

Last month, this Blog wrote about McGowan v. Clarion Partners, LLC , a decision involving the enforceability of a transaction term sheet. In McGowan , Justice Scarpulla of the New York County, Supreme Court, Commercial Division, held that the term sheet before the court was a binding contract because it contained all the material terms of the proposed venture that would reasonably have been expected to be included under the circumstances. This month, by contrast, Justice Singh of the same court ruled that the term sheet at issue was only intended to be an agreement to agree; it was not intended to be a separate, enforceable agreement. See Pate v BNY Mellon-Alcentra Mezzanine III, L.P. What is a Merger Clause ? Sometimes called an integration clause, a merger clause is a provision in a written contract that establishes the parties’ intent that their agreement is a completely integrated writing, representing their complete and final agreement on the matter. A completely integrated contract precludes the introduction of extrinsic proof ( i.e. , parol evidence) to add to or vary its terms. E.g. , Citibank v Plapinger , 66 N.Y.2d 90, 94-95 (1985). Lawyers include merger clauses in contracts because they reduce confusion about whether obligations made outside of the contract are part of the agreement, and force the parties to memorialize all material parts of their agreement in writing. They also help to prevent claims by one party to a contract that the other used fraud and deceit to induce them into entering the agreement (as alleged in Pate ). In New York, to be effective, a merger clause should be specific about what constitutes the merged terms. DiBuono v. ABBEY, LLC , 95 A.D.3d 1062, 1064 (2d Dept. 2012) (“While a general merger clause is ineffective to exclude parol evidence of fraud, a specific disclaimer will defeat any allegation that the contract was executed in reliance upon contrary oral representations.”) (citations omitted). General, boilerplate clauses are ineffective to show the parties’ intent. Id . Consequently, merger clauses such as the following have been found to be effective: This Agreement may not be amended, changed, modified, or altered except by a writing signed by both parties. All prior discussions, agreements, understandings or arrangements, whether oral or written, are merged herein and this document represents the entire understanding between the parties with regard to the subject matter hereof . Pate v BNY Mellon-Alcentra Mezzanine III, L.P. : Background : The case arose out of a failed transaction involving Seven Continents Holdings, LLLP (“Holdings”), an Alabama-based partnership specializing in disaster-relief operations. In early 2013, the plaintiff, Luther S. Pate, IV (“Pate”), caused Holdings, which he then controlled, to purchase several other disaster-relief companies, including DRC Emergency Services, LLC and its affiliates (“DRC”). The purchase was financed by a loan made by defendant BNY Mellon-Alcentra Mezzanine III, L.P. (“Alcentra”), an investment fund managed by BNY Mellon-Alcentra Mezzanine Partners, and defendant United Insurance Company of America (“United”), which Pate personally guaranteed and secured by his interests in Holdings. Pate defaulted on the loan. In August 2013, Alcentra and United notified Pate that they intended to foreclose upon his interests in Holdings. Thereafter, the parties engaged in negotiations to prevent foreclosure and cure the defaults, which resulted in an agreement in principle, the terms of which were set forth in an executed term sheet dated October 22, 2013 (the “Term Sheet”). The Term Sheet provided that the parties would enter into a forbearance agreement by November 15, 2013, subject to the satisfaction of other terms and conditions in the Term Sheet. Upon execution of the forbearance agreement, the Term Sheet provided that Pate and his affiliates would assign and transfer all of their rights and interests in Holdings and its affiliates, and the parties would enter into a series of mutual releases. The Term Sheet also imposed certain obligations on Pate prior to entering into the forbearance agreement, including that Pate would make a total of $5.5 million in payments to DRC and return certain specified assets to Holdings. Further, the Term Sheet set forth certain rights to which Pate would be entitled upon his satisfaction of his obligations under the Term Sheet and the forbearance agreement. The Term Sheet further contained a provision for the transfer to Pate of a limited participation interest in Holdings (10%) for a five-year period. Thereafter, on November 4, 2013, the parties executed the forbearance agreement, titled “Assignment Agreement and Release” (the “Release Agreement”). Under the agreement, Pate agreed to make a cash payment and to transfer all his interests in Holdings and related entities to Alcentra and United, and Alcentra and United agreed to release Pate from his obligations with respect to the loan, including his personal guaranty, and to indemnify Pate with respect to certain other guaranties he had executed for the benefit of Holdings. The contract was fully-integrated, containing a merger clause, which provided: This Agreement sets forth the entire understanding of the Patties with respect to the subject matter hereof and supersedes all prior agreements, written or oral, of the Parties (including any prior term sheet or correspondence) and may be modified only in a writing executed by all of the Parties. The Allegations and Defenses : Notwithstanding the execution of the Release Agreement, Pate alleged that the parties expressly agreed that the Term Sheet itself was enforceable because numerous obligations thereunder had to be performed prior to the execution of the Release Agreement. In that regard, Pate maintained, based on verbal communications with one of the individual defendants, that he understood the Release Agreement to be a supplemental, mechanical document that simply effectuated the transfer, including his right to the 10% economic interest, which had been memorialized in the Term Sheet. Pate contended that when the parties circulated the Release Agreement for execution on November 4, 2013, he relied on the verbal promises that: a) Alcentra and United would transfer a 10% economic interest in Holdings to him; b) the Release Agreement would not affect his right under the Term Sheet to receive that interest; and c) a supplemental document effectuating the transfer would be executed within 30 days of execution of the Release Agreement. Based in part on the verbal representations, Pate maintained that he understood that the merger clause in the Release Agreement would not impact the participation provision. Pate filed a summons and complaint on December 4, 2015. In the complaint, Pate alleged that he had performed all his obligations under the Release Agreement and the Term Sheet, but Alcentra and United had not fulfilled their obligations under the agreements – namely, they failed to assign a 10% economic interest in Holdings to him. Pate asserted claims of breach of contract against United and Alcentra, fraudulent inducement against all the defendants, and breach of warranty of authority against the individual defendants. The defendants moved to dismiss, arguing, among other things, that Pate’s claims were barred by the merger clause contained in the Release Agreement. The Court agreed. The Court’s Ruling : In dismissing the breach of contract claims, the Court found that the Term Sheet was unenforceable for several reasons. First, the Court found that the merger clause “expressly and unambiguously” provided that the Release Agreement superceded “any prior term sheet.” To hold that the Term Sheet was nevertheless binding, said the Court, “would render the clause meaningless.” Such an interpretation would leave one of the clauses in the Release Agreement “without meaning or effect,” a result, Justice Singh said, the courts should avoid. Second, the Court found that the Term Sheet was not intended to be the final agreement; rather, it was an “agreement to agree.”  The Court noted that the Term Sheet “plainly” stated that the parties would “enter into a forbearance agreement (the “Definitive Agreement”)” as their final agreement. Thus, by its very terms, the Term Sheet and the Release Agreement could not be separate, enforceable agreements. Third, because the merger clause memorialized the parties’ agreement “in a clear complete document,” the Court refused to vary that writing through parol evidence: “plaintiff cannot rely on any telephone conversations or e-mails with the defendants, for the merger clause states unambiguously that the release agreement set forth ‘the entire understanding of the parties with respect to the subject matter hereof and supercedes all prior agreements (written or oral).’” Finally, the Court found that the Term Sheet was unenforceable “because documentary evidence utterly refute plaintiff’s contention that he made both of the payments required by the Term Sheet.” For these reasons, the Court dismissed the breach of contract claims against Alcentra and United. The Court also dismissed the fraud in the inducement claims because of the merger clause, stating: “the allegation that plaintiff justifiably relied on pre-contractual representations … is refuted by the merger clause of the release agreement.” Takeaway: Pate is important because it reinforces the rule that a contract containing a specific merger clause that disclaims prior or extra-contractual agreements or representations will bar the parties from relying upon such agreements or representations to assert claims of breach of contract or fraudulent inducement.

On the same day that he signed a directive ordering a review of the Labor Department's fiduciary rule (discussed here ), President Trump signed an executive order directing the Treasury Secretary and other regulators to review existing regulations to determine whether they support six core principles. Included in those principles are: Empowering Americans to make independent financial decisions; Fostering economic growth through more rigorous regulatory impact analysis; Advancing American interests internationally; and Enabling American companies to compete internationally. The order directs regulators to submit a report within 120 days identifying laws and regulations, particularly the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank" or the "Act"),  that are not consistent with the core principles. Treasury secretary nominee Steven Mnuchin reportedly supports rolling back the reform measure. In particular, in his testimony before the Senate Finance Committee, Mnuchin said his priority would be changing the asset thresholds that put banks and systemically important financial institutions under the jurisdiction of the Consumer Finance Protection Bureau. In sum, Mnuchin believes that the complexity and activities of these firms should determine the regulatory framework rather than size. One of the critiques of the reform measure was that it unfairly targeted community banks and impeded business lending. Currently, there is also legislation working its way through Congress that would free banks from Dodd-Frank's capital rule in exchange for complying with a more straightforward leverage ratio of 10 percent. On the other hand, Mnuchin supports the so-called Volcker Rule, a provision of Dodd-Frank that prohibits financial institutions that are ensured by the Federal Deposit Insurance Corporation from engaging in proprietary trading. At the same time, he intends to clarify the rule in order to enhance market liquidity, which in theory would spur lending. While rolling back the Act has the support of a number of industry groups, it is also being met with fierce opposition by a variety of consumer advocates who contend this will trigger another financial collapse. In addition, any change to this regulatory framework will be a lengthy and costly process as financial institutions have already made significant investments to implement systems to comply with the existing rules and regulations. It is also likely that the President's order will spark another round of legal actions challenging the directive. In the final analysis, whether the Act will remain intact remains to be seen.  This Blog will continue to monitor these developments.

In this Blog’s last entry , we discussed the advantages and disadvantages of forming a limited liability company (“LLC”). Today’s entry discusses whether non-managing members of a manager-managed LLC owe fiduciary duties to the other LLC members and to the LLC itself. An LLC is a hybrid business entity having the attributes of both a corporation and a partnership. E.g. , Willoughby Rehabilitation & Health Care Ctr., LLC v. Webster , 2006 NY Slip Op. 52067(U) (13 Misc. 3d 1230(A)), at 3-4 (Sup. Ct. Nassau Co. Oct. 26, 2006). Its owners are its members. Limited Liability Company Law § 417(a) provides that the members of an LLC “shall adopt a written operating agreement relating to the business of the company, the conduct of its affairs and the rights and powers of its members.” The operating agreement is, therefore, the primary document defining the rights of members, the duties of managers and the financial arrangements of the limited liability company. Id . at 3 (citing Rich, Practice Commentaries, 32A Limited Liability Company Law Section 1.A, p. 4 (McKinney’s, 2006); and Lio v. Mingyi Zhong , 10 Misc 3d 1068(A) (Sup. Ct. N.Y. Co. 2006)). Pursuant to Limited Liability Company Law § 409, “a manager shall perform his or her duties as a manager … in good faith and with a degree of care that an ordinary prudent person in a like position would use under similar circumstances.” The acts of working in concert and managing a limited liability company gives rise to a relationship among the members which is analogous to that of partners who, as fiduciaries of one another, owe a duty of undivided loyalty to the partnership’s interests. Id . at 3-4 (citing Birnbaum v. Birnbaum , 73 N.Y.2d 461, 466, rearg . denied , 74 N.Y.2d 843 (1989), and Meinhard v. Salmon , 249 N.Y. 458, 463-64 (1928)). A partner, and by analogy, a member of a limited liability company, has a fiduciary obligation to others in the partnership or limited liability company which bars not only blatant self-dealing, but also requires avoidance of situations in which the fiduciary’s personal interest might possibly conflict with the interests of those to whom the fiduciary owes a duty of loyalty. Id . at 4 (citing Salm v Feldstein , 20 A.D.3d 469, 470 (2d Dept. 2005); Nathanson v. Nathanson , 20 A.D.3d 403, 404 (2d Dept. 2005)). Consequently, based upon the foregoing analysis, New York courts have held that a managing member of a manager-managed LLC has a fiduciary duty to the other members of the LLC. However, while the managing member of a manager-managed LLC owes a fiduciary duty to the non-managing members, non-managing members do not owe a fiduciary duty to each other or to the LLC.  The reason, say the courts, is the absence of a duty imposed on the non-managing members to act in good faith and with due care under Section 409 of the Limited Liability Company Law. Kalikow v. Shalik , 43 Misc. 3d 817, 826 (Sup. Ct. Nassau Co. Feb. 26, 2014). Last month, these principles were addressed by Justice Anil Singh of the Supreme Court, New York County in Landes v. Provident Realty Partners II, L.P. , 2017 NY Slip Op. 30196(U) (Sup. Ct. N.Y. Co. Jan. 31, 2017). Background: The action involved the relationship between several limited partnerships and limited liability companies holding indirect interests in real property. The plaintiffs are limited partners of Provident Realty Partners II, L.P. (“PRP II LP”), a New York limited partnership that was formed to, among other things, acquire, develop, manage, operate and transfer real property. PRP II Corp. is the general partner of PRP II LP. Pursuant to PRP II LP’s Limited Partnership Agreement, PRP II Corp. had a “fiduciary responsibility” to PRP II LP “for the safekeeping and use of all assets of PRP II LP” and was prohibited from “tak or permit another to take any action with respect to the assets of the Partnership which action is not for the benefit of the Partnership.” Defendant Daniel Benedict (“Benedict”) is the President and sole shareholder of PRP II Corp. On or about March 28, 2007, IMICO UN (“IMICO”) joined PRP II LP in a partnership relating to property at 303 East 46 Street, New York, New York (“the Property”). In furtherance of that venture, IMICO and PRP II LP formed 303 BRG-IMICO LLC (“303 LLC”), whose express purpose was to “acquire . . . own, hold, improve, develop, manage, insure and operate” the Property. PRP II LP is the Managing Member of 303 LLC and holds a 50% percentage membership interest in the company.  IMICO, a Delaware corporation authorized to do business in the State of New York, is the other 50% member. Pursuant to 303 LLC’s operating agreement, IMICO was prohibited from “assign , pledg , hypothecat , transfer or otherwise dispos of all or any part of interest in the Company, including, without limitation, the capital, profits or distributions of the Company without the prior written consent of as well as Members holding at least sixty-five (65%) of the Member’s Percentage Interest.” In September 2011, IMICO sold a 49.9% membership interest in 303 LLC to BRG Gramercy Units LLC (“BRG Gramercy”), a company that was owned and controlled by Benedict, for approximately $499,900 (the “Transaction”). According to the plaintiffs, the Transaction could not be effectuated without PRP II LP’s consent. The plaintiffs also maintained that IMICO’s interest in 303 LLC was illiquid but had full value to Benedict – and would have had full value to PRP LP II – since along with Benedict’s position as general partner of PRP II LP, it provided him with 100% beneficial ownership of 303 LLC and unfettered control over its affairs. In February 2013, Benedict advised the plaintiffs of the Transaction. The plaintiffs claimed that the Transaction was effected surreptitiously, without advice to, consultation with or consent of the limited partners of PRP II LP. On or about December 12, 2012, 303 LLC sold the Property for $4,100,000. The plaintiffs claimed that Benedict profited from his purchase of IMICO’s membership interest, effectively realizing in excess of approximately $600,000 from the sale of the building – which profit, claimed the plaintiffs, belonged to PRP II LP. Thereafter, Benedict caused the proceeds from the sale to be invested in BRG Office LLC (“BRG Office”) in a 1031 Tax Exchange Transaction involving the purchase of a 118,000-square foot medical office building located at 711 Stewart Avenue, Garden City, New York (“711 Stewart”). The limited partners of PRP II LP were not provided with any information or documentation concerning the ownership structure of BRG Office or the terms and details of its investment in 711 Stewart, even though PRP LP II owns 50% of 303 LLC which, in turn, owns BRG Office. The plaintiffs commenced the action as a derivative action, alleging: (a) breach of contract and breach of fiduciary duty against PRP II LP and Benedict; (b) aiding and abetting a breach of fiduciary duty against BRG Gramercy and IMICO; (c) the misappropriation of a business opportunity against all defendants; (d) unjust enrichment against PRP II Corp. and Benedict; (e) constructive trust against BRG Gramercy; and (f) an accounting. Each side moved for summary judgment. The Court’s Ruling: On the issue of whether a non-managing member of a manager-managed LLC owes a fiduciary duty to the other members of the LLC and to the LLC itself, the court declined to impose one.  The Court’s ruling was made in connection with the claim that IMICO and BRG Gramercy aided and abetted the breach of fiduciary duty by Benedict. In concluding that IMICO did not provide substantial assistance to Benedict and PRP II LP, the Court noted that IMICO’s alleged inaction was sufficient to satisfy that prong of the claim only if Benedict owed a fiduciary duty to PRP II LP.  The Court found that IMICO, as a 50% non-managing member of the LLC, did not owe a fiduciary duty to PRP II LP, the managing member. In so finding, the Court followed the reasoning in Kalikow v. Shalik , 43 Misc.3d 817 (Sup.Ct. Nassau Co. Feb. 26, 2014), and held that non-managing members of LLCs do not owe fiduciary duties to the LLC or its managing member: A non-managing member of an LLC who has a 50% interest in the LLC, such as IMICO does not owe a fiduciary duty to a managing member of the LLC or directly to the LLC. Although not binding, the court’s ruling in Kalikow v. Shalik , 43 Misc.3d 817 (Sup.Ct. Nassau Co. Feb. 26, 2014), is persuasive. In Kalikow , two sole members of an LLC had a 50% interest, with only one of the members identified as the managing member. The court held that based upon the language of New York L.L.C. Law § 409, and the absence of language related to the duty of good faith or loyalty on behalf of a non-managing member of an LLC, that non-managing members do not owe a fiduciary duty to managing members of the LLC or to the LLC itself. Accordingly, because the plaintiffs could not show that IMICO gave substantial assistance to a breach of fiduciary duty, the Court denied the plaintiffs’ motion for summary judgment and granted IMICO’s motion for the same relief. Takeaway: Landes is significant because, in the absence of appellate authority, it confirms the view that a non-managing member of a manager-managed LLC does not owe a fiduciary duty to the other members and to the LLC itself. This Blog will continue to watch for cases and authority that address this important issue.

New business owners have many decisions to make when they start a business. Many of these decisions will impact the business for years to come. Among them is the correct type of business to form. One of the most common business forms used by entrepreneurs is the Limited Liability Company (“LLC”). While LLCs share many of the same attributes as an S-Corporation or C-Corporation, they are more flexible and require less formalities and paperwork. An S-Corporation (formerly known as a “Sub section S corporation,” and commonly called an “S-Corp.”) is a corporation that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes. Shareholders of an S-Corp. report the flow-through of income and losses on their personal tax returns and are assessed a tax at their individual income tax rates. This allows an S-Corp. to avoid double taxation on the corporate income. An S-Corp. is responsible for the tax on certain built-in gains and passive income at the entity level. The S-Corp. must be a domestic corporation, and must have fewer than 100 shareholders and only one class of stock. Individuals, specific trusts and estates may be shareholders, but partnerships, corporations and non-resident aliens may not be. Additionally, specific financial institutions, insurance companies and domestic international sales companies may not file as S-corporations. A C-Corporation (sometimes called a “C-Corp.”) is a standard corporation that conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders. A C-Corp. is a separate taxpaying entity. Thus, the profits of the corporation are taxed to the corporation when earned, and then are taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any of the corporation’s losses. The legal existence of a C-Corp. is separate and distinct from its owners ( i.e. , the shareholders). This means that when the corporation is sued, shareholders are only liable to the extent of their investments in the corporation. Their personal assets are not at risk, as they would be if the business was a partnership or sole proprietorship. Any debts acquired by the corporation are considered to be the corporation’s responsibility. An LLC is a hybrid type of legal structure that provides the limited liability features of a standard corporation and the tax efficiencies and operational flexibility of a sole proprietorship or  partnership. The “owners” of an LLC are referred to as “members.” An LLC can consist of a single individual, two or more individuals, corporations or other LLCs. Forming an LLC Each state has its own requirements for the formation of an LLC. While there are differences, they all share some common principles: Name the Business . When choosing a name, new business owners should follow three general rules: (1) they cannot duplicate the name of an existing LLC in the state of incorporation; (2) they must indicate that the business is an LLC ( e.g. , “LLC” or “Limited Liability Company”); and (3) they must not use words restricted by the state of incorporation ( e.g. , “bank” and “insurance”). File the Articles of Organization . The “articles of organization” is a document that includes information about the business, such as the name, address, and the names of its members, and how the LLC will be treated for tax purposes. In most states, the articles of organization are filed with the Secretary of State. However, in other states, the articles are filed with a different office. Create an Operating Agreement . Although most states do not require an operating agreement, many lawyers strongly recommend one, especially for multi-member LLCs, because it identifies the LLC’s finances and organization, and provides the rules and regulations for the company’s operation. The operating agreement typically includes, among other things, member interests, the allocation of profits and losses, and member rights and responsibilities. Obtain Licenses and Permits . Once the business owner registers the business, he/she must obtain all required licenses and permits. Publish the Formation of the Business . Some states, such as Arizona and New York, require the business owner to publish a statement in a local newspaper about the LLC’s formation. These states have maintained this requirement, notwithstanding the availability of the information on the internet ( e.g. , the Secretary of State’s website), to put the public on notice that an entity has been formed to do business within a corporate structure that shields its owners from personal liability for the debts, obligations and liabilities of the business. Advantages Tax Benefits : The IRS does not consider an LLC to be a separate entity for tax purposes. This means that the business itself is not taxed. Instead, the LLC’s members will be taxed for the company’s profits and losses – that is the LLC receives “pass through” treatment allowing allocated profits to be taxed only once on each member’s individual income tax return (as opposed to the double tax incurred in a C-Corp.). Although the federal government does not tax the income of the entity directly, some states do.  Therefore, it is important for members to check with their accountants or their state’s income tax agency. There is also a possibility that an LLC’s member can request that the company be taxed as an S-Corp. There are advantages and disadvantages with making such an election, which are best explored with an attorney and/or an accountant. If this course is taken, the LLC remains a limited liability company from a legal standpoint, but for tax purposes it can be treated as an S-Corp. Limited Liability : An LLC is considered a legal entity separate from its individual members.  Like a standard corporation, an LLC provides its members protection from liability. This means that members are not personally liable for the LLC’s debts and judgments, unless there is no functional/operational difference between the LLC and its member(s). (This Blog discussed the consequences of this course of conduct here ). Consequently, vendors and creditors are foreclosed from pursuing the personal assets (such as a home or an individual bank account) of the LLC’s members. Individuals who form a traditional partnership or a sole proprietorship do not enjoy this protection. More Flexibility and Time to Devote to the Business : One of the benefits of creating an LLC is the time new business owners can devote to growing their business. Forming and maintaining an LLC requires less paperwork and compliance with corporate formalities than other entities.  Once registered, an LLC is not required to conform to many of the formalities of a standard corporation ( e.g. , hold an organizational meeting to elect corporate officers and draft and enact bylaws that detail the company’s internal management; hold regular meetings of the board of the board of directors; and convene an annual shareholders meeting), though compliance with some of the formalities will reduce the risk of creditors piercing the corporate veil (such as by drafting an operating agreement). Members of an LLC retain the flexibility to determine how to allocate profits under the terms of their operating agreement (members are not permitted to pay themselves a wage).  They are not limited to their percentage ownership or capital contribution.  However, whatever the agreed-upon allocation, profits may not be distributed when it endangers the LLC’s solvency or when the LLC’s liabilities are equal to or exceed its assets. Additionally, the LLC may not make a special allocation that is predicated on obtaining a tax advantage for the LLC’s members; a special allocation must be based on ownership interests and reflect a legitimate economic circumstance. Silent Investors : Like a limited partnership, members of an LLC do not have to be managers; they can be investors only, having little or no input into the company’s day-to-day operations. Under this circumstance, however, the operating agreement must provide for such investors. No Ownership Restrictions : Unlike an S-Corp., an LLC has no restriction on the domicile or number of members that can own the company. Disadvantages Limited Duration : In many states, when a member leaves an LLC, unless the operating agreement provides otherwise, the business is dissolved and the remaining members must wind down the business, decide if they want to start a new business, or part ways. Self-Employment and Other Taxes : LLC members are considered self-employed and, therefore, must pay Medicare and Social Security taxes. Many states, such as California, New York, and Texas require LLCs to pay a franchise tax or “capital values tax.” Moreover, members can be personally liable for payroll taxes that are not paid by the company. Undefined Management Roles : Unless there is an operating agreement that identifies the roles and responsibilities of the members, LLCs do not have specific managerial roles, unlike a standard corporation, which has a hierarchal management structure ( e.g. , officers, directors, managers and employees). The absence of a management structure can make it difficult for the company and creditors to know who has the authority to bind the company ( e.g. , who can enter transactions, sign checks, encumber the company, etc.).  It can also make it difficult to attract new investor money. Takeaway: Until recently, the standard corporation provided the only protection to new business owners from the risks of unlimited personal liability. With an LLC, new business owners could obtain the limited liability features of a corporation and the operational flexibility and tax efficiencies of a sole proprietorship or partnership. For these reasons, among others, millions of new business owners have registered their companies as LLCs each year. Notwithstanding, it is important for new business owners to understand how LLCs are taxed and operate in comparison to other corporate or business forms. By doing so, entrepreneurs can choose the business structure that is right for them at startup and in the future. It is important, therefore, that new business owners consult with an attorney to discuss the various formation options available to them at the early stage of their business.

In February, the Royal Bank of Scotland was hit with a $85 million civil penalty by the U.S. Commodity Futures Trading Commission ("CFTC") in connection with the bank's attempted manipulation of a benchmark tied to U.S. dollar based swap transactions over a five-year period from January 2007 through March 2012. The commodities watchdog found that RBS bid, offered and executed transactions that were pegged to the U.S. Dollar International Swaps and Derivatives Association Fix that were specifically timed to take advantage of cash-settled swap options (or "swaptions") that were priced against the benchmark. The CFTC was alerted to this conduct by a whistleblower. The enforcement action is part of an ongoing effort, in conjunction with the U.S. Securities and Exchange Commission ("SEC"), to prevent these market manipulation schemes. What is market manipulation? Market manipulation is any conduct aimed at controlling or artificially affecting the trading markets in order to deceive investors, including: Spreading false or misinformation; Inappropriately restricting the number of publicly available shares; and Rigging quotes, prices, or trades to artificially inflate demand. Under the SEC and CFTC whistleblower programs, there are a number of market manipulation schemes that may be eligible for an award, such as benchmark rates manipulation, pump and dump schemes, and so-called spoofing schemes. In particular, the manipulation of benchmark rates continues to be an area of enhanced regulatory scrutiny in the wake of the LIBOR bid rigging scandal. Whistleblower Rewards Whistleblowers who voluntarily provide the regulators with original information about violations of the federal securities and commodities laws that result in a successful enforcement action and that lead to monetary sanctions may be eligible for monetary awards from ten to thirty percent of the sanctions. Since these laws went into effect, millions of dollars has been awarded to numerous whistleblowers, whose identities are protected by the programs.  A whistleblower can report a violation anonymously, provided that he or she is represented by an attorney. Ultimately, the CFTC and SEC believe that detecting market manipulation schemes is crucial for investor  confidence in the integrity of the financial markets. If you have knowledge of a violation of the federal securities of commodities laws, an experienced attorney can advise you on how to report your concerns.

The Anti-Retaliation Provisions of The False Claims Act: The decision to blow the whistle is not an easy one to make, especially when the person blowing the whistle does so on his/her employer. A person’s career, financial security, reputation and sometimes personal safety can be at risk. This is true whether the person worked for the company that is the subject of a potential whistleblower (or “qui tam”) action. Recognizing the risks, Congress amended the False Claims Act (the “FCA” or the “Act”) in 1986 by adding employment protections to stop employers from using the threat of retaliation to keep whistleblowers quiet, and to assure those considering exposing fraud that they are legally protected from retaliatory acts. The protections extend to the whistleblower, anyone assisting the whistleblower, and anyone working with the government “in furtherance of” an action under the Act. Under the Act, any employee who is discharged, suspended, demoted, harassed, or otherwise discriminated against because he/she lawfully reported a violation of the Act is entitled to all relief necessary to make the employee whole. Such relief may include reinstatement with the same seniority status, double back pay, and compensation for any special damages sustained as a result of the retaliation, including litigation costs and reasonable attorneys’ fees. To establish a claim for retaliation, the whistleblower must engage in conduct protected by the Act. The courts require a showing that the defendant have some notice of the protected conduct that the whistleblower was either taking action in furtherance of a qui tam action, or assisting in an investigation or actions brought by the government. Complaining about an employer’s internal misconduct unrelated to false claims is not enough. Nor is it sufficient to allege a non-governmental third party was the victim of fraud. The protection against retaliation extends to whistleblowers whose allegations could support a qui tam action even if the case is never filed. Finally, the whistleblower must show that the discharge, suspension, demotion, harassment or threat was in retaliation for the protected activities. A claim of retaliation can be based upon the whistleblower claims and other violations of state and federal law, and may be brought in federal court. Endicott v. Oakbend Medical Center: On January 30, 2017, a Texas federal court dismissed a retaliation claim brought under the Act by Jana Endicott (“Endicott”), a nurse formerly employed by Oakbend Medical Center (“Oakbend” or the “Hospital”). Endicott alleged that she was fired after she blew the whistle on several hospital executives for using Medicare and Medicaid funds to operate EMR Support Group, LLC (“EMR”), a private company owned by Sue McCarty, Oakbend’s Chief Nursing Officer, and Timothy Earl McCarty, Sue McCarty’s husband and an employee in the Hospital’s IT Department. In particular, she claimed that the Hospital allowed its IT employees to perform work for EMR while being paid by the Hospital. The defendants moved to dismiss, arguing that Endicott’s alleged whistleblowing activity (an internal complaint to Oakbend) did not qualify as protected activity under the FCA because it was not aimed at matters that reasonably could lead to a viable claim under the Act. The Court agreed. The court found that Endicott was not discharged for reporting a fraud on the government: Plaintiff alleges that when she complained about Oakbend paying IT employees who were performing work for EMR, Oakbend terminated her employment. Plaintiff s internal complaints were not that Oakbend submitted false claims to the United States government, but that Oakbend improperly used funds it legitimately obtained from the government. The court concluded that “Plaintiff’s assertion that she believed this constituted fraud against the government is insufficient to state a claim of retaliation under the FCA” because “ he FCA does not … prohibit an employer from paying its employees, even those who are simultaneously performing work for a different employer, from a bank account that includes funds obtained legally and properly from Medicaid and/or Medicare.” Instead, the court said, the Act “prohibits only conduct involving false claims submitted to the United States which cause the government to suffer an economic loss.” Endicott failed to allege that the government suffered an economic loss. The case is U.S. ex. rel. Endicott v. Oakbend Medical Center , Civ. Action No. H-16-1835 (S.D. Tex.). Takeaway: Endicott teaches a simple, but valuable lesson: a whistleblower must engage in protected whistleblowing activities to succeed in a retaliation claim for damages under the Act. This means, the conduct being reported must be of the type that could reasonably lead to a viable claim under the FCA. Anything else, as Endicott learned, will not suffice.

The enforceability of a covenant not to compete is an issue that commercial and business lawyers often consider in their practice. Sometimes, the issue arises when an employee leaves a business to open his/her own shop, while other times the issue arises in the sale of a company.  On January 18, 2017, in Shimon v. Paper Enterprises, Inc. , 2017 NY Slip Op. 30101(U) , Justice Sylvia G. Ash of the Supreme Court, Kings County, Commercial Division, issued an injunction enforcing a covenant not to compete in the latter situation. Covenant Related to the Sale of a Business vs. Covenant Related to Employment: Covenant Not to Compete in The Sale of a Business A covenant not to compete, which relates to the sale of a business and its accompanying good will, is enforceable when it is reasonable in scope and duration and is not unduly burdensome. Mohawk Maintenance Co. v. Kessler , 52 N.Y.2d 276, 283-284 (1981). The purpose of the covenant in this context is to protect the purchaser’s acquisition of goodwill in the going concern. Purchasing Assoc. v. Weitz , 13 N.Y.2d 267, 271 (1963). It does so by preventing the seller from starting a new competing business in which the seller could solicit the business of former customers who would voluntarily follow the seller to the new business. Town Line Repairs, Inc. v Anderson , 90 A.D.2d 517, 517 (2d Dept. 1982). New York courts have applied this “sale of a business” rationale in cases where an owner, partner or major stockholder of a commercial enterprise had sold his/her interest for an immediate consideration which was, in part, payment for the good will of the business, in terms of “continuity of place” and “continuity of name”.   Purchasing Assoc. , 13 N.Y.2d at 271. As noted, a covenant not to compete in the sale of a business is reasonable when it is not broader in terms of time, scope and area than is reasonably necessary to protect the buyer’s interest in the going concern. Purchasing Assoc. , 13 N.Y.2d at 271. Three to five year restrictions have generally been held to be reasonable. See , e.g. , Hakakian v. Think Bronze, LLC , 2010 N.Y. Misc. LEXIS 6513; 2010 NY Slip Op 33597(U), *7 (Nassau Cty. Sup. Ct. 2010) (citing FTI Consulting Inc. v. Price Waterhouse Coopers, LLP , 8 A.D.3d 145 (1st Dept. 2004)). Whether a covenant is reasonable depends on the circumstances of each case. Karpinski v. Ingrasci , 28 N.Y.2d 45, 49 (1971). A covenant not to compete will not be declared invalid merely because it is unlimited in duration if the other restrictions on geographic area and scope are limited and reasonable. Thus, if a particular restriction is considered unreasonable, it can be severed and the covenant in its modified form can be enforced. Karpinski , 28 N.Y.2d at 51. Covenant Not to Compete in Employment Covenants not to compete pursuant to the sale of a business are not treated as strictly as those whose sole purpose is to limit employment. In the employement context, a restrictive covenant will only be subject to enforcement to the extent that it is reasonable in time and area, necessary to protect the employer’s legitimate interests, not harmful to the general public and not unreasonably burdensome to the employee. Courts in New York generally disfavor these covenants because they inhibit a “man’s livelihood” ( Purchasing Assoc. , 13 N.Y.2d at 272), as well as the flow of services, talent and ideas. The courts have determined that employers have a legitimate interest in safeguarding the information and ideas that made the business successful and protecting against commercial piracy. Id . at 274. Thus, covenants not to compete are enforceable only to the extent necessary to prevent the disclosure or use of trade secrets or confidential customer information. However, where the employee’s services are deemed “special, unique or extraordinary”, then the covenant, even if reasonable, may be enforced by injunctive relief though the employment did not involve the possession of trade secrets or confidential customer lists. Shimon v. Paper Enterprises, Inc.: Background The action arose from the purchase of Worldwide Sales & Distributing, Inc. (“WSD”) by Paper Enterprises, Inc. (“PEI”). In connection with the transaction, the parties entered into three agreements: (1) the Asset Purchase Agreement by which PEI purchased certain WSD assets and assumed certain liabilities; (2) the Employment Agreement by which PEI agreed to employ the plaintiff, Barry Shimon (the former owner of WSD), as manager of PEI’s newly formed “Retail Division” for a term of five years; and (3) the Warehousing and Services Agreement by which WSD agreed to allow PEI to store, warehouse, assemble and repackage its merchandise at WSD’s warehouse in Edison, New Jersey. The Asset Purchase Agreement contained a non-compete clause stating, in relevant part, that Shimon agreed that “for a period of five (5) years from and after the Closing Date ... he will not engage in any business similar to or which competes with the Business anywhere in the states of New York, New Jersey, Pennsylvania, Connecticut, Maryland and Delaware, directly or indirectly ....” After two years, Shimon left PEI’s employ and formed a new company in New York called “Great $ Deal Inc. (“Great Deal”). Great Deal competes with PEI. Shimon sought a preliminary injunction to prohibit PEI “from taking any action that would prevent, inhibit and/or otherwise impede ability to obtain employment and/or engage in commerce in order to support himself and his family.” Shimon claimed that PEI breached the three agreements discussed above, thereby relieving him of his performance obligations. In addition, Shimon argued that the non-compete clause was unenforceable because it was overbroad – that is, the five-year restrictive covenant contained in the Asset Purchase Agreement was unreasonable in light of the two-year restrictive covenant contained in the Employment Agreement. PEI also sought a preliminary injunction.  PEI sought to enjoin Shimon from soliciting or attempting to pursue, market or solicit the business of any PEI customers or prospective customers for a five-year period beginning with date of the transaction closing. The Court’s Decision Justice Ash denied Shimon’s motion and granted PEI’s cross-motion only to the extent that Shimon, either directly or indirectly, individually or through any person or entity, was prohibited from soliciting or attempting to pursue, market or solicit the business of any of PEI customers or prospective customers until August 27, 2017 (five years after the deal closed). In so ruling, the Court found: Here, given the undisputed facts, the Court finds that PEI has established entitlement to the injunctive relief that it seeks. First, Shimon’s contention that he is not bound by the Asset Purchase Agreement is without legal support and is otherwise without merit. Secondly, Shimon fails to provide support for his argument that the geographic scope or duration of the subject restrictive covenant is overly broad. He fails to dispute that PEI’s business extends into the six-state Territory. Accordingly, there is no basis to deem the subject restrictive covenant unenforceable. Conversely, Shimon’s application for injunctive relief must fail. Takeaway: Shimon is instructive for two reasons.  First, it demonstrates the ease with which the courts will enforce a covenant not to compete related the sale of a business. Second, it underscores the requirement that the covenant must be reasonable in scope, time and geographic location.

Last month, this Blog wrote about the uncertainty surrounding implementation of the Department of Labor’s (“DOL”) fiduciary rule.  On February 3, 2017, that uncertainty was reinforced with the issuance by President Trump of a memorandum directing the DOL to determine whether the fiduciary rule should be revised or rescinded. The memorandum directs the DOL to delay the implementation date of the rule by 180 days. What is the Fiduciary Rule? The regulations in question expanded the universe of persons who would be considered a fiduciary under the Employment Retirement Income Security Act of 1974. (Click here for this Blog’s discussion of the fiduciary rule.) In general, these regulations, which were to become effective on April 10, 2017, would have imposed a fiduciary duty on registered brokers, financial advisers, and other investment professionals (collectively, “Financial Advisors”), who provide investment recommendations for retirement accounts, such as 401(k)s, IRAs and health savings accounts. Currently, Financial Advisors have no legal obligation to act in their client’s best interest, except for those professionals who are registered as investment advisers with the Securities and Exchange Commission (“SEC”) or in individual states. Instead, Financial Advisors only have to recommend investments that are “roughly suitable” for their customer. This means, for example, that a Financial Advisor, who has a choice between two similar mutual funds, can put a customer in the higher commission and fee investment even though the other fund has lower fees and could generate higher returns. While commissions and other fees are permissible under the regulations, Financial Advisors must commit to charging “reasonable compensation” and cannot receive financial incentives to make inappropriate recommendations. This commitment is set forth in a contract provided to the client in which the advisor promises to put the client’s interests first — the “best-interest contract exemption”. Firms that employ the Financial Advisors would also have to disclose their compensation and incentive arrangements. Conflicted advice costs retirees approximately $17 billion a year, according to a 2015 report from the Obama administration. Notwithstanding, the Trump administration has indicated that it wants to keep the old system in place, arguing that the fiduciary rule will limit investment choices and burden the industry with unnecessary regulations. The President’s February 3, 2017 Memorandum: In addition to directing the DOL to delay implementation of the fiduciary rule, the memorandum directs the DOL to review and analyze the rule and prepare an economic and legal analysis “concerning the likely impact” of the rule on, among other things: “access to certain retirement savings offerings, retirement product structures, retirement savings information, or related financial advice”; the retirement services industry and whether the rule “has resulted in dislocations or disruptions … that may adversely affect investors or retirees”; and litigation and the costs borne by investors and retirees “to gain access to retirement services”. If the DOL finds any of the foregoing points to be impacted by the rule, or if it concludes “for any other reason” that the rule “is inconsistent with the priority identified” in the memorandum, then the DOL is to issue a new proposed rule that revises or rescinds the fiduciary rule. Political and Industry Opposition to the Rule: Republican lawmakers, Financial Advisors and some financial advisory firms have maintained that the fiduciary rule will restrict investment options for investors and retirees. President Trump echoed this sentiment in the memorandum, stating: “One of the priorities of my Administration is to empower Americans to make their own financial decisions, to facilitate their ability to save for retirement and build the individual wealth necessary to afford typical lifetime expenses.…” Republican lawmakers have also argued that the SEC, not the DOL, should oversee and regulate any changes related to financial firms. Many Financial Advisors and financial advisory firms have been opposing the fiduciary rule since the DOL’s approval of the final regulations, arguing the regulations could raise the costs of compliance and the costs of providing advice, thereby making it more difficult to serve lower-income clients. Some have also argued that the increase in costs will price out smaller Financial Advisors who will not be able to service smaller accounts. The Securities Industry and Financial Markets Association, the industry’s top lobby group, estimated the fiduciary rule would cost Financial Advisors and their financial service companies $5 billion to implement and another $1.1 billion annually to maintain. Additionally, business groups, including the U.S. Chamber of Commerce, the National Association for Fixed Annuities, and American Council of Life Insurers have sued to try to block implementation of the rule. (This Blog discussed these and other lawsuits here and here .) Industry Best Practices: Despite the industry’s opposition to the regulations, representatives of some financial service companies have publicly stated that they plan to change their practices to meet the standards contained in the regulations even if the rule is rescinded.  For example, Bill Morrissey, managing director of business development at LPL Financial Holdings Inc., said before the President signed the memorandum, “What investors want is more transparency and lower fees.” On January 26, 2017, Morgan Stanley said that it plans to continue with changes designed to comply with the rule, despite uncertainty over whether the regulation will be implemented. Insurers, including American International Group Inc. and Principal Financial Group Inc., previously stated that they would continue to operate as though the regulations would be implemented. Takeaway: Given the new administration’s position on regulations, it seems likely the DOL will decide to modify or rescind the fiduciary rule. To do so, however, will require new rule making – a process that could take years not months, according to some observers. In the meantime, as noted above, some financial advisory companies recognize that best practices demand compliance with the rule even if it never gets implemented. As these firms note, a fiduciary standard of care is good for the industry despite the costs, because clarity and transparency around compensation builds faith and credibility with investors and retirees. Consequently, the President’s memorandum may prove to be much ado about nothing.

Arbitration is an alternative dispute resolution mechanism that enables parties to resolve disputes without going to court. Arbitration is similar to a trial without the formalities. It is an adversarial proceeding where the parties can call witnesses and present evidence to a neutral arbitrator or panel of arbitrators. The rules of discovery and evidence are relaxed to make it a shorter and more cost-efficient process.  An attorney or retired judge, who works for a private ADR firm, conducts the proceeding.  Often, the parties select the arbitrator or panel of arbitrators. Arbitration can be binding, in which the arbitrator renders a decision that can be enforced by the courts, or non-binding, in which the arbitrator renders an advisory opinion that the parties can accept or reject. In New York, arbitration, like other alternative dispute resolution mechanisms, is valid and enforceable. Westinghouse v. New York City Tr. Auth ., 82 N.Y.2d 47, 54 (1993) (“Considerable authority thus supports the validity and enforceability of alternative dispute resolution mechanisms.”). Like many jurisdictions, New York has a strong public policy that favors arbitration. In fact, arbitration is not only favored, but encouraged “as an effective and expeditious means of resolving disputes between willing parties desirous of avoiding the expense and delay frequently attendant to the judicial process.” Id . Because of the strong public policy favoring arbitration, courts give considerable deference to arbitrators and their awards. Tullett Prebon v. BGC Fin. , 111 A.D.3d 480, 482 (1st Dept. 2013) (“awards are subject to very limited review in order to avoid undermining the twin goals of arbitration, namely, settling disputes efficiently and avoiding long and expensive litigation”). In fact, judicial review of arbitration awards is severely limited in New York. Id .  As this Blog previously noted , setting aside arbitral awards are difficult. Grounds for The Review of Arbitral Awards Upon receiving a motion to confirm an arbitration award, New York courts must confirm the award unless the movant satisfies one of the statutory reasons for modification or vacatur provided by New York Civil Practice Law and Rules Section 7511. See CPLR 7510; see also Bernstein Family Ltd. P’ship v. Sovereign Partners , 66 A.D.3d 1, 7-8 (1st Dept. 2009) (confirmation is mandatory in the absence of grounds for vacatur). The grounds for modification or vacatur under CPLR 7511 are limited.  These include: (1) “corruption, fraud, or misconduct in procuring the award”; (2) partiality of the arbitrator; (3) the arbitrator exceeded his power or imperfectly executed it; (4) failure to follow the procedures of Article 75 of the CPLR. CPLR 7511(b)(1)(i)-(iv).  Only when the record demonstrates one of the foregoing will a New York court vacate or modify an award under the CPLR. (This Blog previously wrote about the importance of a record in the context of vacating an award, here and here .) Corruption, Fraud, Or Misconduct in Procuring the Award: Under CPLR 7511(b)(1)(i), an arbitral award may be vacated or modified when the movant can demonstrate “corruption, fraud, or misconduct in procuring the award.” The party challenging an award on these grounds must establish through clear and convincing evidence that the fraud or corruption was material to the proceeding such that the challenging party could not have discovered the fraud or corruption through the exercise of diligence. See , e.g. , Matter of Klikocki (New York Dept. of Corr., Mount McGregor) , 216 A.D.2d 808, 809 (3d Dept. 1995). Vacatur is also warranted under CPLR 7511(b)(1)(i) where, for example, the arbitrator or parties engage in misconduct. For example, vacatur is appropriate when the arbitrator refuses to hear material evidence ( Goldfinger v. Lisker , 68 N.Y.2d 225, 231 (1986) (“Arbitrators must afford the parties the opportunity to present evidence”)) or conducts an ex parte communication with a party that was substantial and material to the arbitrator’s decision. Id . at 227. Partiality of the Arbitrator: CPLR 7511(b)(1)(ii) permits vacatur or modification when the arbitrator was bias or maintained an undisclosed personal relationship to one of the parties, resulting in a prejudiced decision. J.P. Stevens & Co. v. Rytex , 34 N.Y.2d 123, 129-130 (1974) (“all arbitrators before entering upon their duties should make known any relationship direct or indirect that they have with any party to the arbitration, and disclose all facts known to them which might indicate any interest or create a presumption of bias”). The mere inference of impartiality, however, is insufficient to warrant interference with the arbitrator’s award; the evidence must be stronger; it must be clear and convincing. Matter of Provenzano , 28 A.D.2d 528 (1st Dept. 1967), aff’d , J.D.H. Rest. Inc. v. New York State Liquor Auth. , 21 N.Y.2d 846 (1968). The Arbitrator Exceeded His Power or Imperfectly Executed It: Under CPLR 7511(b)(1)(iii), a movant can vacate or modify an arbitral award when the arbitrator exceeded his or her authority under the arbitration agreement. To succeed under CPLR 7511(b)(1)(iii), the movant must demonstrate that the arbitration agreement limited the arbitrator’s authority to act, and the arbitrator subsequently violated that limitation. New York City Tr. Auth. v. Transport Workers’ Union of Am. Local 100, AFL-CIO , 6 N.Y.3d 332 (2005). The same is true with regard to arbitration mandated by statute.  Vacatur will be warranted where the arbitrator fails to follow the standards and requirements of the subject statute. Forest River, Inc. v. Stewart , 34 A.D.3d 474, 474 (2d Dept. 2006). Absent an agreement or statute, however, as long as an arbitrator addresses the issue(s) submitted for resolution, vacatur will not be granted, unless the award is completely irrational – that is, the resulting award goes beyond the issues before the arbitrator . Rochester City Sch. Dist. v. Rochester Teachers Ass’n , 41 N.Y.2d 578, 583 (1977). In addition to exceeding one’s authority, an award will be vacated when the decision is irrational or is violative of a public policy. See Board of Education of the Dover Union Free Sch. Dist. v. Dover-Wingdale Teachers Ass’n, 61 N.Y.2d 913 (1984); Matter of City of Johnstown , 99 N.Y.2d 273, 278 (2002). In essence, the court must conclude, without any fact-finding or legal analysis, that arbitration of the matter is prohibited by law. Stated differently, “a court must stay arbitration where it can conclude…that the granting of any relief would violate public policy.” Matter of New York City Tr. Auth. , 6 N.Y.3d at 284 (“where a court examines an arbitration agreement or an award on its face and concludes that the granting of any relief would violate public policy without extensive fact-finding or legal analysis, courts may then intervene and stay arbitration”). Failure to Follow the Procedures of Article 75: Finally, vacatur or modification is permitted under CPLR 7511(b)(1)(iv) when the arbitrator fails to follow the procedures set forth by Article 75 of the CPLR. Article 75 affords the parties due process rights, such as: the right to be heard, the right to cross-examine witnesses, and the right to present evidence. Article 75 of the CPLR does not bind an arbitrator to the rules of evidence because arbitrators are not bound by substantive rules of law. There must be some clear, egregious, and evident prejudice to the arbitration participant in vacating under CPLR 7511(b)(iv). Mere errors of law or fact do not suffice. Kalyanaram v. New York Inst. of Tech. , 79 A.D.3d 418, 419-420 (1st Dept. 2010) (“Challenges to the sufficiency or adequacy of the evidence to support an award are not grounds for vacating the award.”). Error of Law by Arbitrator Insufficient Basis to Vacate Award: Matter of Yarmak v. Pension Financial Services Inc. On January 24, 2017, the Appellate Division, First Department issued a decision in Matter of Yarmak v. Penson Financial Services Inc. , 2017 NY Slip Op. 00433, in which the Court held that mere errors of law are insufficient grounds to vacate an arbitral award. Background Facts: The petitioner, Sarah J. Yarmak (“Yarmak”), then a customer of ChoiceTrade, a securities brokerage firm, claimed that ChoiceTrade and the respondent, Penson Financial Services, Inc. (“Penson”), an independent execution, clearing, settlement and technology firm, engaged in a number of activities that caused her financial harm, including: unauthorized withdrawals from her brokerage account; churning; failure to provide the best execution price, failure to supervise, and the failure to disclose material information. On October 28, 2011, six years after the events that gave rise to the dispute, Yarmak initiated an arbitration against ChoiceTrade, Penson, and others. Pension filed motions to dismiss on February 14 and 15, 2012. Following extensive briefing and oral argument on the motions, the arbitration panel unanimously granted the motions. Yarmak filed a motion for reconsideration, and the Panel reversed itself with respect to ChoiceTrade (finding that Yarmak’s claims against ChoiceTrade were not barred by the statute of limitations), but the Panel “decided to uphold the Dismissal of Claims against Penson Financial Services, a Texas entity . . . based on a Texas Statute of Limitations.” On January 11, 2013, while the dismissal motions were pending, Penson filed for bankruptcy protection and, in accordance with that filing, all claims against Penson were automatically stayed. The Panel did not know about the bankruptcy filing or the automatic stay at the time it issued its February 1, 2013 order or when it issued its March 28, 2013 order. Later, when the Panel learned about Penson’s bankruptcy filing, it withdrew its ruling dismissing Penson. Yarmak continued the arbitration to final hearing against the other respondents (including ChoiceTrade). Following four days of evidentiary hearings in August 2013, and another three in March 2014, the panel issued a final order dismissing the claims against all remaining respondents on the merits. It also granted ChoiceTrade’s counterclaim against Yarmak for $348,885.62 plus costs and attorneys’ fees. On December 11, 2014, upon Penson’s application, the United States Bankruptcy Court issued an order retroactively annulling the automatic stay, thereby deeming effective all FINRA orders, including the Panel’s February 1, 2013 order dismissing Penson, and its March 28, 2013 order reaffirming the dismissal of Penson on statute of limitations grounds. On January 2, 2015, Yarmak filed another motion for reconsideration with the FINRA panel and finally, on February 27, 2015, “ fter considering the pleadings, the testimony and evidence presented at the hearing, and post-hearing submissions,” the panel denied Yarmak’s claims in their entirety and reaffirmed Penson’s dismissal from the case. On May 27, 2015, Yarmak filed a petition to vacate the arbitration Award.  In her petition, Yarmak argued that vacatur was appropriate because the panel: exceeded its authority by ruling on the statute of limitations issue before the conclusion of her case in chief; exceeded its authority by applying the Texas statute of limitations as opposed to the FINRA limitations period; and failed to provide a sufficient explanation for its decision. The Supreme Court, New York County rejected each of her arguments. First, the court found that panel properly considered the statute of limitations as a basis for dismissal at the outset of the arbitration under FINRA rules. In doing so, the court noted that FINRA’s rules only discourage rulings on motions to dismiss before the conclusion of the petitioner’s case in chief, they do not prohibit a panel from considering a motion to dismiss. Second, the court found that the panel properly applied the shorter statute of limitations set forth under Texas law, noting that the abbreviated period was contractually agreed upon by the parties. “As arbitration is entirely a creature of contract law,” said the court, “the panel was free to consider … a shortened limitations period such as the one provided under Texas law pursuant to respondent’s Customer Agreement.” Finally, the court rejected the argument that the panel failed to provide a sufficient explanation for its decision. “ review of the award,” said the court, “demonstrates that the reasons provided were sufficient in that the panel explained it was applying the Texas three year statute of limitations to the claims against respondent, a Texas entity, and the six year statute of limitations to the claims against ChoiceTrade.”  The Court concluded that “ he fact that petitioner is not satisfied with explanation or would like more detail is not a basis to vacate the award.” Not surprisingly, Yarmak appealed. The Appeal: In a unanimous decision, the First Department tersely affirmed the Supreme Court’s decision. Applying the legal principles discussed above, the Court held: Even if the arbitrators’ dismissal of petitioner’s claims prior to the completion of her case in chief violated Financial Industry Regulatory Authority (FINRA) Manual rule 12504, which provides that dismissals at such an early juncture are “discouraged,” the arbitrators were entitled to interpret the rule (FINRA Manual rule 12409). In any event, any error in interpretation is a mere error of law that does not provide a basis for vacatur ( see Wien & Malkin LLP v Helmsley-Spear, Inc. , 6 NY3d 471, 479 <2006> , cert dismissed 548 US 940 <2006> ). The same holds true with respect to the arbitrators’ application of the Texas statute of limitations pursuant to the choice of law clause in the parties’ agreement. Takeaway: Yarmak exemplifies the deferential treatment given to arbitrators under New York law and the narrow grounds under which vacatur or modification is permitted under CPLR 7511.  As the title of this article says, overturning an arbitral award is not easy.

New York, NY ( Law Firm Newswire ) February 3, 2017 -  The Law Office of Jeffrey M. Haber is pleased to announce that Mr. Haber, the firm’s principal, has been published in the December 2016 edition of the Wall Street Lawyer (Vol. 20, No. 12), a West LegalEdcenter publication, ©Thomson Reuters. The article, entitled “Will the Public Disclosure Bar Be the Next Provision of the False Claims Act to Be Reviewed by the U.S. Supreme Court?”, covers the basics of the False Claims Act public disclosure bar and the split of authority among the circuits about the test used to determine whether the public disclosure bar should apply to the actions of a would-be relator. The article also discusses United States ex rel. Advocates for Basic Legal Equality v. U.S. Bank , a case that is currently before the United States Supreme Court on a petition for a writ of certiorari. Advocates for Basic Legal Equity involved the dismissal of a qui tam because of the public disclosure bar. A copy of the article is available here . About The Law Office of Jeffrey M. Haber Located in New York City, The Law Office of Jeffrey M. Haber is dedicated to representing corporations, small businesses, partnerships and individuals engaged in a broad range of business and litigation matters. For over 25 years, Mr. Haber have been involved in high-profile complex litigations and arbitrations. He has served in various roles in both individual and class action lawsuits resulting in million and multimillion-dollar settlements and awards. His practice combines the sophistication and counsel of a large national law firm with the economy, flexibility, commitment, and personal attention of a small firm. ATTORNEY ADVERTISING. © 2017 The Law Office of Jeffrey M. Haber. The law firm responsible for this advertisement is The Law Office of Jeffrey M. Haber, 708 Third Avenue, 5th Floor, New York, New York 10017, (212) 209-1005. Prior results do not guarantee or predict a similar outcome with respect to any future matter. Contact: The Law Office of Jeffrey M. Haber 708 Third Avenue, 5th Floor New York, N.Y. 10017 Tel: (212) 209-1005 Fax: (212) 209-7101 Email: info@jhaberlaw.com