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On February 21, 2017, the Supreme Court vacated the judgment in  Bishop v. Wells Fargo & Co . and remanded the case to the Second Circuit “for further consideration in light of Universal Health Servs. v. United States ex rel. Escobar ,” in which the Court recognized the implied certification theory as “a basis for liability” in False Claims Act (“FCA”) lawsuits. In Bishop , the relators, Robert Kraus and Paul Bishop (together, the “relators”), brought a qui tam action under the FCA against Wells Fargo & Company and Wells Fargo Bank, N.A. (together, “Wells Fargo”), alleging that Wells Fargo defrauded the government by falsely certifying that it was in compliance with various banking laws and regulations when it borrowed money at favorable rates from the discount window operated by the Federal Reserve (the “Fed”). The relators contended that the Fed would not have permitted the banks to borrow at those favorable rates had it known that they were undercapitalized (itself a violation of Fed rules) as a result of the fraud. The relators alleged that each time the bank borrowed money from the Fed’s Term Auction Facility, it was falsely certifying to the Fed that they were in sound financial condition. The government declined to intervene in the relators’ suit. Wells Fargo filed a motion to dismiss, which the district court granted, holding that the banks’ certifications of compliance were too general to constitute legally false claims under the FCA and that the relators had otherwise failed to allege their fraud claims with particularity. The relators appealed. The Second Circuit affirmed the district court ruling. Relying heavily on Mikes v. Strauss , 274 F.3d 687 (2d Cir. 2001), the court held that even if the allegations concerning fraudulent accounting practices were true, the relators could not connect the fraud to any implied false claim submitted to the government for payment. Bishop v. Wells Fargo & Co ., 823 F.3d 35, 48-49 (2d Cir. 2016). Because the Federal Reserve Act did not expressly condition Fed loans on compliance, it was irrelevant whether knowing the true capitalization of the banks would have caused the Fed to change its lending terms. Id . at 44 (stating that the FCA “does not encompass those instances of regulatory noncompliance that are irrelevant to the government’s disbursement decisions.”). After Bishop was decided, the Supreme Court issued its decision in Escobar . 136 S. Ct. 1989 (2016). In Escobar , the Court held that implied certification liability under the FCA may exist where the following two conditions are satisfied: (1) the defendant does not merely request payment, but also makes specific representations about the goods or services provided; and (2) the defendant’s failure to disclose noncompliance with material statutory, regulatory, or contractual requirements makes those representations misleading. (This Blog discussed Escobar here .) In response to Escobar , the relators in Bishop filed a writ of certiorari, asking the Supreme Court to revive their lawsuit. The relators argued that the Court’s confirmation of the implied certification theory of liability in Escobar abrogated the Second Circuit’s longstanding rejection of the theory. Takeaway The Court’s summary disposition in Bishop serves as a reminder to the circuit courts, especially those that did not previously recognize the implied certification theory, that the theory is viable and should be considered when properly alleged. The Supreme Court’s summary disposition in Bishop can be found here .

The New York Department of Financial Services' ("DFS") cybersecurity regulations became effective March 1, 2017, but the rules are slated to be phased in on a rolling basis 180 days after the effective date. The rules apply to financial institutions, financial services companies, insurance firms and other entities regulated by the DFS ("Covered Entities").  The rules require Covered Entities to establish and maintain cybersecurity programs in order to identify internal and external cyber risks and detect Cybersecurity Events, defined as “any act or attempt, successful or unsuccessful, to gain unauthorized access to, disrupt, or misuse an information system or information stored on such a system...that has a reasonable likelihood of materially harming any material part of the normal operations." What are the responsibilities of Covered Entities? Under the rules, Covered Entities must develop defensive infrastructure to protect their information systems and prevent the unauthorized access or use of nonpublic information stored on these systems. In addition, Covered Entities must implement policies and procedures and employee training to achieve these objectives. Covered Entities also must have a system in place to respond to cybersecurity events, mitigate adverse effects and recover from these events. There is also a strict reporting requirement that requires the DFS to be notified of an event within 72 hours of the occurrence. Beyond developing defensive capabilities, Covered Entities must be proactive and conduct periodic penetration testing and vulnerability assessments. They are also required to maintain records of internal audits, which must be available for inspection by the DFS. The DFS cybersecurity rules have additional requirements, including: Encryption of nonpublic information Establishing a third-party service provider's security policy Data retention and monitoring procedures Establishment of an incident response plan Finally, the rules mandate the identification of a Chief Information Security Officer ("CISO") to oversee and implement the cybersecurity program. The CISCO is required to report to the board of directors about the program. Thereafter, Covered Entities must submit a certification to the DFS that the board or a senior official reviewed the report and that the cybersecurity program complies with the rules. In the end, while there is a 180 day grace period and the rule is being phased in on a rolling basis, the transition periods are short, therefore it is crucial to take measures now to ensure compliance with the DFS cybersecurity rules.

An important part of any litigation is documentary discovery. As any litigant can attest, especially in complex matters, documents form the foundation of discovery plans and strategies, and, more significantly, proof at trial. Consequently, litigants must collect and preserve their documents, particularly electronically stored information (“ESI”), from the moment they are aware of their involvement in a lawsuit, or when there is a reasonable anticipation that a lawsuit may be filed. Given the importance of documents to a litigation, attorneys will typically send “litigation hold” letters to all custodians ( e.g. , their clients, opposing parties, or third parties) of documents and information, including ESI, to ensure that all steps are taken to preserve them for the litigation. These letters generally (a) identify the subject matter of the litigation and the documents and business records covered by it, (b) reinforce the duty to preserve, and (c) reinforce the ongoing duty to preserve until the lawsuit is resolved. Essentially, parties and non-parties are instructed that nothing should be deleted, removed, hidden, modified, or discarded by anyone while the litigation is pending. When a person or company withholds, alters, hides, or destroys evidence relevant to the litigation, either intentionally or negligently, it is considered “spoliation” of evidence and can lead to sanctions against the party that is guilty of spoliation including, but not limited to, dismissal of the action, striking a pleading, assessing monetary penalties, or permitting the jury to take a negative inference against the spoliating party.  The negative inference at trial can be very damaging to a party because it permits the jury to infer that there was something to hide ( e.g. , the party had a “guilty conscience”) and the missing evidence is unavailable because it negatively impacted that party’s affirmative case or defense. The Law In New York  A party that seeks sanctions for spoliation of evidence must show that the party having control over the evidence possessed an obligation to preserve it at the time of its destruction, that the evidence was destroyed with a “culpable state of mind,” and “that the destroyed evidence was relevant to the party’s claim or defense such that the trier of fact could find that the evidence would support that claim or defense.” Voom HD Holdings LLC v. Echostar Satellite L.L.C. , 93 A.D.3d 33, 45 (1st Dept. 2012) (quoting Zubulake v. UBS Warburg LLC , 220 F.R.D. 212, 220 (S.D.N.Y. 2003); Pegasus Aviation I, Inc. v. Varig Logistica S.A. , 26 N.Y.3d 543, 547-48 (2015). Where the evidence is determined to have been intentionally or wilfully destroyed, the relevancy of the destroyed documents is presumed ( see Zubulake , 220 F.R.D. at 220). On the other hand, if the evidence is determined to have been negligently destroyed, the party seeking spoliation sanctions must establish that the destroyed documents were relevant to the party’s claim or defense. The party requesting sanctions for spoliation has the burden of demonstrating that a litigant intentionally or negligently disposed of critical evidence, and fatally compromised the movant’s ability to prove a claim or defense. Utica Mut. Ins. Co. v. Berkoski Oil Co. , 58 A.D.3d 717, 718 (2d Dept. 2009) (citation and quotation marks omitted); Mendez v. La Guacatala, Inc. , 95 A.D.3d 1084, 1085 (2d Dept. 2012). Under certain circumstances, the failure of a party to institute a litigation hold or to implement any uniform or centralized plan to preserve data or even the various devices used by the key players in the transaction might demonstrate gross negligence, which would gave rise to a rebuttable presumption that the spoliated documents were relevant. E.g. , VOOM HD Holdings , 93 A.D.3d at 45; AJ Holdings Group, LLC v. IP Holdings, LLC , 129 A.D.3d 504, 505 (1st Dept. 2015).  Sanctions for discarding items in good faith and pursuant to a company’s normal business practices are inappropriate in the absence of pending litigation or notice of a specific claim. See , e.g. , Conderman v Rochester Gas & Elec. Corp. , 262 AD2d 1068 (4th Dept. 1999); Gogos v. Modell’s Sporting Goods, Inc. , 87 A.D.3d 248 (1st Dept. 2011)). However, where the party failing to preserve evidence is placed on notice of litigation within or before the time period when the requested evidence is subject to automatic destruction, a sanction will be appropriate. See Strong v. City of N.Y. , 112 A.D.3d 15 (1st Dept. 2013). Ferrara Bros. Bldg. Materials Corp. & Best Concrete Mix Corp. v. FMC Constr. LLC In Ferrara Bros. Bldg. Materials Corp. & Best Concrete Mix Corp. v. FMC Constr. LLC , 2016 N.Y. Slip Op. 26362 (Sup. Ct. Queens Co. 2016), the Court assessed a discovery sanction against the defendant for the improper destruction of ESI during the pendency of the litigation. Background Ferrara Bros . involved a claim by the plaintiff, Ferrara Bros. Bldg. Materials Corp. & Best Concrete Mix Corp. (“Ferrara”), that the defendant, Casa Redimix Concrete Corp. (“Casa”), interfered with its contract with the defendant FMC Construction LLC (“Construction”) to provide cement for a construction project, thereby causing it to lose prospective profits from the job. Casa claimed that it did not know of the existence of the contract between Ferrara and Construction. Ferrara alleged that Casa purposely backdated its contract with Construction to give the impression that it was entered into prior to Ferrara’s contract rather than after Casa’s principals became aware of Ferrara’s contract. Ferrara claimed that electronic data, such as metadata, would reveal the true generation dates and revision histories of the documents. Ferrara sought ESI from the defendants, specifically metadata that would reveal the dates on which the defendants prepared, modified, and executed their contract.  In response to the request, Casa provided an affidavit from an information technology specialist, who claimed that two years after the case was commenced, the computers on which the native information was stored had been replaced and discarded to update Casa’s computer system. Significantly, the update was not done through an automatic process. Ferrara moved for sanctions against Casa for the spoliation of evidence. Because there was no issue that the computer system was destroyed during the pendency of the lawsuit, the only issues before the Court were “whether Casa knew or should have known that the computers would have evidence relevant to the case, whether the plaintiff’s delay waived its right to demand the subject electronically stored information, and what sanction, if any, an appropriate exercise of the Court’s jurisdiction.” The Court’s Ruling As an initial matter, the Court rejected Casa’s argument that Ferrara waived its right to request the ESI ( i.e. , the metadata) due to the passage of time, noting that there was no case authority “that stands for the proposition that a party may discard relevant evidence during the pendency of a litigation if opposing counsel waited until years later in the lawsuit to request it.” Having disposed of the waiver argument, the Court addressed whether the requested ESI was relevant to Ferrara’s claim and whether Casa wrongfully destroyed it. As to the former inquiry, the Court determined that the requested ESI ( i.e. , the metadata showing “the date and time of creation” of the contract) were “relevant to the case at bar” and that Casa failed to rebut the presumption of relevance. In fact, Casa failed to rebut the presumption that it “was negligent, even grossly negligent, in failing to suspend its destruction of the computer system on which the contract in question was generated.” Thus, as to the latter, the Court found that, considering the parties were in litigation at the time of the request, Casa “knew or should have known, even absent a specific demand by the plaintiff, that the creation and modification of the contract, via the defendant’s computer system, would bear upon the parties’ dispute.” Given such knowledge, Casa had an obligation to preserve the ESI and its failure to do so subjected it to sanctions. Noting that the “the lynchpin for spoliation sanctions under New York law, is prejudice” (citation omitted), the Court found that, although Ferrara was prejudiced by the destruction of the system and the consequent inability “to include a forensic analysis of the metadata, to demonstrate … that the … contract was created at a time when had notice of contract with” Construction, it could still present testimonial evidence. As a result, the Court sanctioned Casa by assessing “a negative inference at trial, … to strike balance between the need to ameliorate any prejudice related from the destruction of the computer system, and the absence of demonstrable wilfulness on the defendants’ part.” Takeaway The importance of preserving evidence at the outset of litigation, or in anticipation of litigation, cannot be underscored enough.  While Casa may have needed the computer system upgrade, a litigation hold and periodic reminders of the requirement to preserve evidence would have put it on notice that such an upgrade would expose it to discovery sanction. As Ferrara shows, courts will impose a duty on litigants to have litigation holds in place to ensure that all relevant evidence is preserved, and that the failure to do so can result in sanctions.

Your client is engaged in negotiations to sell his company’s widgets in a purchase and sale transaction. After months of negotiations, the parties verbally agree to the salient terms of the transaction – that is, they agree to price, quantity, and specifications. You summarize these terms in an email on the same day. Your email also confirms that a formal contract will follow. The following day, you send the contract to the buyer and its counsel. The agreement contains the agreed upon material terms, but also includes terms and conditions not discussed over the phone, such as a forum selection/choice of law provision, a waiver of warranty provision, a notice of claim provision, and a merger clause. In your email communication to which the agreement and the accompanying terms and conditions are attached, you inform the buyer and its counsel that they have 48 hours to comment on, or object to, any provision in the contract, including the additional terms and conditions. The deadline passes without objection. Subsequently, a dispute arises over your client’s delivery of widgets in accordance with the specifications in the contract. Rather than send your client notice of the dispute as required by the contract, the buyer sues your client for breach of contract. The foregoing scenario forms the basic fact pattern in Lion Copolymer, LLC v Kolmar Ams., Inc. , 2017 N.Y. Slip Op. 01307 (1 st Dept. Feb. 21, 2017).  As discussed below, Lion Copolymer stands for the proposition that the subsequent confirmation of a verbal agreement by a formal contract containing additional terms and conditions does not negate or modify the original agreement. Background On July 19, 2011, the defendant Kolmar Americas, Inc. (“Kolmar”) and the plaintiff Lion Copolymer, LLC (“Lion”) entered into an agreement whereby Kolmar agreed to sell and Lion agreed to buy 3,000 to 3,500 metric tons of butadiene (a raw material required to manufacture synthetic rubber) (“Butadiene” or the “Product”) for $2.12 per pound. The Butadiene was to be shipped within Exxon Import Specifications to “CFR Baton Rouge, LA (ACT Terminal) via ‘Arctic Gas.’” The parties negotiated the Butadiene purchase by phone. Upon reaching agreement on quantity, price, and shipping specifications ( i.e. , “the major details of the agreed-upon deal”), Kolmar e-mailed Lion on July 19, 2011, to summarize those contractual terms and confirm that a “formal contract follow.” The following day, Kolmar sent Lion the formal contract, which embodied the parties’ full agreement and set forth Kolmar’s Transaction Confirmation (the “Confirmation”) and General Terms and Conditions (“GT&Cs”) (the Confirmation and GT&Cs together are referred to as the “Contract”). The Contract included provisions that were not discussed over the phone. These terms included, among others, that: (1) Kolmar would deliver Butadiene, at loading, that met certain defined specifications, including quality and quantity; (2) title and risk of loss passed to Lion upon loading of the Butadiene aboard the ocean vessel; (3) in the event of any challenge to the quality of the Butadiene that was loaded onto the ocean vessel, Lion was required to provide written notice to Kolmar no later than five (5) calendar days after loading of the Butadiene onto the vessel commenced; and (4) any claims regarding  the quality of the Product were to be submitted to Kolmar in writing with supporting documentation within 90 days of the Product having been loaded aboard the vessel or the claims would be forever “waived and barred.” In addition, the Confirmation contained a forum selection/choice of law provision, a waiver of warranty provision, and a limited liability for damages provision. The Confirmation also contained a merger clause, which specifically provided that it, and the GT&Cs, “constitute the Parties’ full and entire understanding of the sales transaction and may not be contradicted by evidence of any prior agreement or of a contemporaneous oral agreement.” The Confirmation further provided that the “terms of the sales transaction as expressed in this Confirmation will be deemed irrevocably accepted” by Lion unless Lion provided written notice to Kolmar of any errors or omissions to the sales terms within 48 hours of the Confirmation being sent. During discovery, a Lion senior officer testified that the company (i) received the Confirmation and GT&Cs, (ii) understood that the Confirmation and GT&Cs would become part of the Contract if Lion did not object within 48 hours, and (iii) did not object to any of the terms and conditions in the Confirmation and GT&Cs. Between July 27, 2011 and August 5, 2011, Kolmar arranged for several quantities of Butadiene to be loaded aboard the ARCTIC GAS near Flushing, Netherlands. An inspection of the Butadiene revealed, however, that the Butadiene did not meet the specifications set forth in the Contract. On August 22, 2011, the ARCTIC GAS arrived at ACT Terminal Baton Rouge to discharge the Butadiene. On August 30, 2011, Exxon purchased the Butadiene from Lion for $8,879,260.53. In October 2011, Lion submitted a claim against its cargo insurer for $7,955,239.92, representing the difference between the Exxon purchase price and the amount that Lion paid to Kolmar under the Contract. Although the Butadiene did not meet the specification’s in the Contract, Lion did not: (1) send notice in writing, or in any other form, rejecting the Butadiene loaded aboard the ARCTIC GAS, (2) provide Kolmar with any notice that the Butadiene failed to conform to the Contract, and (3) provide Kolmar with written notice of a claim, or any documentation supporting such a claim, at any time before the lawsuit was filed in June 2012. In its complaint, Lion asserted causes of action for breach of contract, negligence and breach of implied warranties related to its purchase of the Butadiene. On October 9, 2015, Kolmar moved for summary judgment on Lion’s causes of action. On April 21, 2016, the motion court granted Kolmar’s motion with respect to Lion’s causes of action for negligence and breach of implied warranties, and denied Kolmar’s motion with respect to Lion’s cause of action for breach of contract. The parties appealed. The First Department’s Ruling The First Department unanimously modified the motion court’s ruling with regard the breach of contract claim to grant Kolmar’s motion. The Court otherwise affirmed the motion court’s decision. The Court found that the “Confirmation and terms and conditions provided by defendant Kolmar Americas, Inc. (Kolmar) formed the parties’ contract.” The fact that the “forum selection, waiver of warranty and notice of claim provisions” came after the salient terms were agreed to over the phone “did not constitute a material alteration such as would require Lion’s consent for enforcement.” Consequently, the notice provision in the Contract controlled. Having determined that the terms and conditions in the Contract controlled the parties’ actions, the Court found that Lion’s failure to comply with it constituted a breach of contract: Kolmar established Lion’s failure to comply with the notice of claim provision. Lion’s assertion that it complied with the two year requirement does not negate its obligation to provide an initial notice of claim within 90 days of discharge. In the absence of a timely notice of claim, Lion is barred from bringing its breach of contract claim, regardless of the questions raised regarding whether the butadiene was nonconforming when it was loaded onto a ship in the Netherlands and whether the butadiene testing in the Netherlands contained manifest errors. As result, the Court reversed the motion court’s denial of Kolmar’s summary judgment motion as to Lion’s breach of contract claim. Takeaway Lion Copolymer is notable for its treatment of contract formation and whether the parties had a meeting of the minds when they agreed to the transaction. As discussed above, where the parties agree on the major terms of a transaction and later confirm those terms in writing, the fact that additional terms and conditions are added to the writing does not negate or modify enforcement of those terms. In fact, the new provisions in the subsequent writing will constitute a part of the parties’ original agreement when no party objects to them.

Over the past few weeks, this Blog has explored the advantages and disadvantages of forming a limited liability company (“LLC”), as well as the fiduciary obligations of non-managing members in manager-managed LLC to each other and the LLC itself ( here and here ). In today’s installment, this Blog will explore the circumstances under which a member in a multi-member LLC can obtain a judicial dissolution of the company. The Law Governing the Dissolution of an LLC   An LLC is a hybrid business entity 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. In New York, LLCs are governed by the Limited Liability Company Law (“LLCL”). There are two fundamental principles underlying the LLCL: (1) members can structure and operate the company as they see fit through the LLC’s articles of incorporation and operating agreement; and (2) unless the operating agreement provides otherwise, members wishing to dissolve the company can avail themselves of the LLCL’s dissolution procedures. Article 7 of the LLCL governs dissolution of an LLC. Under Section 701(a), an LLC will be dissolved and its affairs wound up upon the first to occur of the following: a) the latest date provided in the articles of organization or the operating agreement; if no date is specified, then the existence of the LLC is perpetual; b) the happening of events specified in the operating agreement; c) the vote or written consent of at least a majority in interest of the members (subject to the provisions in the operating agreement); d) at any time there are no members in the LLC, unless a legal representative of the last remaining member agrees in writing within 180 days to continue the LLC and to the admission of the legal representative as a member; and e) the entry of a decree of judicial dissolution pursuant to LLCL §702.  Section 702 applies only when the articles of incorporation and/or the operating agreement do not provide the circumstances under which the LLC will be dissolved. Section 702 of the LLCL empowers a court to dissolve an LLC “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” The LLCL does not define the term “not reasonably practicable.” Judicial dissolution under Section 702 is a drastic remedy. E.g. , In The Matter of Dissolution of 1545 Ocean Ave., LLC , 72 A.D.3d 121, 131 (2d Dept. 2010). For this reason, New York courts strictly apply the standard set by Section 702. Matter of Horning v. Horning Constr., LLC , 12 Misc. 3d 402, 413 (Sup. Ct. Monroe Co., 2006).  As the Horning court observed: “Where the evidence does not demonstrate that it is not reasonably practicable to carry on the business in the circumstances (Limited Liability Company Law § 702), the court’s discretion, conferred by statute only, is not invoked and the petition must be dismissed.” Id . at 411 (footnote omitted). In considering dissolution, LLCL § 702 requires the court to first examine the company’s operating agreement to determine whether it is not “reasonably practicable” for the company to continue to carry on its business in conformity with the operating agreement. 1545 Ocean Ave., LLC , 72 A.D.3d at 128. Where the operating agreement does not address the issue of member withdrawal or dissolution, the petitioning member is bound by the requirements set forth in the LLCL § 702. 1545 Ocean Ave., LLC , 72 A.D.3d at 128. To satisfy the “not reasonably practicable” standard of Section 702, New York courts have required the member seeking dissolution to establish that: (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible. E.g. , 1545 Ocean Ave., LLC , 72 A.D.3d at 131. Common Reasons for Seeking Judicial Dissolution The reasons advanced by petitioners wanting to dissolve an LLC are limitless. Some reasons fit comfortably in the standard set by Section 702 of the LLCL, while others do not. Regardless of the reason advanced, as noted, the petitioner must satisfy the “not reasonably practicable” standard. Below are some of the more common reasons advanced by petitioners to dissolve an LLC. Frustrated Purpose . A member may petition for dissolution because the stated purpose of the LLC can no longer be fulfilled. For example, the stated purpose of an LLC may be frustrated if the company was formed to market and sell light fixtures to a particular company and it loses its operative asset – the sales and marketing agreement with that entity. Similarly, the stated purpose of an LLC may be frustrated if the company was formed to develop and market technology that has become obsolete. Member Breach . A member may petition for dissolution because of a breach of the operating agreement by another member, or because the other member has failed to perform as expected and has not lived up to the benefit of the bargain made by the members. Discord and Dissention . Internal discord and dissention is generally the most common reason for LLC members to seek judicial dissolution.  For example, a member may petition for dissolution because the members cannot agree on the LLC’s strategy and current operations, or on the terms and conditions for raising and using operating capital. Importantly, discord and dissention between and among members is not by itself sufficient to warrant the exercise of judicial discretion to dissolve an LLC that operates in a manner within the contemplation of its purposes and objectives as defined in the articles of organization and/or operating agreement. See , e.g. , Matter of Natanel v Cohen , 43 Misc 3d 1217(A), 2013 N.Y. Misc. LEXIS 2900 *12-13 (Sup. Ct. Kings Co. 2014). As discussed below, it is only where discord and dissention are shown to be inimical to achieving the purpose of the LLC will dissolution under the “not reasonably practicable” standard be considered by the court to be an available remedy to the petitioner. Abandoned Business . A member may petition for dissolution of the LLC because the other members abandoned the business or the company has stopped conducting the business stated in the operating agreement. Deadlock . A member may petition for dissolution of the LLC because the members are deadlocked in the management of the company’s affairs. In this regard, the deadlock is such that they are unable to break the impasse, and irreparable harm to the company is threatened or being suffered, e.g. , the business and affairs of the company can no longer be conducted, or be conducted to the advantage of the company’s members because of the deadlock. Member Misconduct . A member may petition for dissolution of the LLC because another member engaged in serious misconduct, mismanagement, illegality or fraud, or because a member owning a majority share of the company abused or exceeded his/her authority granted under the operating agreement. A Case Study in Judicial Dissolution: Severe Discord Found To Satisfy The Standard of  LLCL § 702 On February 16, 2017, Justice Timothy J. Dufficy of the Supreme Court, Queens County, Commercial Division issued a decision concerning an application to dissolve an LLC under Section 702 of the LLCL. In In the Matter of The Dissolution of 47th Road LLC, a New York Limited Liability Company , 2017 NY Slip Op 50196(U), Justice Dufficy granted the application because the discord between the members was so severe, the LLC could not achieve its operating purpose. Background The case involved the application to dissolve 47th Road LLC, a New York limited liability company owned by two brothers, Vincent Cortazar and James Cortazar. Each brother had a 50% ownership interest in the company. The sole asset of 47th Road, LLC was a residential, four story walk-up apartment building with eight separate units occupied by tenants, having a fair market rental value of approximately $160,000 per year. The apartment building is located in Long Island City, New York. In February 2011, the brothers borrowed $1,200,000 from Hudson Valley Bank (now Santander Bank) to purchase approximately one hundred acres in Rio Del, California. The loan was secured by a $1,200,000 mortgage on the Long Island City property. Unbeknown to Vincent, the California property was titled in his brother’s name only. When Vincent found out about the ownership of the property, he and his brother had “a physically violent confrontation.” In addition to cutting Vincent out of the ownership of the California property, James locked his brother out of the company’s day-to-day operations, claiming that Vincent mismanaged the Long Island City property. With his brother out of the way, James collected the rents from the apartments, but did not pay down any of the indebtedness of the mortgage. On March 1, 2016, the Santander mortgage loan matured. As a result, all amounts due under the note became due and payable. However, James refused to pay the mortgage. Consequently, the property went into foreclosure. In addition to the foreclosure proceeding, there were numerous violations against the Long Island City property, amounting to over $33,000, as well as unpaid taxes, all of which jeopardized the economic feasibility of continuing the corporate existence of 47 th Road, LLC. Finally, during the past few years, the brothers have asserted claims against each other in New York courts, as well as courts outside the state, seeking various forms of relief, including an application by Vincent to dissolve the company. Court’s Ruling The court granted the application to dissolve the company and appointed a receiver to wind down its business and operations. As an initial matter, the court looked to the company’s operating agreement to see if there was any provision governing dissolution. Noting that the operating agreement only stated that the company’s business purpose was to operate an eight-unit residential apartment building in Queens County, N.Y., the court found that there was insufficient guidance on whether it was reasonably practicable for the company to continue to carry on its business operations. Given the broadly defined business purpose of the company, the court looked to the law under Section 702 of the LLCL. As noted above, to successfully petition for the dissolution of an LLC under LLCL § 702, the petitioning member must demonstrate, the following: 1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved; or 2) continuing the entity is financially unfeasible. E.g. , 1545 Ocean Ave., LLC , 72 A.D.3d at 131. The court found that Vincent satisfied this standard: Disputes between members are alone not sufficient to warrant the exercise of judicial discretion to dissolve an LLC that is operates in a manner within the contemplation of it purposes and objectives as defined in its articles of organization and/or operating agreement. It is only where discord and disputes by and among the members are shown to be inimical to achieving the purpose of the LLC will dissolution under the “not reasonably practicable” standard imposed by LLCL § 702 be considered by the court to be an available remedy to the petitioner. In the case at bar, the dissension among the parties has driven the company’s only asset into foreclosure. There are numerous outstanding violations on the property, and the respondent has collected the rents without making repairs, paying the violations, or the mortgage. There are other lawsuits in this and other states between the protagonists. Due to the violent relationship between the two managers, the company will be unable to achieve its purpose of operating an apartment building. The parties seem willing to permit the building to be foreclosed rather than cooperate with each other in the decision-making process. In short, the Court finds that it is not reasonably practicable to carry on the business. Citations omitted. Conclusion Obtaining a judicial decree dissolving an LLC is not easy. 47th Road LLC shows how dysfunctional the relationship between members must be before the court will dissolve the company. Remember, in 47th Road LLC , the discord was so extreme, the brothers came to physical blows and allowed the company’s only asset to go into foreclosure. But, until that point, to the outside world, 47th Road LLC was a viable company –  a prior court declined to dissolve the company because of the inability to demonstrate financial unfeasibility. Aside from highlighting the difficulties in obtaining a judicial dissolution under the LLCL, 47th Road LLC is instructive because it underscores the importance of negotiating and drafting an operating agreement that includes a provision governing how members can exit the LLC. While not every situation demands consideration of exit provisions at the outset of the company, the parties to the operating agreement should understand the consequences of that decision and the risk that they may not be able to agree on dissloution terms at a later date. As the preceding discussions show, reliance on the judicial dissolution provision in the LLCL may not be warranted considering the difficulties satisfying the standard required to obtain such relief.

This Blog has previously written about the bases upon which the losing party in an arbitration can challenge the award. ( Here .) Among the bases discussed include the arbitrator’s impartiality and his/her authority to hear the dispute and rule on the matter. What happens when a party to an arbitration is unhappy with the rulings and the proceeding before an award is issued? Can the unhappy party challenge the fairness of an ongoing proceeding, and, more particularly, the independence and fairness of the arbitrators and their rulings? In Habliston v. FINRA Regulation, Inc. , No. 15-2225 (D.D.C. Jan. 27, 2017), a federal judge in the District of Columbia held that challenges to an ongoing arbitral proceeding are premature and not ripe for judicial review. Background The case arose from an arbitration between the claimants Anna Morton Young Habliston and Seymour R. Young, Jr. (collectively, “Habliston”) and the respondent Wells Fargo Advisors, LLC concerning the claimants’ deceased parents’ brokerage accounts.  Dissatisfied with the rulings in the arbitration, Habliston brought the action against FINRA Regulation, Inc. (“FINRA Regulation” or “FINRA”), alleging that it failed to provide a fair arbitration forum “because the arbitrators are biased, and their procedural rulings to date have been unfair; that FINRA Regulation has failed to carry out its regulatory duties properly; and that the binding arbitration provisions contained in the brokerage contracts are void or unenforceable.” Slip op. at 2 (footnotes omitted). Habliston sought damages under 42 U.S.C. § 1983, and the appointment of new arbitrators to hear the pending arbitration. Defendant’s Motion FINRA moved to dismiss the complaint pursuant to Federal Rules of Civil Procedure 12(b)(1), 12(b)(6), 12(b)(7), and 12(h)(3), arguing, among other things, that: (a) the claims were premature since the arbitration was ongoing; (b) FINRA was immune from suit under the doctrines of arbitral and regulatory immunity; (c) FINRA was not a state actor for purposes of 42 U.S.C. § 1983; (d) the Securities and Exchange Act (the “Act”) does not create a private right of action for alleged violations of the rules enacted under the Act; and (e) the request for new arbitrators was moot because FINRA had already replaced the arbitrators. Id . at 2-3. The plaintiffs did not oppose many of FINRA’s arguments. Consequently, the court considered the motion to be “largely conceded.” However, as to the issues for which the plaintiffs put in an opposition ( e.g. , arbitral immunity, whether FINRA was a state actor for purposes of 42 U.S.C. § 1983, and whether the claim was premature), the court granted the motion, concluding that Habliston’s claims were “not ripe for review, and that defendant entitled to arbitral immunity.”   Id . at 3. The Court’s Ruling As an initial matter, the court addressed Habliston’s failure to address all the arguments raised by FINRA’s motion. The court held that “ hen a plaintiff fails to address arguments made in a defendant’s motion to dismiss, the Court may treat those arguments as conceded.” Id . at 7 (internal quotation marks and citations omitted). Because Habliston failed to address many of FINRA’s arguments, the court treated the motion on those grounds “as conceded” and dismissed the claims that corresponded to them. Id . at 8. Regarding Habliston’s claim that FINRA denied them their due process and equal protection rights (Habliston alleged that FINRA “violated its duty to act objectively and impartially” and acted with the “intent to prejudice” them by influencing “the objectivity and impartiality” of FINRA’s arbitrators), the court found that the claims were not ripe for review.  Noting that the ripeness doctrine is rooted in Article III standing and the “fitness of the issues for judicial decision and the hardship to the parties of withholding court consideration” (citation and internal quotation marks omitted), the court concluded that Habliston did not (and could not) demonstrate any actual injury since the arbitration was ongoing and could result in an award favorable to them: Since the arbitration is still ongoing, plaintiffs’ challenge to the proceeding is not ripe for review. For Article III purposes, plaintiffs cannot demonstrate that they have suffered an actual injury, or that any harm is “imminent or certainly impending.” And prudential considerations favor dismissal as well. While plaintiffs express fear that they will not receive an objective hearing, and they take issue with certain interlocutory procedural rulings such as the denial of the requested discovery and the postponement of hearing dates, the arbitration has not yet concluded, and the outcome - which could be in plaintiffs’ favor - is unknown. So any alleged bias on the part of FINRA Regulation’s arbitrators has not yet produced any adverse consequences, and the record upon which one would determine whether plaintiffs’ constitutional rights have been violated has not yet been developed. Id . at 10-11. (Citations omitted.) Because Habliston’s constitutional claims were deemed not ripe for review, the court declined to decide whether FINRA was a “state actor” for purposes of Section 1983. Nevertheless, in a lengthy footnote, the court concluded that the claim would fail because Habliston did not claim that FINRA acted under state law. In fact, Habliston alleged that FINRA acted “under federal laws” and in violation of “FINRA Rules.” Consequently, as other courts within the jurisdiction had held, FINRA, or its predecessors, were not “state actors” for purposes of a Section 1983 claim.  Id . at n.9. Regarding arbitral immunity for FINRA, the court found that such immunity was conferred on the organization.  Noting that the D.C. Circuit had not yet decided the issue, the court found that FINRA enjoyed such immunity: The doctrine of arbitral immunity “rests on the notion that arbitrators acting within their quasi-judicial duties are the functional equivalent of judges, and, as such, should be afforded similar protection.” As the Sixth Circuit noted in Corey , failing to extend immunity to the boards sponsoring the arbitrators would render the immunity “illusionary” because “ t would be of little value to the whole arbitral procedure to merely shift the liability to the sponsoring association.” Consistent with the purposes of arbitral immunity, the Court will extend the immunity to FINRA Regulation here. Id . at 13. (Citations omitted.) This finding, said the court, was consistent with the decisions in a majority of the circuits, which have “extended arbitral immunity to cover not only the individual arbitrator, but the arbitration forum as well.” Id . at 12. The court found the reasoning of the other circuits “persuasive.” Id . at 13. Takeaway The purposes underlying the ripeness doctrine underscore the correctness of the court’s decision: “to prevent the courts, through avoidance of premature adjudication, from entangling themselves in abstract disagreements over administrative policies, and also to protect the agencies from judicial interference until an administrative decision has been formalized and its effects felt in a concrete way by the challenging parties.” Id . at 9 (citation omitted). Parties to an arbitral proceeding undermine these purposes if they are permitted to challenge the proceeding merely because “they are extremely dissatisfied with how it is going so far.” Id . at 1. Moreover, the judicial endorsement of arbitration “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” ( Westinghouse v. New York City Tr. Auth. , 82 N.Y.2d 47, 54 (1993)) would be rendered meaningless if arbitrators and arbitral forums were not given absolute immunity from civil liability in performing their quasi-judicial duties. As the court in Habliston noted, “ bsolute immunity is thus necessary to assure that judges, advocates, and witnesses can perform their respective functions without harassment or intimidation.”   Id . at 11 (citations omitted).

In a case of first impression for the courts within the Second Circuit, Judge Richard J. Sullivan of the United States District Court for the Southern District of New York answered the foregoing question: no. United States v. L-3 Commc’ns Eotech, Inc. , No. 15-cv-9262 (RJS) (S.D.N.Y. Feb. 3, 2017). An Overview of the False Claims Act and the Whistleblower Reward The False Claims Act (“FCA” or the “Act”) prohibits businesses and individuals from defrauding the government by knowingly presenting, or causing to be presented, a false claim for payment or approval. Violations of the Act can result in a judgment equal to three times the losses sustained by the government, plus civil penalties for each false claim. The FCA requires the whistleblower (also known as a “relator”) to serve the government with his/her complaint and a “written disclosure of substantially all material evidence and information possesses.” 31 U.S.C. § 3730(b)(2). The complaint must be filed ex parte and remain under seal for at least 60 days, and within 60 days of receiving “both the complaint and the material evidence and information,” the government “may elect to intervene and proceed with the action.” Id . “Before the expiration of the 60-day period or any extensions” of that period for good cause, the government must choose between intervening and proceeding with the qui tam action itself, or declining to intervene, in which case the relator has the right to conduct the action. Id . § 3730(b)(4). “From its enactment, the FCA has encouraged private citizens to report fraud by promising a percentage of any eventual recovery.” Bishop v. Wells Fargo & Co. , 823 F.3d 35, 44 (2d Cir. 2016). A person who brings a successful “qui tam” action can receive between 15% and 30% of the government’s recovery depending upon whether the government intervenes in the action. If the government intervenes, the award generally falls between 15% and 25% of the government’s recovery. If the government declines to intervene and the whistleblower pursues the action alone, the award generally falls between 25% and 30% of the government’s recovery. In addition to the intervene-or-abstain options set forth above, the FCA permits the government to pursue other available remedies, while preserving the relator’s right to share in the proceeds of those remedies under certain circumstances. Specifically, the FCA provides that, “ otwithstanding <31 u.s.c. § 3730(b)> , the overnment may elect to pursue its claim through any alternate remedy available to the overnment, including any administrative proceeding to determine a civil money penalty.” Id . § 3730(c)(5). If the government pursues such an “alternate remedy,” the relator retains “the same rights in such proceeding as would have had if the action had continued under this section.” Id . L-3 Communications Eotech, Inc. Background The case arose from the motion by Milton DaSilva (“DaSilva”), a relator who voluntarily dismissed his qui tam complaint without prejudice before the government filed its action, for a declaration that he was entitled to a share of the government’s $25.6 million settlement with the defendants under Section 3730(c)(5) of the FCA. The Court denied DaSilva’s motion. Facts of the Action DaSilva worked as a quality control engineer at EOTech, Inc. (“EOTech”) from May 14, 2013 until June 25, 2013, when EOTech terminated his employment. On August 13, 2013, DaSilva made pre-filing disclosures to the government regarding EOTech’s production and sale of defective weapon sights in violation of the FCA. After discussions with the government regarding his allegations broke down, DaSilva filed a qui tam complaint under seal on April 25, 2014, asserting claims under the FCA and various state statutes on behalf of himself, the United States, the State of New York, the State of California, and the City of Los Angeles. On August 19, 2014, with the government’s consent, DaSilva voluntarily dismissed his qui tam action without prejudice. Approximately two weeks later, the court dismissed DaSilva’s qui tam action without prejudice and directed that the case remain under seal. On November 24, 2015, more than one year after DaSilva’s complaint was dismissed without prejudice, the government filed a complaint against EOTech, L-3 Communications (“L-3”), and Paul Mangano, for violations of the FCA and various state laws. One day later, the parties filed a stipulation of settlement and dismissal settling the government’s claims for $25.6 million. The Motion for Declaratory Relief On April 14, 2016, DaSilva filed a motion for declaratory relief, seeking a declaration that he was entitled to a share of the government’s settlement proceeds under Section 3730(c)(5) of the FCA because the settlement was an “alternate remedy” to pursuing the action initiated by DaSilva. The government opposed the motion arguing that because DaSilva voluntarily dismissed his qui tam action, the government’s own action was not an “alternate” to pursuing DaSilva’s action, and thus DaSilva had no right to share in the government’s recovery. The Court agreed with the government. The Court’s Decision Noting that the issue before the court had not been decided by the courts within the Second Circuit, Judge Sullivan explained that the framework of the FCA “unambiguously preclude recovery” sought by DaSilva: By beginning with the phrase “ otwithstanding subsection (b),” Section 3730(c)(5) makes clear that the “alternate remedy” described in that section is an “alternate” to the government’s options listed in Section 3730(b). Specifically, Section 3730(c)(5) governs the relator’s rights when the government “elect to pursue its claim through any alternate remedy,” 31 U.S.C. § 3730(c)(5) - that is, an “alternate” to the remedies set forth in Section 3730(b)(4), which are limited to (a) intervening and “proceed with the action” or (b) “declin to take over the action” and providing the relator with “the right to conduct the action,” 31 U.S.C. § 3730(b)(4). Slip op. at 7. Under this framework, said Judge Sullivan, it was “clear” that “when there is no  qui tam  action for the government to ‘take over,’ the government’s filing of its own action is not an ‘alternate’ to taking over (or not taking over) a  qui tam  action.” Id . Thus, “a dismissed qui tam suit does not present the government with the choice between acting under subsection (b)(4) or pursuing an ‘alternate remedy’ authorized by subsection (c)(5).” Id . Because DaSilva had dismissed his action, “the government’s commencement and settlement of this action was not an ‘alternate remedy.’” Id . The court found support for its statutory interpretation from Webster v. United States , 217 F.3d 843, 2000 WL 962249 (4th Cir. 2000), the only case it could find that was “precisely on point.” In that case, the plaintiff filed a qui tam action alleging, among other things, that a contractor had “fraudulently obtained money from the by submitting false invoices and vouchers requesting payment for work that had not been performed.” Id . at *1. The government “declined to intervene.” Thereafter, the plaintiff “voluntarily dismissed her qui tam action without prejudice” with the government’s consent. Id . At the time the plaintiff dismissed the case, “criminal charges and a civil forfeiture proceeding were pending against” one of the defendants. Id . The plaintiff believed, therefore, that “there would be nothing left to recover in her qui tam suit once those other actions concluded.” Id . Three months later, the government filed its own civil action against the contractor and several other defendants, “alleging false claims, conspiracy to defraud the government, and several additional common law causes of action.” Id . “The government did not inform of its intent to file the suit,” and the plaintiff sought to intervene once she learned of it. Id . The district court denied the intervention motion, and the Fourth Circuit affirmed, explaining that voluntary dismissal “wipes the slate clean, making any future lawsuit based on the same claim an entirely new lawsuit unrelated to the earlier (dismissed) action.” Id . at *2 (citation and quotation omitted). Thus, the plaintiff’s “assertion that her voluntarily dismissed complaint confer on her a continuing right to participate in the government’s subsequently filed FCA suit simply wrong.” Id . The court reasoned that the plaintiff could not “assert the rights of an original qui tam plaintiff . . . because she abandoned those rights when she voluntarily dismissed her suit.” Id . The court also observed that the plaintiff's reading of the “alternate remedy” provision would unacceptably “allow a private party to file a qui tam false claims suit with no intention of pursuing it, dismiss the suit without prejudice, and then, when the government chose to investigate and prosecute its own claim, clamber back on board.” Id . at *3. Judge Sullivan found the “parallels between Webster and case … obvious” and held that DaSilva had “no basis for claiming a share of the government’s settlement.” Slip op. at 9. “To hold otherwise would contradict the plain language of Section 3705(c)(5) and provide DaSilva with a windfall to which he s not entitled under the statute,” a result the court said it “ s unwilling to do.” Takeaway The alternate remedies provision protects the interests of both the relator and the government. In this regard, the provision expressly contemplates the possibility that the government may use a relator’s information and pending lawsuit to seek a remedy for fraud under other statutes.  31 U.S.C. § 3730(c)(5).  In those circumstances, the FCA permits the relator to share in a recovery under other statutes as if the government had recovered the money under the FCA. As the L-3 and Webster courts concluded, however, the protections provided by the FCA should not extend to non-pending qui tam actions. Relators should not be allowed to file a qui tam action with the intention of dismissing the complaint without prejudice, so that s/he can bear the fruits of the government’s decision to subsequently prosecute and settle its own claim against the same defendants. Not only does such conduct provide an unfair windfall to the relator, but it corrupts the purpose of the reward provisions of the FCA – to encourage individuals to report fraud and other misconduct on the government.

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.