Alleged Breach of Joint Venture Agreement to Develop Significant Mixed Use Development—Capital Calls—Implied Covenant of Good Faith and Fair Dealing—Fiduciary Duties – Tortious Interference With Contract—Derivative Actions

Defendants had moved to dismiss several causes of action in the subject complaint. The plaintiffs are investors in a large condominium development. The defendants include individuals and entities that, in essence, had various roles as part of the “development team” (developer). Pursuant to a joint venture agreement (JVA), the developer exercised day-to-day decision making authority and was empowered to make capital calls. The plaintiffs alleged that the defendants had warranted, inter alia, that their capital contributions would not be sourced from “third parties or managed funds.” Following a fourth capital call, the plaintiffs refused to contribute their full share. Certain defendants made contributions to cover the plaintiffs' share of the capital call and advised the plaintiffs that such contributions were “dilutive.” The plaintiffs contended, inter alia, that the capital call notice was improper and the contributions should be treated as a loan. The plaintiffs further alleged that the defendants failed to obtain approvals for “major decisions,” as required by the JVA. The court granted the defendants' motion in part and held, inter alia, that the plaintiffs' breach of contract claims could proceed to the extent the claims alleged certain improper transfers of ownership interests in violation of the JVA.

The JVA required that certain “major decisions” be approved by the defendants and the plaintiffs and authorized the defendants to make “additional capital calls.” The complaint alleged that the JVA provided that the “sponsor shall disclose to [plaintiffs] any changes to the direct and indirect investors in its holdings.” In 2013, the venture obtained an acquisition loan.

With respect to capital calls, the agreement provided:

When a capital call is made, if a “Member tender[s] its entire share of the required Additional Capital Contribution on or before the Tender Date (a 'Contributing Member') and [another] Member has failed to render its entire share of the required additional capital contributions … (each, a 'Non-Contributing Member'), a Contributing Member shall have the right to make additional capital contributions to cover the shortfall amount”… In such case, the Contributing Member may elect to treat the “Shortfall Contribution” as either (1) a “Member Loan” or (2) “dilutive capital” if, “within five (5) days after the funding of the Shortfall Contribution,” the Contributing Member provides “written Notice” to the Non-Contributing Member of its election of the “dilution remedy”…. If the Contributing Member fails to give proper notice, the “Contributing Member shall be deemed to have elected to have the Shortfall Contribution treated as a Member Loan”…. If the Shortfall Contribution is treated as dilutive capital, however, then the Contributing Member's percentage interest in the Company increases by a multiple of 1.5 times the Shortfall Contribution and the Non-Contributing Member's Percentage Interest is correspondingly reduced by the same amount….

The sponsor had made six capital calls. The parties funded the first three capital calls. However, in 2014, certain defendants made a fourth capital call, allegedly to cover “hard and soft costs” of construction. The plaintiffs claimed that part of such costs “actually related to insurance” and involved “manager overruns,” which did not “qualify as grounds for additional capital contributions under the JVA….” The plaintiffs refused to fund the fourth capital call based on alleged concerns about the “mismanagement of the joint venture's budget and spending….”

The defendants asserted that they had paid the capital call and also made a “short fall contribution ,” as well. The defendants advised the plaintiffs that the short fall contribution was being treated as “dilutive capital.” The plaintiffs argued that the defendants violated the JVA by “relying on third-party financing to fund their portions of the October 2014 capital call and subsequent short fall contributions.”

In December 2014, the defendants made a fifth capital call allegedly “to cover fees and interest payments” related to an extension of the acquisition loan. The plaintiffs alleged that part of such fees “improperly related to insurance.” They refused to pay its share of the December 2014 capital call. The defendants again alleged that it paid its entire share and made a short fall contribution.

The plaintiffs alleged that on or about Jan. 9, 2015, the defendants advised the plaintiffs that they were also treating the December 2014 shortfall contribution as “dilutive capital.” The plaintiffs contended that the defendants “failed to comply with the [JVA's] five-day notice requirement” and could not “treat the shortfall contribution as a dilution,” i.e., it should be treated as “a member loan rather than dilutive capital.”

A sixth additional capital call was made, allegedly to “cover the 'hard and soft'” construction costs. The plaintiffs claimed that part of those costs actually involved insurance and construction of an over budget sales center. The plaintiffs, allegedly concerned that a further dilution of their interests, paid their share of the April 2015 capital call.

Additionally, the plaintiffs claimed that certain defendants had transferred their ownership interests in violation of the JVA and that part of the defendants' capital call payments were paid by third parties.

The plaintiffs further claimed that the defendants failed to submit a required budget. The JVA provides that if the plaintiffs disapprove the budget or fail to respond within ten days, the defendants must operate under the last approved budget. The JVA entitled the plaintiffs to require the defendants to purchase the plaintiffs' equity interest, “for a purchase price equal to an amount giving [plaintiffs] a 20 percent return on its investment, if, after the closing of the construction loan, [plaintiffs] declines to approve a proposed budget in which the hard costs exceed an amount equal to 110 percent of the hard costs set forth in the prior approved budget ('equity put right').” The plaintiffs alleged that the defendants' failure to submit a budget was intended to undermine the defendants' equity put rights.

In discovery, the defendants had produced “a proposed budget,” wherein the hard costs exceeded 110 percent of the prior hard costs approved budget. The plaintiffs disapproved of such budget and attempted “to exercise its equity put right.” The defendants had argued that such “budget was only a draft proposal and did not trigger the equity put right provision.”

The plaintiffs further contended that the defendants failed to seek the plaintiffs' approval for the following major decisions: (1) construction of “a sales office with a…sample luxury apartment;” (2) engagement of a sales agent; (3) setting of condominium prices and the filing of a condominium offering plan; and (4) a “distribution to the company, including to [plaintiffs], in July 2015, without consulting [plaintiffs] first.”

The court stated that the JVA was silent as to financing and did not preclude loans as a source of funding the initial capital contributions and nothing in the JVA rendered loans “impermissible” for additional contributions. The court found that the JVA did “not expressly prohibit financing” under certain circumstances and actually permitted financing by third-party lenders under certain circumstances. Therefore, the court dismissed the breach of contract claim, based on alleged wrongful third-party financing.

The plaintiffs had also alleged that the defendants had breached representations and covenants that required certain individuals to “devote a substantial portion of their time to [the] development,…and operation of the property” and the representation that the “sponsor” and its “principals 'shall comply with any financial net worth and liquidity covenants specifically applicable thereto under any loan.'” The complaint did not allege that “the sponsor or its principals actually failed to devote their time to managing the property; rather, plaintiffs…take issue with how the property was managed.” The court found that such allegations were insufficient to state such breach of contract claim.

However, the court held that the complaint sufficiently alleged that the “funding of a construction loan was delayed as a result defendants' inability to meet the necessary net worth and liquidity requirements….” and sufficiently alleged damages, by citing the June 2014 capital call that allegedly resulted from the defendants' “being unable to secure a construction loan…due to…members' liquidity issues….” Thus, the breach of contract claim based on the failure to comply with the necessary net worth and liquidity requirements was “sufficiently stated.”

With respect to the alleged breach of the major decisions provisions of the JVA, only one of the alleged breaches had been “expressly denominated as a major decision” pursuant to the JVA. That decision was the selection of the sales agent. However, the plaintiffs had approved either one of two firms as the sales agent. To the extent that the plaintiffs claim that they were not consulted on the ultimate choice of sales agent, they had not alleged how they were damaged. The court viewed the plaintiffs' argument that they needed additional discovery to assure that the sales agent was not hired, based on “reasons of self dealing such as having a relationship to one of the defendants,” as “entirely speculative and insufficient to maintain a claim” for breach of contract.

The plaintiffs alleged, inter alia, that $3 million had originally been budgeted for the sales office, they had approved a budget increase to $6 million, but the defendants actually incurred expenses in excess of $9 million. The JVA contemplated a “permitted variance” in the costs. However, the defendants apparently exceeded the “permitted variance” and therefore, that expenditure constituted a major decision. Thus, the court upheld the sufficiency of that claim.

The court rejected the defendants' argument that this allegation had been “improperly based upon a document that was disclosed for 'settlement purposes only.'” Although the CPLR bars “evidence of settlement negotiations,” it does not bar “any evidence, which is otherwise discoverable, solely because such evidence was presented during the course of compromise negotiations.” The cost of the sales office would have been discoverable in litigation.

The JVA major decisions provision included “converting the property to a condominium and entering into any condominium documents.” Thus, the court upheld the plaintiffs' allegations based on the offering plan and condominium documents. However, based on emails from plaintiffs' counsel, which requested “a wire of the distribution funds 'ASAP' and stating that plaintiff's CEO 'would like his share of the refund today,'” the court rejected the claim based on distributions that had been made.

With respect to transfer of interests without consent, the defendants argued that the JVA prohibition only applied to transfers of interest to new members, not “reallocations between existing members.” They also argued that if the JVA transfer prohibition was applicable to internal adjustments of ownership percentages among existing members, it would conflict with dilution provisions of the JVA. The court found that certain transfers were permitted transfers, but that part of the plaintiffs' claim was based on transfers to third parties and such transfers could be actionable.

The court found that the JVA was silent as to the plaintiffs' options if the defendants refused to submit a proposed budget and held that since the defendants never submitted a proposed budget for approval, the plaintiffs could not “invoke the equity put right provision.” However, the court found that since the defendants had allegedly failed to timely submit a proposed budget as required by the JVA and may have “frustrated [plaintiffs'] rights,” plaintiffs may assert “a violation of the implied covenant of good faith and fair dealing.”

With respect to breach of a separate “Manager LLC Agreement,” the plaintiffs alleged that the defendants made direct transfers of their interest without “seeking or obtaining [plaintiffs'] prior written approval” and the defendants breached the implied covenant of good faith and fair dealing by not permitting the plaintiffs the opportunity to use third-party financing. The manager LLC agreement embodied “a restriction on transfer provision” that was “parallel” to the JVA and the court dismissed such claim. However, the manager LLC agreement and the JVA had different language with respect to financing and there was no restriction on third-party financing in the manager LLC agreement. To the extent it was alleged that a defendant received distributions it would not have received if the defendant had not obtained “unlawful third-party financing,” the court dismissed such claim. The court also found that nothing in the manager LLC agreement required a defendant entity “to share opportunities, however lucrative….” The court explained that it could not “rewrite this lack of obligation by treating it as a claim for breach of the implied covenant of good faith and fair dealing, which, under Delaware law, 'operates only in that narrow band of cases where the contract as a whole speaks sufficiently to suggest an obligation and point to a result, but does not speak directly enough to provide an explicit answer.'”

Additionally, the court dismissed a derivative breach of contract claim which alleged that the developer had failed “to use 'commercially reasonable efforts,'” as required by the subject “development agreement.” The plaintiffs had not made a demand on the company to bring such claim and had not “'set forth with particularity' why such a demand would have been futile.” The plaintiffs argued that the developer entity was “an alter-ego of sponsor,” the developer entity and the sponsor were “owned and controlled by the same principals” and that the sponsor could not “properly exercise independent and disinterested business judgment in responding to a demand to sue developer as such suit is, in essence, a suit against itself.”

The court explained that “[s]uch conclusory allegations are insufficient to constitute particularized facts, particularly where plaintiffs were aware of the developer and sponsor's ownership structure when they entered into the joint venture.” The court found that even if “futility” had been adequately pled, “the complaint's vague allegations” as to the failure to “use 'commercially reasonable efforts' are insufficient to state a claim for breach of the developer agreement.” The plaintiffs' allegations, at most, alleged that the developer entity had not devoted “'sufficient time and attention' to the project” and such allegation was “not supported by any particularized facts….”

The defendants contended that “'Delaware law…holds that a putative derivative plaintiff has a disqualifying conflict if it simultaneously' asserts direct and derivative claims….” However, the Delaware Court of Chancery has held that, “while in some instances, the possible conflict inherent in bringing direct and derivative claims may 'be strong enough to warrant bifurcating the litigation or dismissing either the direct or derivative claims,' this is not necessary where the claims 'are not internally inconsistent.'” Thus, the derivative claim was dismissed “for failure to adequately plead demand futility.”

The court also dismissed fiduciary duty and fraud claims. The contracts contained disclaimers of “any duties, including fiduciary duties, 'whether or not, such duties exist in law or in equity.'” Although such provision did not disclaim liability for “fraud, intentional misconduct or a knowing and culpable violation of law,” they made clear that there was “no special relationship between members of the company or manager LLC sufficient to sustain a negligent misrepresentation cause of action.”

The plaintiffs alleged that the defendants were obligated to “disclose any capital sourced from third parties, any direct or indirect transfers of interests in sponsor and control, and the basis for each additional capital contribution, but failed to do so” and that they “intentionally misrepresented their net worth and liquidity.” The court found that such allegations duplicated the plaintiffs' breach of contract allegations and dismissed the negligent and fraudulent misrepresentation claims, as well as the breach of fiduciary duty claims. The court further held that the claim that the defendants failed to disclose financing opportunities, did not fit within a category of “fraud, intentional misconduct or a knowing and culpable violation of law.”

The court also dismissed the plaintiffs' promissory estoppel and unjust enrichment claim because, inter alia, they were duplicative of the contract claims. Additionally, the court dismissed the tortious interference with contract claims and noted that “a company's directors, officers and shareholders generally cannot be held liable for interfering with their company's contracts.…To be individually liable, an individual officer or director's actions must constitute independent tortious conduct. Conclusory allegations that an individual profited from the breach are not sufficient….” Here, the complaint alleged “conclusory allegations of…malice and vague allegations of defendants' self-interest” and such allegations were “insufficient” to meet the applicable pleading standard. The plaintiffs also failed to allege “in nonconclusory terms that defendants had not acted in the corporate interests.”

However, the court denied the motion to dismiss the claims that the defendants had breached their contract concerning maintenance and “access to books and records.” The court also denied the motion to dismiss the plaintiffs' claim for an accounting. The defendants argued that such claim was “improper” because it sought “the equitable remedy of an accounting.” Delaware courts held that since “an accounting is an equitable remedy, it is necessary to look to the underlying claims before granting an accounting” and an accounting may be appropriate where underlying claims are sustained and an accounting would be a “form of relief.” Finally, the court explained if there is a breach of the JVA's cure provision, the defendants may be required to indemnify the plaintiffs for any resultant loss and therefore, such claim should not be dismissed.

Comment: This case illustrates the importance of carefully negotiating the terms of joint venture agreements including, inter alia, terms involving capital calls, the process for making major decisions, the right to transfer of interests and the ability to pursue other business opportunities.

Ambase Corp. v. 111 W. 57th Sponsor LLC, Sup. Ct., N.Y. Co., Index No. 652301/2016, decided Jan. 9, 2018, Bransten, J.

Scott E. Mollen is a partner at Herrick, Feinstein and an adjunct professor at St. John's University School of Law.