The financial services industry is constantly debating the roles and responsibilities of fiduciaries and how they contrast with those of service providers who are sometimes erroneously construed as fiduciaries. In Eurycleia Partners, LP et al. v. Seward & Kissel, LLP, No.88, 2009 WL 1543689, 2009 N.Y. Slip Op. 04299 (June 4, 2009), New York’s highest court shed light on the type of relationship that can give rise to breach of fiduciary duty claims and clarified the pleading standard applicable to fraud and aiding and abetting claims.
The case before the Court of Appeals involved the failed Wood River hedge fund, whose principal, John Whittier, was convicted of securities fraud in connection with his management of the fund. Having lost the bulk of their investments to Whittier’s fraud, 16 Wood River limited partners filed suit in New York State Supreme Court against several of the fund’s outside service providers, including the fund’s outside counsel, Seward & Kissel (“S&K”), seeking $200 million in damages. The plaintiffs' allegations against the fund's counsel were primarily three-part:
(1) S&K learned that Wood River had a concentrated position in the securities of a single small cap stock, Endwave Corporation (“Endwave”), which violated investment restrictions contained in the offering memoranda that S&K prepared;
(2) S&K falsely stated in the offering memoranda that American Express Tax and Business Services, Inc. (“TBS”), was Wood River’s auditor despite S&K’s alleged knowledge that TBS had not been retained to perform any auditing work; and
(3) S&K learned that Wood River had violated SEC reporting requirements by failing to make required disclosures when Wood River’s concentrated position reached 5 percent and, later, 10 percent of Endwave’s outstanding stock.
Based on these allegations, the plaintiffs brought, among other claims, causes of action sounding in fraud, aiding and abetting fraud, and breach of fiduciary duty against S&K. S&K moved to dismiss for failure to state a claim, which the Supreme Court denied.1 Holding, in part, that “as counsel to the fund, not to the investors, S&K’s fiduciary responsibility was to the fund, not to plaintiffs,” the Appellate Division reversed.2
In their appeal to the Court of Appeals, the plaintiffs argued that S&K owed to them, as investors in the fund, a fiduciary duty based on its role as counsel to the fund, and that S&K breached that duty by failing to reveal Whittier’s fraudulent actions. The Court noted that “plaintiffs do not allege that they had direct contact or any relationship - - contractual or otherwise - - with S&K.” Rather, the plaintiffs based their argument exclusively on S&K’s attorney-client relationship with the fund in which they invested.
Looking to First and Second Department precedent, as well as federal court cases that apply New York law, the Court held that fiduciary duties owed by attorneys to limited partnerships do not extend to the limited partners. The Court observed that “S&K’s representation of this limited partnership, without more, did not give rise to a fiduciary duty to the limited partners.” Put another way, S&K’s role as attorneys for the Wood River limited partnership did not automatically convert fiduciary duties owed to the limited partnership itself to fiduciary duties owed to the individual limited partners in the fund. Of course, absent a fiduciary or other relationship that gave rise to a duty, S&K was not legally bound to disclose any alleged knowledge it had of Wood River’s affairs. Consequently, claims predicated on S&K’s silence must “fail for lack of a duty to disclose.”
The Court’s observation that the plaintiffs did not allege a direct contact or any other type of relationship with S&K leaves open the possibility that a duty to disclose could arguably arise depending on the facts and circumstances of the relationship and the extent of direct communications.
With respect to the fraud and aiding and abetting claims, S&K argued that the plaintiffs’ allegations relating to its purported knowledge of falsity were too conclusory without a factual basis and, consequently, did not satisfy the specificity pleading requirements of NY CPLR 3016(b).3 To support their allegation that S&K became aware of Wood River’s concentrated position, the plaintiffs pled that S&K was informed in January 2005 that Wood River had purchased 10 percent of Endwave’s stock. The Court found, however, that this alleged knowledge on S&K’s part was not material because even if S&K knew that Wood River purchased 10 percent of the outstanding stock, this did not mean that Wood River had invested more than 10 percent of its assets in Endwave in violation of the offering memorandum.
The plaintiffs alternatively alleged that S&K knew that TBS was not Wood River’s auditor despite TBS being mentioned in the offering memoranda that S&K drafted. The Court found this allegation “similarly conclusory.” Citing its recent decision in Pludeman v. Northern Leasing, Sys., Inc., 10 N.Y.3d 486 (2008), the Court concluded that “neither the allegations in the complaint nor the surrounding circumstances give rise to a reasonable inference that S&K participated in a scheme to defraud or knew about the falsity of the two contested statements in the offering memoranda.” Thus, the Court of Appeals unanimously affirmed the decision of the First Department dismissing the complaint.
This decision should give third-party service providers some comfort that New York’s courts will exercise appropriate care before expanding the list of traditional relationships that give rise to fiduciary type duties. Had the Court ruled otherwise, industry players would have to take an even harder look at the liabilities to which they are exposed and modify their business models accordingly.
For more information about Mayer Brown’s Securities Enforcement & Investigations practice, please visit www.mayerbrown.com or contact Jay Tharp at email@example.com.
1 No. 600704/06, 2007 WL 5465745 (N.Y. Sup. Ct. May 30, 2007) (Ramos, J.).2 46 A.D.3d 400, 849 N.Y.S.2d 510 (1st Dep’t Dec. 20, 2007).
3 “Where a cause of action or defense is based upon misrepresentation, fraud, . . . breach of trust, the circumstances constituting the wrong shall be stated in detail.” NY CPLR 3016(b).