Breach of Contract and the Faithless Servant Doctrine

• Posted on: Mar 17 2021

Today, we examine Two Rivers Entities, LLC v. Sandoval, 2021 N.Y. Slip Op. 01527 (1st Dept. Mar. 16, 2021) (here), a case involving breach of contract and the faithless servant doctrine. 

Before we examine Two Rivers, we discuss the principles of law at issue in the case.

Breach of Contract

To sustain a breach of contract cause of action, a plaintiff must allege: (1) a valid agreement; (2) the plaintiff’s performance of its obligations under the agreement; (3) the defendant’s breach of that agreement; and (4) damages. Morris v. 702 E. Fifth St. HDFC, 46 A.D.3d 478, 479 (1st Dept. 2007); Furia v. Furia, 116 A.D.2d 694, 695 (2d Dept. 1986); see also Stonehill Capital Mgt., LLC v. Bank of the West, 28 N.Y.3d 439, 448 (2016). 

When reviewing a contract, the court is to construe it “in accord with the parties’ intent.” Riverside South Planning Corp. v. CRP/Extell Riverside LP, 60 A.D.3d 61, 66 (1st Dept. 2008), aff’d, 13 N.Y.3d 398 (2009). “The best evidence of what parties to a written agreement intend is what they say in their writing …. Thus, a written agreement that is clear and unambiguous on its face must be enforced according to the plain terms, and extrinsic evidence of the parties’ intent may be considered only if the agreement is ambiguous. Id. (internal citations omitted). Whether a contract is ambiguous presents a question of law for the court to resolve. Id. at 67. 

The Faithless Servant Doctrine

The faithless servant doctrine provides that an employee who is faithless in performance of their duties (i.e., breaches their duty of loyalty to the employer) is not entitled to recover either salary or commission. See Feiger v. Iral Jewelry, 41 NY2d 928, 928 (1977). While the language of the rule may imply a broad application, courts generally apply the rule relatively narrowly. See, e.g., W. Elec. Co. v. Brenner, 41 N.Y.2d 291, 295 (1977); Maritime Fish Prods., Inc. v. World-Wide Fish Prods., Inc., 100 A.D.2d 81, 88 (1st Dept. 1984). Courts will usually hold an employee liable under the faithless servant doctrine only if the employee has usurped a corporate opportunity or actively stolen from the employer. See Visual Arts Found., Inc. v. Egnasko, 91 A.D.3d 578, 579 (1st Dept. 2012); Soam Corp. v. Trane Co., 202 A.D.2d 162, 162 (1st Dept. 1994) (employee promoted competitor’s products over employer’s); Phansalkar v. Andersen Weinroth & Co., L.P., 344 F.3d 184, 203 (2d Cir. 2003) (employee usurped corporate opportunity).

[Ed. Note: this Blog examined the faithless servant doctrine here, here and here.]

Two Rivers Entities, LLC v. Sandoval

In 2016, defendant Tacho Sandoval became a Class A member of plaintiff Two Rivers Entities, LLC (the “Company”), after investing millions of dollars in the Company. Although investing millions in the Company, Sandoval was not given any management rights.

At the time of his investment, Sandoval’s rights were governed by the Company’s Amended and Restated Operating Agreement (“Operating Agreement”). Under Section 5.7 of the Operating Agreement, members were forbidden from “directly or indirectly invest[ing] in, or engag[ing] in any business which engage[d] in Trading Instruments or in any manner compete[d] with the business of [Plaintiff], except for an ownership interest of less than 2% in any publicly traded Company.”

Section 7.3(a)(vii) of the Operating Agreement provided that members, such as Sandoval, could have their membership terminated for cause if they materially breached the Operating Agreement. Other grounds for a for-cause termination included a member’s negligence or misconduct in the course of his/her membership or in the performance of the Member’s duties or responsibilities or “embezzlement, fraud or dishonestly committed (or attempted) by the Member, or at his direction.”

In October 2019, Sandoval agreed to restructure some of the financing he had provided to the Company. This was effectuated by an Amended and Restated Promissory Note, dated November 1, 2019 (the “Note”). The Note set forth the specifics of the refinancing but did not address the Operating Agreement or Sandoval’s obligations thereunder.

Prior to execution of the Note, between July 2017 and October 2018, Sandoval allegedly violated the federal securities laws by inaccurately and untimely disclosing his acquisition of more than 10% of the stock of Clean Coal Technologies, Inc. (“CCT”), a publicity traded company that focuses on the environmental impacts of coal. Sandoval’s affiliation with the Company and his alleged violations purportedly dissuaded certain prospective investors from investing in the Company. On October 16, 2019, prior to the Note’s execution, the Company asked Sandoval to correct his securities filings, but he allegedly refused to do so.

The Company commenced the action in November 2019. Its amended complaint included two causes of action: (1) breach of the Operating Agreement; and (2) forfeiture of compensation under the faithless-servant doctrine. Sandoval moved to dismiss, arguing that the release in the Note barred both claims. Even if it did not, Sandoval maintained that none of his alleged actions violated any provisions of the Operating Agreement and that he was not subject to the faithless-servant doctrine.

The Motion court agreed (here) and dismissed the  complaint.

As a threshold matter, the motion court held that the release in the Note, though broad in scope, did not encompass the terms of the Operating Agreement. It did “not address the Operating Agreement’s prohibition on Sandoval investing in other companies,” said the motion court, “and ha[d] nothing to do with the alleged securities violations.…” “Had these sophisticated parties intended for the Note’s release to cover these disputes,” observed the motion court, “they would have ensured it expressly did so.” See Fitzgerald v. Fahnestock & Co., 48 A.D.3d 246, 247 (1st Dept. 2008). This was important because had the release applied to the claims asserted, dismissal of the contract and faithless servant causes of action would have been moot.

On the breach of contract cause of action, the motion court held that Section 5.7 of the Operating Agreement did not prohibit Sandoval from investing in other companies, “even for a stake greater than 2%, unless that company ‘engage[d] in Trading Instruments or in any manner compete[d] with the business of the Company.’” According to the motion court, “[t]here [was] no indication in the AC or otherwise that CCT ‘engages in Trading Instruments or in any manner competes with the business of the Company.’” Thus, concluded the motion court, “the Company ha[d] not stated a claim for breach of section 5.7.”

“Nor,” held the motion court, had “it stated a claim for breach of section 7.3(a).” The reason, said the motion court, was the Company had not alleged that Sandoval acted negligently or otherwise “in the course of his membership or in the performance of the [his] duties or responsibilities” as a member of the Company. “The alleged securities violations,” explained the motion court, “ha[d] nothing to do with Sandoval’s membership in or funding of the Company.” The motion court noted that it was “clear that this claim is focused on the erroneous contention that section 5.7 prohibits Sandoval from having a 2% stake in any publicly traded company regardless of whether that company ‘engages in Trading Instruments or in any manner competes with the business of the Company.’” “The 2% limit is clearly a safe harbor to these two prohibitions and not an independent limitation,” concluded the motion court. 

Additionally, the motion court held that the Company failed to plead a violation of the faithless servant doctrine “because the Company ha[d] not alleged any breach that would serve as a predicate for application of the faithless-servant doctrine.…” 

Moreover, the motion court held that the issue was not misconduct in connection with the performance of Sandoval’s employment, but rather the repayment of a loan. “The obligation to repay a loan is purely a matter of contract that does not arise from a fiduciary relationship,” said the motion court.” The motion court explained that “[t]he faithless-servant doctrine cannot be raised to recoup money that the Company repaid someone to satisfy its debt.” This was especially so since the Company did not assert “a separate cause of action for breach of fiduciary duty (likely because Sandoval [was] not a manager and the Operating Agreement [did] not contractually establish non-default fiduciary duties for him…).” In short, concluded the motion court, “Plaintiff cites no authority for use of the faithless-servant doctrine to preclude recovery of loans. The doctrine is about equitable forfeiture of compensation for the services of a disloyal fiduciary.” (Citation omitted).

The First Department’s Decision

On appeal, the First Department unanimously affirmed.

The Court agreed with the motion court in that defendant did not breach Section 5.7 of the Operating Agreement. Slip Op. at *1. The Court noted that the plain language of that section, “unambiguously limits the prohibition on investing to a competing business.” Id. As such, defendant’s acquisition of more than a 2% ownership interest in CCT, a publicly traded company that does not compete with the Company, could not be a breach of the Operating agreement. Id. 

The Court further held that even if defendant breached Section 7.3 of the Operating Agreement, “the company’s remedy under [that section] of the operating agreement [was] for-cause termination of the member, not a claim for breach of contract.” Id. 

As to the Company’s second cause of action (i.e., breach of the faithless servant doctrine), the Court held that the doctrine did not apply to defendant. Id. Noting that the doctrine only applies to “an employee or agent who is faithless in the performance of his or her duties” (citations omitted), the Court found that defendant was “a nonmanaging member of plaintiff, was not an employee and [was] not alleged to have acted on plaintiff’s behalf as its agent.…” Id. Additionally, there were “no allegations that [defendant] funneled business away [from the Company] to a competitor or engaged in theft.” Id. at *1-*2. Accordingly, concluded the Court, “plaintiff’s faithless servant claim was correctly dismissed.” Id. at *2.

Takeaway

In claiming a breach of contract (i.e., enforcing or attempting to enforce a contract), a plaintiff must plead a breach of the contract by the defendant. In that regard, the plaintiff must demonstrate that the defendant failed to perform its obligations under the agreement. Two Rivers highlights this issue.

Two Rivers also highlights the importance of giving the words of the parties’ contract their intended meaning. This is especially important where, as in Two Rivers, the language is clear and unambiguous on its face. 

Two Rivers further highlights the importance of pleading the elements of a claim. As noted by the Court, to plead a faithless servant claim, the defendant must be an employee or agent of the employer, breach a duty of loyalty to the employer, and usurp a corporate opportunity or actively steal from the employer. Plaintiff failed to allege the foregoing.