In the last few editions of the GT M&A Report, we have examined recent Delaware case law on the fiduciary duties of managers of Delaware limited liability companies and limited partnerships. It is clear under the Delaware Limited Liability Company Act (and the Delaware Revised Uniform Limited Partnership Act) that a limited liability company agreement (or limited partnership agreement) may contain provisions that specify and expand, restrict or even eliminate the fiduciary duties that managers, members and partners may owe to their company or to each other.1 However, in cases where a company’s governing agreement fails to define the applicable fiduciary standards or to adequately waive fiduciary duties, a question arises as to whether managers owe default fiduciary duties to the company’s members (or limited partners), just as the board of directors of a corporation owes fiduciary duties to the corporation’s stockholders.
Chief Justice Myron Steele of the Delaware Supreme Court has argued against the application of default fiduciary duties for Delaware limited liability companies and limited partnerships in his legal commentary off the bench, opening a debate on an issue that many had considered settled.2 Since our last edition of the GT M&A Report, the Delaware Supreme Court and Chancery Court have both addressed the issue of default fiduciary duties for the managers of limited liability companies. The opinions make for good reading for their judicial barbs alone, but there is still no definitive answer out of Delaware courts as to whether default fiduciary duties apply.
Ultimately, the answer may come from the legislature. In response to the recent court decisions on the issue, the Corporation Law Section of the Delaware State Bar Association has proposed an amendment to the Delaware Limited Liability Company Act, clarifying that the rules of law and equity relating to fiduciary duties apply to Delaware limited liability companies. If the proposed amendment is ultimately enacted into law, the managers of a Delaware limited liability company will be subject to default fiduciary duties, unless these duties are effectively supplanted or waived in the company’s limited liability company agreement.
Auriga Round Two
Chancellor Strine provided an analysis of fiduciary duties in the limited liability company context in his January 2012 Chancery Court opinion in Auriga Capital Corporation v. Gatz Properties, LLC, confirming that default fiduciary duties apply to managers of Delaware limited liability companies.3 The Chancery Court found that the manager of Peconic Bay, LLC (Peconic Bay) breached both its contractual and equitable fiduciary duties when the owner of the managing entity took steps to deliver Peconic Bay to himself and his family on unfair terms.4 Peconic Bay was formed to lease and develop farm land on Long Island owned by William Gatz and his family into a golf course. The manager of Peconic Bay, Gatz Properties, LLC, was managed and controlled by Mr. Gatz. After a series of management decisions placing Peconic Bay in a distressed situation, the company was sold at auction to Mr. Gatz, the only bidder, for a nominal value over its debt.5
Auriga included an extensive review of the Delaware Limited Liability Company Act and relevant case law, concluding that “where the core default fiduciary duties have not been supplanted by contract, they exist as the LLC statute itself contemplates.”6 Chancellor Strine found that Peconic Bay’s limited liability company agreement did not displace traditional fiduciary duties and emphasized the fact that the agreement did not contain a provision stating that the only duties owed by the manager were set forth in the agreement itself.7
In reaching his decision in Auriga, Chancellor Strine did not, however, rely on default fiduciary duties alone. Peconic Bay’s limited liability company agreement included a provision requiring the consent of the company’s non‐affiliated members for any affiliate agreements offering Peconic Bay terms less favorable than similar agreements that could be entered into with arms‐length third parties.8 Chancellor Strine found that this clause imposed the equivalent of an entire fairness standard and that Mr. Gatz failed to show that he conducted a good faith, responsible examination of what a third‐party would pay for Peconic Bay or that he paid a fair price to acquire the company.9
Chancellor Strine should have stopped at this contractual analysis, according to the Delaware Supreme Court in its appellate decision in Gatz Properties, LLC v. Auriga Capital Corporation issued in November 2012.10 In Gatz, the Supreme Court upheld the Chancery Court decision, but based its analysis entirely on the contractual grounds cited by Chancellor Strine. The Supreme Court agreed with Chancellor Strine that the Peconic Bay limited liability company agreement contractually adopted the fiduciary duty standard of entire fairness and that Mr. Gatz failed to carry his burden of proving that he discharged his contractual obligation.11
The Supreme Court rebuked the Chancery Court, however, for reaching the issue of default fiduciary duties. According to the Supreme Court, given that the dispute over whether fiduciary standards applied to Mr. Gatz could be decided solely by reference to Peconic Bay’s limited liability company agreement, “it was improvident and unnecessary for the trial court to reach out and decide, sua sponte, the default fiduciary duty issue as a matter of statutory construction.”12 The Supreme Court stated that the Chancery Court’s statutory pronouncements must be regarded as dictum without precedential value because Peconic Bay’s limited liability company agreement explicitly and specifically addressed the fiduciary duty owed by Mr. Gatz and no litigant asked the court to decide the default fiduciary duty issue as a matter of statutory law.13 The Supreme Court declined to express any view on whether default fiduciary duties apply, but it did note that it is an issue about which reasonable minds could differ.14
The Supreme Court ended its discussion on default fiduciary duties with a strong reminder to lower court judges:
“We remind Delaware judges that the obligation to write judicial opinions on the issues presented is not a license to use those opinions as a platform from which to propagate their individual world views on issues not presented. A judge’s duty is to resolve the issues that the parties present in a clear and concise manner. To the extent Delaware judges wish to stray beyond those issues and, without making any definitive pronouncements, ruminate on what the proper direction of Delaware law should be, there are appropriate platforms, such as law review articles, the classroom, continuing legal education presentations and keynote speeches.”15
The Chancery Court Responds in Feeley
Chancellor Strine’s default fiduciary duties analysis may not have won over the Delaware Supreme Court, but his fellow Chancery Court judge, Vice Chancellor Laster, found his arguments persuasive. A claim involving default fiduciary duties came before the Chancery Court in Feeley v. NHAOGC, LLC and Vice Chancellor Laster’s opinion in the matter, issued just a few weeks after the Supreme Court’s decision in Gatz, came down squarely on the side of Chancellor Strine and the application of default fiduciary duties to managers of limited liability companies.16
Feeley involved a motion to dismiss counterclaims asserted by members of Oculus Capital Group, LLC (Oculus) contending, among other claims, that Oculus’ managing member breached its default fiduciary duties by acting in a grossly negligent manner or engaging in willful misconduct in connection with a failed real estate transaction and by diverting investment opportunities that should have been passed along to Oculus.17
In his analysis of the fiduciary duty claims in Feeley, Vice Chancellor Laster noted that Chancellor Strine’s opinion in Auriga was preceded by numerous Chancery Court decisions holding that managers of limited liability companies owe fiduciary duties.18 Vice Chancellor Laster acknowledged that the Supreme Court characterized Chancellor Strine’s comments about default fiduciary duties as dictum without any precedential value.19 He stated, however, that Chancellor Strine’s “rationale for imposing default fiduciary duties remains persuasive, at least to me.”20
The Feeley opinion included a review of Section 18‐1101(c) of the Delaware Limited Liability Company Act, the statutory provision that allows members to expand or waive fiduciary duties, referencing Chancellor’s Strine’s analysis of the statute and its legislative history in Auriga.21 Vice Chancellor Laster compared Section 18‐1101(c) to the parallel provision in the Delaware Revised Uniform Limited Partnership Act, stating that “there has never been any serious doubt that the general partner of a Delaware limited partnership owes fiduciary duties.”22 In his conclusion on the issue, Vice Chancellor Laster stated that until the Supreme Court affirmatively decides the issue “the long line of Court of Chancery precedents and the Chancellor’s dictum provide persuasive reasons to apply fiduciary duties by default to the manager of a Delaware LLC.”23
The Vice Chancellor’s next step in the opinion was to determine whether the Oculus limited liability company agreement limited or eliminated the managing member’s fiduciary duties. The opinion referenced Section 18‐1101(e) of the Delaware Limited Liability Company Act which states:
“A limited liability company agreement may provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a member, manager or other person to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement; provided, that a limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.”
According to Vice Chancellor Laster, this section authorizes something different from Section 18‐1101(c), allowing the drafters of a limited liability company agreement to leave default duties in place, but to limit or eliminate monetary liability for breach of duty.24
The Oculus limited liability company agreement contained a provision stating:
“Except as and to the extent required under the Delaware Act or this Agreement, no Member shall be . . . liable, responsible, accountable in damages or otherwise to the Company or the other Members for any act or failure to act in connection with the Company and its business unless the act or omission is attributed to gross negligence, willful misconduct or fraud or constitutes a material breach by such Member of any term or provision of this Agreement or any agreement the Company may have with the Member.”25
Vice Chancellor Laster found that this provision, rather than disclaiming or eliminating fiduciary duties, instead assumes that default fiduciary duties exist, limits only the potential availability of a monetary remedy, and restores the availability of damages as a remedy for gross negligence and willful misconduct.26 Having established that default fiduciary duties apply and that the Oculus limited liability company agreement did not limit or waive these duties; the court found that the pleadings stated a claim for breach of the fiduciary duties of care and loyalty by Oculus’ managing member.27
More from the Chancery Court ‐ Zimmerman v. Crothall
Earlier this year, Vice Chancellor Parsons gave a nod to the Delaware Supreme Court’s default fiduciary duties discussion in Gatz and the Chancery Court’s response in Feeley in his opinion in Zimmerman v. Crothall.28 Zimmerman involved a breach of fiduciary duty claim against the directors and principal equity holders of Adhezion Biomedical LLC (Adhezion), a Delaware limited liability company that was set up with a board of directors and a multiple class unit structure.
Adhezion’s limited liability company agreement brought in several concepts from the corporate context and explicitly provided that the directors were fiduciaries, applying subjective and objective standards of reasonableness to their actions.29 The Adhezion limited liability company agreement also provided that affiliate transactions approved by an interested director were not void or voidable if the material facts of the transaction were disclosed or known to the disinterested directors and approved in good faith by the disinterested directors or the transaction was fair to Adhezion at the time it was authorized.30
The court found that “the parties, through the Adhezion Operating Agreement and consistent with their prerogative under 6 Del. C. § 18‐1101(c), have ‘restricted’ the fiduciary duties that the Director Defendants owed in the context of their dealings with the Company.” 31 Vice Chancellor Parsons limited his analysis to determining whether the directors breached their fiduciary duties as defined in the limited liability company agreement and did not explicitly reach the issue of default fiduciary duties. The opinion did point out in a footnote, however, that the Supreme Court had not yet definitively determined whether the Delaware Limited Liability Company Act imposes default fiduciary duties, but noted that the Chancery Court had recently visited the issue in Feeley and had held that, subject to clarification from the Supreme Court, “managers and managing members of an LLC do owe fiduciary duties as a default matter.” 32
Proposed Legislation Applies Default Fiduciary Duties
In Gatz, the Supreme Court stated that “the ‘organs of the Bar’ . . . may be well advised to consider urging the General Assembly to resolve any statutory ambiguity” on the issue of default fiduciary duties.33 The Corporation Law Section of the Delaware State Bar Association seems to have taken heed of this advice and has proposed an amendment to Section 18‐1104 of the Delaware Limited Liability Company Act. The amendment calls for the insertion of the underlined text below. Ultimately, if approved by the Delaware General Assembly and signed into law, the amended section will read as follows:
“§ 18‐1104. Cases not provided for in this chapter. In any case not provided for in this chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.”
The commentary accompanying the proposed amendment confirms that “in some circumstances fiduciary duties not explicitly provided for in the limited liability company agreement apply. For example, a manager of a manager‐managed limited liability company would ordinarily have fiduciary duties even in the absence of a provision in the limited liability company agreement establishing such duties.” The commentary points out, however, that parties would still be able to expand, restrict or eliminate these fiduciary duties under Section 18‐1101(c) of the Delaware Limited Liability Company Act.
Open Issues and Lessons Learned
The Delaware Supreme Court’s discussion in Gatz leaves open the issue of default fiduciary duties. However, it appears, based on Feeley the Chancery Court will continue to apply default fiduciary duties to the managers of Delaware limited liability companies until the Delaware Supreme Court or the Delaware General Assembly definitively decides the issue.
Wherever the Delaware Supreme Court and the legislature ultimately come out on the issue of default fiduciary duties, Delaware limited liability companies are largely creatures of contract and parties are free to use the limited liability company agreement to decide the issue for themselves, as noted in the comments to the proposed amendments to the Delaware Limited Liability Company Act. The parties will need to determine whether they want clarity with respect to the fiduciary duties of their company’s managers. If so, when drafting the limited liability company agreement, careful thought and attention will need to be given to the relevant provisions as to the scope of the managers’ duties and the consequences of a breach of those duties.
Auriga, Feeley and Zimmerman provide some guidance in this regard. Based on Auriga, if the parties wish to supplant traditional fiduciary duties with contractual duties, they would be well advised to explicitly state in the limited liability company agreement that the only duties owed by the managers are set forth in the limited liability company agreement itself. Feeley provides a reminder not to conflate the concepts of the duties owed with the consequences of a breach of those duties, and Zimmerman confirms that the Chancery Court will give effect to contractually agreed standards that are clearly defined in the limited liability company agreement.
The parties, however, are also free to exclude fiduciary duty provisions and let the courts decide should there be a dispute. At the Chancery Court, at least, there is a very good chance that such default fiduciary duties will be imposed.