Earlier this year, the Delaware Court of Chancery issued an opinion which is of significance with respect to limited liability companies: Auriga Capital Corporation v. Gatz Properties, LLC.

Delaware has long recognized that directors of Delaware corporations have certain duties implied by general principles of equity, notably fiduciary duties, including duties of loyalty and good faith. Section 102(b)(7) of the Delaware General Corporation Law specifically permits a corporation’s charter to have a provision which limits the personal liability of directors for monetary damages for breach of fiduciary duties, but expressly limits this by stating that such a provision shall not eliminate or limit the duty of loyalty or liability for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.

Many corporate charters include a section 102(b)(7) limitation, in part to encourage individuals to be willing to serve as corporate board members and take on the responsibilities of being directors without having to worry that they might be held financially liable for business decisions that did not work out. However, the duty of loyalty is to put the corporation’s interests first, meaning to protect and advance the interests of the corporation, and it may not be eliminated. The same is true about the duty of good faith, which is to act responsibly and exercise due care. That duty may not be eliminated.

LLC law is less mature and the question of whether managers of a limited liability company may (or should) have similar fiduciary duties was unsettled. But the Delaware Chancery Court has now ruled, in the Gatz case, that such duties exist except to the extent that the limited liability company agreement specifically provides otherwise.

Here are the facts in Gatz: Gatz Properties, LLC owned some land on Long Island, New York. Gatz Properties was managed and partly owned by William Gatz. (The court chose to refer to Gatz Properties and Mr. Gatz collectively as “Gatz” because Mr. Gatz controlled Gatz Properties. In this article, we adopt that convention and use the term “Gatz” with like meaning.) Gatz felt that the property could be successfully developed into a high end public golf course. With the participation of Auriga Capital Corporation (which had prior successful experience in developing golf properties) and some other investors, Peconic Bay, LLC was formed and Gatz leased the real estate to Peconic under a 40 year ground lease. Then, with money from the investors and a bank loan, Peconic built the golf course.

Peconic had two classes of ownership, Class A and Class B. Initially, Gatz held a bit over 85 percent of the Class A and a little under 40 percent of the Class B. Investors held the remaining Class A and Class B interests. Understandably, Class B had certain approval rights.

According to the court, the evidence showed that the parties never intended to manage the golf course themselves and as part of the overall plan the course was subleased by Peconic to American Golf Corporation under a 35-year sublease, commencing September 20, 1999. However, the sublease gave American Golf an early termination right after ten years.

The golf course was designed by Robert Trent Jones, Jr., a famous golf course architect, and the parties had high hopes for the success of the venture. However, American Golf was never able to operate the course at a profit and after a few years began to let the course fall into disrepair. Gatz knew by 2005 that American Golf would exercise the early termination right, yet did nothing to plan for American Golf’s exit. Instead, Gatz decided to offer Peconic for sale, but without engaging a broker to market Peconic or the golf course to other golf course owners or managers. In fact, Gatz eventually held an auction at which the only bidder was Gatz, which purchased Peconic for what the court characterized as only a nominal value over Peconic’s debt. Peconic was then merged into Gatz Properties, LLC, which proceeded to manage the course following the merger.

The investors brought suit, alleging that Gatz had breached fiduciary duties to the investors and also breached the Peconic limited liability company agreement, by engaging in a course of conduct motivated to oust the investors in order for Gatz to realize the upside in value in Peconic’s long-term ground lease and the golf course. Gatz’s failure to take any steps to evaluate strategic options for Peconic, as well as his discouragement of a potential third-party purchaser, were specifically complained of in the suit.

Gatz was the sole manager under the Peconic LLC agreement. In addition, Gatz Properties always held control of the Class A interests and, through purchases from some investors, had acquired enough additional Class B interests giving it a majority of that class as well. Consequently, by the time of the auction Gatz controlled Peconic and held sufficient voting power to approve the sale and merger to Gatz Properties. Gatz argued that his actions were not subject to any fiduciary duty analysis because the LLC agreement displaced any role for the use of equitable principles in constraining the manager.

The Chancery Court decided to the contrary. It found that the Delaware LLC Act starts with the principle that managers of limited liability companies owe enforceable fiduciary duties. The court recognized that in 2004 the Delaware LLC Act had been amended to permit an LLC agreement to expand, restrict or eliminate fiduciary duties, but that the LLC agreement cannot eliminate the implied covenant of good faith and fair dealing. The court also recognized that where a contract expressly permits the actions in question, there ordinarily cannot be a breach of a covenant of good faith or fair dealing.  But, said the court, the Peconic LLC agreement did not contain any provisions stating that the only duties owed by the manager to Peconic and its investors were those set forth in the LLC agreement. Therefore, the LLC agreement did not limit the manager’s fiduciary duties and the traditional fiduciary duties of loyalty and care applied to Gatz.

Peconic’s LLC agreement did contain a provision which Gatz tried to invoke as expressly authorizing the sale and merger. Section 15 of the agreement required that agreements with affiliates had to be no less favorable than an arm’s-length agreement with an unaffiliated third party or approved by two-thirds of the disinterested ownership interests. But the court noted that an inquiry into the fairness of the Gatz-Peconic transaction must include a review of the process leading to the self-dealing, holding that an implicit requirement in such a standard is that an effort be made to determine the price at which a transaction with a third party could be achieved. In other words, Gatz had to show that he had performed a responsible examination of what a third-party buyer would have paid for Peconic before he could claim that his self-dealing was fair to Peconic. This he could not show, because he had never made any serious effort to find out what a third-party buyer would pay.

Gatz also tried to invoke an exculpatory provision in section 16 of the Peconic LLC agreement, which stated that the manager could not be liable for any loss or damage incurred by reason of any act or omission by such person on behalf of Peconic in good faith and in a manner reasonably believed to be within the scope of authority conferred on such person by the agreement, unless it constituted gross negligence, willful misconduct or willful misrepresentation. But this, said the court, only insulated action taken in accordance with the other stand-alone provisions of the LLC agreement. His failure to make any effort to find out what the course was worth was a breach of duty that occurred because he failed to act in good faith. Such a breach could not be exculpated by section 16.

In sum, the court found that Gatz pursued a bad faith course of conduct to enrich himself. He failed to act loyally to protect Peconic when it was clear that American Golf would terminate, doing nothing to plan for that eventuality even though he had a duty to try to protect the interests of Peconic. Because he wanted to eliminate the investors, he wanted the business to do poorly so that its value would deteriorate and he could acquire Peconic cheaply. So he chose not to respond to the inquiries of a third-party interested in the course and then made a purchase offer which all but one of the investors rejected. So he put Peconic up for auction and sold Peconic to himself through a process the court called bad faith and grossly negligent.

Finally, it is worth noting that the court was so put out with the manner in which Gatz’ side of the case was handled that it assessed Gatz with one-half of the plaintiff-investors’ legal costs, an extraordinary action. The court justified this by saying that it was clear that the strategy of Gatz and his lawyers was to exhaust the opponents with expensive unnecessary litigation antics and hope they would settle cheaply as a result. That was not acceptable. Said the judge: “In cases of serious loyalty breaches, such as here, equity demands that the remedy take the reality of litigation costs into account as part of the overall remedy, lest the plaintiffs be left with a merely symbolic remedy.” Something to remember.