In this opinion addressing a motion to dismiss claims against the directors, officers, and controlling unitholder of a limited liability company, the Court of Chancery held that (i) upon eliminating the traditional fiduciary duties owed by an LLC’s managing directors and officers, an LLC agreement may instead impose a contractually defined standard of subjective good faith, and (ii) where an LLC agreement’s conflict resolution provision does not expressly provide for the resolution of potential conflicts of interest between members, the interested transaction may still be subject to challenge at least against the interested member, including scrutiny under the entire fairness standard of review, despite the LLC’s compliance with the conflict resolution provision’s requirements.
Plaintiffs, common unitholders of Atlas Energy Resources, LLC (“Energy”), then a publicly-traded limited liability company, brought suit to challenge a merger by which Energy was acquired by its controlling, majority unitholder, Atlas America, Inc. (“America”). Energy was formed in 2006 to develop natural gas production in the Marcellus Shale, a geological formation located in the Appalachian Mountains. Since that time, it had grown into one of the largest producers in the Marcellus Shale region, holding vast tracts of resource-rich land and making cash distributions to its unitholders that had either grown or remained level each quarter since the company’s inception. In early 2009, America, in consultation with both its own management and Energy’s, began to consider various strategic alternatives for Energy, including a possible merger between the two companies. Shortly thereafter, Energy management presented the various alternatives to Energy’s board. After two meetings with management, Energy’s board authorized its Conflicts Committee to consider the alternatives and, subsequently, formed an independent Special Committee charged with formally considering the alternatives and, possibly, negotiating a transaction on behalf of the public minority. After approximately a month of meetings and negotiations, and with the assistance of its legal and financial advisors, the Special Committee approved a merger by which each unitholder would receive 1.16 shares of America stock in exchange for each Energy unit, and Energy would become a wholly owned subsidiary of America. In addition to the stock consideration, which amounted to a 0.3% premium over Energy’s then-current trading price, the merger agreement provided that Energy’s quarterly cash distributions would be suspended pending consummation of the merger. The merger agreement was announced on April 27, 2009, and on September 29, 2009, approved by a majority of all Energy common unitholders.
In class actions brought on behalf of the minority public unitholders, plaintiffs asserted that America, as controlling unitholder, had breached its duties to the minority by negotiating a merger for an unfair price and through an unfair process. Specifically, plaintiffs alleged that the merger undervalued Energy by failing to fully account for its Marcellus Shale assets or the elimination of its quarterly cash distributions. Plaintiffs challenged the process by which the merger was negotiated, alleging that America and certain individuals among Energy’s management dictated the terms of the merger agreement, including its timing – which they alleged took unfair advantage of Energy’s historically low trading price – and the lack of a “majority of the minority” condition for unitholder approval of the merger. Plaintiffs also alleged that members of the Special Committee breached their duties by approving the merger without a complete investigation of its terms, failing adequately to consider Energy’s other strategic options, and failing to negotiate on behalf of the minority in good faith.
Addressing the claims against the individual defendants, the Court held that the LLC agreement had eliminated the traditional fiduciary duties owed by Energy’s officers and directors and replaced them with a contractually defined duty of good faith requiring only that actions and determinations be made with the subjective belief that they are in Energy’s best interest. Mem. Op. 30. The Court rejected plaintiffs’ argument that the LLC agreement’s limited and subjective standard of good faith was unenforceable under the Delaware LLC Act because it impermissibly eliminated the implied contractual covenant of good faith and fair dealing. In the Court’s summation, plaintiffs misconstrued the role of the implied covenant, which does not dictate the terms parties must or must not include in a contract, but instead protects parties from arbitrary conduct that, objectively unanticipated by the terms of the contract, “frustrates the ‘fruits of the bargain that the asserting party reasonably expected.’” Id. at 31 (quoting Nemec v. Shrader, 991 A.2d 1120, 1126 (Del. 2010)). Relying on a recent Chancery decision addressing the implied covenant in the limited partnership context, the Court warned that parties may not invoke the implied covenant as a “back door” through which traditional fiduciary duties will be imposed after they have contractually agreed to the elimination of those duties – through an LLC agreement or otherwise. Id. (citing Lonergan v. EPE Holdings LLC, 2010 WL 3987173, at *8 (Del. Ch. Oct. 11, 2010)). Because plaintiffs had not alleged subjective bad faith on the part of any officer or director, including any member of the Special Committee, the Court dismissed the claims against the individual defendants.
Addressing the claims against America, the Court held that the LLC agreement did not address and, therefore, did not eliminate the duties traditionally owed by a controlling unitholder to the minority. In arguing that the claims against America should nonetheless also be dismissed, defendants relied upon the provision in the LLC agreement governing the resolution of conflicted transactions. Specifically, the agreement provided that a transaction involving a conflict of interest between Energy and any Energy affiliate “shall be permitted and deemed approved by all Members, and shall not constitute a breach of this Agreement,” if, among other things, it were approved by an independent special committee. See Mem. Op. at 17. Defendants argued that the Special Committee’s approval of the transaction thus fully resolved any conflict and precluded any challenge to the transaction from the unitholders, including any challenge brought against the Energy affiliate – in this case, America. Plaintiffs, in contrast, argued that the LLC agreement’s conflict resolution provision addressed only conflicts between Energy and its affiliates, not conflicts between a controlling unitholder and the public minority. The Court agreed and, therefore, held that the conflict resolution provision did not bar claims against America. The Court concluded that the merger was subject to scrutiny under the entire fairness standard for purposes of evaluating America’s performance of its duties in connection with the transaction. Finding sufficient allegations to support the inference that the merger was both procedurally and financially unfair to the minority, the Court denied defendants’ motion to dismiss the claims against America.
The full opinion is available here.