A recent Delaware Court opinion, Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, Case No. 3658-VCS (Del. Ch. Apr. 20, 2008), provides important guidance regarding whether and to what extent managers and members of a limited liability company (“LLC”) organized in Delaware owe duties to the LLC and its members. Section 18-1101(c) of the Delaware Limited Liability Company Act provides that “To the extent that…a member or manager...has duties (including fiduciary duties) to a limited liability company,…the member’s or manager’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.” However, in Bay Center, the Chancery Court held that where the LLC is silent or ambiguous as to the duties members and managers owe to each other, they will be subject to the traditional fiduciary duties that directors of a Delaware corporation owe. It also imposed the duties of good faith and fair dealing on the manager of the LLC to perform its management functions in good faith. Therefore, the Bay Center decision is important in that it underscores the necessity of LLC participants that do not want to be subject to traditional fiduciary duties to clearly and unambiguously modify or eliminate these duties in the LLC operating agreement.

Background

The Bay Center decision arises out a failed condominium project in Emeryville, California. The project was a venture of two entities, Bay Center LLC (“Bay Center”), and Emery Bay PKI, LLC (“PKI”), the latter of which was owned and managed by Alfred E. Nevis. In November 2005, Bay Center and PKI formed Emery Bay Member, LLC (“Emery Bay”), of which PKI was appointed the managing member. The limited liability company agreement of Emery Bay provided that PKI “shall manage and conduct” the affairs of Emery Bay. Pursuant to a separate Development Management Agreement, Emery Bay ETI, LLC, an affiliate of Mr. Nevis (the “Development Manager”), was required to conduct specific day-to-day management of the project. A wholly-owned subsidiary of Emery Bay was the only counterparty to this agreement. Under the limited liability company agreement of Emery Bay, PKI had the “power and authority” to cause the Development Manager to perform its obligation under the Development Management Agreement. Neither Bay Center nor any entity its controlled was a party to the Development Management Agreement.

Emery Bay obtained a third party loan (the “A&D Loan”) which Mr. Nevis personally guaranteed (the “Nevis Guarantee”). In consideration for transferring the real property to the project, Emery Bay issued an unsecured note to Bay Center (the “Bay Center Note”). Emery Bay subsequently defaulted on the A&D Loan. Bay Center alleged that Emery Bay, through Mr. Nevis and PKI, secretly renegotiated the A&D Loan, resulting in the diversion of cash flow from the project that was earmarked to repay the Bay Center Note in order to avoid triggering the Nevis Guarantee and capital calls to PKI. The project also suffered from a number of other problems, including budget overruns, vendor complaints, poor sales and vandalism, which Bay Center alleged were breaches of the Development Management Agreement. The project eventually failed in December 2007.

In its complaint, Bay Center sought monetary damages from Mr. Nevis and the entities he controlled, PKI, the Development Manager and Emery Bay, by claiming, among other things, breaches of duties of good faith and fair dealing and fiduciary duties. Bay Center claimed that PKI breached its duty of good faith by failing to exercise its authority as manager of Emery Bay to ensure the performance of the Development Management Agreement and the Bay Center Note. Bay Center claimed that Mr. Nevis breached his fiduciary duties by renegotiating the A&D Loan to advantage himself personally at the expense of Emery Bay. The defendants moved to dismiss these claims.

The Chancery Court denied the defendants’ motion to dismiss because Bay Center sufficiently stated claims for breaches of the duties of good faith and fair dealing and fiduciary duties. The court held that (i) PKI had an implied duty to exercise its authority as manager of Emery Bay to cause it to enforce performance of the Development Management Agreement in good faith and (ii) Mr. Nevis, the individual who managed Emery Bay through PKI, had a fiduciary duty not to use his control over Emery Bay’s assets to benefit himself at Emery Bay’s expense.

Good Faith and Fair Dealing

Although the Chancery Court acknowledged that Delaware courts employ the implied covenant of good faith sparingly in complex commercial agreements, it also recognized the occasional necessity of implying contract terms to ensure the parties’ reasonable expectations are fulfilled. Under the express terms of the Emery Bay limited liability company agreement, PKI had the obligation to manage Emery Bay and the discretion to cause the performance of the Development Management Agreement and the Bay Center Note. The court focused on the fact that Emery Bay’s breach of the Bay Center Note by diverting funds benefited only Mr. Nevis because it prevented triggering capital calls by PKI and the Nevis Guarantee. Also, the decision not to pursue claims against the Development Manager was a conflicted one, as Mr. Nevis was on both sides of it. By failing to ensure the proper performance of these obligations, the parties’ intent to develop a profitable housing complex was frustrated. The Chancery Court therefore read into the limited liability company agreement an implied covenant of good faith and fair dealing and held that PKI was required “to carry out these functions in good faith, meaning it could not engage in arbitrary or unreasonable conduct that had the effect of preventing Bay Center from receiving the fruits of the bargain.”

Fiduciary Duties

Next, the Chancery Court turned to the claim of breach of fiduciary duties. The court acknowledged that the Delaware Limited Liability Company Act gives parties wide latitude to order their relationships, including the flexibility to limit or eliminate fiduciary duties. It also noted that the Delaware Limited Liability Company Act is silent on what fiduciary duties members of an LLC owe. The Emery Bay limited liability company agreement contained seemingly contradictory provisions as to what duties the members owed to each other. One the one hand, it provided that “The Members shall have the same duties and obligations to each other that members of a [Delaware] limited liability company have to each other” while on the other hand it also provided that “Except for any duties imposed by [the limited liability company agreement]…each Member shall owe no duty of any kind towards the Company or the other Members in performing its duties....” The court resolved the apparent ambiguity by reasoning that the former provision could most reasonably be read as an intention to impose traditional fiduciary duties (i.e., fiduciary duties that directors of a Delaware corporation) on the members and the latter provision as an intention to eliminate only those duties that are not traditional fiduciary duties or are otherwise not expressly contemplated by the agreement.

The court then concluded that PKI’s conduct as a member of Emery Bay in diverting funds that were earmarked for payment to Bay Center in order to avoid capital calls and triggering the Nevis Guarantee, if true, were sufficient to support a claim for a breach of fiduciary duties. However, it is noteworthy that the court also extended to Mr. Nevis certain fiduciary duties, even though he was neither a member nor officer of Emery Bay. The court acknowledged prior precedent that an affiliate who exerts control over the assets of an entity may have fiduciary duties to that entity, although the scope of these duties has not been fully delineated. Noting that Mr. Nevis was alleged to have caused Emery Bay to make cash sweeps to satisfy the renegotiated A&D Loan for his own benefit, the court determined that a reasonable inference existed that Mr. Nevis used his own control over Emery Bay’s assets to shield himself from personal liability at the expense of Bay Center in breach of his fiduciary duties. As such, it denied the defendants’ motion to dismiss.

This decision confirms what many practitioners already suspected: that unless the parties agree otherwise, members and managers of LLCs owe traditional fiduciary duties to the LLC. Nonetheless, it does highlight the importance of drafting with clarity the parties intentions with respect to whether, and to what extent, duties may be owed in the context of an LLC.