Default LLC Fiduciary Duties in Delaware

In an important opinion that will impact the drafting of Delaware LLC agreements, the Chancery Court held that an LLC manager owes default fiduciary duties of care and loyalty to minority members unless such duties are specifically modified or eliminated by agreement.  The decision -- Auriga Capital Corp. et al v. Gatz Properties, LLC et al, C.A. 4390-CS (Del. Ch. Jan. 27, 2012) -- was issued this past Friday.

The Court held that the Manager owed fiduciary duties of loyalty and care to Members because the operative LLC Agreement did not expressly eliminate those duties.  Because the Delaware LLC Act provides that “the rules of law and equity shall govern” in any matter not expressly provided for, and the 2004 Amendments to the Act allowed an LLC agreement to “eliminate” such duties, the Court confirmed that default duties of care and loyalty existed under Delaware law.    

Private equity fund investors typically form LLCs to hold the investment.  The operating agreements for such LLCs should contain language clearly waiving/modifying the default fiduciary duties.  For example:

Notwithstanding anything to the contrary in this Agreement or at law or in equity including but not limited to the Act, each Member agrees that any fiduciary duty imposed under Delaware law (including the duty of loyalty and the duty of care) on the Investor Members or any individual designated by such Investor Member as a Board Member shall be defined, limited and eliminated as provided in this Section [__].

Read more courtesy of DLA Piper's John L. Reed, Jennifer A. Lloyd and Courtney Stewart:

In a recent opinion that should have long-ranging effects on the interpretation and drafting of limited liability company agreements under Delaware law, Chancellor Leo E. Strine, Jr., of the Delaware Court of Chancery held that a manager of a Delaware LLC owes default fiduciary duties of care and loyalty to minority members unless such duties are specifically modified or eliminated by agreement. 

 

The court’s post-trial decision in Auriga Capital Corp., et al. v. Gatz Properties, LLC, et al., C.A. 4390-CS (Del. Ch. Jan. 27, 2012), which provides a detailed statutory analysis of the Delaware LLC Act and related alternative entity statutes, is the first to squarely confront and put to rest an issue of debate in Delaware in recent years – that is, when an LLC agreement is silent on the issue of fiduciary duties, is it governed by default fiduciary duties or does it have no such duties at all?  The opinion should be of great interest to drafters of and parties to LLC agreements governed by Delaware law.

 

The dispute arose out of Auriga Capital Corporation’s minority investment in a Delaware LLC that developed and owned a long-term ground lease for the Long Island National Golf Course in Peconic Bay.  The majority interests were owned by the manager, William Gatz, and his family (who also owned the underlying land).  The LLC financed the golf course’s construction and hired an operator in 2000 to manage the course for a minimum period of ten years.  After losing the golf course operator, turning away a serious bidder for the LLC and making a low-ball offer for the minority interests, the manager bought the LLC at an auction at which he was the only bidder.  After the payment of debt, this resulted in a return of only $20,000 to the minority members from their initial investment of $750,000, while the manager obtained the entire golf course and the opportunity to turn the property into a more lucrative residential development.

 

The court first noted that although the Delaware LLC Act (like the Delaware General Corporation Law) does not explicitly state that traditional fiduciary duties apply, it does state that “the rules of law and equity … shall govern.” 6 Del. C. § 18-1104.  The court then held that because an LLC manager would “easily fit the traditional definition of a fiduciary” (as someone “vested with discretionary power to manage the business”), and fiduciaries owe duties of care and loyalty, an LLC manager owes duties of care and loyalty.  The court found further support in the 2004 amendments to the LLC Act and Delaware Revised Limited Partnership Act (DRLPA) which permitted the “elimination” of fiduciary duties by agreement:   “Why would the General Assembly amend the LLC Act to provide for the elimination of ‘something’ if there were not ‘something’ to eliminate in the first place?”

 

Two policy reasons further supported the court’s conclusion that default fiduciary duties govern Delaware LLCs.  First, “those who crafted LLC agreements in reliance on equitable defaults that supply a predictable structure … will have their expectations disrupted” if no duties existed.  The eradication of such duties would leave an unpredictable gap that could not be adequately addressed by the implied contractual covenant of good faith.  Second, “judicial eradication of the explicit equity overlay in the LLC Act could tend to erode our state’s credibility with investors in Delaware entities.” 

 

Chancellor Strine emphasized, however, that the LLC statute allows the parties to modify, supplant or eliminate default duties, and Delaware courts will give effect to parties’ contractual choices.  Analyzing the specific Peconic Bay Agreement, the court found it did not eliminate the default duties because it did not contain language that “the only duties owed by the Manager are set forth in the Agreement,” and because it contained an “arm’s length” provision for transactions with affiliates.   

 

Having established that default fiduciary duties applied, and after considering several days of trial testimony, the Court of Chancery concluded that the manager breached those duties by (1) failing for five years to address the anticipated loss of the golf course operator and rent payments; (2) turning away a responsible bidder that would have paid a price beneficial to all LLC investors (not merely the majority owners); (3) making an unfair offer to buy out the Minority Members through misleading disclosures, including an inadequate appraisal; and (4) buying the LLC through a sham auction at a distress sale price conducted by an unqualified auctioneer.  The manager also breached the contractual arm’s length provision by purchasing the LLC at a sham auction. 

 

As an equitable remedy, the court awarded the minority members their capital investment with a 10 percent return – what they would have obtained had a fair price been obtained for the LLC – plus half of their attorney’s fees and costs.  The Delaware office of DLA Piper -- attorneys John L. Reed, R. Craig Martin and K. Tyler O’Connell – represented the minority member, Auriga Capital Corporation, in this case.  A copy of the opinion can be found here.   

 

To take advantage of the contractual freedom granted by the Delaware LLC statute, drafters and parties to an LLC agreement should be careful to include clear and unambiguous provisions when they intend to restrict or eliminate traditional fiduciary duties.   Managers and members of Delaware LLC agreements already in place that do not contain explicit language should obtain advice regarding their rights and obligations under this new authority.

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