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Delaware Court of Chancery Rules Default Fiduciary Duties Apply To LLC Manager
Practical Law Legal Update 0-517-7258 (Approx. 5 pages)
Delaware Court of Chancery Rules Default Fiduciary Duties Apply To LLC Manager
by PLC Corporate & Securities
| Published on 02 Feb 2012 • Delaware |
An update on the Delaware Court of Chancery's decision in Auriga Capital Corp. v. Gatz Properties, LLC holding that the managing member of an LLC breached his fiduciary duties in operating the LLC and later squeezing out the minority investors on unfair terms. In finding that the managing member was subject to default fiduciary duties, the court again confirmed its position that the Delaware LLC Act and case law establish core fiduciary duties of loyalty and care absent express language to the contrary in the relevant LLC operating agreement.
On January 27, 2012, the Delaware Court of Chancery issued an opinion firmly reminding members of limited liability companies that managers and controlling members of LLCs must discharge the traditional fiduciary duties of care and loyalty unless the members have otherwise expressly agreed to modify or waive those default duties in the relevant operating agreement. In Auriga Capital Corp. v. Gatz Properties, LLC, the court found that the managing member defendant breached his fiduciary duties by:
- Operating the LLC in bad faith.
- Squeezing out the minority members in a self-dealing transaction on unfair terms.
The court's opinion is particularly noteworthy because of Chancellor Strine's comprehensive explanation of the application of default fiduciary duties under the Delaware LLC Act's (Delaware Act) general principles of equity, coupled with his examination of the supporting case law to date. For a discussion on the core duties of care and loyalty in the corporate context, see Practice Note, Fiduciary Duties of the Board of Directors.
Finding that the members of the LLC did not contractually eliminate the default fiduciary duties in the operating agreement and that the manager's actions (and omissions) were rooted in bad faith and gross negligence, the court ruled in favor of the minority member plaintiffs. The court awarded the plaintiffs a payment that it described as a modest remedy, even though Chancellor Strine admitted that the record supported a higher award for the breach of the manager's fiduciary duties.
Background
The minority members of Peconic Bay, LLC (Peconic) filed suit against its manager and controlling member, Gatz Properties LLC. Gatz Properties is controlled and owned by defendant William Gatz (Gatz) and his family. The minority members claimed that Gatz, as manager, breached both his contractual and fiduciary duties in the operation of, and later purchase of, the minority interests of Peconic.
Peconic held a long-term lease on a golf course that was owned by Gatz and his family. Peconic in turn subleased this valuable property to a national golf course management company that held options on the lease for 40 years. Not long after the sublease arrangement began, the golf course management company was bought out by a company that demonstrated little interest in making the golf course a success. According to the court's findings, six years into the sublease it became clear that the golf management company would not renew the sublease.
Knowing that the existing sublease arrangement would in all likelihood be terminated at the earliest opportunity, Chancellor Strine concluded that Gatz failed to protect Peconic's investors and instead used the situation as an opportunity squeeze out the investors at a bargain and take back complete control over the property. Once Gatz eliminated the minority investors, he and his family could repurpose the property into a more lucrative development without interference and without having to share those additional profits with other members.
In analyzing the record, the court found that Gatz:
- Failed to make any efforts to find a new strategic option for Peconic.
- Frustrated and misled an interested and credible buyer.
- Made "low-ball" bids to the minority investors based on misleading information.
- Conducted a "sham" auction to sell Peconic in which he was the only bidder.
- Acquired the minority investors' LLC interests for only $50,000 on top of Peconic's debt.
Gatz originally claimed that he owned no fiduciary duties of loyalty to the minority LLC members, but later asserted defenses on the grounds that:
- The manager and his family held the majority of the membership interests in Peconic and could force the minority to accept whatever they decided.
- The LLC had lost all of its value at the time of the auction.
Key Litigated Issues
The Auriga decision examined these main issues:
- What duties a manager owes the minority members of an LLC.
- Whether the manager satisfied those contractual and fiduciary duties.
Outcome
Default Fiduciary Duties Are Owed
In his decision, Chancellor Strine found that the manager's conduct breached both his contractual and fiduciary duties. In coming to that conclusion Chancellor Strine clearly accepted the Delaware Act as the statutory basis for the default position that managers of LLCs owe enforceable fiduciary duties, Chancellor Strine concluded that:
- Section 18-1104 of the Delaware Act requires that principles of equity apply to alternative entities such as LLCs.
- Section 18-1101(c) of the Delaware Act provides that traditional fiduciary duties can be expanded, restricted or eliminated by the LLC agreement.
- Reading those two provisions together, "the most logical reading" is a conclusion that LLC managers are fiduciaries who must discharge the duties of care and loyalty until the LLC agreement provides otherwise.
Chancellor Strine's opinion also examined case law in both the Court of Chancery and the Delaware Supreme Court, which he read as affirming the principle that default fiduciary duties apply to managers of alternative entities such as LLCs. Chancellor Strine cited the Delaware Supreme Court case of William Penn Partnership v. Saliba as supporting a finding of default fiduciary duties of care and loyalty, except in circumstances where the LLC members expressly modify or eliminate those duties in the governing operating agreement (13 A.3d. 749 (Del. 2011)).
Interestingly, and as an aside, Chief Justice Steele of the Delaware Supreme Court has on several occasions publicly stated his personal view that LLC members and managers should only be bound by those duties expressly set out in an operating agreement, rather than the traditional corporate default duties. He has also suggested that the decision in Saliba, which he authored, does not stand for the proposition that the Delaware Act imposes default fiduciary duties (see Article, Q&A with Chief Justice Myron T. Steele of the Delaware Supreme Court).
The Fiduciary Duties Were Breached
Chancellor Strine acknowledged in his opinion that one cannot evaluate fiduciary duty claims without carefully reviewing the applicable LLC agreement to determine whether any provision eliminates or modifies the members' and managers' traditional fiduciary duties, or limits or eliminates liability for breaches of those duties. This is permissible under Section 18-1101(e) of the Delaware Act, which states that the LLC agreement can eliminate the members' and managers' liabilities entirely, except for liability for breach of the implied covenant of good faith and fair dealing.
The Peconic LLC agreement, however, contained no general provision stating that the only duties owed by the manager to the LLC and its investors are contained within the operating agreement. In addition, Section 15 of the Peconic LLC Agreement generally provided that a manager could only enter into a transaction with an affiliate unless it was fair and approved by a majority of the minority LLC members. Chancellor Strine determined that Section 15 of the LLC agreement "...essentially incorporates a core element of the traditional fiduciary duty of loyalty."
On determining that the duties of care and loyalty would apply to Gatz, Chancellor Strine examined all of the relevant facts surrounding the conduct of the manager in his operations and eventual sale of the LLC. He held that Gatz breached his duties of loyalty and care in many ways and acted in bad faith at several critical points during his tenure as Peconic's manager.
The court awarded the plaintiffs a payment that it described as a modest remedy, even though Chancellor Strine admitted that the record supported a higher award for the breach of the manager's fiduciary duties. The court also awarded the plaintiffs one-half of their attorneys fees, noting that the fee shifting is appropriate under the "bad faith exception to the American Rule" and that it "...ensures that the disloyal manager is not rewarded for making it unduly expensive for the minority investors to pursue their legitimate claims to redress his [Gatz's] serious infidelity."
Practical Implications
The Auriga decision serves as another reminder that unless there is a clear contractual limitation in the LLC operating agreement, members and managers hold traditional fiduciary duties.
While the Delaware Supreme Court has yet to rule squarely on this issue, Chief Justice Steele's personal views on the matter leave a somewhat open question as to the ultimate outcome once the Delaware Supreme Court has an opportunity to review an appeal on these issues. Until it does, however, practitioners should assume that default fiduciary duties do apply, as that has repeatedly been the position taken by the Delaware Court of Chancery.