Delaware Supreme Court Fails to Resolve Applicability of Default Fiduciary Duties to LLC Managers | Practical Law

Delaware Supreme Court Fails to Resolve Applicability of Default Fiduciary Duties to LLC Managers | Practical Law

The Delaware Supreme Court upheld the decision of the Court of Chancery that the defendant violated its contractually-agreed-to fiduciary duties, while rejecting as unnecessarily decided the Court of Chancery's holding that the Delaware LLC Act imposes default fiduciary duties. 

Delaware Supreme Court Fails to Resolve Applicability of Default Fiduciary Duties to LLC Managers

by PLC Corporate & Securities
Published on 14 Nov 2012 • Delaware
The Delaware Supreme Court upheld the decision of the Court of Chancery that the defendant violated its contractually-agreed-to fiduciary duties, while rejecting as unnecessarily decided the Court of Chancery's holding that the Delaware LLC Act imposes default fiduciary duties.
On November 7, 2012, the Delaware Supreme Court in Gatz Properties, LLC v. Auriga Capital Corp, upheld the decision of the Delaware Court of Chancery and affirmed damages and award of attorneys' fees to minority members of Peconic Bay, LLC (Peconic). In Auriga Capital Corp. v. Gatz Properties, LLC, minority members of an LLC brought a claim against the controlling member-manager, Gatz, claiming that he breached both his contractual duties and statutory default fiduciary duties in operating the LLC in bad faith and squeezing out the minority members in a self-dealing transaction on unfair terms (for further analysis of the Court of Chancery 's opinion see, Legal Update, Delaware Court of Chancery Rules Default Fiduciary Duties Apply To LLC Manager).
In the Court of Chancery opinion, Chancellor Strine posited that a default fiduciary duty under the Delaware LLC Act was owed by the controlling member-manager to the minority members of the LLC and held that the managing member breached both his contractual duties as well as his statutory default fiduciary duties.
While affirming the damages granted by the Court of Chancery on contractual fiduciary duty grounds, the Supreme Court determined it was unnecessary in this case to consider (and left open the question) whether statutory default fiduciary duties are imposed on managers or members of Delaware LLCs in instances where the operating agreement remains silent on the issue. In doing so, the court strongly rebuked Chancellor Strine for his analysis of the default duties issue and his use of a judicial opinion as a platform from which to propagate his personal world view.

Background

In Auriga Capital Corp. v. Gatz Properties, LLC, the minority members of Peconic filed suit against Gatz claiming that Gatz, as manager and controlling member, breached both his contractual duties as well as his statutory default fiduciary duties in operating the LLC in bad faith and squeezing out the minority members in a self-dealing transaction on unfair terms. In his decision, Chancellor Strine found that the manager's conduct breached both his contractual and default fiduciary duties. In coming to that conclusion, in Chancellor Strine's opinion, the Delaware LLC Act imposes as a default the traditional fiduciary duties of care and loyalty on managers and controlling members of LLCs unless the members have otherwise expressly agreed to modify or waive those default duties in the relevant operating agreement.

Key Litigated Issues

Gatz appealed the decision of the Court of Chancery, and the case raised issues of contract interpretation that the Delaware Supreme Court reviewed de novo.

Outcome

Contractual Fiduciary Duties

The Supreme Court agreed with the Court of Chancery's interpretation that Section 15 of the LLC Agreement imposed contractual fiduciary duties on the managers in transactions between the LLC and affiliated persons, despite the use of any magic words such as "fiduciary duties" or "entire fairness" in the operative language. In the Supreme Court's opinion, Delaware law does not mandate the use of specific words to impose fiduciary standards as a contractual matter and, in this case, the applicable provision of the LLC Agreement created a fiduciary duty standard of entire fairness for affiliated transactions (specifically when the manager caused the LLC to engage in an affiliated transaction with the manager to purchase assets from the LLC without the approval of the majority-of-the-minority of the members).
The Supreme Court also agreed with the Court of Chancery's analysis that, without that approval, Gatz had the burden under the contract of showing both fair dealing as well as a fair price. Because he was unable to do so, Gatz was liable for a breach of his contractual fiduciary duties. It also agreed with the Court of Chancery's conclusion that due to his bad faith efforts to squeeze out the minority members, Gatz failed to satisfy the criteria of Section 16 of the LLC Agreement permitting exculpation or indemnification by the LLC for his actions as manager.
In addition to upholding the award of damages solely on contractual grounds, the Supreme Court upheld the Court of Chancery's award of attorneys' fees to the plaintiffs. It agreed that Gatz had exhibited various examples of bad faith litigation conduct, such as:
  • The fact that Gatz's counsel allowed Gatz to be the primary collector of responsive documents.
  • Gatz deleted relevant documents while litigation was either pending or highly likely.
  • Gatz and his counsel punctuated the record with a series of legally and factually implausible assertions.

Default Fiduciary Duties

The Supreme Court also considered the Court of Chancery 's ruling that default fiduciary duties apply to managers and controllers of Delaware LLCs unless the LLC agreement expressly sets out that those duties shall not apply. The Supreme Court concluded that it was unnecessary for the Court of Chancery to decide the issue of default duties under the Delaware LLC Act and that the question remains open. In doing so, it strongly rebuked Chancellor Strine, expressing that if felt compelled to address the issue so his position was not misinterpreted in future cases as a correct rule of law. The Supreme Court stated that Chancellor Strine's opinion on the default issue should be regarded as dictum without any precedential value, providing five reasons for its conclusion, including:
  • Because the LLC agreement in this case specifically addressed the fiduciary duty issue, the case could be decided solely under the terms of the LLC Agreement and the default fiduciary duty analysis was unnecessary.
  • No litigant had asked the Court of Chancery or the Supreme Court to decide the default duty issue as a matter of statutory law.
  • It is improper for the Court of Chancery to imply that its decision is the final word on matters of Delaware law.
  • The merits of the issue is one about which reasonable minds could differ. Therefore, rather than resolving it on their own, the Court of Chancery is advised to consider urging the General Assembly to resolve any statutory ambiguity on this issue.
  • The digression into the issue of default fiduciary duties strayed beyond the proper purview and function of a judicial opinion and the obligation to write judicial opinions on the issues presented is not a license to use those opinions as a platform from which to propagate individual world views on issues not presented.

Practical Implications

This case provides a strong reminder that, despite the long held belief based on relevant Court of Chancery cases that default fiduciary duties apply to Delaware LLCs in the absence of an explicit elimination of these duties in the LLC agreement, the issue is still undecided under Delaware law. Until the Supreme Court or the General Assembly decides this issue, practitioners should continue to assume that traditional fiduciary duties may apply and that they should be explicitly eliminated in the LLC Agreement if so desired. Conversely, practitioners who wish to create fiduciary duties for Delaware LLC managers and controllers should be wary of relying solely on default fiduciary duties and create express fiduciary duties in the LLC Agreement.
In either case, practitioners should keep in mind that, since the Delaware LLC Act is primarily a default statute containing provisions that can be altered by agreement among the members, practitioners bear much of the responsibility when drafting LLC Agreements to describe the parties entire relationship by contract, including the economics of the venture, governance rights and any fiduciary duties.
For a long-form US LLC agreement to be used in connection with an investment transaction with multiple members which explicitly eliminates any fiduciary duties, see Standard Document, LLC Agreement (Multi-Member, Board-Managed) (Private Equity Buyout).

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