The question of how courts should shape the director-shareholder relationship and the limits of managerial freedom continues to impact Delaware corporate law. Daniel Rubin of Practical Law Company sat down with Chief Justice Myron T. Steele of the Delaware Supreme Court to discuss how this question bears on the issues of fiduciary duties in Delaware limited liability companies and the availability of Caremark claims against directors for business-risk decisions.

Chief Justice Steele: The reason I disagree with the view that there are default fiduciary duties is that LLCs are creatures of statute, not common law. The philosophical basis for the view that typical or traditional fiduciary duties should be the default position in an LLC arises out of the manager-owner relationship. Under common law, there is an understanding that when a party manages other people's investments, it does so with fiduciary duties in mind. Whether that results from an agency relationship, a receiver relationship or from the role as an executor/administrator of a trust or an estate, the focus is always on the relationship.

Those who advocate for default fiduciary duties (the typical, traditional corporate default duties) are looking at the relationship. But they miss the fact that the LLC form was created by statute, and that statute's explicit policy is to maximize contractual freedom. The way to maximize contractual freedom is to look at what the parties want to create in the contract. And in the absence of the parties imposing duties upon each other, regardless of how much their relationship looks like a traditional fiduciary relationship, their entire relationship is driven by the terms of the contract.

Chief Justice Steele: Yes. The statute in Section 18-1101(c) says that the covenant of good faith and fair dealing cannot be eliminated. It exists, like it did at common law, for every contract. My view aims to avoid a clash between interpreting language in a contract, where there is explicit bargaining and exchange of consideration for duties and rights, and governing that relationship under a regime of duties that have not been negotiated. This requires a strict reading of the contract. Duties not contained within the contract should not be implied, except for the duty that the parties are required to deal with each other in a manner consistent with the covenant of good faith and fair dealing.

Chief Justice Steele: Both positions are reasonable views. I do think my view is clearer, more predictable and more consistent with the legislative intent. I certainly understand the thought process that focuses on the manager-investor relationship, for those who think otherwise. But LLC business relationships are driven by contract. The good-faith element of the parties' duties to one another, to the extent they are not spelled out in the contract, stems from the implied covenant of good faith and fair dealing. To find otherwise creates a wholly unnecessary tension. If the duty of loyalty and duty of care, both of which must be carried out in good faith, are encapsulated by default, there is the immediate prospect of a clash between the way one carries out their duty of loyalty in good faith and the implied covenant of good faith and fair dealing. Which line of cases do we look at to resolve a dispute when one party complains that the other has breached a duty to them in bad faith?

Chief Justice Steele: The statute is not as clear as it ought to be. I can read the statute and follow the argument that if the statute says the parties are free to eliminate fiduciary duties, their fiduciary duties must first exist. My answer to that argument is that it is similar to DGCL Section 102(b)(7). It is confusing because it is the product of compromise. We need to draw a line. I don't care which way it is drawn. But the law, particularly Delaware law, is obligated to create predictability and consistency. We do not have that now.

Chief Justice Steele: The problem with that is the Delaware Court of Chancery is imbued with the concept of equity. If they see a contextual set of facts that calls upon them to redress something because it runs afoul of equity, they automatically look to concepts of the duty of loyalty and the duty of care, even if the parties expressly eliminate fiduciary duties in the LLC agreement. While I would like to think that if somebody expressly eliminated fiduciary duties the problem would be taken care of, I suspect it will not. The real issue will be just how explicitly the parties declared that fiduciary duties were eliminated. Did they identify both duties? Did they make it absolutely clear that it applies in every instance? It would be clearer if the default position is that if fiduciary duties are not mentioned they do not apply.

There also remains the potential for inconsistent interpretations of what carrying out one's duty of loyalty in good faith means, as opposed to complying with the implied covenant of good faith and fair dealing. These days we do not see a complaint filed that does not allege both as an "in the alternative" cause of action, sometimes with different requests for remedies.

(For an example of a provision eliminating fiduciary duties in an LLC agreement, with explanatory notes and drafting tips, see Standard Document, LLC Agreement (Multi-Member, Board-Managed) (Private Equity Buyout).

Chief Justice Steele: Yes. I sat on the Delaware Court of Chancery for six years. I later analyzed the cases I wrote in this area, and I found that in several of them, even though they were either limited partnerships or LLCs, I naturally gravitated toward breach-of-duty concepts. I did that because I was trying to fix a problem outside the contract that the parties had not dealt with in the contract terms. It is a natural tendency to do that when courts rule in equity.

We need better discipline. We need to understand that parties entering into a business relationship have rejected corporate concepts by accepting the LLC as their form of organization. They have accepted the governance arrangement spelled out in their agreement, with the understanding that the only prohibition in setting up that relationship of relative rights and responsibilities is the limitation that they must deal with one another in a manner consistent with the covenant of good faith and fair dealing. From my point of view, that is the direction in which to head. It is less convoluted and raises fewer questions about what is going to happen down the road.

Chief Justice Steele: I was not giving the view of the Delaware Supreme Court. I do not have anything to work with if the parties say, "This is our business relationship. We both agree that we believed that there were fiduciary duties owed in this relationship." At that point, the presence or absence of fiduciary duties is not in dispute. The parties believe the contract created that relationship. That is their operating basis and they concede that. There is no issue in controversy on which to rule otherwise.

That sentence should not be examined in isolation. It was very carefully drafted to convey that the parties had an understanding that fiduciary duties were owed.

Chief Justice Steele: That is an unresolved issue. It has never been squarely presented to the Delaware Supreme Court and therefore never squarely decided by the Delaware Supreme Court.

Chief Justice Steele: In my view, the Citigroup case was correctly decided. I think reading it together with the AIG case, which was almost contemporaneously decided, is the best way to figure out which way the Delaware courts would go in the business-risk arena.

If there is an independent board, and there is no dispute about their independence (for example, there is no credible prima facie claim in a complaint that the board acted in a way that was interested, and they meet everyone's definition of independence) it would be extremely difficult to question in hindsight what amounts to business risk when there is a process in place for assessing risk, and the board followed that process. This holds true even if the board failed to assess the risk consistently with the way in which the economy or that risk played out over time.

It is wholly different from the risk of an explosion or other similar kind of business risk, or from cases like Stone v. Ritter or Caremark where there is federal regulation that sets out compliance responsibilities. Compliance is different than business risk. In this situation it is more likely that the business judgment rule would govern and there would not be a Stone v. Ritter or Caremark compliance analysis.

Chief Justice Steele: The business risks associated with the economic downturn were taken in an area of the economy that is heavily regulated by multiple federal agencies. The real question is what role the Delaware court system plays, with hindsight, given that we are in a very narrow lane dealing with the internal corporate governance of Delaware corporations.

The traditional prism of fiduciary duty works. It tries to assess the encouragement of sound risk-taking without penalty so that a board is not chilled by the prospect that they could likely be found personally liable for their actions or are likely to be enjoined if their decisions involve risk. Otherwise, boards are going to sit on money and companies are not going to be competitive internationally, or even in their own business sector, if they are not careful. We want to try to find the right balance between encouraging principled conduct and incurring liability for unprincipled conduct without adversely affecting the ability to build wealth for the investor. I think every investor understands that.

I do not think the issue can be cast as dramatically as "there is a big gap," meaning, there is a gap between criminal activity and gross negligence and that gap has not been filled by the law. The gap has been filled in terms of carrying out the duties of loyalty and care in good faith, because a board that consciously disregards its duties would have acted more than grossly negligently.

People who invest in a corporation with Section 102(b)(7) provisions understand that the corporation's charter provides exculpation for gross negligence, and they accept this as part of the investment's risk profile. But they want to be protected from directors and officers who act criminally or in ways that consciously disregard the interests of the investors, or who pay no attention to the way in which their decision-making process is affecting the investment. However, if a corporation exculpates its directors and officers for gross negligence, there is no other gap.

No one has to invest in a corporation that allows exculpation for gross negligence. Not every corporation has that provision.