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Elimination of LLC Manager’s Fiduciary Duties Divides Appellate Panel

Posted in Delaware, LLCs, Operating Agreement

The Delaware limited liability company (LLC) is the preferred entity of choice for many New York-based business ventures for a number of reasons, including greater latitude in restricting or even eliminating the fiduciary duties of the LLC’s managers. Delaware case law remains relatively sparse on issues of scope and adequacy of fiduciary disclaimers in LLC agreements. As a result, New York courts have limited guidance when called upon, as they often are, to adjudicate fiduciary breach claims against managers of Delaware LLCs doing business in New York.

Last month, in Kagan v. HMC-New York, Inc., 2012 NY Slip Op 01514 (1st Dept Feb. 28, 2012), a divided Manhattan appellate panel by 3-2 vote affirmed the summary dismissal of fiduciary breach claims brought by the non-managing member of two Delaware LLCs against the managing members. The majority ruled that the fiduciary claims were precluded under Delaware law because (1) they were based on the same facts underlying the plaintiff’s contract claims and (2) a provision in the LLC agreement limiting the liability of the managers eliminated default duties even though it did not say so in haec verba.

The two dissenting judges (who joined the majority opinion in other respects) would have sustained the fiduciary claims on the grounds (1) the allegations of financial manipulation by the managers were sufficiently outside the contract claim to make out a viable claim for breach of fiduciary duty and (2) the disclaimer language used in the LLC agreement did not explicitly eliminate the traditional fiduciary duties otherwise applicable by default.

Let’s take a closer look at Kagan, particularly its discussion of the fiduciary disclaimer.

Background

The plaintiff, Howard Kagan, is an investment professional in the money management industry. The defendants, which include two investment funds (the Onshore Fund and the Offshore Fund), are part of a group of entities and individuals associated with a New York-based private investment firm known as Harbinger Capital. The subject Funds are managed by two management companies organized as Delaware LLCs (the Onshore Manager and the Offshore Manager).

Kagan provided consulting services starting in early 2003 and, in 2006, became a member of the Onshore and Offshore Managers. Under the LLC agreements, his membership interest entitled him to receive a portion of the manager entities’ performance compensation which rose and fell on the performance of the Onshore Fund.

In August 2008, the managing members involuntarily terminated Kagan’s relationship with the Harbinger entities. Kagan sued in 2009, claiming that he was owed over $62 million for performance-based compensation in 2007 and 2008. His complaint asserted claims, among others, for breach of contract and the implied covenant of good faith and fair dealing, and for breach of fiduciary duty against the managing members of the manager entities and their controlling persons. The fiduciary claims alleged that the managers purposely failed to pay Kagan amounts they acknowledged to be owed; conditioned payment on Kagan’s signing a release and waiver of certain rights; asserted the right to pay Kagan in part with worthless securities; failed to properly calculate amounts owed; and failed to ensure that sufficient assets would be available to pay Kagan. (Click here to read a copy of the complaint.)

The defendants moved to dismiss the breach of contract claims as against the member managers, and to dismiss the remainder of the complaint in its entirety. In part they relied on the following two provisions in the LLC agreements concerning manager duties and exculpation:

§ 7.9 Duties of Managers. The Managers shall act in good faith and in the best interest of the Company and with such care as an ordinarily prudent person in a like position would use under similar circumstances.

§ 7.10 Limitation of Liability. No Manager or Officer shall have any liability to the Company or any Member or Holder for any loss suffered by the Company or any Member or Holder that arises out of any act or omission by the Manager or Officer, if such Manager or Officer performs its duty in compliance with the standard set forth in the immediately preceding sentence, except loss or damage resulting from intentional misconduct, knowing violation of law, gross negligence or a transaction from which the Manager or Officer received a personal benefit in violation or breach of the provisions of this Agreement. . . .

(Click here to read a copy of the complete LLC agreement.)

The lower court, in a decision dated May 28, 2010, dismissed all of Kagan’s claims except those for breach of the LLC agreements. As to the fiduciary breach claims, the lower court based dismissal not on the exculpatory language in § 7.10, but solely on the ground that the allegations of fiduciary breach mirrored the contract breach claims.

Both sides appealed to the Appellate Division, First Department, which handed down its decision late last month. The five judges on the panel unanimously agreed that the lower court erred by not dismissing the contract claims against the member managers, including the claim for breach of implied duty of good faith and fair dealing, under the exculpatory provision in § 7.10. The panel also unanimously affirmed the dismissal of the remaining claims with the exception of those for fiduciary breach as to which three judges voted for dismissal and two voted against.

Justice Catterson’s Majority Opinion

The majority opinion, authored by Associate Justice James M. Catterson and joined by Associate Justices David B. Saxe and Sallie Manzanet-Daniels, concludes that the lower court properly dismissed the fiduciary breach claims under Delaware case law holding that when “the same facts that underlie [a plaintiff's] contract claim also form the basis of plaintiff’s fiduciary claim, the fiduciary claim is precluded” (citing Gale v. Bershad, 1998 WL 118022, 1998 Del Ch LEXIS 37 (Del. Ch. 1998), and other cases).  Since the defendant managers’ obligation “to properly calculate and distribute monies owed to the plaintiff arises out of the LLC agreements,” Justice Catterson writes, the plaintiff’s fiduciary claims “are substantially identical to the breach of contract claims [and] were properly dismissed.”

The majority opinion next addresses the dissent’s view that Delaware law requires “explicit elimination or restriction of fiduciary duties otherwise such duties apply by default . . .” (italics in original). Justice Catterson offers that the dissent’s view is based on the mistaken ”belief that ‘explicit’ requires such elimination or restriction to be written into an agreement in haec verba.” The provision for manager’s duties set forth in § 7.9 (“The Managers shall act in good faith and in the best interest of the Company”), Justice Catterson reasons,

imposes only specific limited contractual obligations on the managers, thus eliminating the traditional fiduciary duties imposed under Delaware law; expressio unius est exclusio alterius [the expression of one thing is the exclusion of another].

Justice Catterson also finds misplaced the dissent’s reliance on Kelly v. Blum, 2010 WL 629850, 2010 Del Ch LEXIS 37 (Del. Ch. 2010), in which then Vice Chancellor (now Chancellor) Leo Strine ruled that similar provisions in an LLC agreement did not explicitly disclaim the applicability of default principles of fiduciary duty. The distinction, according to the majority opinion, is that the LLC agreement’s provision in Kelly analogous to § 7.10 in Kagan referred to liability arising out of a “willful breach of [the Manager's] contractual or fiduciary duties” (emphasis added), thereby warranting the court’s finding in Kelly that the parties intended traditional fiduciary duties to apply. In Kagan, writes Justice Catterson, “[n]o such reference to the fiduciary duties of managers appears in the applicable section 7.10 in this case. On the contrary, it is explicitly omitted.”

Justice Moskowitz’s Dissenting Opinion

The dissenting opinion, authored by Associate Justice Karla Moskowitz and joined by Associate Justice Peter Tom, begins its analysis by noting that § 18-1101(e) of the Delaware LLC Act  expressly authorizes provision in the LLC agreement “for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties).” It next notes defendants’ argument that  § 7.9 of the LLC agreement in Kagan ”replaces the managers’ fiduciary duty that would exist under common law with a contractual one” and that, accordingly, “plaintiff cannot assert a cause of action for breach of fiduciary duty whatsoever.”

Citing Kelly v. Blum, Justice Moskowitz concludes that “Delaware law does not support defendants’ interpretation” because, as in Kelly, “no clause in the LLC agreements explicitly restricts or eliminates the fiduciary duties that exist at common law.” Justice Moskowitz explains further:

The parties do not dispute that member managers would traditionally owe fiduciary duties to non-managing members. Thus, as the LLC agreements do not explicitly eliminate these traditional fiduciary duties, they remain to the extent they do not duplicate a claim for breach of contract or fall within the terms of an exculpatory clause. 

Justice Moskowitz then goes on to find that, although there is “some overlap” between Kagan’s contract claims and fiduciary claims, his allegations

that the member managers breached their fiduciary duty by failing to ensure sufficient assets were available to pay plaintiff and by transferring assets to other members of the manager entities that they should have used to pay plaintiff are sufficiently outside the contract to sustain a claim for breach of fiduciary duty. . . . At this early pleading stage, considering the nature of the allegations, it would be inappropriate to dismiss this claim as duplicative of claims for breach of contract.

Justice Moskowitz concludes her analysis of the point by finding that Kagan’s allegations of deliberate self-dealing by the member managers fall within the “intentional misconduct” exception to the exculpatory provision in § 7.10 of the LLC agreement.

What’s a Drafter to Do?

It’s too early to say whether Kagan will at some point be presented or accepted for review by New York’s highest appellate tribunal, the Court of Appeals. Such review certainly would provide welcome guidance for transactional and litigation attorneys tasked with advising clients, who already have formed or seek to form Delaware LLCs based in New York, on important issues surrounding the fiduciary obligations of the LLC managers. (Even better would be a procedure for certification of questions of Delaware law to the Delaware Chancery or Supreme Court, akin to the process that allows the federal circuit courts to certify questions of law to the state supreme courts, but that’s just wishful thinking on my part.)

So what’s a drafter to do in the meantime? The cautious approach for the drafter who seeks to eliminate the traditional fiduciary duties is to use a strong form of broad, unequivocal disclaimer such as the one enforced by former Chancellor Chandler in Fisk Ventures, LLC v. Segal, 2008 WL 1961156 (Del. Ch. 2008), where the LLC agreement stated that “no member shall have any duty to any Member of the Company except as expressly set forth herein or in other written agreement.” In his recent opinion in Auriga Capital  Corp. v. Gatz Properties, LLC,  C.A. 4390-CS (Del. Ch. Jan. 27, 2012) (read here my article on Auriga), Chancellor Strine commented consistent with Fisk that a “general provision stating that the only duties owed by the manager to the LLC and its investors are set forth in the Agreement itself” will “displace the traditional fiduciary duties of loyalty and care owed to the Company and its members . . ..”  Such general language also ought to satisfy the principle espoused by Chancellor Strine in footnote 70 of his Kelly opinion, that

drafters of and parties to an LLC agreement should be expected to provide parties and anyone interpreting the agreement with clear and unambiguous provisions when they desire to expand, restrict, or eliminate the operation of traditional fiduciary duties.

How about what not to do? Look no further than Chancellor Strine’s 2009 decision in Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. 2009), where the LLC agreement contained “two separate and seemingly contradictory provisions,” one of which stated that “members shall have the same duties and obligations to each other that members of a limited liability company formed under the Delaware Act have to each other” while the other stated that “[e]xcept for any duties imposed by this Agreement . . . each Member shall owe no duty of any kind towards the Company or the other Members in performing its duties and exercising its rights hereunder or otherwise.” Chancellor Strine proceeded to construe the latter provision narrowly, as eliminating only those duties “that are not traditional fiduciary duties or are otherwise not expressly contemplated in the LLC Agreement.”

Update November 10, 2012:  By order dated June 26, 2012 (read here), the Court of Appeals sua sponte dismissed Kagan’s appeal from the First Department’s decision on the ground that the orders appealed from do not finally determine the action within the meaning of the Constitution. The trial court’s docket, which lists the case as “disposed,” reveals no subsequent case activity.

  • http://www.lisapom.com Lisa Renee Pomerantz

    Query whether it is a good thing for the success of an LLC or its members for the members not to have fiduciary duties to each other.