A major difference between the New York and Delaware statutes governing limited liability companies is the latter’s provision, found in Section 18-1101 of the Delaware LLC Act, permitting the operating agreement to restrict or eliminate manager and member fiduciary duties. For this and other reasons, many New York-based business ventures, especially highly capitalized ones with sophisticated outside investors, use Delaware LLCs with carefully drawn operating agreements insulating managers from liability for fiduciary lapses.
In the absence of a forum selection clause in the operating agreement, requiring that any dispute among the members be litigated in Delaware, New York courts frequently host litigation by non-managing members of New York-based Delaware LLCs asserting claims for financial abuse or other fiduciary breach by managers. When these suits occur, the New York courts must apply governing Delaware law under the so-called “internal affairs” doctrine.
On the same day last week, two different panels of the Manhattan-based Appellate Division, First Department, issued rulings in two cases deciding claims for breach of fiduciary duty against managers of Delaware LLCs. In Melcher v. Apollo Medical Fund Management LLC, 2011 NY Slip Op 04083 (1st Dept May 17, 2011), the court upheld a rare jury verdict against the individual manager awarding the plaintiffs a half-million dollars for breach of fiduciary duty based on diversion of management fees. In Coventry Real Estate Advisors, LLC v. Developers Diversified Realty Corp., 2011 NY Slip Op 04097 (1st Dept May 17, 2011), the court affirmed an order dismissing fiduciary breach claims against a non-managing member who, the plaintiffs alleged, acted as de facto manager.
Melcher v Apollo Medical Fund Management
Melcher‘s affirmance of a jury verdict illustrates the interplay of default rules, the operating agreement and Section 18-1101 of the Delaware LLC Act, as articulated by Vice Chancellor Strine of the Delaware Chancery Court in Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, Del. Ch. No. 3658-VCS (Apr. 20, 2009):
The Delaware LLC Act gives members of an LLC wide latitude to order their relationships, including the flexibility to limit or eliminate fiduciary duties. But, in the absence of a contrary provision in the LLC agreement, the manager of an LLC owes the traditional duties of loyalty and care to the members of the LLC. [Footnotes omitted.]
The plaintiffs in Melcher alleged that the managing member breached fiduciary duty by using his own, separate, investment advisory firm to manage certain offshore funds and thereby diverted incentive fees instead of sharing them with the plaintiffs. The defendant relied on language in the operating agreement stating that ‘[a] Member does not violate a duty or obligation to [the LLC] merely because the Member’s conduct furthers the Member’s own interest.” The trial court’s charge to the jury stated that this language “does not absolve a manager of his financial duty to the company and to the members who own it.” The jury found in plaintiffs’ favor.
In the subsequent appeal, the First Department rejected the defendant’s challenge to the jury charge. The appellate court quoted from Bay Center to hold that the supposedly exculpatory provision in the operating agreement relied on by the defendant does not “explicitly” disclaim the applicability of default principles of fiduciary duty pursuant to which LLC members “owe each other the traditional duties that directors owe a corporation” including the fiduciary duties of “due care, good faith, and loyalty.”
For those who’d like to learn more about the Melcher case, read here and here the defendant’s and plaintiffs’ post-trial briefs, respectively, and here the trial court’s post-trial decision upholding the jury’s verdict.
Coventry Real Estate Advisors v Developers Diversified Realty
If the Melcher case teaches a lesson to would-be Delaware LLC managers about under-protective limitations on liability, the Coventry case teaches a lesson to would-be investors about the need to contract for specific duties of non-manager members to whom significant management authority may be delegated.
The plaintiffs in Coventry alleged that the defendant real estate management firm (“DDR”) mismanaged the leasing and development of a dozen or so real properties. The governing agreements delegated to DDR, a non-managing member, most of the day-to-day management responsibility in exchange for fees. The complaint accused DDR of maximizing its own fees thereby causing the investments to fail. Plaintiffs also alleged that some of the properties were acquired by defendants at distress prices after they extracted fees and wiped out plaintiffs’ equity. (For a more detailed recitation of the facts, read here the trial court’s June 2010 decision dismissing the plaintiffs’ claim for breach of fiduciary duty.)
The appellate court’s decision, affirming the dismissal of the fiduciary breach claim against DDR, focuses on what could be considered a corollary to the Bay Center rule, namely, the imposition of traditional fiduciary duties on LLC members in the absence of limiting language in the operating agreement only applies to managers and those designated as controlling members of the LLC. It does not apply to non-managing minority members, such as DDR.
The Coventry decision cites two cases in support, both decided last year. One of them, In re South Canaan Cellular Investments, LLC, 2010 WL 3306907 (Bankr. ED Pa 2010), interpreted Delaware law drawn mostly from corporate and limited partnership cases as exempting from common law fiduciary duty LLC members who lack control or management responsibility over the LLC. The Delaware Chancery Court reached the same conclusion in the other cited case, Kuroda v. SPJS Holdings, LLC, 2010 WL 925853 (Del. Ch. 2010), notable for its Lewis Carroll reference in footnote 30 (“To believe that the parties in this complex web of contractual arrangements intended to superimpose fiduciary duties upon a non-managing, non-controlling LLC member would require me to surpass even the White Queen’s ability to believe six impossible things before breakfast.”).
The Coventry court also was not impressed with the plaintiffs’ effort to paint DDR as a de facto manager with fiduciary duties:
We reject plaintiffs’ contention that, regardless of its designation under the LLC Agreements, DDR was the LLCs’ de facto managing member by virtue of its control over LLC operations. Notwithstanding the extensive powers accorded to DDR under the Management Agreements, the LLC Agreements do not mandate that the LLCs enter into any Management Agreements with DDR. Instead, the decision of whether to enter into those agreements is left up to each LLC’s “Investment Committee,” which is not controlled by DDR. Hence, the LLC Agreement’s “default setting” leaves principal management responsibility with the Managing Member, not DDR. Since DDR is not a majority or controlling member of the LLCs under the LLC Agreements, it has no fiduciary duties thereunder.
This is a very significant point, especially in light of the past tendencies of New York courts — at least when it comes to New York LLCs — to employ equitable principles when determining the duties of LLC members. By maintaining a bright-line rule based on member status as defined in the operating agreement, the court in Coventry remains true to Delaware’s freedom-of-contract principle expressed in Section 18-1101 of the Delaware LLC Act.