[This is the first of a two-part series on the basis for imposition of fiduciary duties on LLC managers. This first post examines a recent Delaware Chancery Court decision that is required reading on the subject. Part Two (read here) compares New York’s framework for holding LLC managers responsible as fiduciaries.]
Delaware’s Chancery Court, generally regarded as the country’s premier business court, undeniably has had great influence over the development of New York’s corporate law jurisprudence. As I see it, the influence drivers are twofold. First, New York judges decide many cases involving the internal affairs of New York-based Delaware corporations, to which they must apply Delaware statutory and case law. Second, the steady output and, more importantly, the consistent, unsurpassed depth and quality of the Chancery Court’s opinions on corporate law issues create a gravitational tendency for attorneys and judges in New York to look to Delaware case law for guidance in deciding difficult cases under New York’s corporate laws.
This tendency already is seen at work in the relatively undeveloped jurisprudence for limited liability companies (LLCs) which have existed in Delaware and New York only since 1992 and 1994, respectively. For instance, in a 2010 decision by the Manhattan-based Appellate Division, First Department, the court relied on Chancery Court precedent in construing manager indemnification rights under New York’s LLC Law (read here). More significantly, the Brooklyn-based Appellate Division, Second Department’s 2010 decision in the 1545 Ocean Avenue case, in which the court redefined the standard for judicial dissolution of LLCs, drew heavily on the contract-based approach formulated by the Chancery Court (read here).
One very important area of LLC jurisprudence that, so far, has garnered scant analysis by New York courts is fiduciary duty of LLC managers. Identifying the source, contours and beneficiaries of an LLC manager’s fiduciary duty is no simple affair, given the LLC Law’s sparse legislative history, it’s amalgam of provisions drawn from corporate and partnership statutes, and its novel structure largely as a set of default rules subject to contractual modification.
A decision last month by Chancery Court’s top judge, Chancellor Leo E. Strine, Jr. (pictured), in Auriga Capital Corp. v. Gatz Properties, Inc., Slip Op., C.A. 4390-CS (Del. Ch. Jan. 27, 2012), may spur the kind of analysis of LLC manager fiduciary duty that so far has eluded New York decisional law. The case involves a dispute between the minority and controlling members of a Delaware LLC structured as a holding company for a long-term ground lease for a golf course in Riverhead, New York, known as the Long Island National Golf Club. In his 74-page post-trial decision awarding damages against the LLC’s manager, who engineered a sale of the LLC’s assets to himself on highly unfair terms, Chancellor Strine holds that the manager of a Delaware LLC by default owes traditional duties of loyalty and care to minority members unless such duties are explicitly modified or eliminated by the operating agreement.
The decision exhibits the usual thoroughness, scholarship, wit and linguistic dexterity that has come to characterize Chancellor Strine’s writings. What interests me most about the decision is not its holding, which is consistent with a number of prior Chancery Court rulings on LLC manager fiduciary duty, but the analytic framework Chancellor Strine uses to identify the source of the duty (i.e., common law, the LLC Act, or the operating agreement) and to determine the means and extent to which the members may alter or eliminate the manager’s default duty. These issues are no less important in analyzing fiduciary duty of the New York LLC manager recognizing, however, that Delaware’s LLC Act and New York’s LLC Law diverge in certain aspects that may or may not be important.
The Auriga Decision
I won’t lay out in detail the facts in Auriga, and I won’t cover all the issues addressed in the decision. For readers who want a broader treatment, I recommend Francis Pileggi’s post on Auriga here. Also, Doug Batey comments on Auriga here.
In a nutshell, a number of investors took a minority position in Peconic Bay, LLC which was formed to hold the ground lease and develop a Robert Trent Jones-designed golf course on land owned directly or indirectly by Williams Gatz, who also held the majority interest and was sole manager of Peconic Bay. Gatz brought in a golf course operator under a sublease with a minimum 10-year term. After only a few years it became obvious that the operator was not interested in making the course a success and would not renew the sublease. Instead of finding a new strategic option for Peconic Bay that would protect its investors, Gatz, realizing that the land could be developed more profitably as a residential community, discouraged third-party offers to take over the golf club operations, made a (rejected) low-ball bid to buy out the minority investors, and eventually conducted a sham auction for the LLC at which he was the only bidder, with a "winning" bid of $50,000 in excess of the LLC’s debt on which Gatz was a guarantor.
The minority investors sued for damages, contending that Gatz breached his contractual and fiduciary duties. Gatz’s defenses boiled down to his contentions, first, that Peconic Bay’s operating agreement displaced any fiduciary obligations that otherwise might exist under equitable principles and, second, that as majority member he was free to pursue his own, selfish interests even to the detriment of the minority members.
The heart of Chancellor Strine’s fiduciary duty analysis appears on pages 15 to 27 of his slip opinion. Here’s a summary of the salient points:
- The Delaware LLC Act (the "Act"), similar to the Delaware General Corporation Law ("DGCL"), contains no statement that the traditional fiduciary duties of loyalty and care apply by default to managers or members. (Page 16)
- However, the Delaware Supreme Court, in its 1971 ruling in Schnell v. Chris-Craft, rejected an argument that such absence in the DGCL displaced "equitable fiduciary duties" owed by corporation directors, "stating famously that ‘inequitable action does not become legally permissible simply because it is legally possible.’" (Page 16)
- Application of "fiduciary duties grounded in equity" to LLC managers has an even stronger, statutory justification as reflected in §18-1104 of the Act providing that "[i]n any case not provided for in this chapter, the rules of law and equity . . . shall govern." (Pages 16-17)
- Under traditional principles of equity, "a manager of an LLC would qualify as a fiduciary of that LLC and its members" because "the manager is vested with discretionary power to manage the business of the LLC." (Pages 17-18)
- Because the Act provides for principles of equity to apply, and because fiduciaries owe traditional duties of loyalty and care, "the LLC Act starts with the default that managers of LLCs owe enforceable fiduciary duties." (Page 19)
- The Act, when adopted in 1992, provided that fiduciary duties could be "expanded or restricted" by the operating agreement. Following a Delaware Supreme Court ruling construing the state’s limited partnership statute concerning default fiduciary duties, the legislature in 1994 amended the Act (1) by amending §18-1101(c) to permit the "elimination" of fiduciary duties in an LLC agreement, and (2) by providing in §18-1101(e) for full contractual exculpation for breaches of fiduciary duty, except for the implied contractual covenant of good faith and fair dealing. If equitable fiduciary duties did not apply in the first instance by default, there would have been no need for the legislature to provide for the elimination of, and exculpation for, something that did not exist. (Pages 19-20)
- While the statute "incorporates equitable principles" that "view the manager of an LLC as a fiduciary" and subject the manager by default "to the core fiduciary duties of loyalty and care," the statute in §18-1101(c) "allows the parties to an LLC agreement to entirely supplant those default principles or to modify them in part." The courts will give effect to the parties’ contract choice, but when "the core default fiduciary duties have not been supplanted by contract, they exist as the LLC statute itself contemplates." (Page 21)
- The non-waivable, statutory duty of good faith and fair dealing serves a limited purpose as an "equitable gap-filler" for express contractual terms. It does not address a "potential for managerial abuse" and does not delimit a manager’s fiduciary obligations. (Pages 22-23)
- The "eradication of the explicit equity overlay in the LLC Act could tend to erode [Delaware’s] credibility with investors in Delaware entities" who, as a result of the legislative amendments to the Act, reasonably expect that managers of Delaware LLCs owe fiduciary duties of loyalty and care except to the extent the LLC agreement says otherwise. (Pages 24-27)
Chancellor Strine goes on to find that the express terms of Peconic Bay’s operating agreement neither eliminate Gatz’s traditional fiduciary duties nor exculpate him from the breach of those duties. He notes that the agreement contains no general statement that the manager’s duties are limited to those set forth in the agreement, i.e., the agreement does not displace the traditional fiduciary duties of loyalty and care owed to the LLC and its members. Chancellor Strine also relies on a section of the agreement which prohibits the manager from engaging in self-dealing transactions without the minority members’ consent except on terms and conditions "of similar agreements which could be entered into with arms-length third parties." This provision, Chancellor Strine writes, "reaffirm[s] that a form akin to entire fairness will apply to" Gatz’s purchase at auction of the LLC.
After finding that Gatz’s entire course of conduct, beginning with his failure to pursue strategic alternatives for the benefit of all the LLC members when he realized that the golf club operator would not renew its sublease, and ending with the "sham" auction at which Gatz acquired the LLC essentially for the amount of its debt, constituted a breach of Gatz’s fiduciary duties of loyalty and care, Chancellor Strine awarded the plaintiffs damages of about $776,000 representing the return of their capital investment plus a 10% return. He also awarded 50% of plaintiffs’ attorneys’ fees and costs under the bad-faith exception to the American Rule. In my favorite line from the decision, in footnote 184, Chancellor Strine admonishes Gatz and his counsel that, should they contest the amount of fees incurred by plaintiffs’ counsel, they "should remember that it is more time-consuming to clean up the pizza thrown at a wall than it is to throw it."