Recent developments in Delaware law have sparked renewed debate among legal practitioners and academics as to whether default fiduciary duties apply to the managers of a Delaware limited liability company (“LLC”) where the operating agreement is silent as to such duties. Decisions emanating from the Delaware Court of Chancery have affirmed what many practitioners already believed to be true: that absent contractual language to the contrary, the manager of a Delaware LLC owes fiduciary duties to the LLC and its members. As emphasized in the Supreme Court's decision Auriga Capital Corp. v. Gatz Properties LLC, however, the Delaware Supreme Court has yet to decide the question, and considerable uncertainty remains as to how the court would rule.
Importantly, the Delaware General Assembly and the Governor will shortly consider certain targeted amendments to the Delaware Limited Liability Company Act (the “Delaware LLC Act”) that may resolve some of the uncertainty around the question. However, unless and until Delaware clarifies the issue, practitioners may well want to take affirmative steps to resolve the uncertainty in preparing LLC agreements. Currently, under the Delaware LLC Act, default fiduciary duties may be modified or eliminated by the terms of the LLC agreement itself.1 Parties may also contract explicitly for the traditional fiduciary duties of care and loyalty. In light of the continued uncertainty regarding the status of default duties, the savvy practitioner should make abundantly clear what duties, if any, the parties intend to apply.
Delaware has long imposed the default fiduciary duties of care and loyalty on the officers and directors of corporations.2 When Delaware created certain statutory alternatives to the corporate form, including limited partnerships and LLCs, many practitioners assumed that such duties would be imported from the corporate context. Decisions from the Delaware Court of Chancery appeared to confirm that assumption, as the court previously routinely concluded that managers of Delaware LLCs owe traditional fiduciary duties to the LLC and its members.3
Some commentators, including, most notably, Myron T. Steele, Chief Justice of the Delaware Supreme Court, however, have criticized that approach. Chief Justice Steele argues that because LLCs are creatures of contract, Delaware courts should, as an initial matter, engage in contract construction, to determine the fiduciary duties, if any, created by the operating agreement. Currently, default fiduciary duties are not mandated by the Delaware LLC Act and economic and policy analysis suggests that such duties should not be imposed, Justice Steele contends.
Particularly in light of Chief Justice Steele's stated position, followers of Delaware corporate law eagerly awaited the Delaware Supreme Court's decision in Auriga Capital, where the Delaware Supreme Court might have the opportunity to finally resolve the status of default duties in Delaware LLCs. Rather than resolving the issue, however, the Auriga Capital decision has raised new questions and reinforced the uncertainty.
On January 27, 2012, in Auriga Capital Corp. v. Gatz Properties LLC,4 the Delaware Court of Chancery held defendants Gatz Properties, LLC (“Gatz Properties”), manager of Peconic Bay LLC (“Peconic Bay”), and William Gatz (“Gatz”), controller and part owner of Gatz Properties, liable for breach of their fiduciary duty to the minority investors in Peconic Bay. Consistent with prior decisions, the Court of Chancery held, after a detailed analysis, that managers of Delaware LLCs owe fiduciary duties of loyalty and care to the LLC and its members unless such duties are expressly waived or modified by the terms of the LLC agreement.5
The dispute in Auriga Capital arose out of the development and management of a golf course.6 The Gatz family owned real estate and sought to develop the land into a high-end golf course.7 To do so, Gatz formed Peconic Bay with Auriga Capital to raise capital for the development and lease of the property. Independently, Gatz formed Gatz Properties to hold title to the property and to lease the property to Peconic Bay.8 Peconic Bay in turn subleased the property to a third party operator.9 Although Peconic Bay was not initially controlled by Gatz and his family, over time the Gatz family increased their holdings to 52.8 percent.10
With majority control, Gatz and his family gained “Majority Approval,” as defined in the Peconic Bay LLC agreement, allowing Gatz Properties to control major decisions with respect to Peconic Bay including veto power over the LLC's strategic options.11 After Gatz got word that the third party operator planned to exercise its optional early termination of the sublease, Gatz, through Gatz Properties, allegedly took various steps to artificially deflate the value of the LLC, squeeze out the minority investors, conduct a sham auction, and deliver Peconic Bay to Gatz at a distressed price.12
The Court of Chancery held, in a decision authored by Chancellor Strine, that since the Peconic Bay LLC agreement contained no general provision eliminating implied fiduciary duties and no specific contractual provision inconsistent with default fiduciary duties, the Peconic Bay LLC agreement did not displace the traditional, default fiduciary duties of loyalty and care. The court found both Gatz Properties and Gatz liable for breach of their implied fiduciary duties to the minority investors of Peconic Bay.
Gatz appealed the Court of Chancery's decision to the Delaware Supreme Court, giving the Supreme Court the opportunity to rule, for the first time, on whether default fiduciary duties exist in the LLC context in the absence of contrary provisions in the LLC agreement. Notably, in the limited partnership context, in a 2002 decision, the Delaware Supreme Court explicitly blessed the Chancery Court's dictum—that absent contractual language to the contrary, a general partner owes the default fiduciary duties of loyalty and care to a Delaware limited partnership and its partners.13 Consequently, some thought the Court might take the opportunity to resolve the issue in the LLC context or perhaps the alternative entity context more broadly, finally putting the issue to rest. However, on November 7, 2012, the Delaware Supreme Court upheld the Court of Chancery's decision in Auriga Capital on other grounds—finding that the LLC agreement contemplated contractual fiduciary duties—and leaving for another day the resolution of default fiduciary duties in the LLC context.14
Although the Delaware Supreme Court upheld the Court of Chancery's finding of liability against the defendants for breach of fiduciary duty, it devoted five pages of its opinion to explain that the Court of Chancery's ruling with respect to default fiduciary duties was mere dicta.15 The Supreme Court criticized the Court of Chancery for its findings with respect to default fiduciary duties, which the Supreme Court deemed unnecessary, and for engaging in improper judicial activism.16 The Supreme Court reminded the Chancery Court of its place in the judicial hierarchy—cautioning the Court of Chancery that notwithstanding the fact that “the Court of Chancery has decided an issue,” and “practitioners' rely on that court's decisions,” the Supreme Court, as “an appellate tribunal and the court of last resort in this State” has the power to rule otherwise.17 Indeed, the Delaware Supreme Court has the final say on the issue in Delaware, and there remains considerable uncertainty as to how it would rule.
Previous decisions emanating from the Court of Chancery have concluded that managers of Delaware LLCs owe default fiduciary duties to the LLC and its members. Most recently in Feeley v. NHAOCG, LLC, Vice Chancellor Laster explained that although Chancellor Strine's discussion regarding default fiduciary duties in Auriga Capital was not precedential, it was persuasive.18 As in Auriga Capital, the Court in Feeley observed that because the Delaware LLC Act states that courts should be governed by “the rules of law and equity” in “any case not provided for” by the Act, courts should interpret LLC agreements against the background of established fiduciary law.19 Because the managing member of an LLC easily fits the definition of a fiduciary, those decisions contend, the traditional duties of care and loyalty should apply.
Further, the Court of Chancery has found that imposing default fiduciary duties is consistent with the text of Section 18-1101(c) of the Delaware LLC Act, which allows parties to modify or eliminate duties, “to the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to [the company, its members, or another person] … .”20 As the court observed in Feeley, such language supports the existence of default fiduciary duties, because without them, “there would be nothing for the operating company agreement to expand, restrict, or eliminate.”21 Lastly, the Court of Chancery has noted the important role default fiduciary duties play as an equitable gap-filler to parties' often incomplete, minimalistic or informal operating agreements.22
Drawing an analogy to the default fiduciary duties owed by general partners to Delaware limited partnerships and their partners, courts have held, supports the conclusion that managers of Delaware LLCs owe default fiduciary duties.23 Like the Delaware LLC Act, the Delaware Uniform Limited Partnership Act (the “Delaware LP Act”) references “the rules of law and equity,” which, according to the Court of Chancery, suggests a legislative intent to import equitable fiduciary duties into the limited partnership context.24 Like the Delaware LLC Act, the Delaware LP Act also permits the parties to a limited partnership agreement to contractually opt out of such duties. Accordingly, in numerous decisions, the Court of Chancery has found that default duties apply in the limited partnership context.25
However, the Court of Chancery's position with respect to default fiduciary duties in the LLC context remains controversial. Because LLCs are entirely creatures of contract with no roots in corporate or partnership law, some legal scholars have argued, the only duties a manager owes to the LLC and its members should be those imposed by the operating agreement itself. Legal scholars have argued, moreover, that the rationale for imposing default fiduciary duties in the limited partnership context is simply not analogous in the LLC context.26Unlike the Delaware LLC Act, the Delaware LP Act, where silent as to duties, defaults to the duties imposed by the Delaware Uniform Partnership Act (the “Delaware Partnership Act”).27 The Delaware Partnership Act explicitly provides that a partner is “accountable as a fiduciary.”28 It is argued that because the Delaware LLC Act does not refer to the Delaware Partnership Act, or currently any other organic source of fiduciary duties, the Delaware LLC Act does not import the same default fiduciary principles into a Delaware LLC.29 It is further argued that managers of an LLC, unlike the general partner of a limited partnership, are not inherently fiduciaries, as LLCs are, by default, member managed.30 In a member managed LLC, all members manage the LLC, in contrast to a manager managed LLC where the LLC is managed by a separate manager. In a member managed LLC, the argument goes, there is no need for default fiduciary duties because the LLC is not controlled by a manager in which the members place their trust and confidence, the traditional hallmarks of a fiduciary.
Adding a nuanced argument to the debate are articles by Chief Justice of the Delaware Supreme Court, Myron Steele,31 in which he asserts for himself and not for the Delaware courts, his belief that the Delaware courts, when analyzing the duties of parties to an alternative entity, should focus on the contractual relationship formed by the operating agreement and avoid imposing common law notions of fiduciary duties on such freely negotiated contractual terms. Steele argues that courts should not impose fiduciary duties on parties to an alternative entity, unless such duties are contractually created. When read carefully, Steele acknowledges the likelihood that, absent clear language to the contrary, a court could fashion fiduciary duties if the provisions of the operating agreement contemplate such duties. However, Steele argues that such duties, if they are found to exist at all, must be consistent with the language of the contract itself and not imposed universally.
The current debate over default fiduciary duties largely presumes the issue is binary—either default fiduciary duties apply where the operating agreement is silent or not32—or put in Steele's terms—either the presumed status relationship trumps where the operating agreement is silent or the contractual relationship trumps such that if the operating agreement does not explicitly provide for fiduciary duties there are none.33 This binary approach overlooks a practical alternative to the all or nothing application of default fiduciary duties—where the operating agreement is silent as to the application of fiduciary duties, the court may look to the actual status relationship created by the specific operating agreement to determine whether fiduciary duties apply.
Alternative entities, particularly LLCs, are used for a myriad of business purposes, from actual operating companies to joint venture vehicles to holding companies for non-operating assets to mere corporate shells. The day-to-day role that a manager plays with respect to the LLC may fall within a broad spectrum, from completely passive to a true fiduciary, and the application of one-size-fits-all fiduciary duties to such managers may not reflect the true relationship among the parties. Where the operating agreement does not eliminate fiduciary duties and where fiduciary duties would not be inconsistent with the terms of the operating agreement, the Court of Chancery, sitting in equity, may impose fiduciary duties based on the status relationship between the parties created by the operating agreement, i.e., the role being played by the manager, the relationship of the manager to the entity, the level of discretion provided to the manager under the operating agreement and the facts of the case. A world without default fiduciary duties does not mean a world without fiduciary duties or a world without an equitable gap-filler.
This nuanced approach nicely reconciles the “to the extent a member or manager or other person has duties (including fiduciary duties)” language in the Delaware LLC Act as leaving to the court's determination, on a case by case basis, whether, based on the terms of the operating agreement, the role being played by the manager, the manager's relationship to the entity and the facts of the case, the manager owes fiduciary duties to the LLC and its members.34 Under such an approach, the manager of a Delaware LLC would owe fiduciary duties to the LLC “to the extent” the manager's relationship to the LLC and its members is a fiduciary relationship as a matter of agency law.
The Alternative Entity Subcommittee in Delaware has recently recommended an amendment to the Delaware LLC Act to clarify that traditional fiduciary duties may apply even in cases where the parties have not expressly provided for them in the operating agreement. Specifically, the Committee has recommended to the Delaware General Assembly that it amend Section 18-1104 of the Delaware LLC Act to provide that the rules of law and equity, including “the rules of law and equity relating to fiduciary duties,” shall apply. The proposed amendment would also revise the Committee comments to the Act to make clear that, at least in certain circumstances, managers of manager-managed LLCs owe traditional fiduciary duties to the LLC and the members of the LLC.35Although it remains to be seen whether the proposed amendments to the Delaware LLC Act and the comments will acknowledge the variety of purposes for which Delaware LLCs are formed, and therewith the varying degrees to which fiduciary duties may be imputed to a Delaware LLC, the proposed amendments nonetheless bring some potentially much needed clarity to the issue of the applicability of fiduciary duties to Delaware LLCs.
It remains to be seen whether fiduciary duties will be imposed on every Delaware limited liability company and limited partnership agreement which fails to contractually eliminate such duties. Against this backdrop of uncertainty, until the Delaware courts or the legislative process in Delaware clarify the issue, practitioners should explicitly contract for the specific duties they wish the manager or general partner to be bound to in the governing agreement.
If the goal is to create a baseline of fiduciary duties with specific contractual carve-outs, drafters should explicitly and unambiguously provide that the limited liability company or limited partnership agreement contractually creates the common law or corporate-like fiduciary duties of loyalty and care, except where modified by the agreement. If the goal is to create a limited liability company or a limited partnership in which the manager or the general partner is not subject to any common law fiduciary duties, drafters should expressly eliminate such duties in the limited liability company or limited partnership agreement, enumerate any specific conduct limitations and perhaps note that such limitations do not operate to create any other duties implied in law or equity.
As always, careful and consistent drafting is essential. Regardless of how the issue of default fiduciary duties is ultimately resolved, a Delaware court will evaluate the entire agreement to determine whether the parties intended for fiduciary duties to apply.36 The Delaware Court of Chancery has held that contractual provisions inconsistent with default fiduciary duties may constitute an express intent to eliminate or modify implied fiduciary duties.37 The court will examine, among others, contractual provisions: (1) exculpating the general partner or manager; (2) granting the general partner or manager the right to act in its sole discretion; and (3) detailing the approval process for conflict transactions, to determine whether such provisions are inconsistent with default or contractual fiduciary duties.38
Now more than ever—clear, express, and unambiguous language in the limited liability company or limited partnership agreement, defining the scope of a manager or general partner's duties to the entity and its members or partners, is critical to ensure that the agreement is enforced as the parties so intended.
Peter Welsh is a partner in Ropes & Gray's Boston office. He focuses his practice on the areas of transactional and securities litigation as well as government enforcement, corporate governance, and director and officer representations. An experienced litigator, Peter has litigated contested merger transactions, including strategic, financial, and going private transactions, complex securities and corporate litigation matters, including the representation of the directors and officers of several public companies in securities class actions and breach of fiduciary duty actions. He can be reached at email@example.com.
Aliza Goren is an associate in the firm's Boston office. She also focuses her practice on the areas of transactional and securities litigation as well as government enforcement, corporate governance, and director and officer representations. Aliza has successfully represented clients in matters concerning fiduciary duties in financial and strategic transactions. She can be reached at firstname.lastname@example.org.
The authors wish to thank Ropes & Gray associate Kevin Angle for his valuable contributions to this article.
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