Delaware Supreme Court Sidesteps
Question of Default Fiduciary Duties in LLCs While Squarely Head-Butting
Chancellor Strine
It had been hoped that
the decision of the Delaware Supreme Court in Gatz Properties v. Auriga would resolve the question as to what
are, if any, the default fiduciary duties imposed by the Delaware LLC Act. In
the end, the Delaware Supreme Court has managed to avoid this question, finding
that the contractual standards set forth in the limited liability company
agreement of the LLC at issue provided a standard; consequently, the issue of a
default duty in the absence of agreed contractual standard was not before the
Court. At the same time, the Supreme Court, in a per curiam decision, chastised Chancellor Strine for his decision’s
expansive explication of the question of what would be those default duties. Gatz Properties, LLC v. Auriga Capital Corp.,
___ A.2d ___, 2012 WL 5425227, 2012 Del.
LEXIS 577 (Del. Nov. 7, 2012), affirming 40 A.3d 389 (Del. Ch. 2012).
The
Facts of the Dispute
Peconic Bay LLC was organized
to hold a leasehold interest in certain property, to develop the property into
a golf course, and to sublease the property to a golf course operator. The Gatz
family and their affiliates held over 85% of the Class A and over 52% of the
Class B membership interests in Peconic Bay.
By 2004 the golf course was
failing and Gatz believed that the lease operator planned to exercise its early
termination rights under the sublease. Instead of attempting to identify a new lessee
to operate the golf course, Gatz hatched a plan intending that he could
purchase Peconic Bay at a distressed price. Among other things, Gatz
discouraged a potential third-party purchaser, provided misleading information
to minority members about potential buyers, including understating their interest
in the property, and conducted a “sham” auction. Gatz, the only bidder at the
auction, purchased Peconic Bay. The minority members of Peconic Bay, LLC
(“Peconic Bay”), sued Gatz Properties, LLC (“Gatz Properties”), the manager of
Peconic Bay, and William Gatz (“Gatz”), who owned and controlled Gatz
Properties, arguing that Gatz Properties breached its fiduciary duties. The
Court of Chancery ruled in favor of the plaintiffs on both contractual and
statutory grounds, from which ruling the defendants appealed.
Where the Supreme
Court and the Chancery Court Agreed
The
Delaware Supreme Court affirmed the finding that Gatz/Gatz Properties
(collectively “Gatz”) violated the contracted-for fiduciary duty by refusing to
negotiate with a third-party bidder and causing the company to be sold to
himself at an unfair price in the flawed action. The relevant contractual
provision of the LLC Agreement provided:
Neither the Manager nor any other
Member shall be entitled to cause the Company to enter into any amendment of
any of the Initial Affiliate Agreements which would increase the amounts paid
by the Company pursuant thereto, or enter into any additional agreements with
affiliates on terms and conditions which are less favorable to the Company than
the terms and conditions of similar agreements which could then be entered into
with arms-length third parties, without the consent of a majority of the
non-affiliated Members (such majority to be deemed to be the holders of 66-2/3%
of all Interests which are not held by affiliates of the person or entity that
would be a party to the proposed agreement).
The Supreme Court wrote,
“[v]iewed functionally, the quoted language is the contractual equivalent of
the entire fairness equitable standard of conduct and judicial review.” It further determined that Gatz had acted in
bad faith, in consequence of which Gatz was not entitled to the benefit of an exculpation
and indemnification provision, of the LLC Agreement, it containing a carve-out
for acts of gross negligence, willful misconduct or willful misrepresentation.
Where the Supreme
Court and the Chancery Court Disagreed
Having
disposed of the matter on the basis of the contract at issue and its definition
of what were the manager’s fiduciary obligations, the Delaware Supreme Court
held that the Court of Chancery acted improperly in addressing whether and what
default fiduciary duties apply when the LLC agreement is silent on the issue.
The Supreme Court characterized the Court of Chancery’s determination that
default fiduciary duties exist “as dictum
without any precedential value.”
The
Court of Chancery had held that the “Delaware Limited Liability Company Act
imposes ‘default’ fiduciary duties upon LLC managers and controllers unless the
parties to the LLC Agreement contract that such duties do not apply.” The Supreme Court found that the issue had not
been properly raised below, and that in any event it need not have been reached
given the explicit duties detailed in the LLC Agreement. Moreover, according to
the Delaware Supreme Court, “the merits of the issue whether the LLC statute
does — or does not — impose default fiduciary duties is one about which
reasonable minds could differ” and one that has not previously been decided by
the Delaware Supreme Court. The Supreme Court expressed its view that one could
reasonably conclude the LLC statute is “consciously ambiguous” in that regard,
and suggested that the “‘organs of the Bar’ . . may be well advised to consider
urging the General Assembly to resolve any statutory ambiguity on this issue.”
Some Other Background
The views of Chancellor Strine
to the effect that there do exist default fiduciary duties in the Delaware LLC
Act runs directly contrary to a position previously taken by Chief Justice
Steele. Rather, in Freedom of Contract and Default Contractual Fiduciary Duties in
Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L. J. 221 (Summer 2009), he
posited that there are no default fiduciary duties in limited partnerships or
LLCs organized Delaware law.
Chancellor’s Strine’s opinion in Gatz
is directly contrary to this view.
What This Decision Means in Kentucky
At the broadest level, this
decision has no impact upon Kentucky law.
The Delaware LLC Act is silent as to the fiduciary duties owed by a
member or manager. It is consequent to
that silence that there exists a dispute as to whether fiduciary duties exist
in that form, and if they do exist, what are they. Kentucky’s LLC Act, in contrast, specifies
default fiduciary duties that may then be modified in a written operating
agreement. See KRS § 275.170. Where the
written operating agreement does not provide otherwise, the statutory
provisions apply. See KRS § 275.003(8). Hence,
in Kentucky, there cannot be a questions of “what are the fiduciary duties when
the operating agreement is silent”; the statute has already addressed that
question.
On a slightly more subtle
level, this decision highlights the danger of knee-jerk reference to Delaware
law. While it is indeed true that on
many manners Delaware serves as the best authority when Kentucky law does not
address a point, that reference presupposes that the policies of Delaware and
Kentucky bear some high degree of similarity.
As to this specific point, in that Kentucky has defined what are the
default fiduciary duties in an LLC, it is ultimately of no concern what
Delaware may ultimately resolve to be the default fiduciary duties in LLCs
organized in that jurisdiction. Where
Kentucky law has spoken to a point, the reference to foreign law as to its
interpretation and application needs to be restricted to those states that have
made similar determinations. As such, an
Arkansas decision as to the fiduciary duties in LLCs, the Arkansas LLC Act
being, as to that point, nearly identical to that in Kentucky, would be far
more availing than would be a reference to Delaware law.
The last impact of this
decision in Kentucky, and this is a bifurcated point, is upon
practitioners. Initially, with an
appreciation that the Kentucky and Delaware Acts are so dissimilar from one
another, there should come as well the realization that mastery of the Kentucky
LLC Act does not qualify one to practice in Delaware LLCs. Initially, the significant differences
between the Kentucky and Delaware Acts often precludes skill transfer between
the two forms. Second, with Delaware’s
reliance upon its own contract law as the background against which LLCs
agreements are drafted, one must, in order to effectively draft and interpret
Delaware LLC agreements, master not only the LLC Act but the full range of Delaware’s
contract law.
The second arm of this
bifurcated point is that practitioners who aspire to draft operating agreements
in multiple jurisdictions, even if limited only to Kentucky and Delaware, need
to have a careful appreciation of the background against which the operating
agreement is written. In drafting an
operating agreement for a Kentucky LLC that is silent as to fiduciary duties,
you in effect write into the agreement the statutory default rules. Whether, on a normative matter, with respect
to any particular venture those are the most appropriate rules is a different
question, the answer to which could well land the drafter into hot water for
failure to consider their implications.
In contrast, one who drafts a limited liability company agreement for a
Delaware LLC that is likewise silent as to fiduciary duties has introduced a
significant ambiguity into the relationship, namely what fiduciary duties, if
any, apply? The ex post resolution of
that ambiguity likely will be, at minimum, expensive. Failure to appreciate the problem created is
even worse.
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