Delaware Supreme Court Sidesteps Question of Default Fiduciary Duties in LLCs

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.