Delaware Chancery Court Rules On Default Fiduciary Duties Of The Manager Of A Delaware LLC

Steven D. Goldberg, Esq. Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law. Delaware Forms and Publications are available at http://www.delawarellclaw.com

The issue of whether a manager of a Delaware LLC has default fiduciary duties akin to a corporate director has been an unsettled area of Delaware law. Several members of the Delaware Court of Chancery have touched on the issue in written opinions, generally finding default duties to exist. The Delaware Supreme Court has not, however, ruled on the issue. Chief Justice Steele has written and spoken extensively on the issue positing that the Act does not create such duties and as the LLC is a creature of contract, the Court should not create duties where no such duties exist legislatively.

Many practitioners have expressed the belief that in the “public deal” where the structure is corporate in nature, there should be default duties as it would be against public policy in such cases that the manager’s conduct was not circumscribed by fiduciary duties. Section 18-1101(c) of the Delaware LLC Act provides:

To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.

Here the legislature expressed an intent that if a member or manager has duties, at law or in equity, including fiduciary duties, those duties may be “expanded, restricted or eliminated”. The “implied contractual covenant of good faith and fair dealing” may not be eliminated. The implied covenant, however, only comes into play where the parties have not addressed an issue which could not have been reasonably anticipated when the agreement was drafted and is not an opportunity for the court to “fix a wrong”. The question then is whether the legislature intended, without expressing, that there are default duties or was the legislature expressing the thought that there are not necessarily duties, but to the extent that they may exist, then they may be modified as provided. In the case of Auriga Capital Corporation, et al v. Gatz Properties, LLC, et al, CA 4390-CS Decided January 27, 2012 Auriga Capital Chancellor Strine held that the manager of this LLC had an equitable duty of care and loyalty to the LLC and its members which was not restricted or eliminated in the LLC company agreement. Generally when courts consider fiduciary duties in the corporate context they include a somewhat amorphous duty of “good faith”. In this case the Court inexplicably did not address good faith. The LLC which was the subject of this litigation was established as a blind investment where the investors put up their money and the manager created the investment from the funds raised. The Court found that the manager manipulated the LLC for the benefit of the manager and its affiliated family members to the detriment of the non-family members. [The manager was an entity with an individual as the sole member, in this context the Court ascribed the actions of the entity to its member and referred to the member as the “manager” of the subject LLC.] This is a case of very bad facts where the manager who took advantage of the minrity investors argued that there were no fiduciary duties owed to the members, and if any existed the exculpation provisions of the agreement absolved the manager from liability. In the manager’s defense it asserted that it had the voting power to cause a sale of the LLC’s property to itself, a matter at the core of the complaint, and the right to “exploit the minority”. The Court stated at p.5,

“The manager was free not to vote his membership interest for the sale. But he was not free to create a situation of distress by failing to cause the LLC to explore its market alternatives and then to buy the LLC for a nominal price. The purpose of the duty of loyalty is in large measure to prevent the exploitation by a fiduciary of his self-interest to the disadvantage of the minority.”

The Chancellor first concludes that fiduciary duties exist under the Act and then goes on to analyze their foundation.

The Delaware LLC Act starts with the explicit premise that “equity” governs any case not explicitly covered by the Act. [18-1104] But the Act lets contracting parties modify or even eliminate any equitable fiduciary duties, a more expansive constriction than is allowed in the case of corporations. For that reason, in the LLC context, it is typically the case that the evaluation of fiduciary duty claims cannot occur without a close examination of the LLC agreement itself, which often tailors the traditional fiduciary duties to address the specific relationship of the contracting parties.

. . . .

The Delaware LLC Act does not plainly state that the traditional fiduciary duties of loyalty and care apply by default as to managers or members of a limited liability company. In that respect, of course, the LLC Act is not different than the DGCL, which does not do that either. In fact, the absence of explicitness in the DGCL inspired the case of Schnell v. Chris-Craft. Arguing that the then newly-revised DGCL was a domain unto itself, and that compliance with its terms was sufficient to discharge any obligation owed by the directors to the stockholders, the defendant corporation in that case won on that theory at the Court of Chancery level. But our Supreme Court reversed and made emphatic that the new DGCL was to be read in concert with equitable fiduciary duties just as had always been the case, stating famously that “inequitable action does not become legally permissible simply because it is legally possible.”

The LLC Act is more explicit than the DGCL in making the equitable overlay mandatory. Specifically, § 18-1104 of the LLC Act provides that “[i]n any case not  provided for in this chapter, the rules of law and equity…shall govern.” In this way, the LLC Act provides for a construct similar to that which is used in the corporate context. But unlike in the corporate context, the rules of equity apply in the LLC context by statutory mandate, creating an even stronger justification for application of fiduciary duties grounded in equity to managers of LLCs to the extent that such duties have not been altered or eliminated under the relevant LLC agreement.

It seems obvious that, under traditional principles of equity, a manager of an LLC would qualify as a fiduciary of that LLC and its members. Under Delaware law, “[a] fiduciary relationship is a situation where one person reposes special trust in and reliance on the judgment of another or where a special duty exists on the part of one person to protect the interests of another.”  Corporate directors, general partners and trustees are  analogous examples of those who Delaware law has determined owe a “special duty.” Equity distinguishes fiduciary relationships from straightforward commercial arrangements where there is no expectation that one party will act in the interests of the other.

The manager of an LLC – which is in plain words a limited liability “company” having many of the features of a corporation – easily fits the definition of a fiduciary. The manager of an LLC has more than an arms-length, contractual relationship with the members of the LLC. Rather, the manager is vested with discretionary power to manage the business of the LLC.

Thus, because the LLC Act provides for principles of equity to apply, because LLC managers are clearly fiduciaries, and because fiduciaries owe the fiduciary duties of loyalty and care, the LLC Act starts with the default that managers of LLCs owe enforceable fiduciary duties. [Citations omitted]

Looking for a legislative basis the Chancellor discussed the 2004 amendment to the LLC Act which added the “elimination” of duties in 18-1101(c). He concluded that if the duties he discussed did not apply to LLCs the legislation “would have been logically done differently.” He analyzes the use in the amendment of the term “eliminate” rather than the legislature stating that the manager and members “shall owe no duties of any kind to the LLC…” It is my opinion that this is a weak construct to bootstrap fiduciary duties. If indeed the legislature had believed there should be default fiduciary duties, the legislature knows how to say that and this reverse logic is inappropriate.

The DGCL and corporate laws generally can trace their history back to English Common Law which existed prior to separation. The LLC Act to the contrary has no counterpart at Common Law and is wholly a legislative construct, notwithstanding the fact that much of the LLC Act is based on the Delaware Revised Uniform Limited Partnership Act, which did have a counterpart at Common Law. It is true that the DGCL does not specifically provide for default fiduciary duties, however there is a clear Common Law and historical basis for implying such duties. It is dangerous to apply corporate constructs to LLCs notwithstanding the fact that the LLC may have a corporate structure by agreement and may have been called by the legislature a limited liability “company”. The courts have made it clear that the LLC agreement is a matter of “private ordering” and based upon “…rules of law and equity, including the law merchant,…” (18-1104). This concept should not cause the Court to incorporate wholesale the corporate rules of governance. The parties in this case were very litigious, therefore there is the possibility that an appeal will be taken and the Supreme Court will have the opportunity to speak definatively on the issue.

I can be reached at sgoldberg@stevendgoldberg.com, my direct dial number is 302.351.4490