Delaware Chancery Court imposes personal liability on affiliates of a LLC Managing Member

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

On April 20, 2009 the Delaware Court of Chancery, Vice Chancellor Strine, issued an opinion, on a motion for summary judgment, in the case of Bay Center Apartment Owners, LLC v. Emery Bay PKI, LLC, Emery Bay ETI, LLC, Alfred E. Nevis, and Emery Bay Member, LLC.  memorandum_opinion_3658-vcs This case is important as the Court determined on summary judgment that it could imposed personal liability upon the non party individual who controlled the managing member of the LLC and an affiliate which he also controlled based upon a breach of the implied contractual covenant of good faith and fair dealing, a breach of fiduciary duties, aiding abetting and fraud.

FACTS. The case arose out of a failed real estate development. The facts of the case are complicated and convoluted. The basic facts are that the plaintiff (Bay Center) and Emory Bay PKI, LLC (PKI) entered into an LLC Agreement for Emory Bay Member, LLC (Emory Bay) to develop a property. Under the LLC agreement PKI was the managing member with general authority to manage the LLC , subject to certain matters upon which Bay Center must approve. PKI cause Emory Bay to enter into a construction loan which Nevis personally guaranteed. PKI renegotiated the loan on several occasions without giving Bay Center notice as required under the LLC Agreement. The negotiations avoided defaults which would have triggered Nevis’ guarantee. The LLC and ETI, an affiliate of PKI, also owned by Nevis, entered into a Development Management Agreement (DMA) under which the affiliate was given general authority to manage the project. Bay Center transferred the property being developed to a LLC owned by Emory Bay in exchange for an unsecured note (Note) and a pledge of certain cash flows.The project was mismanaged and eventually failed. The renegotiations of the loan diverted cash flows which were pledged to Bay Center without Bay Center’s approval.

Bay Center sued PKI, the other member of Emory Bay, as well as the LLC itself, Nevis, the individual who controlled PKI and ETI, the party to the DMA which was also controlled by Nevis. Plaintiff alleged that PKI, ETI and Nevis

1. violated the implied covenant of good faith and fair dealing
2. breached fiduciary duties owed to Emory Bay and Plaintiff
3. aided and abetted a breach of fiduciary duty
4. committed fraud against Plaintiff

1.  PKI was a signatory to the LLC agreement but not a party to the either the DMA or the Note. Nevis, while he had signed the documents on behalf of his controlled companies, was not personally a party to any of the agreements. In examining the application of the implied covenant the Court stated:

Delaware courts rightly employ the implied covenant sparingly when parties have crafted detailed, complex agreements, lest parties be stuck by judicial error with duties they never voluntarily accepted.
Nevertheless, Delaware courts have “recognized the occasional necessity of implying contract terms to ensure the parties’ reasonable expectations are fulfilled.” In the context of corporate entities, “[t]he implied covenant functions to protect stockholders’ expectations that the company and its board will properly perform the contractual obligations they have under the operative organizational agreements.” Part of corporate managers’ proper performance of their contractual obligations is to use the discretion granted to them in the company’s organizational documents in good faith
Here, PKI had the obligation to manage Emery Bay and the discretion to cause the Supporting Agreements to be performed. PKI was required to carry out these functions in good faith, meaning PKI could not engage in “arbitrary or unreasonable conduct” that had the effect of preventing Bay Center from “receiving the fruits of the bargain.”

This bargain was, essentially, that in exchange for contributing the real estate to be developed, Bay Center would reap the rewards of PKI’s project management skills and efforts. PKI’s conduct allegedly frustrated the parties’ intent to develop a profitable condominium complex because PKI in bad faith failed to force the entities that were contractually obligated to perform tasks that were crucial to the Project’s success to fulfill their obligations, even though PKI had the express authority to do so.

And Bay Center has pled facts from which it can reasonably be inferred that PKI’s decision not to cause performance of the Supporting Agreements was not in good faith. For starters, Emery Bay’s alleged breaches of the Bay Center Note benefited PKI by diverting cash that Emery Bay was supposed to use to repay the Note to fund the depleted A&D Loan reserves, which PKI would have otherwise had to fund through capital calls. And, the decision not to pursue claims against ETI under the Development Management Agreement was a conflicted one because Nevis, as the controller of both Emery Bay and ETI, stood on both sides of it.

2. The LLC Agreement was poorly drafted and contained conflicting provision regarding the presence of fiduciary duties. For the purpose of summary judgment the court found that PKI had fiduciary duties to the LLC and to Bay Center. The court then went on to explore the extension of those duties to Nevis personally:

 The analysis regarding Nevis is less straightforward. Nevis himself is  not a member or officer of Emery Bay, and is thus beyond the normal scope of those who owe fiduciary duties in the corporate context. Bay Center’s theory of liability rests on a line of cases, beginning with In re USACafes, L.P. Litigation holding that “those affiliates of a general partner who exercise control over the partnership’s property may find themselves owing fiduciary duties to both the partnership and its limited partners.” Importantly, the defendants do not challenge the general applicability of this doctrine in the LLC context. Instead, the defendants argue that USACafes type liability can only be imposed in limited circumstances that are not present here.

It is true that USACafes does not apply to all affiliates in all circumstances. First, to have any fiduciary duties to an entity, the  affiliate must exert control over the assets of that entity. Here, the defendants concede that Bay Center has sufficiently pled that Nevis himself exerted direct control over Emery Bay’s property. Second, USACafes suggests that controlling affiliates do not have the full range of traditional fiduciary duties, although that case specifically disclaims any effort to fully delineate the scope of controlling affiliate duties:

While these authorities extend the fiduciary duty of the general partner to a controlling shareholder, they support as well, the recognition of such duty in directors of the General Partner who, more directly than a controlling shareholder, are in control of the partnership’s property. It is not necessary here to attempt to delineate the full scope of that duty. It may well not be so broad as the duty of the director of a corporate trustee. But it surely entails the duty not to use control over the partnership’s property to advantage the corporate director at the expense of the partnership.

Later cases have similarly declined to expound on the full scope of USACafes duties. In practice, the cases applying USACafes have not ventured beyond the clear application stated in USACafes “the duty not to use control over the partnership’s property to advantage the corporate director at the expense of the partnership.” Limiting the application of USACafes to this duty provides, in my view, a rational and disciplined way of protecting investors in alternative entities with managing members who are themselves entities, while not subjecting all the individuals who work for managing members to wide-ranging causes of action. Bay Center must therefore plead that Nevis benefited himself at the expense of Emery Bay in order to withstand this motion to dismiss.

The court held that Bay Center had met it burden of proof because Nevis used his control over Emery Bay’s assets to stave off personal liability.

3. The court held that to state a case for aiding and abetting the plaintiff must demonstrate (1) the existence of a fiduciary relationship, (2) the fiduciary breached its duty, (3) a defendant, who is not a fiduciary, knowingly participated in a breach and (4) damages to the plaintiff resulted from the concerted action of the fiduciary and the non fiduciary. The court found each of the elements present.

4. Next the Court found that the defendants committed fraud from “silence in the face of a duty to disclose.” As previously stated, the Court found that PKI was subject to the traditional fiduciary duties of a director of a Delaware corporation.

As a general matter, the board of directors of a corporation has a “fiduciary duty to disclose fully and fairly all material information within the board’s control when it seeks shareholder action.” The principle applies by analogy to the fiduciaries of an LLC when they seek members’ consent. Here, the LLC Agreement requires Bay Center’s consent, which necessarily requires disclosure to Bay Center, of any refinancing or restructuring of the A&D Loan. Bay Center alleges that the A&D Loan was modified on seven separate occasions, but that PKI only informed Bay Center of one of the modifications. The fiduciary duty of directors to disclose material facts when shareholders are required (or have the right) to make a decision is precisely implicated here. Emery Bay had a right to make a decision regarding the renegotiations of the A&D Loan, and PKI therefore had a fiduciary duty to inform Bay Center of all material facts concerning the renegotiations. The alleged fact that PKI failed to inform Bay Center that most of the renegotiations were taking place illustrates PKI’s failure to make Bay Center aware of even the most basic facts that Bay Center was entitled to know. Thus, Bay Center has sufficiently pled a fraud claim against PKI based on PKI’s failure to disclose material facts in the face of its fiduciary duty to do so.

And, because Bay Center has pled that Nevis personally participated in this fraud by PKI, Bay Center has also stated a claim against Nevis individually. Under settled Delaware law, “[a] corporate officer can be held personally liable for the torts he commits and cannot shield himself behind a corporation when he is a participant.” This includes situations where a corporate agent participates in corporate fraud.