Recently, the Delaware Court of Chancery issued a ruling on the question of whether a manager (or managing member) of a Delaware limited liability company owes fiduciary duties to the company and its members. The court ruled that it does.
As a legal practitioner, this result is unsurprising. I think most business lawyers, both when representing LLC managers and when representing LLCs and their members, operate under the assumption that a manager owes a fiduciary duty of care and loyalty to the company and its members.[1] What is somewhat surprising is (a) that this conclusion was ever in doubt and (b) more importantly, in light of recent comments made by the Chief Justice of the Delaware Supreme Court, this conclusion may still be in doubt if the ruling is appealed.
The case is called Auriga Capital Corporation v. Gatz Properties, LLC. It arose from a failed golf course venture, where the land on which the golf course is situated was leased by an LLC from a family affiliate of the LLC’s manager. The LLC was funded by outside investors who owned a minority interest in the LLC. The LLC then subleased the land to American Golf Corporation. The terms of the sublease permitted American Golf to terminate its sublease in early 2010. Because the golf course was unable to operate profitably, American Golf exercised its early termination option. Ultimately, the LLC was put up for auction and was bought by the manager at a low price, resulting in a large investment loss to the minority members. The minority members filed suit alleging that the manager engaged in a pattern of intentional mismanagement, including rejecting a serious offer from a 3rd party for a purchase of the LLC that would have earned the minority members a full return on their investment. They further alleged that this intentional mismanagement constituted a breach of the manager’s fiduciary duties.
One of the issues in contention was whether, in the absence of any language explicitly addressing the issue, a manager of a Delaware LLC owes fiduciary duties to the company and its members. While the Delaware Limited Liability Company Act does not expressly provide that the traditional fiduciary duties of care and loyalty apply by default to the managers or members of an LLC, the court concluded that such duties are implicit. Indeed, the Delaware General Corporation Law also does not explicitly provide for fiduciary duties for a corporation’s management and yet they are indisputably present.
This conclusion is in line with the expectations of most parties to Delaware LLC operating agreements and with the expectations of most attorneys who draft them. However, whether this conclusion will be upheld on appeal is somewhat in doubt. At a recent seminar, Chief Justice of the Supreme Court of Delaware Myron Steele stated that “[c]ourts should not imply traditional fiduciary duties when LLC agreements are silent.” He based this on the fact that limited liability companies are new entities based on contracts and are not derived from common law. Given that Delaware’s LLC Act emphasises freedom of contract (in section 18-1101(b)) and that contract law provides some level of protection to parties of LLC operating agreements through the implied covenant of good faith and fair dealing, his conclusion was that if an LLC’s operating agreement does not expressly provide for fiduciary duties of managers, “courts should assume the parties did not want [fiduciary duties] to apply at all.” These statements are in direct contradiction to the holding of Auriga, and if Chief Justice Steele should find that two or more other justices on Delaware’s Supreme Court agree with him, the holding may be overturned on appeal. [2]
In light of this decision and in Chief Justice Steele’s subsequent comments, drafters and parties to LLC operating agreements should be careful to include unambiguous language on whether they intend to include, eliminate, or restrict fiduciary duties. In addition, while this is not a new issue, in contrast to the Delaware General Corporation Law or the limited liability company acts of many other states, Delaware’s Limited Liability Company Act permits parties to an LLC operating agreement to waive a manager’s fiduciary duties. This itself may come as a shock to many seasoned corporate practitioners since fiduciary duty, especially the duty of loyalty, is generally regarded as an unwaivable duty in many other situations.
Footnotes
[1] The fiduciary duties of care and duty of loyalty arise from common law. Under Delaware corporate law, the fiduciary duties of care and loyalty require that a corporation’s directors (1) must act in good faith, with the care of a prudent person, and in the best interest of the corporation; (2) must refrain from self-dealing, usurping corporate opportunities,
and receiving improper personal benefits; and (3) make decisions made on an informed basis, in good faith, and in the honest belief that such action was taken in the best interest of the corporation.
[2] The Delaware Supreme Court has five members.
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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
