Updates on Delaware Corporate Law and Alternative Entity Law
This blog post provides selected excerpts and bullet points from a Delaware State Bar Association-sponsored seminar held today at the Hotel duPont entitled: Recent Developments in Delaware Corporate and Alternative Entity Law.
Delaware Supreme Court Chief Justice Myron Steele presented on the topic of Alternative Entity Litigation.
His Honor emphasized that his presentation did not represent the views of the entire Delaware Supreme Court and he is only one of five members of the Court. He addressed three primary topics:
1) Fiduciary duties of managers and members of LLCs.
2) Implied duties of good faith and fair dealing in an LLC agreement.
3) How the Delaware courts will construe agreements related to the above two topics.
Fiduciary Duties of Managers and Members of LLCs
Freedom of contract is the starting point for any analysis of this issue. The LLC statute allows duties to be modified. Recent Delaware Supreme Court decisions make it clear that fiduciary duties are categorized in two parts: loyalty and due care. Good faith has been firmly ensconced within the duty of loyalty as opposed to a separate “stand alone” duty.
The Chief Justice addressed the exceedingly important issue of “what duties apply when the LLC agreement is unclear or does not address what duties apply." There are two potential “default rules” that may answer that question in Delaware. ( I would add that the outcome of that issue may depend on what jurist or what Court one is arguing in. E.g., the Court of Chancery or the Delaware Supreme Court.)
His Honor described the “First Default Position” as follows: If it is not absolutely clear in the agreement what duties apply, if any, then the implied covenant of good faith and fair dealing is the duty that will apply.
The “Second Default Position” was described by the Chief Justice in the following manner: If it is not absolutely clear in the agreement what duties apply, then traditional fiduciary duties will apply.
The Delaware Supreme Court has not conclusively resolved which of the “default rules” apply to determine what duties will govern members or managers of an LLC when the operating agreement is silent or unclear on this issue. But see generally, Kelly v. Blum. The Court of Chancery in this case determined, based on the facts of that case, that in the absence of clarity, traditional fiduciary duties apply based on the need for accountability.
See also Kuroda. This Chancery decision touches on the subject but is better understood as being driven by the facts of the case. Whether or not there is a fiduciary relationship based on the facts of that case was touched on but because it was not necessary to the final decision, the opinion did not specifically address the default rule.
Delaware’s top judicial officer observed that he has seen briefs that cite his two law review articles on the topic but his views in those articles are not always accurately stated by others. Moreover, it should be emphasized that those articles are not opinions of any court. In those articles he has posited that the better policy decision is to apply the implied covenant of good faith and fair dealing to LLC agreements that do not otherwise specify what duty applies, as opposed to the traditional panoply of fiduciary duties.
Implied Duty of Good Faith and Fair Dealing
The implied duty of good faith and fair dealing as a part of contract law has a long and venerable history in Delaware. In 1874, Delaware cases first discussed the implied covenant of good faith and fair dealing as being imposed on all Delaware contracts
He observed that Sections 204 and 205 of the Restatement, Second, of Contracts should be consulted on this topic. Section 204 allows the court to imply a term that is reasonable under the circumstances when the parties have not done so and such a term is essential to the rights of a party that has been treated badly by another party.
How Delaware Courts Address the Implied Duty of Good Faith and Fair Dealing
Nemec was a recent Delaware Supreme Court decision that indicates how reasonable people can easily differ on the application of the implied duty of good faith and fair dealing. The vote of the Court resulted in an unusual 3-2 decision. The case involved the redemption of shares prior to the increase that would have resulted in the value of the shares after a merger. The majority reasoned that the exercise of a clear contract right in this case did not violate the implied duty of good faith and fair dealing. The dissent thought the redemption was done in bad faith because, in part, the board members benefited from the decision made on the timing of the redemption in a manner that the cashed-out shareholders did not. The Chief Justice acknowledged that the dissent’s reasoning was also compelling in some ways and that these matters often involve good arguments on both sides. It was humorously mentioned as an aside that because the majority affirmed the decision of the Chancellor, it might be suggested that the vote was really 4 to 2.
Contract Drafting Tips were suggested by His Honor on this issue as a general observation. The point was made, as stated in many Delaware decisions, that simply because two parties disagree on the interpretation of a contract does not, per se, create an ambiguity. The Court interprets contracts in a manner similar to its interpretation of a statute. The best approach for drafters to anticipate provisions of an agreement that may be read differently, is to include “defined terms” when drafting the agreement.
When there is a disputed interpretation of a contract provision, the Courts prefer not to delve into drafting history unless absolutely necessary. In part, the disinclination is due to the reality that it is expensive to do all the discovery needed for that analysis, and it often does not make the issue any clearer in the end anyway.
Conclusion: As a matter of established, unequivocal law decided by the Supreme Court, in Delaware it remains an open issue which of the two “default positions” the Delaware Supreme Court will adopt regarding the application of either fiduciary duties or the implied covenant of good faith and fair dealing to an LLC agreement that is either silent or ambiguous on the issue. Delaware’s Top Jurist reminded the assembled lawyers (and at least one judge) in the audience that despite the law review articles he has written, the views in those publications only represent one vote on a 5-member court–and may never become the law of Delaware.
Prof. Steven Davidoff, author of The Deal Professor column at The New York Times DealBook Blog, and other publications, who teaches at the University of Connecticut School of Law, provided a presentation entitled: Form Over Substance? Management Buy-Outs, Management Buy-Ins and the Value of Corporate Process.
During the introduction to his presentation, the good professor discussed the Landry’s case which he has covered extensively on his blog and which was the subject of the last decision by Vice Chancellor Lamb before he left the Delaware Court of Chancery. Prof. Davidoff told the assembled lawyers (and some members of the Delaware bench in attendance), that after a deposition last week, a settlement was announced–though the terms are not public yet.
He provided highlights of a statistical analysis that is the subject of a forthcoming paper about Management Buy-Outs (MBOs). A few soundbites from his analysis include the following:
• Most MBOs involve litigation and most of those cases settle based on additional disclosures. Delaware seems to be more generous in terms of the attorneys’ fees awarded, but the litigation does not appear to have a substantial impact in terms of derailing the transaction.
• Attorneys’ fees awarded in the cases that challenged these transactions indicate that the mean amount of fees awarded was about $1.3 million and the high was about $29 million (in the Cablevision case).
• Wheelabrator is the “only MBO case out there”. No Delaware Supreme Court decision provides clear direction to address exactly how to purge a conflict in this specific context.
• Practitioners need more judicial guidance on how to deal with an MBO outside of the controlling shareholder context, though Hammonds provides some insight.
• Kahn v. Lynch is notable as it seeks to promote an arm’s length process despite a controlling shareholder
Prof. Gordon Smith and Donald Wolfe, Esq. discussed: The Evolving Role of the Delaware Stockholder.
The good professor reviewed different conceptual theories of the relationship between shareholders and directors. For example:
• Historically, the shareholder’s role is based on the metaphor of beneficiaries of a trust and the directors as trustees.
• More recently, another metaphor used is one of agency, which in a conventional sense would suggest that the shareholders are principals and the directors are agents. This is part of a contractarian view though some may argue that the metaphor breaks down in some ways because agents have a duty of obedience which most directors would not deem applicable.
• Professor Bainbridge has championed a director primacy theory that provides for minimal shareholder control with the goal being shareholder wealth maximization.
Professor Smith, a well-known corporate law expert of The Conglomerate fame who is also Associate Dean and Glen L. Farr Professor of Law at Brigham Young University Law School, discussed the Delaware Supreme Court decision in CA, Inc. v. AFSCME. The Court in this opinion invalidated bylaws that would require a board to act in a certain way or limit the board’s ability to exercise its discretion. The Court invoked the decisions in QVC and Quickturn to prevent directors from abdicating their responsibility, or in this case, where stockholders attempted to constrain the power of the directors.
Don Wolfe, co-author of the iconic treatise (referred to as a bible for some), entitled: Corporate and Commercial Practice in the Delaware Court of Chancery, discussed DGCL amendments implemented in 2009 as they relate to stockholders. At the time these amendments were being drafted and considered, the country was in a crisis mode. During this period, the U.S. Congress had also proposed legislative fixes some of which were aimed at directors of corporations who allegedly did not adequately protect shareholders.
Delaware’s reaction to the financial market meltdown was more muted and took an approach that is flexible and endorses private ordering to allow companies to tailor proxy access to their own circumstances and the Delaware approach avoids a “one size fits all”.
Three key DGCL changes in 2009 applicable to shareholders include the following:
• Section 112 authorizes bylaws to include shareholder nominations in proxy materials, and eliminates an argument that such bylaw is not allowed. It also permits a non-exhaustive list of reasonable restrictions on such access (e.g., amount and duration of ownership of stock). This new section is only intended to apply to “short slates”.
• Section 113 codifies CA, Inc. v. AFSCME and allows for reimbursement of costs to shareholders in a proxy contest subject to certain conditions such as measuring success for eligibility for reimbursement.
• Section 213(a) permits a board of directors to fix a record date for voting separate from the record date for notice of a stockholders’ meeting.
There was much more about the seminar but my goal was to provide merely a few highlights.