Chancery Explains Basis for Fiduciary Duty Default Standards Applicable to LLCs

Auriga Capital Corp. v. Gatz Properties LLC, C.A. No. 4390-CS (Del. Ch., Jan. 27, 2012), read opinion here.  

What this Case is About and Why it is Important

This case establishes a high-water mark in terms of providing the most comprehensive explanation, based on legislative history and a review of Delaware cases, to explain why the default standard in the LLC context is that fiduciary duty principles will apply to managers of an LLC unless those duties are expressly and clearly limited or eliminated in an LLC agreement.  Prof. Larry Hamermesh, Director of the Institute of Delaware Corporate and Business Law, comments on the decision here. Professor Ann Conaway provides her insights on this opinion here.

UPDATE: On Nov. 7, 2012, the Delaware Supreme Court affirmed the conclusion of this case but eviscerated what it described as dictum to the extent this opinion addressed the issue of default fiduciary dutes for LLCs. The net result of the Supreme Court decision is that as of November 7, 2012, it is an open question in Delaware whether default fiduciary duties exist in the LLC context in the absence of a clear waiver in the LLC agreement.

Background

This case involves claims by the minority members of an LLC against the majority owner and manager of an LLC.  The manager of the LLC was a man named Gatz and the majority ownership of the LLC was held by him and his family.  He and his family owned land in Long Island that they developed into a public golf course.  They entered into a long term lease with a national golf course management company that managed the golf course.  The LLC and its investors were intended to be passive. Shortly after the venture got started, however, the golf course management company was purchased by a private equity firm who consolidated its various golf courses under management, which resulted in lack of maintenance and poor performance of the golf course involved in this case.  Although the management company had options that extended the lease for 40 years, due to its poor performance, Gatz realized that it was likely to decide to exercise a clause that allowed it to terminate the lease early.  Gatz saw this as an opportunity to “buy back” the golf course at a bargain price and at the same time squeeze-out his minority investors who he came to view as contentious and bothersome intermeddlers.

This 75-page decision provides an extensive description of the background details but among the most important are the documented facts which the Court found, after trial, demonstrated the following:  (i) Gatz knew several years prior to the termination of the lease by the management company that the LLC would either need to be sold or a new management company found to run the golf course; (ii) Gatz, who with family controlled the LLC, and had veto power over any sale, actively discouraged potential bidders and admitted that he wanted to be the only buyer; (iii) He conducted what the Court described as a sham auction in which he was the only bidder, and was represented by conflicted counsel who represented him in connection with his status as a manager of the LLC, but also represented him in his capacity as a bidder at the auction; (iv) Gatz failed to provide information to prospective bidders; failed to negotiate with prospective bidders who were interested; and failed to market the LLC and golf course to any buyers who were most likely to be interested; (v) Gatz provided incomplete or misleading information to the minority members regarding the potential buyers who expressed interest; (vi) Gatz threatened to sue the minority members when they expressed their dissatisfaction with the way the auction and sale were being handled; (vii) Gatz failed to preserve relevant electronically stored information and advanced frivolous and constantly changing legal arguments, which justified, in part, the fee-shifting and award of attorneys’ fees based on the bad faith exception to the American Rule.

Legal Analysis

The length of this opinion (at 75-pages long), is not unusual for Chancery opinions, but the reason why this decision may warrant the appellation of magnum opus is based on the breadth and depth of the extensive footnotes that provide, along with the text of the opinion, the most comprehensive treatment to date in any Delaware opinion of the statutory history and construction of those provisions of the LLC Act that provide a basis for the Court’s conclusion that default fiduciary duty standards apply to managers of LLCs in the absence of an expressly, clearly defined elimination or limitation of those duties.  In addition, this opinion includes the most comprehensive review of Delaware case law on the issue of the application of fiduciary duties in the LLC context, that I recall in the decision of any Delaware court.

When I read decisions like this, I wish that Professor Larry Ribstein were still with us.  His untimely passing last month will be especially missed because, as one of the leading experts in the country on alternative entities, and the author of the leading treatise on the topic, we all would have benefited from his analysis of this opinion.  In order to keep this summary at a manageable length, and because this opinion could be the subject of a law review article-length analysis, at this time I am going to merely highlight the most important principles recited in this decision, with reference to the page and footnote numbers in the slip opinion.

Default Fiduciary Duties in the LLC Context

The Court begins its analysis to explain why default fiduciary duties exist in the LLC context, at pages 16 and 17 of the slip opinion.  The Court compared the Delaware General Corporation Law with the Delaware LLC Act, and the fact that the DGCL, like the LLC Act, “does not plainly state” that traditional fiduciary duties of loyalty and care “apply by default.”  But as in the DGCL, the Delaware Supreme Court in the seminal case of Schnell v. Chris-Craft, 285 A.2d 437 (Del. 1971), stated famously that even if a particular action was expressly permissible under the DGCL, it would not necessarily be endorsed by the Court because of the maxim that:  “Inequitable action does not become legally permissible simply because it is legally possible.”  Id. at 439.  See also Section 18-1104 of the LLC Act which provides that:  “In any case not provided for in this chapter, the rules of law and equity . . . shall govern and underlying rules of law and equity shall govern.”  (emphasis in opinion.)  See footnote 65 regarding the basis for default fiduciary duties.

Definition of Fiduciary Relationship

The Court described the types of relationships that can be defined as fiduciary relationships, and explains why managers of an LLC easily qualify under this category.  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 a person to protect the interest of another.”  See footnote 35.  See also footnote 38 (citing a Delaware case that found that even a limited partner, who did not manage the business, based on the facts of that case, did owe a fiduciary duty.) 

History and Statutory Construction of the Delaware LLC Act

The Court explains the amendments to the LLC Act which currently allow for the elimination and limitation of fiduciary duties except it does not allow for the waiver of the implied duty of good faith and fair dealing.  After citing to the various amendments and the older version of the LLC Act that preceded the amendments, the Court asks the simple rhetorical question:  If the statute was amended to allow for the elimination by contract of fiduciary duties, and if default fiduciary duties did not otherwise apply, then why was there a need to allow one to eliminate those duties by contract?  See page 20.

Overview of Case Law on Fiduciary Duties in an LLC and other Alternative Entities

The Court reviews the Delaware decisions that have addressed the application of equitable principles in the alternative entity context.  The Court concludes that the current status of Delaware case law supports the application of fiduciary duty principles to managers of an LLC unless the parties have eliminated or limited those fiduciary duties.  See footnotes 50 through 53.  The Court further explains why it would be a mistake to expand the concept of the implied duty of good faith and fair dealing to confuse it with the separate fiduciary duties of loyalty and care.  See slip op. at 22 and footnotes 54 to 59.

Affirmative Aspects of Fiduciary Duty of Loyalty

The Court explains that in some contexts there is a duty to take affirmative steps to fulfill the duty of loyalty and those affirmative aspects, which apply outside the alternative entity context as well, are explained at footnote 88 with respect to the LLC context.

Fiduciary Duty toward Minority and Nuances of Fiduciary Duty to Deal Fairly

The Court explained that the duty of a fiduciary to deal fairly requires that the fiduciary “not time or structure a transaction to manipulate the corporation’s value, so as to permit or facilitate the forced elimination of the minority stockholders at an unfair price.”  See footnote 101. 

Nor, the Court emphasized, may a fiduciary “play hardball” with those to whom he owes fiduciary duties.  For example, this means that a fiduciary may not use his power to coerce the minority into economic submission.  See footnote 137.  The law of Delaware provides recourse against disloyal fiduciaries or controllers who use their power to coerce the minority into economic submission.  See slip op. at 52.  The Court cited to a Chancery decision at footnote 137, from 1923, that was summarized by the Court for the principle that:  simply because a majority finds a source of its power in a statute, “supplies no reason for clothing it with a superior sanctity, or vesting it with the attributes of tyranny.” 

When the powers of a fiduciary are used in such a way that it violates principles prohibiting its oppressive exercise, “it is the special province of equity to assert and protect, and its restraining processes will unhesitatingly issue.”

Damages and Remedies for Breach of Fiduciary Duty

When a breach of fiduciary duty is established, uncertainties in determining damages are resolved against the wrongdoer.  See footnote 156.  Moreover, the Court observed that a defendant whose wrongful conduct has rendered difficult the ascertainment of the precise damages suffered by the plaintiff, is not entitled to complain that they cannot be measured with the same exactness and precision as would otherwise be possible.  See footnote 160.  See also footnote 183 explaining the basis of shifting attorneys’ fees as part of the damages for breach of fiduciary duty.

Fee Shifting

The Court explains, beginning at page 71 of the slip opinion, why it partially shifted fees based on the bad faith exception to the American Rule, and also as part of its remedy for breach of fiduciary duty.  See footnotes 172 to 176.  The Court had scathing language for the conduct of both Gatz and his counsel which the Court described as making the case unduly expensive for minority members to pursue.  The Court also criticized the frivolous arguments such as the assertion that there were no fiduciary duties owed at all.

The Court explained the basis for applying the bad faith exception to the American Rule which provides that each party is ordinarily responsible for its own litigation expenses.  The Court cited many cases to support its decision to depart from the American Rule.

Attorneys’ Fees Imposed in Part due to Failure to Preserve Electronically Stored Information (ESI)                 

The Court suggested that one of the reasons it was imposing fees on the defendant was due to Gatz’s failure to preserve electronically stored information (“ESI”).  The Court also observed that Gatz may not have been adequately counseled by his legal advisors and as a result deleted relevant documents while litigation was either pending or highly likely.  See footnote 182. 

The Court also quoted from the transcript of its questioning of the attorney for Gatz, who said that he did not get the hard drives himself but relied on the client to copy the hard drives.  The Court criticized Gatz and its counsel for “creating evidentiary uncertainty” by “leaving to Gatz himself the primary role of collecting responsive documents.”  Slip op. at 72.  The Court quoted from pre-litigation letters from counsel for Gatz which threatened litigation, and based on the post-trial opinion, were not grounded in sound legal analysis.

The Court explained one of the reasons for its shifting of fees as follows:  “In cases of serious loyalty breaches, such as here, equity demands that the remedy take the reality of litigation costs into account, as part of the overall remedy, less the plaintiffs be left with a merely symbolic remedy.”  See cases cited at footnote 183.

Amount of Fees Awarded

In a final and colorful footnote, the Court explained that the attorney for the winning minority plaintiffs should submit an affidavit setting forth the amount of his fees, and that if counsel for Gatz objected, counsel for Gatz would need to “fully produce their own billing records in full in support of an argument that the minority members’ bills are too high.”  The Court also suggested that it would be an uphill battle with the following closing lines of the footnote:  “In objecting to the amount of the fee, Gatz and his counsel should remember that it is more time-consuming to clean up the pizza thrown at a wall than it is to throw it.” [The Court's  subsequent decision on the amount of fees was highlighted on this blog here.]

Supplement: Predictably, this epic decision has attracted substantial commentary. In addition to the commentary linked above, for example, Peter Mahler on his New York Business Divorce blog, provides an analysis from a New York perspective, and Seattle lawyer Doug Batey on his LLC Law Monitor blog provides a more national perspective. Postscript: Kevin Brady and Francis Pileggi discuss this case in a LexisNexis videocast available here.