Delaware Supreme Court Upholds Chancery Decision but Rejects Dicta on Default Fiduciary Duties in LLCs

Gatz Properties LLC v. Auriga Capital Corp., No. 148, 2012 (Del. Supr. Nov. 7, 2012) (Per Curiam).

Issue Addressed

Delaware’s High Court held that the manager of an LLC violated a contracted-for fiduciary duty that adopted the equitable standard of entire fairness in a conflict of interest transaction between the LLC and its manager.

Brief Background

The Delaware Supreme Court upheld the decision of the Court of Chancery, highlighted here, which found that the manager of an LLC violated his fiduciary duty by refusing to negotiate with a third-party bidder and then, by causing the LLC to be sold to himself at an unfair price in a flawed auction that he himself engineered.  In addition to finding the manager liable for that breach of fiduciary duty, the Court upheld the finding that because the manager acted in bad faith and made willful misrepresentations, the LLC Agreement did not afford him exculpation or indemnification.  The Delaware Supreme Court upheld the award of damages solely on contractual grounds and also affirmed the award of the trial court of attorneys’ fees.

For a more detailed background of the case, refer to the highlights of the trial court decision summarized on these pages here, as well as a separate summary of the trial court award of attorneys’ fees here.

Overview of Analysis

The Supreme Court observed that its review of contract interpretation issues is de novo.  The Court focused on what it referred to as the pivotal legal issue of whether Gatz, the manager of the LLC, owed contractually-agreed-to fiduciary duties to its minority investors based on the provisions of the LLC Agreement.  Both the trial court and the appellate court interpreted Section 15 of the LLC Agreement to impose fiduciary duties in connection with transactions between the LLC and affiliated persons even though the “operative language” did not actually use the words fiduciary duty.  Specifically, the Court explained that when:  “Viewed functionally, the quoted language is the contractual equivalent of the entire fairness equitable standard of conduct and judicial review.”  See footnotes 18 – 20.

The Supreme Court noted the contrast of this result with the outcome that would obtain in the traditional corporate law setting, where an informed majority-of-the-minority shareholder vote operates to shift of burden of proof on the issue of fairness.  See footnote 20 (citing Kahn v. Lynch Communications Systems, Inc., 630 A.2d 1110, 1117, (Del. 1994)).

The High Court reviewed the trial court’s detailed factual findings and was satisfied that the manager, Gatz, failed to carry his burden of proving that he discharged his contracted-for entire fairness obligation.  Thus the court affirmed the determination of the trial court on liability solely on contractual grounds.

Exculpation/Indemnification

The Supreme Court also reviewed Section 16 of the LLC agreement that permitted both exculpation and indemnification under specified circumstances, which Gatz did not satisfy.  He was not entitled to exculpation because the trial court properly found that he acted in bad faith and made willful representations in the course of breaching his duties.

Bad faith has been defined in the corporate fiduciary duty of loyalty context as:  “A failure to act in the face of a known duty to act,” which demonstrates a “conscious disregard of one’s duties.”  See footnote 48.  The Court recounted the detailed factual basis for the trial court’s finding that Gatz acted primarily to ensure that offers to buy the golf course would be thwarted, and Gatz also conducted the auction in a bad faith manner that was destined to return the golf course to his control.  Also, the “rigged” auction was destined not to obtain a fair value for the assets.  Moreover, Gatz provided incomplete and misleading information to the minority shareholders about the negotiations for the sale and the auction.  Thus, Gatz was not entitled to the immunization from liability that would otherwise be allowed under the LLC Agreement.

Unnecessary Construction of LLC Statute to Provide Default Fiduciary Duties

This is the part of the opinion that is most unusual and will receive extensive attention.  Before describing those juicy parts, I state one important substantive result of this opinion.  The net result of this opinion is that:

The issue of whether default fiduciary duties apply to Delaware LLCs when the LLC agreement is silent on the matter is an open issue in Delaware and anything the trial court said to the contrary in this case is mere dictum.  See footnote 62.

The Supreme Court in its per curiam opinion explained why the trial court “should not have reached or decided” the issue of whether default fiduciary duties are imposed on LLC managers and controllers unless the parties to the LLC agreement waive such duties.  The Court explained that it was “improvident and unnecessary for the trial court to reach out and decide, sua sponte, the default fiduciary duty issue as a matter of statutory construction.”

Delaware’s High Court provided five reasons why the Court of Chancery’s “statutory pronouncements must be regarded as dictum without any precedential value.”  See footnote 62.

The first reason the Court regarded that section of the trial court’s opinion as dictum is because the LLC agreement specifically addressed the fiduciary duty issue which controls the dispute.  Second, no litigant asked the Court of Chancery or the Supreme Court to decide the default fiduciary duty issue as a matter of statutory law.

Thus, the Delaware Supreme Court emphasized that:  “We decline to express any view regarding whether default fiduciary duties apply as a matter of statutory construction.  The Court of Chancery likewise should have so refrained.”  Slip op. at 25.

The third reason why the Court regarded that section of the trial court opinion as dictum is because the trial court should not imply that its decision is the final word on matters of Delaware law.  Although stare decisis may require other trial judges to rely on the decisions of the trial court, the Delaware Supreme Court is:  “not so constrained.”  See footnote 68.  The fourth reason why the Delaware Supreme Court regarded the trial court discussion of default fiduciary duties based on a statutory analysis as dictum is because the merits on the issue of whether the LLC statute does, or does not, impose default fiduciary duties is:  “One about which reasonable minds could differ.”  See Slip op. at 26.  In that regard, the Delaware Supreme Court noted at footnote 70 that the statutory analysis of the trial court “may have been influenced by its misreading of two cases:  Cantor Fitzgerald, L.P. v. Cantor, 2000 WL 307370 (Del. Ch. Mar. 13, 2000) and William Penn Partnership v. Saliba, 13 A.3d 749 (Del. 2011).”

The fifth reason why the Court described portions of the trial court opinion as dictum was because:  the “trial court’s excursus on this issue strayed beyond the proper purview and function of a judicial opinion.”  The Court explained that:  “A judge’s duty is to resolve the issues that the parties present in a clear and concise manner.  To the extent Delaware judges wish to stray beyond those issues and, without making any definitive pronouncements, ruminate on what the proper direction of Delaware law should be, there are appropriate platforms, such as law review articles, the classroom, continuing legal education presentations, and key note speeches.”  See footnote 73.

Damages
The Supreme Court observed that the standard of review for damages is an abuse of discretion.  See footnote 75.  The Delaware High Court found that the award of damages was “based on conscience and reason” and upheld it.  See footnote 86.

Attorneys’ Fees

The Delaware Supreme Court reviews an award by the trial court of attorneys’ fees based on an abuse of discretion standard.  See footnote 87.  The Court observed that the Court of Chancery has equitable powers to shift attorneys’ fees and properly did so in this case.  Although this case involved a legal dispute over a contractual provision of an LLC agreement, Delaware’s High Court instructed that:  “Even at law a court has inherent authority to shift fees where necessary to control the court’s own process.”  See footnote 83.  In particular, the Supreme Court upheld the bad faith exception to the American Rule based on the trial court’s finding that trial conduct met the definition of bad faith in this context as follows:  “Where parties have unnecessarily prolonged or delayed litigation . . . or knowingly asserted frivolous claims.”  See footnotes 89 through 92.  The High Court also agreed that there was ample support in the record for the following description of the litigation conduct of the losing party:

“Particularly troubling are the findings that Gatz’ counsel left to Gatz himself the primary role of collecting responsive documents, and that Gatz deleted relevant documents while litigation was either pending or highly likely.”  See footnotes 93 and 94 (internal quotes omitted).

Practice Tip

The foregoing quote about the shifting of attorneys’ fees being justified at least in part due to counsel for a party relying primarily on the client alone to collect responsive documents should be a warning to all litigants in Delaware courts:  If they rely exclusively on their clients to collect responsive documents – - they do so at their peril.

In addition to the trial court decision in this case, and this affirming Supreme Court opinion, other cases highlighted on these pages have indicated that Delaware courts expect Delaware counsel to be actively involved in the discovery process and not “simply take the word of their client” for purposes of determining whether all responsive documents have been produced.  See generally,  Eagle Rock decision highlighted here, and recent Lake Treasure decision highlighted here.

In addition, regarding the basis for the award of fees, the Delaware Supreme Court noted the trial court finding that:  “Gatz and his counsel simply splattered the record with a series of legally and factually implausible assertions.”  See footnote 95.  One would expect to see that description in future requests for exceptions to the American Rule.  As the trial court opinion highlighted at the link above indicated, there were some positions that the defendant took which the Court regarded as unsupported by the facts or the law.

Finally, as a practice tip, footnote 96 of the Supreme Court opinion instructs the parties and their counsel that when seeking attorneys’ fees in an appeal to the Delaware Supreme Court, although Supreme Court Rule 20(f) allows for the award of attorneys’ fees in the case of a frivolous appeal, the request for attorneys’ fees will not be considered if only made informally in briefs or in oral argument.  Rather, a formal motion for fees must be made and presented in accordance with Supreme Court rules for motions.

Postscript: Peter Lattman has an article in The New York Times that discusses this case. Doug Batey on his LLC Law Monitor provides practical commentary on the case.  The Wilmington News Journal also has an article that references this case.