Chancery Addresses Default Fiduciary Duties in LLC and Advancement Issues

Zimmerman v. Crothall, C.A. No. 6001-VCP (Del. Ch. Jan. 31, 2013)

Issue Presented 

This 74-page opinion addresses the allegations of a minority unitholder in an LLC who asserts claims that the directors breached their fiduciary duties in connection with several financing transactions.

Brief Overview 

Zimmerman claimed that the challenged transactions should be analyzed under the entire fairness standard of review based on the actual control by a majority of the directors interested in the challenged transactions and who received an exclusive benefit, but in any event, Zimmerman argued unsuccessfully that the directors could not demonstrate the fairness of the transactions which were alleged to be a violation of their duty of loyalty.  Zimmerman also claimed that the transactions did not receive the necessary approval from all of the members.  See prior Chancery decision in this matter summarized on these pages here.

The Court concluded after a three-day trial and post-trial briefs that even though a declaratory judgment would be entered that the directors exceeded their authority in engaging in the financing transactions, the Court found that the directors’ breach did not cause any damages.  The Court also ruled that the directors were entitled to both advancement and indemnification, notwithstanding the breach by the directors of the LLC operating agreement.

The Court provided an extensive description of the applicable law for interpreting an ambiguous contract such as the one involved here.  The Court also observed that the applicable statute, the Delaware LLC Act, allows parties wide latitude in crafting an agreement customized to their needs.  See pages 21 and 22.  For example in this case, the LLC Agreement involved the issuance of ownership interests in units as opposed to admitting members, and it also incorporated certain corporate law terms, such as a board of directors.

The Court discusses in extensive detail under what circumstances additional units can be issued under the LLC Agreement.  The Court noted that the LLC Act establishes “no formalities that must be observed for the creation and issuance of limited liability company interests,” as opposed to the analogous situation in a corporate context.  See footnote 100 and accompanying text.

The Court concluded that the board breached the operating agreement in undertaking each of the challenged transactions regarding the issuance of additional units.

The Court explained that in determining the contractual intent of the parties, the “true test is not what the parties to the contract intended it to mean, but what a reasonable person in the position of the parties would have thought it meant.”  See footnote 117.  The Court also applied the rule that construing and ambiguous contract against the drafter is appropriate based on the rule of contra proferentum.

The Court considered the breach of duty of loyalty claims that were based at least in part on the argument that certain unitholders owed fiduciary duties in light of their controlling interest.  The Court described the case law that determines when an interest in an entity will be considered controlling, even if it is less than 50% or when actual control over a board takes place in the course of a particular transaction.  See footnote 129 and accompanying text.

However, the Court found that the parties involved “neither acted together nor were connected in some legally significant way” so that they were not acting in concert in a manner that was sufficient to establish control.  Because the Court concluded that the two unitholders were not acting in concert or otherwise exerting “actual control” over the board, there was no basis for the breach of fiduciary duty claim that rested on the finding of a control group of shareholders.

The Court next considered the fiduciary duties under the terms of the operating agreement and found that the operating agreement did provide that the directors of the LLC were fiduciaries.

Importantly, at footnote 145, the Court of Chancery noted that the Delaware Supreme Court has not yet “definitively determined whether the LLC statute imposes default fiduciary duties,” but also cited a more recent decision of the Court of Chancery that held that “subject to clarification from the Supreme Court, managers and managing members of an LLC do owe fiduciary duties as a default matter.”  (citing Feeley v. NHAOCG, LLC, 2012 WL 5949209, at * 8-10 (Del. Ch. Nov. 28, 2012)).

Moreover, the Court found that the fiduciary duties were restricted pursuant to 6 Del. C. Section 18-1101(c) to the extent that the agreement gave the directors the right to engage in transactions with the company.

The Court interpreted the provision of Section 6.13 of the LLC Agreement requiring the transactions with the company be “fair” as “effectively calling for review under an entire fairness standard.”  See footnote 159 (noting that magic words such as “entire fairness” or “fiduciary duties” are not necessary in order to impose fiduciary standards of conduct as a contractual matter).  However, the Court also found that the entire fairness standard was not shown to have been breached.

The Court also observed that the concepts of Section 144 of the Delaware General Corporation Law were incorporated into the LLC Agreement by reference.  Section 144 allows for self interested transactions with the director’s corporation to survive the common law concept that they are voidable.  Although this concept has no analogue in the LLC context; because it was incorporated into the agreement, the Court had to address it.  See footnotes 153 and 154 and accompanying text.  The Court found in this case that the defendants did comply with at least one of the safe harbors in Section 144 that was incorporated into the LLC Agreement by reference.  Thus, because the Court found that the challenged transactions were approved in good faith by informed disinterested directors, and should receive the benefit of the business judgment rule, the Court found that the burden of proof of entire fairness shifted to Zimmerman.  The Court also found the challenged transactions to be fair.

Remedy 

The Court concluded that Zimmerman was entitled to judgment in his favor on the breach of contract claim but not on the breach of fiduciary duty claim.  The appropriate remedy would be to recover damages resulting from the breach of the agreement but the Court determined that the transactions were fair and therefore there were no such damages.

Zimmerman also asked the Court to order defendants to reimburse the company for over $1 million in legal fees that it advanced to the law firm representing the defendants.  The Court reasoned that:

“Whether a party has the ultimate right to an advancement depends on whether his underlying conduct is indemnifiable.” 

(citing Reddy v. Elec. Data Sys. Corp., 2002 WL 1358761, at * 5 (Del. Ch. June 18, 2002)).  The Court found that the agreement required indemnification for the defendants based on the circumstances of this case.  See footnote 210.

Quoting the applicable parts of the LLC agreement, the court explained that even though the defendants breached the agreement, there was no evidence that the breach was the result of willful misconduct or other disqualifications to indemnification contained in the LLC agreement.  In addition to the LLC agreement, “at least some” of the defendants were also parties to separate agreements that also provided for advancement and indemnification.

The trial having been concluded, and the right to indemnification established, the court observed that Zimmerman could have sought a pre-trial ruling on advancement.  Nonetheless, there was no basis for the court to invalidate the board decision to grant advancement which was consistent, the court reasoned, with the LLC agreement’s requirement that the company indemnify its directors “to the fullest extent permitted by law.” See footnotes 216 and 219.

In this post-trial opinion, the right to advancement was largely moot, but the Court explained that even though the operating agreement “does not explicitly address advancement rights,” the board had the authority to approve the advancement of legal fees based on broad authority to make decisions for the company not otherwise provided for in the LLC Agreement.