Chancery Court Imposes Fiduciary Duties on LLC Members
Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, Del. Ch., No. 3658-VCS (April 20, 2009), read opinion here. This Delaware Chancery Court decision addresses fiduciary duties and related issues in an LLC context, and should be of great interest to those lawyers who practice business litigation.
Legal Issues
This opinion is noteworthy because it denies a motion to dismiss and allows to proceed to trial, the following claims that do not often survive in the context of a dispute among members of an LLC whose relationship is defined by a formal, sophisticated LLC agreement:
- Breach of the implied covenant of good faith and fair dealing;
- Breach of fiduciary duties;
- Common law fraud;
- Aiding and abetting breach of fiduciary duties and fraud.
Factual Background
The "alphabet soup" of parties needs to be sorted out first in order to make sense of this matter.
Plaintiff Bay Center LLC and defendant Emery Bay PKI, LLC ("PKI") formed defendant Emery Bay Member LLC ("Emery Bay") to develop a condominium project in California (the "Project"). PKI was designated as the managing member. Defendant Alfred Nevis owned and managed PKI. The LLC Agreement provided for PKI to manage the project. The details of the management duties were outlined in a separate management agreement that was only signed by a subsidiary of PKI called Emery Bay ETI, LLC ("ETI"). The only counterparty to that agreement was a subsidiary of Emery Bay.
Bay Center and PKI as the sole members of Emery Bay executed an LLC Agreement on November 1, 2005, providing for PKI to be the managing member. The Project was to be conducted through a number of affiliated entities, and the duties and obligations of those entites would be defined through a series of agreements. At the center of this layered structure was PKI and its sole equity holder, Nevis. Another entity, known as EB North, actually owned the property for the Project.
The day-to-day management of the Project was not defined in the LLC Agreement. Rather, those details were described in the separate Development Management Agreement, which was an exhibit to the LLC Agreement. Instead of PKI, the Development Manager was merely an affiliate of PKI, controlled by Nevis, called ETI, an entity that was not a contractual partner of Bay Center (the plaintiff).
Regardless of what entity served as the Project Manager, the court found that PKI had the power and the authority to make sure that contract was performed.
Problems with the Project
Problems began soon after the Project commenced. Bay Center alleges that a loan that was in default was secretly renegotiated by the defendants, resulting in the diversion of cash flow from the Project, and avoiding the triggering of the Personal Guarantee of the loan that Nevis had guaranteed. After a default on the loan, a lender filed suit in California in which case a receiver was appointed for the Project. That receiver prepared a report which revealed extensive mismanagement of the Project by the defendants.
This case warrants a longer treatment due to the important legal principles stated.
The Complaint
Counts I and II are breach of contract claims against PKI and Emery Bay. Count III is offered in the alternative to Count I, and alleges that even if PKI was not obligated by the explicit terms of the LLC Agreement to ensure performance of the Development Management Agreement, the implied duty of good faith and fair dealing required it to do so.
Count IV, V and VI bring fiduciary duty claims. Count IV alleges that both Emery Bay and Nevis have fiduciary duties to Bay Center that they breached in the course of their mismanagement of the Project. Counts V and VI allege that ETI and Nevis, to the extent that Nevis does not have primary liability, aided and abetted the breaches alleged in Count IV.
Finally, Count VII alleges that both PKI and Nevis committed fraud by failing to inform Bay Center of material developments at the Project. In case Count VII fails to state a claim against Nevis, Count VIII alleges that Nevis aided and abetted PKI’s fraud. Only Counts II through VI were the subject of a motion to dismiss under Rule 12(b)(6). In order to dismiss a claim under this standard, the court “must determine with reasonable certainty that, under any set of facts that could be proven to support the claims asserted, the plaintiffs would not be entitled to relief.”
The Implied Covenant of Good Faith and Fair Dealing
It is not common for this claim to prevail in most Chancery Court cases but this case is different. This Count III was brought in the alternative in the event that the court did not agree with the breach of contract arguments based on the LLC Agreement. In order to understand this Count III for the breach of an implied covenant of good faith and fair dealing, it is helpful to understand the breach of contract claims. In the breach of contract claim, Bay Center argues that PKI was required to cause ETI to perform its obligations under the Development Management Agreement and to cause Emery Bay to perform its obligations under the loan documents.
Importantly, the main argument by Bay Center for breach of contract is that PKI unambiguously had the power and authority to cause performance of the related agreements which meant that PKI also had the obligation to do so. PKI’s duty to manage the affairs of the Project, according to the court, can reasonably be read to mean that PKI had the obligation to exercise its authority on behalf of the members.
The court explained how the Delaware courts have been hesitant and cautious in applying the implied covenant of good faith and fair dealing, especially in detailed, complex agreements. Here, however, in order to ensure that the reasonable expectations of the parties are fulfilled, the court reasoned that:
“PKI had the obligation to manage Emery Bay and the discretion to cause the Supporting Agreements to be performed. PKI was required to carry out these functions in good faith, meaning PKI could not engage in ‘arbitrary or unreasonable conduct’ that had the effect of preventing Bay Center from ‘receiving the fruits of its bargain.’ This bargain was, essentially, that in exchange for contributing the real estate to be developed, Bay Center would reap the rewards of PKI’s project management skills and efforts." (See footnotes 29 and 30.)
Moreover, the breaches by Emery Bay of the loan documents benefited PKI by diverting cash that Emery Bay was supposed to use to repay the loan which PKI would have otherwise had to fund through capital contributions. Moreover, the decision not to pursue claims against ETI was a conflicted one because Nevis, as the controller of both Emery Bay and ETI, stood on both sides of it. Thus, the court determined that Bay Center sufficiently pled that PKI had an implied duty to cause performance of the supporting agreements.
Breach of Fiduciary Duty
The LLC Agreement’s Treatment of Fiduciary Duties
The court began with the truism that the Delaware LLC Act gives members of an LLC wide latitude to limit or eliminate fiduciary duties. On page 18 of the slip opinion, the court reiterates several statements of Delaware law regarding LLCs and fiduciary duties that are especially noteworthy:
1) The court stated that “in the absence of a contrary provision in the LLC Agreement, the manager of an LLC owes the traditional fiduciary duties of loyalty and care to the members of the LLC.” (See footnote 33.)
2) In addition, the court noted that “the LLC cases have generally, in the absence of provisions in the LLC Agreement explicitly disclaiming the applicability of default principles of fiduciary duty, treated LLC members as owing each other the traditional fiduciary duties that directors owe a corporation.” (See footnote 33) (case citations omitted) (emphasis added)
The two foregoing statements of Delaware LLC law are extremely important for their uncommon clarity on these very important descriptions of the legal duties of members and/or managers of a Delaware LLC.
The foregoing legal principles were applied in this case for the following reasons. The court described the arguments of both parties as diametrically opposed in their interpretation of the LLC Agreement. Specifically, one party argued that the LLC Agreement eliminated fiduciary duties; but the other party argued that the same LLC Agreement preserved the traditional fiduciary duties. The court acknowledged the usual principle that in the context of a Rule 12(b)(6) motion it could not choose between reasonable interpretations of ambiguous contract provisions at this early procedural stage; thus the court could not choose either of the opposing interpretations of the LLC Agreement.
Moreover, the court reasoned that “the interpretive scales also tip in favor of preserving fiduciary duties under the rule that the drafters of chartering documents must make their intent to eliminate fiduciary duties plain and unambiguous.” (See footnote 38) (case citations omitted.) Thus, the court ruled that the parties' LLC Agreement requires the members of Emery Bay to act in accordance with traditional fiduciary duties.
Breach of Fiduciary Duty by PKI and Nevis
The fiduciary duty analysis as applied to Nevis was more involved because Nevis himself was neither a member nor an officer of Emery Bay and “thus beyond the normal scope of those who owe fiduciary duties in the corporate context.” Rather, Bay Center’s theory of liability rested on a line of cases beginning with In Re USACafes, L.P. Litigation, 600 A.2d 43 (Del. Ch. 1991), holding that “those affiliates of a general partner who exercise control over the partnership’s property may find themselves owing fiduciary duties to both the partnership and its limited partners.” The applicability of that doctrine in the LLC context was not contested. Rather it was argued that the limited circumstances in which that doctrine applies were not present.
The court noted that the USACafes doctrine only applied in the following circumstances: First, to have any fiduciary duties to an entity, the affiliate must exert control over the assets of that entity. That requirement was satisfied here due to the control that Nevis exerted directly over the property of Emery Bay. Second, USACafes suggests that controlling affiliates do not have the full range of the traditional fiduciary duties and focused on “the duty not to use control over the partnership’s property to advantage the corporate director at the expense of the partnership.” (See footnote 49.)
The court found that it was sufficiently pled that Nevis used his control over the assets of Emery Bay to stave off personal liability, thus benefiting himself at the expense of Emery Bay, and withstanding a motion to dismiss under the reasoning of USACafes and its progeny.
Aiding and Abetting a Breach of Fiduciary Duty
The court recited the elements for stating a claim of aiding and abetting a breach of fiduciary duty. The court held that because it had previously ruled that Bay Center adequately alleged that PKI and Nevis committed breaches of fiduciary duty, it found that the other requirements for stating an aiding and abetting claim have been met. (The aiding and abetting claims against Nevis were applied in the alternative. Although it was not necessary, the court addressed the count for completeness purposes.)
The Fraud Claims
Bay Center alleged that PKI and Nevis committed fraud by failing to disclose the severe problems that were developing at the Project. The court described three ways that common law fraud can be demonstrated: “1) Overt misrepresentation; 2) Silence in the face of a duty to speak: or 3) Deliberate concealment of material facts." (See footnote 52.)
Silence in the Face of a Duty to Disclose
In order to commit a common law fraud through silence, one must have a duty to speak that arises by operation of law, rather than purely by contract. (See footnote 53.) This so-called independent tort doctrine is satisfied if, in addition to a contractual duty, the party was subject to an independent duty, such as a fiduciary duty. (See footnote 54.) The court explained that “the same circumstances may give rise to both breach of contract and tort claims if the plaintiff asserts that the alleged contractual breach was accompanied by the breach of an independent duty imposed by law.” However, it was acknowledged that the general rule is that an action based entirely on a breach of the terms of a contract and not on a violation of an independent duty imposed by law requires a plaintiff to sue in contract and not in tort.
In this case however, the court considered that PKI was subject to the traditional fiduciary duties of a director of a Delaware corporation and defendants conceded that if the court found a breach of fiduciary duty that there was a basis for fraud claims. The court relied on well-settled case law for the analogous duty of a board of directors of a corporation to “disclose fully and fairly all material information within the board’s control when it seeks shareholder action,” (citing Stroud v. Grace, 606 A.2d 75, 84 (Del. 1992)).
Applying this principle by analogy to the fiduciaries of an LLC where they seek members’ consent, the LLC Agreement required the consent of Bay Center which necessarily required disclosure to Bay Center of any refinancing or restructuring of the loans. In this case, Emery Bay had a right to make a decision regarding the renegotiation of the loans and therefore PKI had a fiduciary duty to inform Bay Center of all material facts regarding the renegotiations. The court reasoned that because of the alleged fact that PKI failed to inform Bay Center that most of the renegotiations were taking place, PKI failed to make Bay Center aware of even the most basic facts that Bay Center was entitled to know. Thus, Bay Center sufficiently pled a fraud claim against PKI based on the failure of PKI to disclose material facts in the face of its fiduciary duty to do so. The court also noted at footnote 59 that allowing the fraud claim to proceed because of a fiduciary duty to disclose, generates a redundancy, but cites cases where that redundancy has been permitted.
Individual Liability
The court also discussed the concept that a “corporate officer can be held personally liable for the torts he commits and cannot shield himself behind the corporation when he is a participant.” (See footnote 60). This includes situations where a corporate agent participates in corporate fraud. The court referred to the “Responsible Corporate Officer Doctrine,” where if a “corporate officer participates in the wrongful conduct, or knowingly approves the conduct, the officer, as well as the corporation, is liable for the penalties.” Moreover the court cited authority for the position that: “a corporate officer or agent who commits fraud is personally liable to a person injured by the fraud. An officer actively participating in the fraud cannot escape personal liability on the ground that the officer was acting for the corporation.”
The court discussed the third type of fraud theory, active concealment, for the sake of completeness. The critical distinction between active concealment and silence theories of fraud is that active concealment does not require a pre-existing duty to speak but this alternative theory of fraud was not sufficiently pled. In sum, despite the infirmity regarding active concealment, the court determined that Bay Center has pled a claim of fraud against PKI and Nevis based on their failure to disclose loan modifications when they had a duty to do so.
UPDATE: Professor Larry Ribstein, one of the country's leading authorities on LLCs, fortunately provides his usual scholarly analysis of this case here.
COMPARISON: The North Carolina Business Litigation Report here, describes a recent decision from the N.C. Business Court, affirmed by the N.C. Court of Appeals, that contrasts sharply with the above Delaware decision. The N.C. ruling highlighted at the foregoing link held that : (i) non-majority members of an LLC do not have fiduciary duties; and (2) managers of an LLC do not have fiduciary duties to members.
