Wood v. Baum, (Del. Supr., July 1, 2008), read opinion here. This Delaware Supreme Court decision is an important ruling regarding the defense by LLC managers to fiduciary duty and Caremark claims against them in light of the exculpatory terms of an LLC agreement.
Based on the exculpatory terms of the Operating Agreement and the LLC Act, Delaware’s High Court summarized what the plaintiff needed to establish as follows:
Therefore, under the Operating Agreement and the LLCA, the MME directors’ exposure to liability is limited to claims of “fraudulent or illegal conduct,” or “bad faith violation[s] of the
implied contractual covenant of good faith and fair dealing.”
The money quote from the opinion, (which is precious "manna from heaven" in light of the relative paucity of Supreme Court decisions on liability of LLC members), follows:
Where directors are contractually or otherwise exculpated from liability for certain conduct, “then a serious threat of liability may only be found to exist if the plaintiff pleads a non-exculpated claim against the directors based on particularized facts.”13 Where, as here, directors are exculpated from liability except for claims based on “fraudulent,” “illegal” or “bad faith” conduct, a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter, i.e., that they had “actual or constructive knowledge” that their conduct was legally improper.14 Therefore, the issue before us is whether the Complaint
alleges particularized facts that, if proven, would show that a majority of the defendants knowingly engaged in “fraudulent” or “illegal” conduct or breached “in bad faith” the covenant of good faith and fair dealing. We conclude that the answer is no.
The court provides a pithy summary of the demand futility tests under Aronson and Rales, and then explains the lack of particularity in the conclusory allegations in the complaint–juxtaposed against the provisions of the operating agreement requiring a showing of fraud or bad faith before the defendants could be found liable. Specifically, the court explained:
The Board’s execution of MME’s financial reports, without more, is insufficient to create an inference that the directors had actual or constructive notice of any illegality.
* * *
Delaware law on this point is clear: board approval of a transaction, even one that later poves to be improper, without more, is an insufficient basis to infer culpable knowledge or bad faith on the part of individual directors.
Footnote: See, e.g., Guttman v. Huang, 823 A.2d 492, 498 (Del. Ch. 2003) (dismissing complaint that was “devoid of any pleading regarding the full board’s involvement in the preparation and approval of the company’s financial statements” and of “particularized allegations of fact demonstrating that the outside directors had actual or constructive notice of the accounting improprieties.”)
Other reasons the court dismissed fiduciary claims and Caremark claims are more easily quoted than summarized. The court explained its affirmance of the Chancery Court ‘s dismissal of the claims with the following recitation of black letter Delaware law:
Plaintiff also asserts that membership on the Audit Committee is a sufficient basis to infer the requisite scienter. That assertion is contrary to well-settled Delaware law. In Rattner v. Bidzos, for example, the Court of Chancery declined to infer that the directors had a culpable state of mind based on allegations that certain board members served on an audit committee and, as a consequence, should have been aware of the facts on which the plaintiff premised her interpretation of “SEC rules and regulations, and FSAB and GAAP standards.”19 (emphasis added).
Finally, plaintiff claims that the Board knowingly ignored “red flags.”20 Under Delaware law, red flags “are only useful when they are either waved in one’s face or displayed so that they are visible to the careful observer.”21
I will leave you with a gem from the court’s opinion. I call it a gem because the "implied duty of the covenant of good faith and fair dealing" is not as fully developed in the LLC context as are common aspects of corporate law in Delaware:
The implied covenant of good faith and fair dealing is a creature of contract, distinct from the fiduciary duties that the plaintiff asserts here.22 The implied covenant functions to protect stockholders’ expectations that the company and its board will properly perform the contractual obligations they have under the operative organizational agreements.23 Here, the Complaint does not allege any contractual claims, let alone a “bad faith” breach of the implied contractual covenant of good faith and fair dealing. Nor, as discussed above, does the Complaint contain any particularized allegations that the defendants acted with the requisite scienter (in “bad faith”).
This case is but another replay of other similar cases where the plaintiff failed to allege with particularity any facts from which it could be inferred that particular directors knew or should have been on notice of alleged accounting improprieties, and any facts suggesting that the board knowingly allowed or participated in a violation of law.24
UPDATE: Professor Larry Ribstein posts about the case here, with his customarily insightful analysis, including his observation that one of the reasons this case is important is because Delaware’s High Court has now confirmed that exculpatory provisions of an LLC will be honored even when the LLC is publicly-held. That is, this case "enshrines in judicial concrete" (my words) what is already in the LLC statute–namely, unlike in corporations, fiduciary duties can be waived in an LLC. In this case, in order to avoid dismissal, the complaint had to satisfactorily allege fraud and other "higher threshold" claims, which it failed to do.