Restructuring

Delaware limited liability companies are creatures of contract. And, under the Delaware Limited Liability Company Act, fiduciary duties traditionally imposed upon those in control of an entity can be eliminated or restricted in the operating agreement. If the members of a limited liability company fail to exercise their contractual authority to restrict or eliminate fiduciary duties, however, the Delaware courts borrow default fiduciary duties from corporate law and impose them on the LLC’s managers; specifically, the duty of loyalty and the duty of care. But a recent Delaware decision suggests that even when fiduciary duties are clearly eliminated, parties can sometimes reimpose those duties by stray language in additional provisions purporting to exculpate the managers from liability or claims respecting the duties which have been eliminated. In other words, parties may eliminate fiduciary duties with one stroke of the pen and then reimpose them with another.

In re Cadira Group Holdings, LLC Litigation, 2021 WL 2912479 (Del. Ch. July 12, 2021) involved a suit by members of a limited liability company against its manager alleging, among other claims, breach of fiduciary duties. The LLC’s operating agreement stated that the Manager was required “to perform his duties ‘in good faith, in a manner [he] reasonably believe[s] to be in the best interest of the Company, and with such care as an ordinarily prudent person in a like position would use under similar circumstances.’” Immediately after that statement, however, the Manager was exculpated from liability for all of its actions or omissions: “[a] Manager … shall not be liable to the Company or to any Member … for any loss or damage sustained by the Company or any Member so long as such action or omission does not constitute fraud, gross negligence, willful misconduct or a material breach of this Agreement by such Manager or is not made in knowing violation of the provisions of this Agreement.” The operating agreement also stated that “[i]t is the intent of this [section of the operating agreement] to restrict the liability and fiduciary duties of Members and the Managers to the maximum extent permitted by applicable law.” But in the next sentence, the operating agreement provided that “[n]either the Company nor any Member or Manager shall have any claim against any Member or Manager, provided that such act or omission was performed by the Member or Manager within the scope of its authority under this Agreement and that such act or omission did not involve the Member’s or Manager’s bad faith, gross negligence, willful misconduct or actual fraud.”

The Manager sought to dismiss the fiduciary duty claims because the plaintiff members had failed to allege any specific breach of the contractual duties set forth in the operating agreement, and had instead alleged a breach of traditional fiduciary duties, which the operating agreement had eliminated by restricting those duties to the maximum extent permitted by law (and the maximum extent permitted by law is the complete elimination of fiduciary duties in an alternative entity agreement). But the court rejected this effort to dismiss the fiduciary duty claims because “[w]here an LLC agreement purports to replace traditional fiduciary duties with duties not to engage in bad faith, willful misconduct, or gross negligence, that agreement essentially ‘replaces’ traditional fiduciary duties with identical contractual duties.” Stated differently, the court held that “a contractual duty to refrain from ‘willful misconduct ‘ or ‘bad faith’ corresponds with the traditional duty of loyalty, and a contractual duty to refrain from ‘gross negligence’ corresponds with the traditional duty of care.” Thus, according to the court, the manager had in fact agreed contractually that it “owe[d] the default traditional fiduciary duties of care and loyalty to [the Members]” because, by “green-light[ing] claims against the Manager arising from the ‘Manager’s bad faith, gross negligence, [or] willful misconduct,’” after purporting to eliminate fiduciary duties, the LLC operating agreement had effectively reimposed them.

Hmm. Is that what this agreement actually did with its exculpatory clause that carved out bad faith, gross negligence and willful misconduct, coupled with the second sentence of the disclaimer of fiduciary duties that limited “any claim” against the Manager for the Manager’s actions or conduct unless those actions or conduct involved the “Manager’s bad faith, gross negligence, [or] willful misconduct?”

In a much earlier case decided by the Delaware Court of Chancery, Fisk Ventures, LLC v. Segal, 2008 WL 1961156 (Del. Ch. May 7, 2008), the court rejected the argument that a fiduciary duty waiver provision that was followed by an exculpatory clause limiting liability for members to “gross negligence, fraud or intentional misconduct,” somehow imposed a replacement “duty to act without gross negligence, fraud or intentional misconduct.” And, in Dawson v. Pittco Capital Partners, L.P., 2012 WL 1564805 (Del. Ch. April 30, 2012), the court considered a similar provision to that involved in Fisk Ventures and held that:

The Court in Fisk Ventures read Genitrix LLC Agreement § 9.1 as a provision that sought only to eliminate duties and limit any potential liability; it did not interpret this provision as attempting, in any sense, to create any duties or any potential liability. Following this line of thought, § 7.1 may be interpreted as such: (1) the first sentence “eliminate[d] fiduciary duties to the maximum extent permitted by law by flatly stating that [M]embers [and directors] have no duties other than those expressly articulated in the [a]greement”; and (2) in an abundance of caution, the second sentence states that, if any duties are ever found in any agreement, unless such agreement expressly states otherwise, the directors, officers, and Members can only be liable as a result of those duties if the damage suffered was a result of gross negligence, fraud, or intentional misconduct. In essence, the second sentence is a “just in case” measure meant to ensure that any duty established (inadvertently or otherwise) is limited (at least in terms of liability) to gross negligence, fraud and intentional misconduct.

It is important to note that, except for the implied covenant of good faith and fair dealing (which is less a duty than a means of fairly interpreting an agreement that fails to deal with a specific issue), the Delaware Limited Liability Company Act permits either, or both, the limitation or elimination of duties (including fiduciary duties), and/or the limitation or elimination of liability for the violation of any such duties (including fiduciary duties).¹ The only real distinction between the clause in Fisk Ventures and the clause in In re Cadira is the fact that the sentence that followed the attempted limitation of fiduciary duties in Fisk Ventures spoke in terms of limiting “liability,” whereas the clause that followed the attempted waiver of all fiduciary duties in In re Cadira spoke in terms of limiting “any claim” being made. But how that distinction resulted in the imposition of an actual duty in In re Cadira is far from clear. It seems that the only duty imposed on the Manager in the operating agreement under consideration in In re Cadira was the obligation to “act in good faith, in a manner [he] reasonably believe[s] to be in the best interest of the Company, and with such care as an ordinarily prudent person in a like position would use under similar circumstances.”²

Another recent Delaware Court of Chancery decision, Smith v. Scott, 2021 WL 1592463, at *10 (Del. Ch. Apr. 23, 2021), held that an LLC operating agreement that clearly disclaimed default fiduciary duties, did reimpose some, but not all, default fiduciary duties by language requiring that the manager “must act ‘in accordance with this Agreement and the implied covenant of good faith and fair dealing and in a manner that does not constitute gross negligence or fraud.’” According to the court:

While these contractual standards track, to some extent, Delaware’s common law fiduciary duties, they can and must stand on their own as contractual covenants that expressly and exclusively govern the conduct of managers and members. Parties intending to impose a duty of loyalty through contractual standards will include language that prohibits conflict transactions or makes clear that managers or members may not act in “bad faith” or engage in “willful misconduct.” When parties to an LLC operating agreement elect not to include contractual standards that track the common law duty of loyalty, that election cannot be ignored. The parties to the LLC Agreements at issue here made that election and, by doing so, made clear that only claims for breach of the [implied contractual covenant of good faith and fair dealing] (already addressed), “gross negligence” (duty of care) or fraud may be brought against managers or members.

In other words, in this case, only the fiduciary duty of care was contractually reimposed, notwithstanding the disclaimer of default fiduciary duties, not the duty of loyalty. But note that the provision that reimposed the fiduciary duty of care was a provision that seemed to be directly addressing a standard of conduct required by the manager, not an exculpation clause limiting liability for any actions of the manager. Nonetheless, we have to seriously consider In re Cadira and its apparent interpretation of a provision limiting claims against the manager, except for certain specified actions, as effectively imposing duties on the manager not to engage in the actions excepted from the exculpation.

There is a wonderful story from Chinese history that might help illustrate the problem potentially created by In re Cadera’s interpretation of exceptions to an exculpatory clause as imposing affirmative duties. The story involves the exploits of Zhuge Liang, a military leader of one of the groups opposed to Cao Cao at the Battle of Red Cliffs in the winter of 208-209 CE. According to the story, which if it isn’t true should be, Cao Cao, a northern warlord with a massive army, was threatening to overtake opposing forces from southern China. Among other problems facing the southern forces was their lack of arrows. Zhuge Liang is said to have come up with a solution. He arranged for some boats to be lightly manned by human soldiers, with straw figures made to look like soldiers filling up the rest of each boat. He then launched these boats into the river across from Cao Cao’s encampment while there was still a morning fog, and made enough noise to alert Cao Cao’s camp. Cao Coa’s troops thinking the boats were filled with soldiers attacking their position, fired arrows at the boats filled with the straw figures, and the arrows stuck in the straw without damaging them. Zhuge Liang thereby collected (or “borrowed”) his needed arrows from Cao Cao’s forces, which could then be shot back at (or lethally “returned” to) them in the upcoming battle.³ So, as the story goes, Cao Coa’s arrows, which were intended to defeat the southern forces, were ultimately used by the southern forces to defeat Cao Coa.

In re Cadira suggests that, sometimes, when a party covers an issue clearly, and then adds a “just in case” additional provision, the added provision can be the functional equivalent of shooting an arrow into a strawman that can then be shot back at the drafter to undermine the benefit of the original provision. If your intention is to remove or limit fiduciary duties in your alternative entity agreement, be sure you are not effectively reimposing them with stray language regarding liability/claim limitations that exclude “gross negligence,” “bad faith” or “willful misconduct.”⁴ While the other side of the deal may not actually be the functional equivalent of Zhuge Liang, encouraging you to fire those just-in-case arrows, you may nonetheless be the functional equivalent of Cao Cao when you fire them.