Restructuring

This is the first installment of a three-part series on recent decisions from the Delaware courts on the fiduciary duties of members and managers of limited liability companies.  When a company is financially distressed, its owners and managers often face difficult decisions regarding which restructuring strategies to implement, including whether or not to file the company for bankruptcy.  Clearly delineated fiduciary duties can serve as a guidepost for which actions owners and managers should or should not authorize and, once action is taken, as a potential shield from personal liability when disgruntled parties seek redress for perceived breaches of those duties.
A bedrock principle of the corporate law of Delaware (as well as the corporate law of every other U.S. state) is that officers and directors owe fiduciary duties of loyalty and care to their corporation and its stockholders.  A body of well-developed case law also lays out the contours of the duties of loyalty and care, which require officers and directors to act in the best interests of the corporation, disclose conflicts of interest, and inform themselves of all material information reasonably available.
The fiduciary duties (if any) owed by owners and managers of Delaware limited liability companies (LLC), however, are less than clear.  To a far greater extent than is true of Delaware corporations, Delaware law permits the owners of Delaware LLC’s to customize the terms of their relationship between each other and with management.  Delaware LLCs are governed by the Delaware Limited Liability Company Act (the LLC Act), which places paramount importance on parties’ freedom of contract, including the freedom to expand, restrict, or eliminate altogether fiduciary duties imposed by law or equity, other than the implied contractual covenant of good faith and fair dealing.  Determining the scope of duties of members or managers of a Delaware LLC thus requires an analysis of the duties imposed, limited, or eliminated by contract under the LLC agreement.  But what happens if the LLC agreement does not clearly prescribe which fiduciary duties do or do not apply?  Does this mean that members and managers owe no duties to the LLC and to each other, or does the LLC Act impose “default” fiduciary duties upon them?
The Delaware Supreme Court’s decision in Gatz Properties, LLC v. Auriga Capital Corporation provides some guidance.  In Auriga, the minority members of a Delaware LLC, Peconic Bay, LLC (the Company), sued the controlling member and manager of the Company, Gatz Properties, LLC, and the person acting on behalf of the member-manager, William A. Gatz, for breach of fiduciary duties and contractual duties.
The Company was formed to hold a long-term lease on property owned by the Gatz family.  The lease provided that the property be developed and used only as a first-rate public golf course.  The Company borrowed approximately $6 million to pay for the construction of the golf course and put up the property as collateral for the loan.  The Company then sub-leased the property to a third-party operator under a lease agreement that also granted the operator an early termination right.  Then things went into the rough.  Under the operator’s management, the golf course fell into disrepair and failed to turn a profit.  Long before the early termination right could be exercised, the controlling member-manager was made aware that the third-party operator would not renew the sub-lease.
Rather than explore strategic options for the Company that would protect the minority members, such as search for a replacement third-party operator, explore whether the Company could operate the property itself, or market the property to other buyers, the member-manager instead maneuvered to buy the property himself through a sham auction.  Indeed, when an interested buyer requested permission to conduct due diligence on the property, the controlling member-manager refused; when the same interested buyer suggested it might be willing to purchase the Company for a price “north of $6 million,” the member-manager failed to apprise the minority members and retained auctioneer of the potential offer.  Instead, he presented the minority members his own offer for the property for $5.6 million, which was subsequently rejected by all but one of the minority members.
Furthermore, during the 90-day marketing period before the auction, the member-manager engaged in a series of actions that discouraged competitive bidding for the property and forced the Company to be sold at a distressed price.  Among other things, he failed to contact golf course brokers, managers or operators, provided inadequate due diligence materials to interested bidders and only upon their payment of a fee, set auction terms that required buyers to purchase the property without any representation or warranties, and required winning bidders to repay the Company’s debt in full or assume it with bank consent.  Unsurprisingly, the controlling member-manager ended up the only bidder at the auction.  He bid $50,000 for the Company’s assets, plus assumption of its debt.  When all was said and done, the minority members received only $20,985.
The minority members filed suit in Delaware Chancery Court, alleging that the member-manager and Gatz breached their fiduciary duties and contractual duties when they engaged in self-interested conduct to eliminate the minority members’ interests in the Company.  The minority members alleged that the controlling member-manager wanted to realize for itself the increased value of the golf course once it was released from the long-term leasehold with the Company.  The self-interested conduct alleged included the member-manager’s failure to evaluate strategic options, active discouragement of an interested buyer, use of leverage to attempt to coerce a buy-out of the minority members, and acquisition of the Company through a sham auction.
After trial, the Delaware Chancery Court concluded that the LLC Act imposed default fiduciary duties upon the controlling member-manager, and because the Company’s LLC Agreement did not limit the fiduciary duties applicable to only those in the LLC Agreement, the controlling member-manager was bound by the fiduciary duties of care and loyalty.  Further, the Chancery Court held that Section 15 of the Company’s LLC Agreement distilled the traditional fiduciary duties into a burden on the controlling member-manager’s part to prove the price paid for the Company at the auction was substantively fair.  The Chancery Court then found that the controlling member-manager had breached both its fiduciary duties of loyalty and care and its contractual duty to acquire the Company at a fair price.  The member-manager appealed.
The central legal question the Delaware Supreme Court tackled on appeal from the Delaware Chancery Court was whether the member-manager owed contractually-imposed fiduciary duties to the Company and its minority members.  The court noted that if the Company’s LLC Agreement answered this question, then there would be no need to engage in a lengthy and superfluous discussion – as the Chancery Court had – regarding default fiduciary duties imposed on the member-manager as a matter of law.  In reviewing Section 15 of the Company’s LLC agreement, the Supreme Court agreed with the Chancery Court that the agreement imposed a duty akin to the “entire fairness” standard to transactions with the Company’s affiliates, including the member-manager – notwithstanding the absence of “magic words” such as “fiduciary duties” or “entire fairness” from the Company’s LLC Agreement.  The Supreme Court further agreed with the Chancery Court that the LLC Agreement’s language requiring that the “terms and conditions” of any conflicted transaction with an affiliate could not be “less favorable than the terms and conditions of similar agreements” effectively adopted the “fair price” prong of the entire fairness standard, and the member-manager bore the burden to show that he paid a fair price for the Company.
The Delaware Supreme Court also agreed with the Delaware Chancery Court that more than sufficient evidence existed in the record to determine that the member-manager breached its contractually imposed fiduciary duty to the minority members.  The court held that the Chancery Court below had properly relied on a discounted cash flow analysis submitted by the minority members’ expert witness that indicated the Company was worth approximately $8.9 million.  Additionally, the Supreme Court affirmed the Chancery Court’s conclusion that had the controlling member-manager dealt fairly with the interested purchaser who approached the Company before the auction, the Company could have likely sold for over $6 million.  Furthermore, the Supreme Court held that the Chancery Court properly concluded that the auction process conducted by the controlling member-manager was “not a process that anyone acting with minimal competency and in good faith would have used to obtain fair value” for the Company.
Because the Delaware Supreme Court believed that the Company’s LLC Agreement obviated any need to reach the issue of whether the LLC Act imposed default fiduciary duties on the Company, it did not address that question, and criticized as “improvident and unnecessary” and “dictum with no precedential value” the Delaware Chancery Court’s conclusion that the LLC Act does impose default fiduciary duties.  To the extent the Chancery Court’s decision had provided some guidance on what duties, if any, are imposed on LLC members and managers by law, the Supreme Court took it away, rebuking the lower court for straying “beyond the proper purview and function of a judicial opinion,” declaring that “reasonable minds could differ” on the issue of whether default fiduciary duties existed, and suggesting that the statutory ambiguity in the LLC Act should be resolved by the Delaware General Assembly.
The Auriga decision is interesting for several reasons.  First, the Delaware Supreme Court’s failure to express a definitive view about whether or not the LLC Act imposes default fiduciary duties reminds lawyers and professionals alike that clarity is more important than ever when drafting and negotiating agreements governing the relationship between controlling members, minority members, and managers of an LLC.  Parties should not assume that courts will find that default fiduciary duties bind members and managers where an LLC agreement is silent on the issue.  Second, the Supreme Court’s analysis in Auriga indicates that “magic words” are not necessary for the court to impose a higher standard of scrutiny or conduct in certain contexts.  To protect against the possibility that a court will impose more restrictive duties than intended, parties may want to consider explicitly stating in the LLC agreement which fiduciary duties do not apply and explicit standards that would govern transactions like a sale of the business.  Lastly, notwithstanding the Supreme Court’s declaration that “reasonable minds could differ” on whether the LLC Act imposes default fiduciary duties in Delaware LLCs, the trend in Delaware Chancery Courts is to find that it does, and, as we’ll discuss in the next installment of this series, even the Supreme Court’s admonition in Auriga that the legislature should be urged to decide the issue has not deterred Delaware Chancery Courts from reaffirming this viewpoint in later decisions.