Restructuring

This is the second 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.  In our first post, we highlighted the question of whether the Delaware Limited Liability Company Act (the LLC Act) imposes “default” fiduciary duties on the managers and members of a Delaware limited liability company (LLC).  There, we discussed the Delaware Supreme Court’s decision in Gatz Props., LLC v. Auriga Capital Corp. LLC  (Auriga II) which provided some helpful guidance on the issue but ostensibly left the question open for the Delaware legislature to resolve.  Here, we discuss the Delaware Chancery Court’s decision in Feeley v. NHAOCG, LLC – handed down merely three weeks after Auriga II – which reaffirmed the Chancery Court’s original conclusion in Auriga Capital Corp. v. Gatz Props., LLC (Auriga I) that “default” fiduciary duties do indeed apply to managing members of Delaware LLCs.
Background
In Feeley, the managing member, AK-Feel, LLC, of Oculus Capital Group, LLC, a Delaware LLC, sued to block the non-managing member from taking control as manager.  Both members held a 50% interest in Oculus, but only the managing member had the authority to run the day-to-day business.  The non-managing member filed a series of counterclaims against AK-Feel and AK-Feel’s managing member, Christopher J. Feeley, who controlled the day-to-day management of AK-Feel and, thereby, Oculus.  The non-managing member alleged that AK-Feel and Feeley breached their contractual and default fiduciary duties by (i) failing to ensure Oculus provided a timely and sufficient deposit to a counterparty as required under a real estate purchase agreement, which caused the counterparty to cancel the contract and Oculus to forfeit the deposit and business opportunity, and (ii) diverting real estate business opportunities from Oculus to a different entity owned and controlled by Feeley.  The parties eventually resolved the control issues by stipulation, and AK-Feel and Feeley moved to dismiss the remaining counterclaims.  The Delaware Chancery Court granted their motion, in part, but upheld the breach of default fiduciary duties counterclaims.
Analysis
The Delaware Chancery Court began its analysis of the breach of fiduciary claims much the same way it did in Auriga I:  by first addressing whether the LLC Act imposed default fiduciary duties on the managing member before looking to the governing LLC agreement.  In reviewing several provisions of the LLC Act, the Chancery Court found ample support for its conclusion that default fiduciary duties apply to managing members.  While the LLC Act does not explicitly incorporate the fiduciary duties of loyalty or care, it does explicitly state in Section 18-1104 that the traditional rules of law and equity govern.  Under the traditional rules of equity, a managing member of an LLC would qualify as a fiduciary.  Managing members, like corporate directors, general partners and trustees, are vested with discretionary power by other members and the LLC to manage the business in a way that protects the entity’s and others’ interests.  As a fiduciary, the managing member would be bound by fiduciary duties, including the duties of loyalty and care, to the LLC and to the other members.  Accordingly, the LLC Act starts with the default that managers of LLCs owe enforceable fiduciary duties.
The Delaware Chancery Court further concluded that the drafting history and language of Section 18-1101(c) of the LLC Act supported this reading.  As the court discussed in Auriga I, it was in response to Gotham Partners, L.P. v. Hallwood Realty Partners, L.P. – where the Delaware Supreme Court questioned whether default fiduciary duties could be fully eliminated in the limited partnership context – that the Delaware legislature amended the statutes governing Delaware limited partnerships (LPs) and LLCs to clarify that duties owed by a member, manager or other person may be eliminated by contract.  The Chancery Court viewed the legislature’s amendment of the statutes governing both Delaware LPs and LLCs as reflecting not only its acceptance of Gotham Partners’ implicit holding that default fiduciary duties were applicable to Delaware LPs, but also its presumption that default fiduciary duties would be similarly applicable to Delaware LLCs.
Moreover, unlike the Delaware Supreme Court which declared it “consciously ambiguous,” the Delaware Chancery Court viewed the introductory language “to the extent that” in Section 18-1101(c) of the LLC Act as efficient drafting that acknowledged situations where a member, manager or other person may not owe fiduciary duties by default – without implying that all members or all persons always or never owe default fiduciary duties.  In explaining its reasoning, the Chancery Court drew heavily on Delaware LP law, because the same introductory phrase appears in a corresponding provision of the Delaware Revised Uniform Limited Partnership Act (the LP Act) which governs Delaware LPs.  The Chancery Court noted that general partners of Delaware LPs owe default fiduciary duties, but passive limited partners do not.  When passive limited partners take an active role in management, however, courts have imposed upon them default fiduciary duties.  Similarly, a person might not owe fiduciary duties to a partnership, or it could owe fiduciary duties as an officer, employee, or agent of that partnership or as a party who controls an entity that serves in a fiduciary capacity to that partnership.  The introductory phrase “to the extent that” merely acknowledges that whether a partner or other person owes fiduciary duties will depend on the role they played, the relationship they had with the entity and the facts of the case.  The Chancery Court noted that the same legal principles apply to LLCs.  Managing members would owe default fiduciary duties to the LLC, but passive members would not.  When a passive member controls or actively manages an LLC, however, courts may choose to impose default fiduciary duties upon those members.  The LLC Act’s inclusion of the introductory phrase “to the extent that” is merely meant to provide a flexible statutory framework that incorporates and acknowledges that whether a party is a fiduciary to a Delaware LLC will depend on the role they played, the relationship they had with the LLC and the facts of the case.
Lastly, the Chancery Court discussed how default fiduciary duties play a critical role as an equitable gap-filler.  The LLC Act expressly contemplates that an LLC agreement can be oral, implied or written.  Thus, an LLC agreement can be comprehensive or bare-bones, even incomplete.  Overlaying default fiduciary duties in LLCs provides important protections for non-managing members that may not otherwise exist where the LLC agreement has considerable gaps.
After concluding that the LLC Act imposes default fiduciary duties on managing members, the Chancery Court then examined Oculus’s LLC agreement and determined that the agreement did not explicitly limit or eliminate the managing member’s default fiduciary duties.  Rather, the operative section of the LLC agreement assumed the existence of default fiduciary duties and carved out the potential for a monetary remedy, except in certain instances, including gross negligence and willful misconduct.  Along with the other facts pled regarding AK-Feel and Feeley’s willful misconduct and AK-Feel’s gross negligence, the Chancery Court found that the non-managing members successfully pled the predicate elements for a breach of default fiduciary duties claim.
The Delaware Chancery Court’s discussion of default fiduciary duties in Feeley and Auriga I on the one hand, and the Delaware Supreme Court’s discussion of default fiduciary duties in Auriga II on the other, illustrate a fundamental divide in the thinking of Delaware courts, one not likely to be resolved soon.  In Feeley and Auriga I, the Chancery Court addressed the default fiduciary duties question by first looking outside the governing contract to the LLC Act’s language and history to support that such duties existed.  Only after determining that default fiduciary duties existed, did the court then look to the four corners of the LLC agreement to determine if those duties were modified, restricted or eliminated.  In Auriga II, however, the Delaware Supreme Court first looked to the four corners of the LLC agreement to determine which fiduciary duties, if any, the LLC agreement could be construed to apply.  Having found language that provided some basis for the application of specific duties, it then determined there was no need to look outside the agreement to reach the issue of whether or not the LLC Act imposed the additional duties of loyalty and care.
Drafters of LLC agreements and members and managers alike should bear in mind the different approaches employed by Delaware courts to determine which fiduciary duties apply in a particular case.  While it is axiomatic that clear drafting is critical to avoiding disputes regarding which fiduciary duties apply, what constitutes clear drafting to a particular court is often not obvious.  Courts employing the approach of Feeley and Auriga I view the fiduciary duties of care and loyalty as fundamental protections and are likely to apply those duties unless unambiguously eliminated from an LLC agreement.  Courts employing the approach of Auriga II view contractual duties as paramount and are unlikely to apply the fiduciary duties of care and loyalty unless unambiguously incorporated into an LLC agreement.  Understanding what explicit language different courts are looking for in LLC agreements to guide its fiduciary duty determinations should provide some assistance to drafters in clearly conveying the intent of the parties to an LLC agreement so that courts of both viewpoints will understand the agreement’s intended meaning.