Do LLC Managers and Controlling Members Have Default Fiduciary Duties? Maybe.

November 12, 2012

In Gatz Props., LLC v. Auriga Capital Corp.[1] (“Auriga II”), the Delaware Supreme Court visited an issue that had seemingly been resolved by the Delaware Court of Chancery–whether the Limited Liability Company Act imposes fiduciary duties by default upon managers and controlling members of LLCs–and thrust the issue back into the realm of uncertainty.  Until this issue is clarified by either the Delaware legislature or a subsequent Delaware Supreme Court decision, contracting parties who desire to have fiduciary duties apply to the managers or controlling members of a Delaware LLC should state so explicitly in their LLC agreement.

Background

In Auriga Capital Corp. v. Gatz Props, LLC[2] (“Auriga I”), the Delaware Court of Chancery had examined a self-dealing transaction by the manager and controlling member of an LLC.  The limited liability company in Auriga was majority-controlled by William Gatz and his family, and was formed as an investment vehicle to develop and lease a property (also controlled by Gatz) to be used as a public golf course.  Moreover, the LLC agreement designated a Gatz-controlled entity as manager of the LLC.  The LLC subleased the property to an operator that, following an economic downturn, was unable to generate a profit.  Knowing that the operator was close to terminating the sublease, Gatz commissioned an appraisal that showed the land was worth more if developed than if used as a golf course.

Desiring to reacquire the property for development, Gatz rejected a third party’s offers to take over the LLC’s long-term lease, and structured what the Court found to be a “sham” auction of the LLC.  The winner of the auction was Gatz, who purchased the LLC for significantly less than the amount offered by the third party.

Contractually Imposed Fairness

The LLC agreement provided that agreements with affiliates, unless approved by 66-2/3% of the non-affiliated members, could not be “less favorable to the Company than the terms and conditions of similar agreements which could be entered into with arms-length third parties….”  The Supreme Court affirmed that the contracting parties explicitly assumed “an obligation subjecting the manager and other members to obtain a fair price for the LLC in transactions between the LLC and affiliated persons.”[3]

Although the contractual provision only spoke to a “fair price,” the Supreme Court affirmed the Court of Chancery’s consideration of the fairness of the process, “because the extent to which the process leading to the self-dealing either replicated or deviated from the behavior one would expect in an arms-length deal bears importantly on the price determination.”[4]  The Supreme Court decided, therefore, that the LLC agreement’s “fair price” provision was the equivalent of the entire fairness standard applied in Delaware corporation law, and that Gatz had the burden of proving that he discharged his contracted-for entire fairness obligation.  After a review of the facts, the Supreme Court was satisfied with the Court of Chancery’s finding that Gatz failed to carry such burden.

The Act and Default Fiduciary Duties

Most will remember Auriga I, however, for the Court of Chancery’s discussion of the Limited Liability Company Act, and whether it imposes equitable fiduciary duties by default on the managers and controlling members of an LLC.  The Court reasoned as follows:  (1) fiduciary duties are owed in the corporate context; (2) § 18-1104 of the LLC Act explicitly calls for an equitable backstop (the DGCL does not have this statutory mandate); (3) under traditional principles of equity, the manager of an LLC easily fits the definition of a fiduciary in that he has more than an arms-length, contractual relationship with members of the LLC; and (4) the legislative history of the Act supports this interpretation; and thus fiduciary duties apply by default to managers and controlling members of LLCs.  The Court acknowledged that the Act permits parties to an LLC agreement to modify or disclaim those default principles.  The Court in Auriga I further cautioned that, in the Court’s view, eliminating default fiduciary duties would upset the expectations of those currently party to LLC agreements and would make Delaware a less attractive place for LLC investors.

Auriga II agreed on the ultimate result–that the manager of the LLC did breach his fiduciary duties–but did so purely on contractual grounds.  The Supreme Court noted that the members of the LLC contracted for an entire fairness obligation and that neither party had even asked the Court of Chancery to decide the issue of whether default fiduciary duties applied.  The Delaware Supreme Court stated that the Court of Chancery could have–and should have–decided the case without recourse to a discussion of default fiduciary duties.  As a result, Auriga I‘s statutory interpretation “must be regarded as dictum without any precedential value.”[5]  The Supreme Court stated that it felt compelled “to address this dictum ‘because it could be misinterpreted in future cases as a correct rule of law,’ when in fact the question remains open.”[6]  The Court noted that although lower courts had previously made similar findings,[7] and practitioners and parties may have conformed their conduct to the understanding embodied in Auriga I, the Supreme Court was not swayed; the Court reminded its audience that, “as an appellate tribunal and the court of last resort in [Delaware],” it was not constrained by the Court of Chancery’s decisions.[8]

Auriga II thus leaves open the question of whether the Act applies fiduciary duties by default to the managers and controlling members of LLCs.  The issue, the Court said, was one on which “reasonable minds could differ,” and was an ambiguity that the “organs of the Bar” may be “well advised to consider urging the General Assembly to resolve….”[9]

Practical Implications

Auriga II provides practitioners with two key considerations for crafting LLC agreements.

First, when drafting a provision governing affiliate transactions, parties may consider adopting a safe harbor in the form of an objective measure of the price (e.g., a third-party appraisal) or an objectively performed procedure (e.g., approval by a majority of the minority members).  Absent satisfaction of such an objective standard,[10] a contractual provision seeking a “fair price” will be viewed as adopting a fiduciary standard of entire fairness, and the burden of proof will be placed on the fiduciary.

Second, if contracting parties desire that managers or controlling members owe fiduciary duties to a limited liability company or its members, the LLC agreement should specifically describe those duties, and whether those duties are modified or disclaimed.  Remaining silent on fiduciary duties in an LLC agreement may provide the Delaware Supreme Court with its ideal test case.