Understanding Fiduciary Obligations
Applicable To Delaware Limited Liability
Companies
Keith H. Berk
George J. Spathis
Keith H. Berk and George J. Spathis
Be careful when a manager’s interests are at
odds with those of the LLC.
Keith Berk, a partner at the Chicago firm of Horwood
Marcus & Berk Chartered, serves middle-market businesses, often acting as part-time general counsel. Keith
emphasizes a hands-on and goal-oriented approach to
the practice of law focusing on mergers and acquisitions, growth strategies, and management incentive
plans. George Spathis, of counsel at Horwood Marcus
& Berk, is a seasoned trial attorney with extensive experience in matters involving corporate governance, having represented and counseled clients both in and out
of litigation in a wide array of shareholder/member disputes, and having prosecuted and defended numerous
actions involving alleged breaches of fiduciary duties
by officers/managers in both state and federal courts.
Mr. Berk can be reached at [email protected]
and Mr. Spathis can be reached at gspathis@hmblaw.
com. The authors gratefully acknowledge the significant contributions to this article by Anne K. Rowles, a
valued law clerk at the firm, and a 2012 graduate of DePaul University College of Law.
Delaware’s corporate-friendly laws
have long made the state one of the most popular choices
for the formation of all types of business entities, based
upon a steadfast adherence to a market-based philosophy
that generally promotes the negotiated will of seemingly
sophisticated business-people, over the impulse to impose
paternalistic regulation. Limited Liability Companies
(“LLCs”), which by many measures have become among
the most popular form of business entity formed in Delaware, are no exception to this rule. In fact, the legal landscape for LLCs in Delaware has shifted decidedly over the
past decade, ensuring participating members of an LLC
an array of basic rights, but empowering them to negotiate with their fellow members and agree upon their own
rules of engagement.
In theory, therefore, members could agree to substantially restrict or even eliminate entirely any and all fiduciary duties that might otherwise apply to protect the interests of members — and particularly those with minority
interests — from the overbearing actions or self-dealing
of the LLC’s managers. In practice, however, it is hard
to fathom a circumstance where anyone would accept (or
The Practical Lawyer | 31
32 | The Practical Lawyer pay for) membership in an LLC without, at least,
a baseline protection of their rights and interests.
As such, it is unusual to see fiduciary duties eliminated entirely by agreement, and far more common that the applicable governing agreement will
be silent on the topic of fiduciary duties. In such
cases, the Delaware Limited Liability Company
Act (the “Act”) imposes “equitable principles” as a
default. For members, and in particular managing
members, it is imperative that they understand how
these equitable principles apply, and must, at times,
be balanced against their individual interests. The
decision of the Delaware Chancery Court in Auriga Capital Corp., et. al, v. Gatz Properties, LLC, (C.A
4390-CS, Jan. 27, 20120, discussed below, serves as
a stark warning to managers and members alike regarding the consequences of ignoring that balance.
This article analyzes the fiduciary obligations applicable to LLCs under Delaware Law, the threshold
protection imposed to protect minority members,
and the balance reflected in the Court’s decision in
Auriga.
THE SOURCE OF FIDUCIARY OBLIGATIONS IN DELAWARE LLCs • Like corporations and limited partnerships, LLCs are creatures
of statute that combine the advantages of a corporation (limited liability) with those of a partnership (pass through taxation). Thus, to determine an
LLC’s rights, powers, and obligations, as well as the
rights, powers and obligations of its members, you
must begin by looking at the applicable provisions
of the Act.
The Act, however, is merely a starting point. Significantly, effective in 2004, the Act was amended to
expressly permit the elimination of default fiduciary
duties owed by and between an LLC, its members
and its managers. Before this amendment, the Act
provided that fiduciary duties, to the extent they existed, could only be expanded or restricted by the
LLC agreement. As such, an equally important
source for ascertaining the fiduciary obligations ap-
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plicable to an LLC, its members and its managers is
the Operating Agreement. The Act authorizes (but
does not require) LLCs to enter into an Operating
Agreement (6 Del. C. §18-101(7)). The Act also affords a fair degree of latitude to waive or modify the
provisions of the Act in the Operating Agreement,
although the Act ensures certain threshold protections that cannot be excluded, discussed below.
Finally, although this article focus on the fiduciary duties owed internally by and between the
LCC and its members and managers, it should also
be noted that the LLC and its managers may owe
fiduciary duties to the LLC’s creditors to the extent
the LLC becomes insolvent. Indeed, most jurisdictions impose some degree of fiduciary duties upon
officers, directors and LLC managers to protect the
interests of creditors when the corporation becomes
insolvent, although claims of this nature must be
brought derivatively, not directly, by a creditor.
THE NATURE OF FIDUCIARY OBLIGATIONS IN DELAWARE LLCs • LLCs vary
greatly in size and structure. On the one end of the
spectrum, an LLC can consist of a single member
that actively manages all of the affairs of the entity.
At the other end of the spectrum, an LLC can have
many members, and vest management of the entity’s affairs in a small group of managers that may
or may not be members.
Unlike many jurisdictions, the Act does not distinguish between “member managed” and “manager managed” LLCs. Member managed LLCs
generally resemble general partnerships or closely
held corporations in the manner in which each is
governed. In jurisdictions that recognize the distinction, each member in a member managed LLC
is deemed an agent of the entity, and is vested with
the apparent authority to generally bind the LLC
with respect to matters that fall within the ordinary
scope of the LLC’s business. Members in a member
managed LLC generally enjoy equal rights in the
management and conduct of the LLC’s business,
Fiduciary Obligations and Delaware LLCs | 33
and are empowered to make all decisions, generally
by majority vote. This broad authority to bind the
LLC generally carries concomitantly default fiduciary obligations. In a member managed LLC, and
unless otherwise agreed, each member owes fiduciary duties of care and loyalty to the LLC and the
other members with respect to the management of
the LLC.
Manager managed LLCs more closely resemble
limited partnerships or large corporations, where
privileges of ownership do not equate to the right to
manage the entity’s affairs. In jurisdictions that recognize the distinction, the managers in a “manager
managed” LLC — and not the members at large
— are generally empowered to make all decisions,
subject to an enumerated list of matters in the Act
that require the consent of all members. In a manager managed LLC, unless otherwise agreed, the
managers owe fiduciary duties of care and loyalty
to the LLC and the other members with respect
to the management of the LLC. A non-managing
member is not deemed an agent of the entity, and
thus lacks the authority to bind the LLC. It follows,
therefore, that such members in a manager managed LLC, generally owe no fiduciary duties to the
LLC or to their fellow members solely by reason of
being a member. Those fiduciary duties may arise,
however, even for a non-managing member if he
or she exercises some or all of the authorities of a
manager pursuant to the terms of the LLC’s Operating Agreement. In such an instance, the member
is held to the same standard of care and loyalty in
discharging his or her duties as the member of a
member managed LLC.
Notably, Delaware does not recognize a legal
distinction between “member managed” and “manager managed” LLCs. Under the Act, unless otherwise agreed, each member and manager has the
authority to bind the LLC. See §18-402 (all section
references are to the Act unless otherwise noted).
Moreover, the Act does not expressly speak in terms
of fiduciary duties of loyalty and care owed by and
between members and managers of the LLC. But
the Delaware courts have long recognized the existence of equitable duties arising out of the nature
of the business relationships, with the Delaware Supreme Court, having succinctly held, “inequitable
action does not become legally permissible simply
because it is legally possible.” See Schnell v. Chris-Craft
Indus., Inc., 285 A.2d 430, 439 (Del. 1971). As such,
section 18-1104, which provides that “[i]n any case
not provided for in this chapter, the rules of law and
equity … shall govern,” makes fiduciary duties applicable to LLCs.
This equitable overlay, however, is not mandatory. Before 2004, section 18-1101(c) of the Act provided that fiduciary duties, to the extent they existed,
could only be “expanded or restricted” by the LLC
agreement. In 2004, the Delaware General Assembly amended the Act to permit the elimination of
default fiduciary duties and even contractual liability by express agreement of the members, except for
the implied contractual covenant of good faith and
fair dealing, which may not be eliminated. See 181101(e). The Amended Act also included default
exculpatory protection, providing that unless otherwise provided in an LLC agreement, a member or
manager who acts under an LLC agreement should
not be liable to the LLC, its members or managers,
or any other person who is a party to or is otherwise
bound by the LLC agreement for breach of fiduciary duty for such member’s or manager’s good-faith
reliance on the provisions of the LLC agreement.
18-1101(d).
THE PRACTICAL IMPLICATIONS OF THE
ACT’S FIDUCIARY OBLIGATIONS.• Unless
eliminated by agreement, there is a well-settled
body of case law that has emerged from the adjudication of Delaware partnership and corporate disputes that provides comprehensive guidance with
respect to fiduciary duties and appropriate safe harbors that any manager or member should always
endeavor to comply with. Generally speaking, the
34 | The Practical Lawyer duty of loyalty under the Act should not be construed to flatly preclude self-dealing, but rather to
merely require that any dealings between any member (and in particular, any manager) and the LLC
be fully disclosed, and that the resulting transaction
be objectively fair to the LLC. When engaging in
any transaction in a posture adverse to the LLC,
a member should endeavor to obtain competing,
arm’s-length bids and/or a fairness opinion against
which the proposed transaction can be objectively
judged.
Similarly, the Act does not broadly foreclose a
member or manager from engaging in work outside
the LLC, but requires that the member or manager
not usurp opportunities in which the LLC might
have an interest. A manager, in particular, should
err on the side of caution and disclose any opportunity that is in any way related to the LLC’s business,
even if might otherwise seem remote, tangential,
or economically unfeasible. And under no circumstances should a manager devote LLC assets or resources to pursue such an opportunity.
Likewise, the duty of care imposed upon the Act
is geared toward ensuring the integrity of the process, and not necessarily upon the ultimate result of
a particular decision. The “business judgment rule”
protects members and managers who do not have
or disclose any potential conflict, inform themselves
of relevant facts, and based thereon, reasonably believe that the relevant action is in the best interest of
the LLC.
The Act’s mandate that members and managers exercise their rights under the Act and any
Operating Agreement “consistent with the obligation of good faith and fair dealing” should not be
read broadly to change or expand the obligation of
members and managers. The obligation of “good
faith and fair dealing” is an obligation traditionally
implied under Delaware law into every agreement,
and is narrowly construed. It does not, itself, support a cause of action for breach, but rather limits the exercise of contractual discretion in a way
December 2012
that would frustrate the fundamental expectations
of the contracting parties. Generally, when a party
to a contract has expressly reserved or negotiated a
specific right, it can enforce that right without regard to its impact on the opposing party.
IDENTIFYING AND PROTECTING THE
RIGHTS OF MINORITY MEMBERS • The
members’ ability to agree to abrogate default protections of the Act is not without limits. In addition
to the obligation of “good faith and fair dealing,”
there are other enduring threshold protects that are
imposed without regard to any agreement to the
contrary:
• First, section 18-305 of the Act ensures that
all members shall have the right to access the
LLC’s books and records at the company’s principal place of business or such other reasonable
location specified in the Operating Agreement.
Additionally, section 18-305(f) expressly provides that any member may bring a cause of
action against the LLC or any other member
to enforce the member’s right to access information. However, the Act expressly permits the
members to restrict the rights of a member or
manager to obtain information in an original
Operating Agreement or in any subsequent
amendment approved or adopted by all of the
members or in compliance with any applicable
requirements of the limited liability company
agreement. See §18-305(g);
• Second, section 18-802, expressly provides for
the right of any member to seek a judicial decree of dissolution predicated whenever it is not
reasonably practicable to carry on the business
in conformity with a limited liability company
agreement;
• Third, section 18-702 provides that the limited
liability company interest is assignable in whole
or in part except as provided in a limited liability company agreement. Such a transfer will
not vest any voting or management rights upon
Fiduciary Obligations and Delaware LLCs | 35
the transferee except as provided in an operating agreement or without the unanimous consent of the remaining members. See §18-702(a);
• Fourth, section 18-603, Delaware treats LLCs
similar to corporations by preventing the resignation or withdrawal of a member unless specifically authorized by the operating agreement.
As a practical matter, therefore, the operating
agreement can effectively prevent or at least
substantially curtail the member’s right to dissociate;
• Fifth, section 18-1001 provides the right for a
member to bring a derivative action on behalf
of the LLC if the managers otherwise refuse to
do so or a request that they do so would likely
be futile.
Nevertheless, despite the safeguards built into the
Act, the most direct, effective, and efficient means
for any member to protect his or her interest is to
have specific, desired protections included in the
operating agreement. Careful planning and insistence of provisions in an operating agreement that
provide for or require, for example, supermajority
approval for enumerated actions, criteria that must
be met before distributions can be made, interim
distributions of sufficient cash for the members to
pay their tax liabilities on the LLC’s income, employment agreements with defined or limits on
compensation of managers and pre-emptive rights
to contribute capital as necessary to avoid dilution
go a long way toward defining members’ expectations, and avoiding tumultuous and costly internal
disputes.
To illustrate the point, consider one of the most
fundamental and critical rights — the right of any
member to disassociate from the LLC and force the
purchase the member’s distributional interest. Although the Act assures the right of any member to
disassociate from the LLC, it only provides for the
right to receive “fair value” for the interest in the
LLC. See §18-604. The term “fair value” is not defined in the Act, which is itself a formidable hurdle
to reaching a suitable compromise. That hurdle is
compounded, however, when the distributional interest is a minority interest. Indeed, in determining
a fair market value of stock, most valuation treatises
and professionals typically apply discounts for lack
of control and lack of marketability of any intangible asset. Courts have routinely applied such discounts when determining the value of a stock holder exercising “dissenter’s rights” to reflect market
reality, and this rationale would apply with equal
vigor to a minority interest in an LLC. Under the
circumstances, therefore, the Act might afford little
meaningful protection against recalcitrant managers determined to steeply discount the value of a
minority interest in the LLC. By contrast, however,
a buy/sell obligation in the Operating Agreement
with either a fixed price or pre-approved valuation
formula would preserve the value of such an interest, and expedite the process of disassociation.
AURIGA CAPTIAL CORP., ET. AL, v. GATZ
PROPERTIES, LLC, ET. AL • The practical implications of the Act and the fiduciary duties imposed upon a manager come more clearly into focus when viewed through the lens of the Chancery
Court’s recent decision in Auriga Capital Corp., v. Gatz
Properties, LLC, supra. The Defendants included the
managing member of a Delaware LLC who, together with his family, owned a controlling interest
in the LLC. The remaining interest was held by seven minority members. The LLC held a long-term
lease to operate a golf course on property in Long
Island, New York owned by the manager. From the
outset, the LLC was formed to serve a passive role in
the operation of the course. The LLC entered into
a sublease with a large management corporation
known for its expertise in operating golf courses.
Shortly into the term of the sublease, however, the
management company (sub-lessee) was purchased
by a third party. The new owner shifted attention as
36 | The Practical Lawyer well as resources away from the course that it managed for the LLC, and even signaled its intention to
exercise an early termination option in the sublease.
This signaled termination loomed significant.
Indeed, as the Court noted, it served as an early
alert as to problems that the LLC would face, that
should have left the manager with ample time to develop alternate opportunities and strategies to protect and preserve the interests of the LLC. Instead,
the manager neither made an effort to find a new
operator, nor made any effort to market the golf
course for sale. In fact, as a minority member grew
wary of the stagnant state of affairs, he sought out
and presented a prospective buyer to the manager.
The manager, however, was entirely disinterested,
failing to furnish even threshold due diligence materials, driving the prospective purchaser away and
scuttling a possible sale. Then, seemingly seeking to
exploit the developing sense of distress that loomed
over the property, the manager made a low-ball
offer to buy out the minority, making misleading
statements to the investors in the process to heighten their fears. The minority rejected the offer, and
demanded that the manager resume negotiations
with the prospective buyer. Instead, the manager
announced plans for an auction of the LLC’s assets. The auction was ill conceived and poorly promoted, announced in a print listing that was no
bigger than an average postage stamp. Not surprisingly, the auction attracted no third-party bidders.
Undaunted, however, the manager purchased the
LLC’s assets for a mere $50,000 more than its secured debt, and took over sole control of the golf
course. The minority investors, who collectively
received only $20,000 from the sale of the assets,
sued the manager for breach of his fiduciary duty
of loyalty.
The manager defended on two grounds. First,
the manager argued that he owed no fiduciary duties, and that his voting control could be exercised
as he saw fit, even if it was to pursue his own selfinterest. And second, he argued that at the time of
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the auction, the LLC’s assets were virtually worthless in the wake of the broad market downturn, as
evidenced by the absence of any third party bidder,
and thus the price he paid was fair and reasonable.
After a trial on the merits, the Court entered judgment for the minority investors, reasoning that the
default “equitable principles” had not been supplanted by the Operating Agreement, which was
silent as to duties owed by the manager to the LLC
and the minority members. To the same end, the
Court rejected the manager’s attempt to assert as
a defense the general exculpatory language in the
operating agreement akin to the default language
in section 18-1101(d) that applied to actions taken
“in good faith” and “on behalf of the LLC.” The
Court flatly refused to stretch this exculpatory provision to justify the actions of the manager that neither seemed to have been taken “in good faith” nor
on the LLC’s behalf.
While recognizing that as a majority owner of
the LLC, the defendant was not obligated to vote in
favor of any sale or strategic alternative presented
to the members, the Court reasoned that such self
interest must still be balanced against the fiduciary
duties owed as a manager. The Court held that at
the very least, the manager should have fully explored strategic options that would have preserved
the LLC, and likely would have yielded a modest
return on the minority’s investment. In articulating the balance between the Defendant’s rights as
a member, and his obligations as the manager, the
Court succinctly held:
“The manager was free not to vote his membership interest for a sale. But he was not free to create
a situation of distress by failing to cause the LLC
to explore its market alternatives and then to buy
the LLC for a nominal price. The purpose of the
duty of loyalty is in large measure to prevent the
exploitation by a fiduciary of his self-interest to the
disadvantage of the minority.”
Fiduciary Obligations and Delaware LLCs | 37
The Court also rejected the manager’s argument that there were no recoverable damages because the LLC lacked value at the time of the auction. The Court reasoned that a poorly promoted
auction could not serve as a suitable proxy for the
value of the LLC, and further concluded that any
distress that may have depressed the value of the
golf course lease was the result of the manager’s deliberate actions and inaction. The Court similarly
rejected the manager’s suggestion that the market
downturn was an intervening cause of damage for
which he should not be responsible, reasoning that
the LLC was in a good position to pursue strategic
alternatives as early as 2007 thereby avoiding the
impact of the downturn. Instead, the Court awarded damages based upon a valuation that had been
presented at trial by the Plaintiff, and the premise
that in the absence of the manager’s breach of fiduciary duties, a sale or “other suitable strategic alternative” would have netted a full return of the minority’s invested capital, plus a 10 percent return on
their investment. The Court entered judgment in
that amount, less the $20,000 in auction proceeds
received, compounded monthly from the relevant
period. Moreover, despite the absence of a relevant
fee shifting provision in the operating agreement,
the Court also awarded the plaintiff half of its attorneys’ fees and costs, citing the myriad of frivo-
lous arguments raised by the Defendant that protracted the litigation.
CONCLUSION • The significance of Auriga
Capital lies well beneath the surface. The historical account of the manager’s thinly veiled attempt
to “squeeze out” the minority so that he could regain complete control of the golf course, reads as a
“how-to” manual for inviting a lawsuit and a substantial adverse judgment. The greater significance
lies, in large part, in the Court’s express recognition
of the delicate balance that a manager faces any
time his or her self interest diverges from the interest of the LLC and/or the minority members. And
perhaps of even greater significance is the Court’s
tacit recognition that as long the manager had fully
and fairly explored the LLC’s market alternatives,
he could have voted his membership interest against
pursuing any of those alternatives without penalty.
In the end, the “integrity of the process” offers
little comfort to members that lack the votes to control the LLC’s decision at the end of that process.
It is a fitting reminder that the only protections of
which a member can truly be assured are those that
are negotiated and included in the operating agreement, thereby highlighting the challenge faced by
members and their counsel of anticipating how interests might evolve, diverge, and conflict over time.
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