Capital Infusion: A Recommendation for Clarifying LLC Fiduciary Duties

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Delaware has gained some notoriety of late with the uncertainty surrounding fiduciary duties in governance of limited liability companies (LLCs). LLCs are born from statutory law, and governed by the Delaware Limited Liability Company Act (the “Act”). Consequently, one of the most significant advantages of choosing an LLC structure is the opportunity for parties to modify their LLC agreements and tailor them to the particular requirements or preferences of the equity holders. It is undisputed that parties are free to eliminate, restrict or modify managers’ or managing members’ fiduciary duties to LLCs, but an issue arises when parties neglect to state unambiguously their intentions in the LLC agreement – when should a court apply default fiduciary duties in the LLC context?

On March 20, 2013, the Delaware State Bar Association announced that it was going to consider certain amendments to the Act. Specifically, one amendment required that LLC managers or managing members be subject to default fiduciary duties in the absence of contractual language to the contrary. This amendment became effective August 1, 2013 and alters § 18-1104 of the Act to state, “[i]n any case not provided for in this chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.” This amendment is the direct result of recent conflicting Delaware court opinions.

In Gatz Properties, LLC v. Auriga Capital Corp.[1] the Delaware Supreme Court upheld the chancery court’s opinion that the managers had breached their fiduciary duties, but refused to adopt the chancery court’s view that in the absence of contract language, default fiduciary duties apply to an LLC’s controlling members and managers. Instead, the Delaware Supreme Court found that the LLC agreement language addressed the fiduciary duties and thus, the court did not need to clarify whether traditional fiduciary duties applied and resolution of the issue was better left to the legislature. However, three weeks later, the chancery court once again reaffirmed its stance that in the absence of language to the contrary, or if the language is ambiguous, managing members would be held accountable for fiduciary duties by default.[2] As the Delaware Supreme Court noted, the chancery court’s opinion was merely a pronouncement, and thus not binding law, so a void in LLC law has remained in the hopes that the legislature would address the issue.

The prevailing belief is that the recent amendment is the answer to this open issue of whether LLCs have default fiduciary duties. The amendment appears to be determinative only in cases where the contract language is ambiguous or neglects to specify the applicable fiduciary duties of the LLC’s managers or managing members. Thus, the amendment will serve not only to clarify the Act, but also as an important reminder for parties to draft unambiguously their LLC agreements, instead of leaving interpretation to a court’s discretion. Furthermore, the amendment will not affect § 18-1101(e) of the Act, which permits parties to eliminate completely the managing members’ and managers’ fiduciary duties, except for the implied covenants of good faith and fair dealing (as discussed below).

Private equity and hedge funds which utilize LLCs should take note of the amendment because fiduciary duty disputes may arise if an LLC agreement neglects to address the issue. Since many managers represent multiple funds, it is common for a manager to make decisions that are not necessarily the most beneficial for a specific LLC due to conflicting obligations. Thus, in negotiating an LLC agreement, it is important to focus on a standard of care to which managers or managing members will be accountable, without unduly restricting a manager’s responsibilities to other entities. Some examples of relevant provisions that replace or modify the default fiduciary duties standard include:

  • Lowering the threshold of liability so managers or managing members will not be liable for action or inaction so long as the act or inaction does not constitute gross negligence, fraud or willful misconduct.
  • Modifying fiduciary duties by removing the restrictions of traditional fiduciary duties when the managing member or manager is acting in his or her sole discretion. Certain specified actions would be subject to a sole discretion standard, which should be defined in the LLC agreement, and would be distinct from the normal fiduciary duty standard. However, if the parties incorporate such a provision, a court may interpret the sole discretion standard to include a good faith obligation, which would still require managers or managing members not to act against the best interests of the company.[3]
  • Utilizing special committees by forming advisory committees to approve certain transactions. Advisory committee approval would ensure that managers’ or managing members’ decisions adhere to the company’s interests, by requiring that representatives of other members agree with the decision or transaction at issue.

Nevertheless, it is critical to ensure that the contractual language accurately and unambiguously expresses the parties’ intent.

Lastly, although the amendment does not alter the parties’ right to amend or eliminate the fiduciary duties, parties cannot eliminate the implied covenants of good faith and fair dealing. Under Delaware law, these implied covenants exist in all contracts and are considered to be gap fillers. Thus, if there is an undetermined issue under an LLC agreement, courts use the implied covenants of good faith and fair dealing to determine what the parties would likely have negotiated if the issue had been addressed in the contract. Generally, these implied covenants require parties to “refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.”[4] However, if the contract explicitly and unmistakably includes applicable fiduciary duties, courts will not substitute implied covenant analysis for the defined fiduciary duty analysis and will instead look only to the terms of the agreement.

The amendment should settle the uncertainty surrounding LLCs and the duties owed by managers and managing members and how such standards are determined. However, the amendment is unlikely to significantly impact LLCs due to the great freedom that the Act grants parties in their ability to draft agreements. The amendment should be viewed as a reminder for parties to be thorough in both negotiating and drafting contractual language to ensure the parties’ intentions are expressly and unambiguously stated in the LLC agreement. The amendment, as well as the courts, will generally leave LLCs to their own devices as long as the parties are clear in the LLC agreement about the intentions at the time of negotiation and the future standards to which the parties will adhere.[5]


[1] 59 A.3d 1206 (Del. 2012).

[2] Feeley v. NHAOCG, LLC, C.A. No. 7304—VCL, 2012 WL 5949209 (Del. Ch. 2012).

[3] See Paige Capital Mgmt., LLC v. Lerner Master Fund, LLC, 2011 WL 3505355 *114-15 (Del. Ch. 2011)

[4] Dunlap v. State Farm and Casualty Co., 878 A.2d 434, 442 (Del. 2005).

[5] The authors would like to thank Brooke Panno, a summer associate from SMU Dedman School of Law, for her valuable contributions to this article.

 

Topics:  Contract Drafting, Covenant of Good Faith and Fair Dealing, Fiduciary Duty, Hedge Funds, LLC, Private Equity

Published In: Business Organization Updates, Business Torts Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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