Private Equity Fund Considerations In Light Of Delaware’s LLC Debate

by Pepper Hamilton LLP
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This article was previously published in the Expert Analysis section of Private Equity and Contract Law360 on February 20, 2013, and in the corresponding Law360 newsletters on February 21, 2013. Reprinted here with permission.

Partners of private equity funds and other investment partnerships should take notice of recent Delaware court decisions that have created some uncertainty over whether Delaware limited liability company (LLC) managers owe “default” fiduciary duties. This uncertainty highlights the often ignored need for private equity funds to specify the scope of fiduciary duties for holding companies of the portfolio investments to make clear the extent, if any, of the fiduciary duties of the directors of that holding company.

To avoid any uncertainty, in drafting or amending an LLC agreement used by a fund, draftspersons should explicitly specify any fiduciary duties for both managers and controlling members, including whether they wish to adopt, restrict or eliminate fiduciary duties. By clearly specifying the fiduciary duties of the members and/or managers in the LLC agreement, private equity fund managers can increase certainty regarding governance of the entity by ensuring any fiduciary duties are limited to only those enumerated in the LLC agreement.

The Delaware Debate

The Delaware Limited Liability Company Act, 6 Del. C. §§ 18-101, et. seq. (DLLCA) does not expressly provide for default fiduciary duties for LLC managers. Moreover, the Delaware Supreme Court has not ruled whether LLC managers owe fiduciary duties, absent an express imposition in the LLC agreement.

Although the Supreme Court has never formally ruled on the issue, Chief Justice Myron T. Steele, in his article “Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies,” 32 Del. J. Corp. L. 1 (2007), argues that LLC managers do not owe traditional fiduciary duties, unless the LLC agreement so specifies. The other justices on the court have neither adopted nor rejected Chief Justice Steele’s position. The Court of Chancery, on the other hand, has held that such duties do exist, unless eliminated.

Chief Justice Steele takes the position that the DLLCA does not impose default fiduciary duties upon LLC managers. He bases his conclusion on three main justifications: (1) freedom of contract; (2) the fact that LLCs did not exist at common law; and (3) the DLLCA’s silence on the issue. First, Chief Justice Steele points to §18-1101(b) of the DLLCA, which provides that “[i]t is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements,” and argues that applying default fiduciary duties would “violate the strong policy favoring freedom of contract enunciated by Delaware’s legislature.”

Specifically, Chief Justice Steele argues that courts should only imply the default duties in contracts, such as the implied covenant of good faith and fair dealing, into LLC agreements. He reasons that implying default fiduciary duties creates a risk that courts will apply the default fiduciary duty standards instead of thoroughly interpreting the contract and that such behavior violates freedom of contract principles. Chief Justice Steele states “[t]he danger in applying default fiduciary duties is that, rather than determining the ex ante intent of the parties as contemplated by their agreement, a court might be wooed by plaintiffs’ fiduciary duty claims and accept their proposal to apply an ex post fiduciary duty analysis.”

Chief Justice Steele also asserts that default fiduciary duties derive from common law and that LLCs did not exist at common law. He argues that LLCs and default fiduciary duties are unharmonious and that LLC managers should not have fiduciary duties unless imposed by the LLC agreement. Finally, he argues that the General Assembly, by not addressing the issue in the statute, intended to leave the issue to the parties to address through the LLC agreement.

By contrast, on January 27, 2012, in Auriga Capital Corp. v. Gatz Props. LLC, 40 A.3d 839, 849-856 (Del. Ch. 2012), the Court of Chancery reiterated its position that LLC managers do owe fiduciary duties to LLC members, unless waived, restricted or eliminated by the LLC agreement. Chancellor Leo E. Strine, Jr., writing for the court, bases his conclusion on (1) the DLLCA’s mandate that rules of law and equity shall govern where the DLLCA is silent, (2) the definition of fiduciary and the role of an LLC manager, and (3) the history of the DLLCA.

Chancellor Strine points to §18-1104 of the DLLCA, which provides that “[i]n any case not provided for in this chapter, the rules of law and equity ... shall govern,” and argues that the DLLCA must be read in concert with the rules of equity, including fiduciary duties. He also points to the Delaware Supreme Court decision Schnell v. Chris-Craft, 285 A.2d 437, 439-40 (Del. 1971), in which the Supreme Court held that the Delaware General Corporation Law (DGCL) must be read in concert with rules of equity, including fiduciary duties. Chancellor Strine emphasizes that the DLLCA is more explicit in mandating an equitable overlay than the DGCL because the DLLCA, unlike the DGCL, specifically provides that the rules of equity shall govern issues not addressed by the DLLCA.

Chancellor Strine also asserts that an LLC manager falls squarely within the definition of “fiduciary.” He states that “the manager of an LLC — which is in plain words a limited liability ‘company’ having many of the features of a corporation — easily fits the definition of a fiduciary.” He reasons that managers, like corporate directors, general partners and trustees, are “vested with discretionary power to manage the business of the LLC” and that such powers make the manager a fiduciary to the LLC and its members.

Chancellor Strine finally argues that the history of the DLLCA confirms the conclusion that LLC managers owe default fiduciary duties. Chancellor Strine emphasizes the simultaneous amendment to Sections 18-1011(c) and 18-1101(e), which authorize the elimination and exculpation of LLC manager fiduciary duties, and questions “why would the General Assembly amend the [DLLCA] to provide for the elimination (and the exculpation for) ‘something’ if there was no ‘something’ to eliminate (or exculpate) in the first place.”

Chancellor Strine conducted this analysis in Auriga even though the issue was not contested by the parties. Because of this, on November 7, 2012, the Supreme Court strongly criticized Chancellor Strine’s “excursion” on the issue in Gatz Props. LLC v. Auriga Capital Corp. (Del. Nov. 7, 2012). The Delaware Supreme Court ruled that the Court of Chancery’s pronouncement that the DLLCA imposes default fiduciary duties “was improvident and unnecessary” and “must be regarded as dictum without any precedential value.”

The Supreme Court reasoned that the issue was not a justiciable controversy because the LLC agreement specifically addressed the existence of fiduciary duties and neither party contested whether the DLLCA imposes such fiduciary duties by default. The Delaware Supreme Court did note, however, that “the merits of the issue whether the LLC statute does — or does not — impose default fiduciary duties is one about which reasonable minds could differ.”

On November 28, 2012, the Court of Chancery once again addressed the issue of whether LLC managers owe fiduciary duties in Christopher J. Feeley, AK-Feel LLC v. NHAOCG LLC (Del. Ch. Nov. 28, 2012). In this case, unlike in Auriga, the fiduciary duty issue was directly addressed by the parties.

Vice Chancellor J. Travis Laster, writing for the Court of Chancery, addressed the Delaware Supreme Court’s rebuke of Chancellor Strine’s discussion of default fiduciary duties, stating “[a]lthough the Delaware Supreme Court determined that the Chancellor should not have reached the question of default fiduciary duties, his explanation of the rationale for imposing default fiduciary duties remains persuasive, at least to me.”

Vice Chancellor Laster then discussed Chancellor Strine’s reasoning in Auriga and concluded that LLC managers do owe default fiduciary duties. Vice Chancellor Laster did recognize, however, that the Delaware Supreme Court is “the final arbiter on matters of Delaware law” and “indisputably has the power to determine that there are not default fiduciary duties in the LLC context.”

Analysis

Given the Supreme Court’s strong admonishment of the Court of Chancery’s “excursion” in Auriga, Chief Justice Steele’s writings, and the DLLCA’s silence on the issue, the status of default fiduciary duties for fund managers is uncertain. Because of this uncertainty and the amount of attention Delaware courts have given this issue recently, the Delaware Supreme Court or the Delaware General Assembly may feel compelled to address this issue. Until the Delaware Supreme Court or the General Assembly hold otherwise, fund managers should continue to manage the business of any LLC that is controlled by the fund under the assumption that managers owe fiduciary duties to the LLC and its members.

In drafting or amending LLC agreements for any entity controlled by a fund, draftspersons should clarify the scope of fiduciary duties, including whether they wish to adopt, restrict or eliminate fiduciary duties of managers and controlling members in the LLC agreement. For example, a possible contractual provision modifying fiduciary duties could be drafted as follows:

“Notwithstanding any fiduciary duties owed by the members/managers of XYZ LLC at law or in equity, the fiduciary duties of members/managers will be limited to only those enumerated below: (a) ... (b) ... (c) ...”

By utilizing the contractual freedom enshrined in Section 18-1101 and clarifying the scope of fiduciary duties in the LLC agreement, private equity fund managers can obtain certainty regarding the scope of any fiduciary duties that they may owe to members. This certainty in the scope of fiduciary duties will provide guidance to fund managers to make appropriate governance decisions for the LLC and avoid claims and litigation by members of the LLCs.

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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