Volume 12, Number 6 - July/August 2003

Corporate directors, LLCs and liability
It's not settled, but caution is advised
    By Victor Peterson and Alison N. Zirn

Dangers abound for directors today. And if their corporation manages an LLC, directors could owe fiduciary duties to more parties than they think, especially if they're accused of self-dealing.

Limited liability companies (LLCs) combine attractive features of corporations and partnerships. Like corporations, LLCs limit liability of owners for obligations of the business, though courts occasionally "pierce the veil" normally afforded by the corporate or LLC form of entity. LLCs are generally taxed as partnerships, so earnings flow through to investors without double taxation. LLC statutes are very flexible and usually permit LLCs to be managed directly by the members or centrally managed, separating ownership and control.

While LLC managers and members typically enjoy limited liability for obligations of the LLC to outside parties, LLC managers may owe fiduciary duties of loyalty and care to LLC members, although the scope of such fiduciary duties is established — and may be modified — by contract. For example, when an LLC is managed by a corporation, the corporation owes fiduciary duties to the LLC members to the extent specified by contract.

It remains unclear whether such a corporation's directors, in addition to the corporation itself as LLC manager, owe fiduciary duties to the LLC members. Do directors owe fiduciary duties only to their corporation and its shareholders, or do fiduciary duties of directors extend to members of an LLC managed by their corporation? If fiduciary duties owed by a corporate manager of an LLC to LLC members cannot be imputed to the directors of the corporation, then the LLC members would be without legal recourse against directors who caused their corporation to breach its fiduciary duty as an LLC manager to the LLC members.

But if directors of a corporation that manages an LLC do owe fiduciary duties to the LLC members, these directors could confront a dilemma if their fiduciary duties to the LLC members conflict with their fiduciary duties to their corporation and its shareholders.

State LLC statutes contain relatively few mandatory provisions and instead largely supply default rules, which govern only in the absence of express contractual terms. This gives contracting parties wide discretion in drafting operating agreements to structure LLCs as they wish. See, for example, Elf Atochem North America Inc. v. Jaffari, 727 A.2d 286, 290-91 (Del. 1999) (interpreting Delaware's LLC Act as modeled on its Limited Partnership Act in allowing "substantial freedom of contract").

Delaware's LLC Act (the act) does not itself impose any fiduciary duties on LLC members or managers; it merely provides that whatever fiduciary duties other laws or common law principles impose on LLC members or managers may be "expanded or restricted" by the LLC's operating agreement. 6 Del. Code §18-1101(c). In an analogous limited partnership case, Delaware's Supreme Court recently cautioned that fiduciary duties may be "restricted" by contract but not completely eliminated. See Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., et al., 817 A.2d 160, 167-68 (Del. 2002)(dicta).

The act contemplates corporate management of LLCs when it includes a "corporation" in its definition of a "person," which in turn may be an LLC "manager." 6 Del. Code §18-101(10) and (12). However, the act does not mention directors of corporate LLC managers, let alone any fiduciary duties they may owe to LLC members.

Corporations often serve as general partners of limited partnerships, and the case law on limited partnerships is more developed than that on LLCs. Accordingly, it makes sense to consider analogous cases in the limited partnership context in order to see whether directors of corporate general partners or limited partnerships have been found personally liable for breach of fiduciary duty to limited partners.

General partners of limited partnerships are exposed to unlimited liability for obligations of the partnership, while LLC managers enjoy limited liability for LLC obligations. Despite this difference, both general partners of limited partnerships and managers of LLCs owe fiduciary duties to their limited partners or LLC members. (On the analogy between centrally managed LLCs and limited partnerships, see Elizabeth M. McGeever, "Hazardous duty? The role of the fiduciary in noncorporate structures," Business Law Today, 51, 54 (March/April 1995) (following Larry E. Ribstein and Robert R. Keatinge, Ribstein and Keatinge on Limited Liability Companies, § 9 (West, 2001)).)

A limited partnership case that provides guidance on the issue of whether corporate directors owe fiduciary duties not just to their corporation and its shareholders, but also to parties owed fiduciary duties by the corporation that they control, is In re USACafes, L.P. Litigation, 600 A.2d 43 (Del. Ch. 1991). The Delaware Chancery Court held that directors of a corporate general partner of a limited partnership personally owed fiduciary duties to the limited partners.

Limited partner investors in the USACafes Limited Partnership had sued the partnership, its corporate general partner and the corporation's individual shareholders and directors (Sam and Charles Wyly) for breach of fiduciary duty by authorizing the sale of the partnership's assets at a deficient price because they allegedly received substantial side payments from the buyer. The director defendants moved to dismiss for failure to state a claim:

The gist of this motion is the assertion that the directors of the general partner owed the limited partners no duty of loyalty or care. In their view their only duty of loyalty was to the general partner itself and to its shareholders (i.e., the Wyly brothers). Thus, in alleging that the director defendants breached duties of loyalty and care running to them, the directors say the limited partners have asserted a legal nullity. USACafes, 600 A.2d at 48.

The Wylys' defense was that as directors they owed fiduciary duties only to their corporation and its shareholders, who happened to be themselves, not to the limited partners of the limited partnership whose general partner was the corporation — even though the corporation, as general partner, admittedly owed fiduciary duties to the limited partners. The court rejected this argument: "[T]he assertion by the directors that the independent existence of the corporate general partner is inconsistent with their owing fiduciary duties directly to limited partners is incorrect." USACafes, 600 A.2d at 48.

The Delaware Chancery Court's rationale for its holding in USA Cafes that directors of a corporate general partner owe fiduciary duties "directly" to limited partners is quite broad. Indeed, the basis for the holding in general fiduciary principles applies as readily in the LLC context:

While I find no corporation law precedents directly addressing the question whether the directors of a corporate general partner owe fiduciary duties to the partnership and its limited partners, the answer to it seems to be clearly indicated by general principles and by analogy to trust law. I understand the principle of fiduciary duty, stated most generally, to be that one who controls property of another may not, without implied or express agreement, intentionally use that property in a way that benefits the holder of the control to the detriment of the property or its beneficial owner. USACafes, 600 A.2d at 48.

Thus, when directors of a corporate general partner control the partnership's property because of their control of the corporation that in turn controls the limited partnership, they owe a fiduciary duty to the limited partners as beneficial owners of the property. By focusing on a fiduciary's control over property entrusted to it for another's benefit, the court denied the defendants' attempt to evade personal liability on grounds that a corporate entity stood between themselves and the beneficial owners of the property.

The reasoning of USACafes, based on the fiduciary relationship as such and extended by the court from corporate-controlled trusts to corporate-controlled limited partnerships, can readily be extended further to LLCs managed by corporations, where a fiduciary relation clearly also exists. Therefore, despite the absence of statutory authority or even case law directly on point, it appears likely that directors of a corporation that manages an LLC could be held personally liable for breach of fiduciary duty owed to LLC members.

The precise extent of this fiduciary duty awaits judicial determination, but it would clearly cover facts similar to the self-dealing in USACafes in which directors of a corporate LLC manager use their control to profit personally at the expense of LLC members. See USACafes, 600 A.2d at 49.

This conclusion is buttressed by additional limited partnership cases, in which directors, officers or controlling shareholders (including parent corporations) of corporate general partners were found to owe fiduciary duties to limited partners. In Gotham Partners, a corporate general partner sought to entrench itself by various means in violation of fiduciary duties imposed contractually by the limited partnership agreement. The Delaware Supreme Court quoted with approval the Chancery Court's holding that:

"where a corporate general partner fails to comply with a contractual standard [of fiduciary duty] that supplants traditional fiduciary duties and the general partner's failure is caused by its directors and controlling stockholder, the directors and controlling stockholder remain liable." Gotham Partners, 817 A.2d at 173 (addition in original) (quoting Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., et al., 795 A.2d 1, 34 (Del. Ch. 2001)).

Here the court imputed fiduciary duties of the corporate general partner to its directors and controlling stockholders because they caused their corporation to breach its fiduciary duties.

In Integrated Resources, a corporation in bankruptcy reorganization was the sole shareholder of a corporate general partner of a limited partnership. In the bankruptcy court's analysis, the parent corporation was potentially liable directly to the limited partners for breach of fiduciary duty, when it sought to sell its shares in the general partner to a bidder that allegedly planned to use its newly acquired control to loot the limited partnership's assets.

However, the court concluded that the acquisition would not result in looting, so the parent corporation did not breach its fiduciary duty to the limited partners by selling its shares in its general partner subsidiary. See In re Integrated Resources Inc., 1990 WL 325414 (Bankr. S.D.N.Y.).

Kahn v. Icahn involves a derivative suit brought by limited partners against the corporate general partner and its sole shareholder, CEO and certain affiliates, claiming they breached their fiduciary duty of loyalty to the limited partners by usurping business opportunities of the limited partnership. However, the limited partnership agreement permitted the general partner to compete with the business of the limited partnership.

The court ruled that this contractual restriction of traditional fiduciary duties effectively created a safe harbor that prevented the general partner from breaching fiduciary duties to the limited partners by competing with the limited partnership. See Kahn v. Icahn, 24 Del. J. Corp. L. 738, 1998 WL 832629 (Del. Ch.), aff'd 746 A.2d 276, 2000 WL 140018 (Del.).

In Wallace v. Wood, investors in a limited partnership brought a derivative suit against the corporate general partner and its officers, affiliates and parent corporation for breach of fiduciary duty to the limited partners by seeking to circumvent a contractual ceiling on indebtedness for acquisitions. Following USACafes, the Delaware Chancery Court held that "[o]fficers, affiliates and parents of a general partner may owe fiduciary duties to limited partners if those entities control the partnership's property." Wallace v. Wood, 752 A.2d 1175, 1178 (Del. Ch. 1999) (emphasis in original) (citing similar cases at note 23).

USACafes and these other analogous cases in the limited partnership context indicate that courts — at least in Delaware — are likely to hold directors responsible for breaches of fiduciary duty by the corporations they control to members of LLCs managed by these corporations.

When directors owe fiduciary duties to members of LLCs managed by their corporations as well as to their own corporations and shareholders, the concern arises that these fiduciary duties may conflict. One author identifies this potential conflict in the limited partnership context, arguing that when such a conflict cannot be avoided,

... the duty to limited partners should trump the duty to shareholders and creditors of the corporate general partner. Any other rule leaves innocent parties without remedy, encourages directors to authorize breaches of fiduciary duty if they might profit personally from the breach, and almost certainly is inconsistent with the reasonable expectations of limited partners that invest capital in the venture. Robert W. Hamilton, "Corporate General Partners of Limited Partnerships," 1 J. Small & Emerging Bus. L. 73, 96 (1997).

However, such apparent conflicts of fiduciary duty turn out to be illusory. Under these circumstances, directors' fiduciary duty to their own corporation and its shareholders is to ensure that the corporation fulfills its own fiduciary duties as an LLC manager or general partner.

Imputing fiduciary duties "up" to directors — and also to officers and controlling shareholders, including parent corporations and perhaps, in turn, their directors, officers and controlling shareholders, etc. — is an instance of a more general concept of an inferential chain, so to speak, of fiduciary duty that cuts across hierarchically nested entity structures. To illustrate such a fiduciary chain:

A general partner in a limited partnership stands in a fiduciary relationship with the limited partners of that limited partnership. [citations omitted] Atkins was a general partner of TSG. Thus, Atkins owed a fiduciary duty to TSG's limited partners. Additionally, TSG was a general partner of Groups. Therefore, because Atkins owed a fiduciary duty as a general partner of TSG and TSG was a general partner of Groups, Atkins' fiduciary duty extended to Groups." In re Monetary Groups, 2 F.3d 1098, 1103 (11th Cir. 1993).

Courts have also imputed fiduciary duties in the other direction, that is, "downwards": Delaware's Chancery Court has concluded that "fiduciary duties may be imputed to a separate entity formed and controlled by fiduciaries for the purpose of engaging in a transaction with an entity to whom those duties are owed." Barbieri v. Swing-N-Slide Corp., 1997 Del. Ch. LEXIS 9.

The basic lesson is that fiduciary duties, unlike liability to outside parties for entity obligations, cannot be avoided structurally by interposing entities. Hierarchical entity structures are widely used to limit liability to outside parties, but this analysis suggests that they are not effective in structurally containing fiduciary duties, which pierce through intermediate entities to reach those who — directly or indirectly — cause entities they control to breach their fiduciary duties.