In January 2012, the Delaware Court of Chancery issued a decision in Auriga Capital Corp. et al. v. Gatz Properties, LLC. The decision caught the attention of practitioners within and without Delaware, because the Court definitively ruled that traditional fiduciary duties of care and loyalty apply by default to managers of Delaware limited liability companies absent a contractual provision that clearly alters or eliminates such duties. While numerous decisions from the Court of Chancery over the years suggested as much, Auriga was the first instance where the Court made an unequivocal pronouncement. On appeal, the Delaware Supreme Court, acting en banc, affirmed the trial court's award of damages and attorneys' fees, but squarely rejected the "court's pronouncement that the Delaware Limited Liability Company Act imposes 'default' fiduciary duties on upon LLC managers and controllers unless the parties to the LLC Agreement contract that such duties shall not apply."
The dispute in Auriga centered on the acquisition of Peconic Bay LLC by Gatz Properties, LLC (Gatz Properties), which was the company's sole manager, and which held majority voting control in Peconic Bay. Defendant William Gatz (Gatz) and certain of his family members owned and controlled Gatz Properties, which held title to property owned by the Gatz family in Long Island, New York. Gatz Properties leased the property to Peconic Bay under a ground lease with a 40-year term. The ground lease restricted the property's use to a high-end, daily fee, public golf course. In 1998, Peconic Bay sublet the property to American Golf Corporation, which ran the day-to-day operations of the golf course until 2004. Upon learning that American Golf did not intend to renew its sublease, Gatz engaged in a series of actions that placed Peconic Bay in an economically vulnerable position so that he could acquire the company at a steep discount and, thereby, avoid the long-term ground lease that prevented him from developing the property into a private, residential golf course. The coup de grace - a "sham" auction to squeeze out Peconic Bay's minority investors - led the investors to sue Gatz and Gatz Properties. The minority investors alleged that Gatz breached both his fiduciary duties and Peconic Bay's operating agreement. Gatz countered that he owed no fiduciary duties, because such duties had been eliminated by the operating agreement.
The Chancery Court began its analysis by answering the question of whether traditional fiduciary duties apply to managers of a Delaware limited liability company affirmatively. His approach was straightforward. Section 18-1104 of the Delaware Limited Liability Company Act, which states, in part, that "[i]n any case not provided for in this chapter, the rules of law and equity . . . shall govern," is more explicit than its corporate counterpart "in making the equitable overlay [of traditional fiduciary duties] mandatory" in the LLC context to the extent that those duties have not been altered or eliminated by the relevant operating agreement. As the court explained, the "manager of an LLC has more than an arms-length, contractual relationship with the members of the LLC." Rather, an LLC manager is "vested with discretionary power to manage the business of the LLC." As such, the manager qualifies "as a fiduciary of that LLC and its members." Because "the rules of equity apply in the LLC context by statutory mandate, . . . because LLC managers are clearly fiduciaries, and because fiduciaries owe duties of loyalty and care," it is only logical that Delaware LLCs start "with the default that managers of LLCs owe enforceable fiduciary duties."
In reaching this conclusion, the court squarely rejected a competing view that fiduciary duties should not apply to LLC managers by default. First, if the Delaware courts "judicially excised" the equitable overlay of fiduciary duties in the statute, "those who crafted LLC agreements in reliance on equitable defaults that supply a predictable structure for assessing whether a business fiduciary has met his obligations to the entity and its investors will have their expectations disrupted." In other words, the "equitable context in which the contract's specific terms were to be read will be eradicated, rendering the resulting terms shapeless and more uncertain." The second problem follows directly from the first: "Judicial eradication of the explicit equity overlay in the LLC Act could tend to erode [Delaware's] credibility with investors in Delaware [alternative] entities."
The court next considered whether the parties "displac[ed the default] fiduciary duties altogether or tailor[ed] their application, by substituting a different form of review." Peconic Bay's operating agreement contained no provision expressly eliminating default fiduciary duties. Nor were default fiduciary duties displaced by Section 15 of Peconic Bay's operating agreement, as Gatz claimed. Section 15 stated:
"[N]either a manager nor any other member shall be entitled to cause the Company to enter . . . into any additional agreements with affiliates on terms and conditions that are less favorable to the Company than the terms and conditions of similar agreements which could be entered into with arms-length third parties, without the consent of a majority of non-affiliated members. . . ."
In Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., the Court of Chancery interpreted similar contractual language "as imposing the equivalent of the substantive aspect of entire fairness review, commonly referred to as the 'fair price' prong." The Auriga court explained that the "fair dealing" prong of the entire fairness review does not "fall away, 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." In other words, Section 15 "distill[s] the traditional fiduciary duties as to the portion of the Minority Members' claims that relates to the fairness of the Auction and Merger into a burden to prove the substantive fairness of the economic outcome." Thus, to enjoy Section 15's safe harbor, and thereby avoid the need for minority member approval of the auction and merger, "Gatz [had] the burden to show that he paid a fair price to acquire Peconic Bay, a conclusion that must be supported by a showing that he performed, in good faith, a responsible examination of what a third-party buyer would pay for the Company." The court reasoned that the remainder of Gatz's alleged misconduct leading up to the auction and merger were "governed by traditional fiduciary duties of loyalty and care because the LLC Agreement does not alter them."
The court held that Gatz breached both his contractual and fiduciary duties to the minority members of Peconic Bay by engaging in a series of acts and omissions over the years that left Peconic Bay in a tenuous financial position, which Gatz exploited "by buying [Peconic Bay] at an auction on terms that were well-designed to deter any third-party buyer, and to deliver the LLC to Gatz at a distress sale price." Because Gatz acted in bad faith, the exculpatory provision in Peconic Bay's operating agreement did not absolve him of monetary liability for his wrongdoing. Accordingly, the trial court awarded the minority members damages in the amount of $776,515 as well as pre-judgment interest at the statutory rate, compounded monthly, until the date of the final judgment. The court also awarded the minority members a portion of their attorneys' fees, finding that Gatz engaged in abusive litigation tactics including asserting implausible factual and legal arguments and destroying relevant documents both during litigation and when litigation was likely.
On appeal, the Delaware Supreme Court identified the "pivotal" legal issue as "whether Gatz owed contractually-agreed-to fiduciary duties to Peconic Bay and its minority investors." The Supreme Court answered the question affirmatively. That Section 15 of the operating agreement did not contain the words "fiduciary duties" or "entire fairness" was inapposite, because there is "no requirement in Delaware that an LLC agreement use magic words" to "impose fiduciary standards of conduct as a contractual matter." The parties in Auriga adopted the "contractual equivalent of the entire fairness equitable standard of conduct and judicial review" through Section 15. The Supreme Court reasoned that Gatz's admissions that he owed fiduciary duties and that those duties had not been waived in the operating agreement confirmed their contractual interpretation. The Delaware Supreme Court affirmed the trial court's finding that Gatz breached his contracted-for fiduciary duties to the minority members of Peconic Bay, and agreed that Gatz was not entitled to exculpation by virtue of the exculpatory language in Section 16 of the operating agreement, because "he had acted in bad faith and had made willful misrepresentations in the course of his breaching his contracted-for fiduciary duty." Accordingly, the Supreme Court affirmed the Chancery Court's award of damages and attorneys' fees to the minority members.
However, the Delaware Supreme Court took the unusual step of admonishing the Chancery Court for its "unnecessary construction" of Delaware's LLC Act to provide for application of default fiduciary duties. The Supreme Court explained: First, "the dispute over whether fiduciary standards apply could be decided solely by reference to [Section 15] the LLC Agreement. . . ." Second, no party asked the trial court "to decide the default fiduciary duty issue as a matter of statutory law." Indeed, by trial, the parties were no longer contesting the existence of fiduciary duties under the operating agreement. Third, the Supreme Court is not bound by prior decisions of the Court of Chancery, which hold, implicitly or otherwise, that default fiduciary duties apply to managers of Delaware LLCs. Lastly, the Supreme Court noted that the issue - whether the Delaware LLC Act does, or does not, impose default fiduciary duties - "is one about which reasonable minds could differ," and posited that resolution of any "statutory ambiguity on the issue" may be better left to the Delaware Bar and the General Assembly.
Reading the Delaware Supreme Court's decision in Gatz Properties, LLC v. Auriga Capital Corporation immediately brought to mind the famous and long-running commercial for Tootsie Pops that began in 1970, where a boy asks a fox, a turtle, and finally an owl "how many licks does it take to get to the Tootsie Roll center of a Tootsie Pop?" Unfortunately, the owl, like the fox and turtle before it, cannot withstand the temptation to bite through the hard candy exterior in a sugar-fueled rush to get to the Tootsie Roll in the center. So, "[h]ow many licks does it take to get to the Tootsie Roll center of a Tootsie Pop? The world may never know." And so too, the world may never know whether default fiduciary duties apply to managers and general partners of Delaware alternative entities.