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Liability PhotoDelaware limited liability companies have become a popular vehicle for real estate joint ventures and preferred equity investments in real estate. As a manager, co-manager or managing member of an LLC, you may have certain duties and liabilities to your partners and to the company itself, even beyond those expressly set forth in the limited liability company agreement. In this article, we will look at a couple of recent decisions under Delaware law and how those decisions affect attempts to minimize liability to LLC managers.

Under traditional principles of equity in Delaware, a manager of an LLC owes fiduciary duties of care and of loyalty to the company and the members; however, the Delaware statutes expressly allow for those duties to be limited or extinguished. There is also an implied covenant of good faith and fair dealing that governs all contracts, and that duty can not be eliminated — but it can be limited or, at least, fleshed out. More on this later.

Fiduciary Duties of Loyalty and Care

What is a fiduciary duty? Generally, it is a duty that one party owes to another because of a special relationship, often where one party has entrusted another with the ability to manage certain affairs on its behalf. For example, fiduciary duties exist between attorney and client, between partners in a partnership and between corporate officers and shareholders. In the corporate law context, courts have recognized fiduciary duties of loyalty (to act in good faith and in the best intersts of the corporation and not to engage in self-dealing) and care (to act prudently in light of all available information).

Of course, this is a very cursory summary of the concept of fiduciary duty under corporate law. For purposes of this article, it is important only to understand that under Delaware law, the persons charged with managing a company can have liability to the company for failing to fulfill fiduciary duties. These duties can be, and often are, eliminated or substantially circumscribed in real estate joint venture agreements. However, recent developments in Delaware case law affect how this can be effectively accomplished.

Implied Covenant of Good Faith and Fair Dealing

The implied covenant of good faith and fair dealing is an implied agreement between the parties to every contract that they will not act unreasonably or arbitrarily to prevent the other party from receiving the benefits that they bargained for. The covenant is deemed to exist in every contract even though it is not expressly stated. It is used by courts in Delaware as a so-called “gap-filling” measure to address developments that could not have been anticipated at the time the contract was signed.

The Delaware LLC Act

There are two provisions of the Delaware Limited Liability Company Act (the “LLC Act”) that provide the basis for minimizing the liability of managers in real estate joint ventures.

Section 18-1101(c) of the LLC Act provides that the provisions of an LLC agreement may expand, restrict or eliminate any duties that a manager has to the company or to the other members, except the implied covenant of good faith and fair deal may not be eliminated.

Similarly, Section 18-1101(e) of the LLC Act provides that an LLC agreement may provide for the limitation or elimination of any and all liability of a manager, both for breach of contract and breach of any duty, except the agreement may not limit or eliminate liability for a bad faith violation of the implied covenant of good faith and fair dealing.

Recent Delaware Law Decisions

We turn now to two recent Delaware law decisions that affect the limitation of liability of managers of limited liability companies. The first relates to the provisions in the LLC Act that permit the members of an LLC to eliminate fiduciary duties of managers (or managing members), as outlined above. The second relates to the implied covenant of good faith and fair dealing, which the LLC statute specifically excludes from the types of manager liability that can be extinguished.

On January 27, 2012, the Delaware Chancery Court handed down a decision in Auriga Capital Corp. v. Gatz Properties, Inc. In that opinion, the court explains the interplay between common law fiduciary duties and the provisions of the LLC Act outlined above.

Prior to this decision, it was not entirely clear whether managers of an LLC owe fiduciary duties to the company and the other members by default, i.e. whether those duties exist when the LLC agreement neither expressly imposes the duties nor expressly eliminates them. In the Auriga decision, it was made clear that they do.

The court held that a manager of an LLC by default owes traditional fiduciary duties of loyalty and care to the other members unless the LLC agreement expressly modifies or eliminates those duties. So unless the LLC agreement clearly eliminates the fiduciary duties of a manager, the manager could be found liable for breach of a fiduciary duty.

While Auriga was not the first case to find that an LLC manager had fiduciary duties by default, it is notable for its extensive analysis of the statute and the clarity of its reasoning. After Auriga, there is little doubt that unless you clearly set forth limitations on liability in your joint venture agreement, you risk liability for breach of fiduciary duty as a manager or managing member of an LLC.

Turning now to the second recent Delaware decision, the Chancery Court’s decision on April 4, 2012 in In Re K-Sea Transportation Partners LP Unitholders Litigation involved, among others things, a claim of breach of the implied covenant of good faith and fair dealing. While this decision involved a limited partnership and not an LLC, the Limited Partnership Act provisions at issue are identical to the LLC Act provisions set forth above, so a similar analysis could be applied in the LLC context.

That case involved the merger of a publicly-traded Delaware limited partnership into a non-affiliated third party. In connection with the merger and apart from the acquisition price, there was a separate payment to the general partner of the LP being acquired, in exchange for certain interests that it held exclusively, which the limited partners claimed was excessive.

Because of the apparent conflict of interest, the transaction was reviewed by a committee of independent directors who approved the deal, relying on a fairness opinion from an investment bank.

The plaintiffs claimed the committee was not truly independent and that the general partner breached its fiduciary duties.

In granting the defendants’ motion to dismiss, the court addressed whether there could have been a breach of the implied covenant of good faith and fair dealing, given the facts and in light of particular language in the limited partnership agreement. That language provided that the general partner would be presumed to have acted in good faith if it relied on the advice of an expert as to any matter reasonably believed to be within such expert’s area of competence.

Since there was no allegation that the approval of the merger was outside of the investment bank’s area of competence, the general partner was entitled to the presumption that it acted in good faith, since it relied on the advice of the investment bank.

The court then addressed the question of whether there could be an allegation of breach of the implied covenant of good faith and fair dealing where the limited partnership agreement afforded the general partner the conclusive presumption that it acted in good faith. The court answered that question in the negative and cited a case with similar facts from earlier in the year (Gerber v. Enter. Prods. Holdings, LLC):

“Under the plain terms of the LPA, the general partner is protected from any claims asserting that the action was taken other than in good faith. That would include good faith claims arising under the duty of loyalty, the implied covenant, and any other doctrine. In contrast to this broad pronouncement, our Supreme Court has determined that the implied covenant is a gap-filler, and may not be used to ‘infer language that contradicts a clear exercise of an express contractual right.’ Moreover, our Supreme Court has repeatedly stated that ‘one generally cannot base a claim for breach of the implied covenant on conduct authorized by the agreement.’

“The drafters of the LPA foresaw that claims against the general partner asserting a failure to act in good faith could arise in a number of circumstances. The drafters decided that none of those claims could be asserted if the general partner acted in reliance upon the opinion of an expert. Under the LPA, the general partner has an ‘express contractual right’ to rely upon the opinion of an expert. The Court may not ‘infer language that contradicts a clear exercise’ of that right.” (edited for clarity)

So while it is not possible to eliminate, or limit liability for a breach of, the implied covenant of good faith and faith dealing, it is possible to establish a conclusive presumption of good faith. Doing so can create a safe harbor and protect managers from claims of breach of the implied covenant.