LLC Controlling Member Fiduciary Liabilities

Posted by Chancellor William B. Chandler III, Wilson Sonsini Goodrich & Rosati, on Thursday February 23, 2012 at 9:42 am
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Editor’s Note: Chancellor William Chandler is a partner at Wilson Sonsini Goodrich & Rosati, and former Chancellor of the Delaware Court of Chancery. This post is based on a WSGR Alert by Chancellor Chandler and Ryan McLeod. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Last month, the Delaware Court of Chancery issued an important post-trial decision that held the majority and managing member of an LLC liable for breaches of fiduciary duty in connection with the member’s management and eventual purchase of the company. The opinion unequivocally shows that the Court of Chancery considers Delaware’s LLC Act to impose default fiduciary obligations analogous to those in the corporate context absent a clear expression otherwise in the LLC agreement.

Background

The case involves Peconic Bay LLC, a limited liability company formed to develop a golf course in Long Island, New York. William Gatz, through Gatz Properties LLC, held a majority stake in Peconic. In 2009, Gatz bought out the minority investors for roughly $50,000 and the assumption of the LLC’s $5.4 million in debt. The court found that from 2004 onward, Gatz had known that Peconic’s sublease with the golf course operator likely would come to an end in 2010, but rather than seek a new operator or market Peconic or its assets, Gatz took no action. When approached by another entity the court deemed a “credible buyer” about purchasing Peconic or taking over the sublease and operating the golf course, Gatz demurred, refusing to negotiate with the bidder or provide any due diligence materials. Moreover, Gatz withheld information from the minority investors about the nature of the bid and his discussions with the bidder. Armed with the knowledge, however, that the other investors were looking for an exit, Gatz “attempt[ed] to play ‘hardball’ with the minority members” and put together an unnecessary “fire sale” auction at which Gatz was the only bidder and which the court labeled “a bad faith sham.” The minority investors sued, alleging that Gatz illegally squeezed them out of their investment and breached his fiduciary obligations. Gatz argued that he owed no such fiduciary duties, and that, even if he did, his actions comported with them.

Court of Chancery’s Decision

Chancellor Leo E. Strine began his analysis by strongly rejecting the suggestion that traditional fiduciary duties of loyalty and care do not apply in the context of alternative entities like LLCs. To the contrary, the Chancellor ruled, the LLC Act explicitly states that the rules of equity shall govern unless displaced by statute or contract, and “[i]t seems obvious that . . . a manager of an LLC would qualify as a fiduciary of that LLC and its members.” Though the court “give[s] full effect to the parties’ contract choice” when the LLC agreement “entirely supplant[s] th[e] default principles” of fiduciary duty, the elimination of those duties must be clear. The court found no such elimination in the Peconic Bay LLC agreement, and it held that Gatz owed duties as both the managing member and controller of the company.

As for the substantive claims, the court held that Gatz breached his duties in several ways. First, Gatz breached his “duty to address in good faith known, material risks that threaten the viability of the business” by “failing for five years to take any steps” to prepare Peconic Bay for the expected loss of the golf course operator. Instead of searching for a replacement, attempting to modify Peconic’s business model, or seeking a buyer for the company, Gatz did nothing, allowing “the clock on the Sublease to run for the selfish reason of placing Peconic Bay in a position of economic weakness, which he could later exploit for the exclusive financial benefit of himself and his family.” Second, even when approached by a “credible buyer for the LLC,” Gatz “did all [he] could to discourage a good bid, frustrating and misleading the interested buyer.” Finally, Gatz used the emergence of the potential buyer to smoke out the minority investors’ interest in selling—and the price at which they would sell—to play “hardball” and squeeze out the minority at the lowest possible price, staging a “distress sale” auction with limited marketing efforts that was run by an inexperienced auctioneer. Though the court stressed that a holder of a controlling interest “has no duty to sell his interests,” the fact that a controller does not wish to sell “does not mean that he had a free license to mismanage Peconic Bay so as to deliver it to himself for an unfair price.” Moreover, the Chancellor ruled, “[a] fiduciary may not play ‘hardball’ with those to whom he owes fiduciary duties,” and that if the controller seeks to buy out the minority, “he ha[s] to do so at a fair price.”

Having concluded that Gatz breached his fiduciary duties and acted in bad faith, the court ruled in favor of the minority investors, awarding damages as if the company had been sold for $6.5 million and shifting half of the minority’s legal fees to Gatz.

Implications

This decision powerfully counsels that the Delaware courts will consider LLC managers as fiduciaries in the same vein as corporate directors absent clear contractual language supplanting those duties. Moreover, it serves as a forceful reminder that holders of a controlling interest must take special care when considering a buyout of their minority investors, because the courts will painstakingly scrutinize the course of conduct leading to the sale in order to determine whether the price paid was entirely fair.

  1. [...] full article……via LLC Controlling Member Fiduciary Liabilities — The Harvard Law School Forum on Corporate Governanc…. Share OptionsPrintEmailMoreFacebookLinkedInStumbleUponTwitterPinterestRedditDiggTumblrLike [...]

    Pingback by LLC Controlling Member Fiduciary Liabilities — The Harvard Law School Forum on Corporate Governance | Accounting and Small Business /Beverly Shares — February 23, 2012 @ 2:17 pm

  2. I think the courts decision was just given the circumstances. No matter how you slice it, this majority and managing member of Peconic Bay LLC clearly was out to exploit his minority LLC members by not renewing the golf course lease and thereby devaluing the worth of the LLC for his own economic benefit.

    The lesson I’m left with is that of due diligence on the proper vetting of management or business partners. While choosing how to structure your business entity is important, LLC’s gaining in popularity, somebody’s got to be responsible for managing it. Seems cliche but you have to be selective in choosing your business partners.

    Comment by Nick Brand — March 7, 2012 @ 10:34 am

 

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