The Delaware courts have issued a number of interesting and controversial decisions in the last year or so, and there will no doubt be a few more before 2012 ends. Three alternative entity law decisions from 2012 have garnered a fair amount of attention: Auriga Capital Corp. et al. v. Gatz Properties, LLC; Gerber v. Enterprise Products Holdings, LLC, et al.;and In re K-Sea Transportation Partners L.P. Unitholders Litig. In Auriga, Chancellor Leo E. Strine, Jr., 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. Old news, you say? True, many practitioners have long-believed that default fiduciary duties applied to LLC managers, and numerous decisions from the Court of Chancery suggested as much. However, Auriga was the first instance where the court made such an unequivocal pronouncement. Indeed, one commentator on Delaware law went so far as to refer to the opinion as "epic," for that very reason. On the other hand, in Gerber and In re K-Sea, Vice Chancellors Noble and Parsons, respectively, dismissed plaintiffs' claims that the defendants violated their contractual and fiduciary duties to the minority investors by approving conflicted transactions, because the defendants satisfied the contractual standards of review set forth in the partnership agreements, which displaced default fiduciary duties and constrained application of the implied covenant of good faith and fair dealing.
The Gerber decision prompted one person to ask: "How far will Delaware courts allow an agreement to permit self-dealing in an LLC? The case I've found allowing the most leeway is Gerber... Any comments on whether this case shows the wisdom or the folly of Delaware law? Does anyone have a better case to offer?" UCLA Law School Professor Stephen Bainbridge posted this inquiry on his blog along with the following response from another individual: "It is pretty clear that under Delaware limited partnership and LLC law, the partnership/operating agreement can entirely legitimize self-dealing, subject to the non-waivable contractual covenant of good faith and fair dealing. What's remarkable about Gerber is the extent to which the case permits an agreement to restrict the operation of the non-waivable duty of good faith and fair dealing." So, are the decisions in Gerber and In re K-Sea the result of wisdom or folly, and how does one square those decisions with Auriga?
Auriga: Default Fiduciary Duties Exist
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 PeconicBay. 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 PeconicBay 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, PeconicBay 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 PeconicBay 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 PeconicBay's minority investors--led the investors to sue Gatz and Gatz Properties. The minority investors alleged that Gatz breached both his fiduciary duties and PeconicBay's operating agreement. Gatz countered that he owed no fiduciary duties, because such duties had been eliminated by the operating agreement.
Chancellor Strine began his 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 Gatz owed default fiduciary duties--a more specific inquiry based on the facts of the case. PeconicBay's operating agreement contained no provision expressly eliminating default fiduciary duties. Nor were those default 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." However, as Chancellor Strine explained in Auriga, 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 remainder of Gatz's alleged misconduct leading up to the auction and merger, however, were governed by traditional fiduciary duties of loyalty and care because the operating agreement did not alter those duties.
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 PeconicBay's operating agreement did not absolve him of monetary liability for his wrongdoing.
Gerber and In re K-Sea: Contracting Away Judicial Protection
In contrast to the PeconicBay operating agreement, the partnership agreements in Gerber and In re K-Sea displaced default fiduciary duties and constrained application of the implied covenant of good faith and fair dealing with a contractual standard of review, thereby limiting the Court of Chancery's broad remedial powers.
In Gerber, plaintiff Joel A. Gerber filed a class action suit on behalf of the former public holders of limited partnership units of Enterprise GP Holdings, LP (EPE) against Enterprise Products Partners, LP (Enterprise Products), Enterprise Products Holdings, LLC (Enterprise Products GP), members of Enterprise Products GP's Board of Directors (the Director Defendants), the estate of Dan L. Duncan (Duncan), which controlled the foregoing entities, and an affiliate of Enterprise Products--Enterprise Products Company (EPCO), alleging, among other claims, fiduciary and contractual breaches relating to EPE's sale of Texas Eastern Product Pipeline Company, LLC (Teppco) to Enterprise Products and the later merger of EPE with Enterprise Products.
In 2007, EPE purchased Teppco from a Duncan affiliate for $1.1 billion in EPE limited partnership units. Two years later, Enterprise Products acquired Teppco from EPE in exchange for $39.95 million in Enterprise Products limited partnership units, and Enterprise Products' general partner, which EPE owned, received an increase in its general partner interest in Enterprise Products worth $60 million (the 2009 sale). The Audit, Conflict, and Governance Committee of the Enterprise Products GP Board of Directors (the ACG Committee), which was comprised of three independent directors, approved the sale following receipt of a fairness opinion from Morgan Stanley. The Enterprise Products GP Board approved the sale upon the recommendation of the ACG Committee. The following year, Enterprise Products proposed a merger with EPE, whereby each EPE limited partnership unit would be converted into the right to receive 1.5 Enterprise Products limited partnership units. The ACG Committee received another fairness opinion from Morgan Stanley, opining that the merger was fair to the holders of EPE limited partnership units. In reliance on the fairness opinion, the ACG Committee recommended the merger to the full board. The merger closed in November 2010.
The court began its analysis by noting that Enterprise Products GP, the Director Defendants, Duncan and possibly EPCO owed fiduciary duties to EPE and its minority investors. However, because the 2009 sale and the merger were conflicted transactions, default fiduciary duties were supplanted by four alternative standards of review set forth in Section 7.9(a) EPE's partnership agreement:
Unless otherwise expressly provided in this Agreement, whenever a potential conflict of interest exists or arises between [Enterprise Products GP] or any of its Affiliates, on the one hand, and [EPE] or any Partner, on the other hand, any resolution or course of action by [Enterprise Products GP] or its Affiliates in respect of such conflict of interest shall be permitted and deemed approved by all Partners, and shall not constitute a breach of this Agreement or of any agreement contemplated herein or therein, or of any duty stated or implied by law or equity, if the resolution or course of action in respect of such conflict of interest is (i) approved by Special Approval, [which means "approval [of the transaction] by a majority of the members of the [ACG Committee]"...
Because the ACG Committee, which was comprised of independent directors, unanimously approved the 2009 sale and the merger, the court reasoned that the conflicted transactions were "'permitted and deemed approved by all Partners, and [did] not constitute a breach of [the partnership agreement].'" The inquiry did not end there, however, because the court had determined in an earlier, related action that the implied covenant of good faith and fair dealing constrains the special approval process and, thus, must be considered.
Enterprise Products GP, the only defendant that signed the partnership agreement, had an obligation to employ the special approval process in good faith. However, Section 7.10(b) provided Enterprise Products GP with a safe harbor. If Enterprise Products GP acted in reliance on the opinion of an investment banker "as to matters that [Enterprise Products GP] reasonably believes to be within such Person's professional or expert competence[, the act] shall be conclusively presumed to have been done... in good faith and in accordance with such opinion." In connection with both the 2009 sale and the merger, the ACG Committee received and relied upon fairness opinions from Morgan Stanley. Though the members of the ACG Committee were a subset of the Enterprise Products GP Board, the "only reasonable interpretation of the well-pled facts of the complaint is that Enterprise Products GP relied upon the fairness opinions in deciding whether to use the special approval process to take advantage of the contractual duty limitations provided by Section 7.9(a)." Having "conclusively presumed" under the terms of the partnership agreement that Enterprise Products GP acted in good faith in deciding to use the special approval process, the court asked whether the plaintiff could plead a claim for breach of the implied covenant of good faith and fair dealing in the negative. Because Section 7.10(b) applies to any action taken by Enterprise Products GP, the court concluded that it was protected from any good faith claim "arising under the duty of loyalty, the implied covenant, and any other doctrine."
In contrast to Gerber, the merger at issue In re K-Sea did not involve an affiliate of the general partner of the limited partnership. Therefore, Vice Chancellor Parsons relied on the contractual standard of review in the limited partnership agreement relating specifically to mergers, rather than the partnership agreement's more general "special approval" process in dismissing the complaint against the defendants.
In March 2011, K-Sea Transportation Partners L.P. ("K-Sea" or the "Partnership") entered into a merger agreement with Kirby Corporation (Kirby), whereby Kirby agreed to acquire all of K-Sea's equity interests. The parties allocated $18 million of the merger consideration to acquire incentive distribution rights (IDRs) held exclusively by K-Sea's general partner (K-Sea GP). Recognizing a potential conflict of interest, K-Sea's board directed a committee of independent directors (the Conflicts Committee) to review Kirby's offer and make a recommendation. A few months before the merger negotiations began, the K-Sea Board granted "phantom units" to each member of the Conflicts Committee, which entitled the holders to one K-Sea unit or its cash equivalent with vesting of the units occurring immediately upon a change of control transaction. Plaintiffs attacked the merger, arguing that the Conflicts Committee's approval process was defective, and that K-Sea GP, its affiliates and the K-Sea Board committed contractual and fiduciary breaches.
The court began its three-step analysis of the plaintiffs' claims with a review of the partnership agreement. Articles 7 and 14 of that agreement supplanted the defendants' default fiduciary duties with a contractual standard of review, governing the approval of mergers. Sections 7.8 and 7.10 of the partnership agreement established a contractual standard of review: "K-Sea GP, KSGP, and the members of the K-Sea Board may be liable for money damages for a breach of the LPA, or of any default fiduciary duty not eliminated by the LPA, only if that breach resulted from an act or omission done in bad faith, and K-Sea GP is conclusively presumed to have acted in good faith if it relied on an expert it reasonably believed to be competent to render an opinion on the particular matter." Next, the court looked to Article 14 of the partnership agreement, which dealt with mergers, because the alleged contractual and fiduciary violations related to defendants' approval of the merger. Sections 14.2 and 7.9(b) of the partnership agreement afforded K-Sea GP discretion in deciding whether to approve a merger. Though K-Sea GP was "entitled to consider only such other interests and factors as it desires," and need not consider the interests of the partnership or the limited partners, it could not exercise its discretion "in a manner inconsistent with the best interests of the Partnership as a whole." When Sections 14.2, 7.9(b), and 7.10(d) are read together, the court reasoned that for plaintiffs to state a claim predicated on defendants' approval of the merger agreement, plaintiffs must establish that K-Sea GP approved the merger agreement in bad faith. However, Section 7.10(b) entitled K-Sea GP to "a conclusive presumption of good faith whenever it acts in reliance on an expert opinion..." K-Sea GP relied on a fairness opinion from Stifel Nicolaus & Co., stating that the merger was fair to K-Sea's common unitholders.
The court rejected plaintiffs' reliance on Section 7.9(a) of the partnership agreement, which applied in the case of a conflicted transaction. That section was virtually identical to Section 7.9(a) of the partnership agreement in Gerber discussed above, and expressly permitted "special approval" of a conflicted transaction. However, nothing in Section 7.9(a) or Article 14 of the partnership agreement required that the merger be "fair and reasonable," because Kirby was an unaffiliated third party. Though K-Sea GP could have used the special approval process to immunize the merger, its decision not to do so did not mean that liability followed automatically. Rather, as discussed, K-Sea GP had to establish that it exercised its discretion in good faith. Consistent with its earlier decision in Gerber, the court held that a plaintiff cannot plead a claim for breach of the implied covenant of good faith and fair dealing where a defendant is conclusively presumed to have acted in good faith by the terms of the governing agreement. Because K-Sea GP was conclusively presumed to have acted in good faith by relying on Stifel's fairness opinion, the court found that plaintiffs could not identify any reasonably conceivable set of circumstances susceptible to proof that would support a finding that any defendant breached a duty by approving the merger.
Auriga, Gerber, and In re K-Sea: Investors' Folly
Though some may disagree, the decisions in Auriga, Gerber, and In re K-Sea exhibit the court's wisdom, not folly. Moreover, these decisions are entirely consistent with each other. Auriga provided needed clarity to Delaware alternative entity law by confirming what practitioners have long thought: those in control of Delaware alternative entities owe traditional fiduciary duties by default unless those duties are expressly altered or eliminated by the partnership or operating agreement. Auriga also reaffirmed the Court of Chancery's respect for the investors' right to contract away those default rights and protections. To put it more bluntly, the decision in Auriga should be recognized for what it is-- judicial recognition of the parties' right to order their affairs by contract, and for what it is not--judicial paternalism. The parties in Auriga chose not to, or failed to, eliminate default fiduciary duties and, in doing so, left intact the court's very powerful gap-filling and remedial powers. The court simply exercised those powers to address the parties' dispute.
By contrast, in Gerber and In re K-Sea, the parties effectively displaced default fiduciary duties and constrained the application of the implied covenant of good faith and fair dealing in the partnership agreements, thereby eliminating the court's most powerful "remedial and gap-filling powers," as the Court of Chancery explained in Lonergan v. EPE Holdings LLC:
When parties exercise the authority provided by the LP Act to eliminate fiduciary duties, they take away the most powerful of a court's remedial and gap-filling powers. As a result, parties must draft an LP agreement as completely as possible, and they bear the risk of incompleteness. If the parties have agreed how to proceed under a future state of the world, then their bargain naturally controls. But when parties fail to address a future state of the world-and they necessarily will because contracting is costly and human knowledge imperfect-then the elimination of fiduciary duties implies an agreement that losses should remain where they fall...
Respecting the elimination of fiduciary duties requires that courts not bend an alternative and less powerful tool into a fiduciary substitute... To use the implied covenant to replicate fiduciary review "would vitiate the limited reach of the concept of the implied duty of good faith and fair dealing."
Indeed, as the court noted in Gerber, the implied covenant is nothing more than a gap-filler. Where the contract has no gaps, as was the case in Gerber and In re K-Sea, the implied covenant is not applicable. Thus, the folly, if any, in Gerber and In re K-Sea was not the court's, but the minority investors'. After all, in Delaware, as in many states, investors are charged with assessing and accepting the risks that come with investing in an alternative entity, where the operating or partnership agreement eliminates or drastically alters default fiduciary duties and constrains the application of the implied covenant.
Stay tuned. The decisions in Gerber, Auriga, and In re K-Sea are all on appeal to the Delaware Supreme Court, which may issue a ruling in each case by the end of the year.