The Delaware Court of Chancery has recently reiterated that “[w]hen considering the rights of persons who choose to invest in alternative entity structures . . . it always must be kept in mind that the express policy of [Delaware] is to give maximum effect to the principle of freedom of contract.” Dieckman v. Regency GP LP, 2016 WL 1223348, at *11 (Del. Ch. Mar. 29, 2016). In support of this proposition, the Court cited provisions of the Delaware Limited Liability Company Act, 6 Del. C. §§ 18-101 et seq. (the LLC Act) and the Delaware Revised Uniform Limited Partnership Act, 6 Del. C. §§ 17-101 et seq. (DRULPA), which set forth the same principle of freedom of contract. It has become a well-known and oft-repeated fact that Delaware’s most popular alternative entities, the limited liability company (LLC) and the limited partnership (LP), offer parties broad contractual authority to vary the terms of their governing statutes. Not as well-known, however, is that the same principle applies to a less commonly used third type of alternative entity, the Delaware statutory trust.
A Delaware statutory trust is an independent legal entity created under the provisions of the Delaware Statutory Trust Act, 12 Del. C. §§ 3801 et seq. (the DSTA). The DSTA provides significant flexibility with regard to a statutory trust’s governance, operations, and purposes. Similar to the LLC Act and DRULPA, Section 3825 of the DSTA provides that “[i]t is the policy of this subchapter to give maximum effect to the principle of freedom of contract and to the enforceability of governing instruments.” Although Delaware courts addressing freedom of contract in the alternative entity context have treated LLCs and LPs interchangeably and consistently upheld the contractual terms of their governing instruments, there is very limited Delaware case law addressing the extent of contractual freedom under the DSTA.
In Grand Acquisition, LLC v. Passco Indian Springs DST, 145 A.3d 990 (Del. Ch. 2016), the Delaware Court of Chancery was presented with a rare opportunity to address this issue. Specifically, the court was asked to determine whether a contractual right to inspect the books and records of a statutory trust trumped the statutory defenses and preconditions for inspection set forth in Section 3819 of the DSTA. The court, relying on established Delaware LLC and LP law, determined that the contractual language of a statutory trust’s governing instrument created a separate, distinct right of inspection that displaced the DSTA’s default inspection preconditions and rendered the DSTA’s defenses inapplicable.
The remainder of this article will briefly discuss the “freedom of contract” policy and the preconditions of inspection and defenses under Section 3819 of the DSTA. It will then examine the Court of Chancery’s decision in Grand Acquisition and provide several key takeaways.
Freedom of Contract within the Delaware Alternative Entity Context
Each of Delaware’s alternative entity statutes allows parties significant flexibility to privately order their affairs by structuring each alternative entity’s governing instrument. In fact, the LLC Act and the DSTA are modeled directly on DRULPA, the policy of which “is to permit partners to have the broadest possible discretion in drafting their partnership agreements and to furnish answers only in situations where the partners have not expressly made provisions in their partnership agreement or where the agreement is inconsistent with mandatory statutory provisions.” Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 170 (Del. 2002) (internal quotations omitted). Given a Delaware court will look to statutory default rules for guidance only in such limited circumstances, parties seeking a remedy are generally limited to relying upon the terms of the alterative entity’s governing instrument.
Section 3819 of the DSTA
Section 3819(a) of the DSTA sets forth certain preconditions that a beneficial owner of a statutory trust must satisfy in order to obtain the records of the trust, unless the governing instrument of the trust dictates otherwise. Section 3819(a) provides:
Except to the extent otherwise provided in the governing instrument of a statutory trust, each beneficial owner of a statutory trust . . . has the right, subject to such reasonable standards . . . as may be established by the trustees . . ., to obtain from the statutory trust [certain categories of information related to the affairs of the statutory trust] from time to time upon reasonable demand for any purpose reasonably related to the beneficial owner’s interest as a beneficial owner of the statutory trust . . . .
Section 3819(c) of the DSTA provides the trustee of a statutory trust the right to keep confidential information it in good faith believes is not in the best interest of the statutory trust to reveal, unless the governing instrument of the trust specifies otherwise. Specifically, Section 3819(c) states:
Except to the extent otherwise provided in the governing instrument of a statutory trust, the trustees . . . of the statutory trust shall have the right to keep confidential . . . any information [they] reasonably believe to be . . . information the disclosure of which [they] in good faith believe is not in the best interest of the statutory trust or could damage the statutory trust or its business . . . .
Grand Acquisition, LLC v. Passco Indian Springs DST
Summary of Facts
On September 30, 2015, Grand Acquisition, LLC (GA), a beneficial owner of Passco Indian Springs, a Delaware statutory trust (the Trust), sent the Trust a letter demanding to inspect a current list of the Trust’s beneficial owners, the beneficial owners’ contact information, and each beneficial owner’s respective interests in the Trust (collectively, the Requested Information). The Trust denied GA’s demand and requested that GA provide a reasonable basis for its demand that was sufficiently related to its ownership interest in the Trust.
On December 18, 2015, GA sent a supplemental demand letter to the Trust stating that it need not have a reasonable basis for its demand because Section 5.3(c)of the Amended and Restated Trust Agreement (the Trust Agreement) effectively eliminated all preconditions to inspection under Section 3819. Section 5.3(c) provided beneficial owners of the Trust with the right to “inspect, examine and copy the Trust’s books and records,” as long as the examination took place “during normal business hours.” The Trust failed to respond to GA’s supplemental demand letter.
On February 16, 2016, GA filed a verified complaint in the Court of Chancery seeking to inspect the Requested Information. After discovery, both parties agreed to resolve the case through cross motions for summary judgment.
Parties’ Arguments
GA contended, inter alia, that Section 5.3(c) of the Trust Agreement provided GA with an unfettered contractual right to inspect the books and records of the Trust that displaced the preconditions of Section 3819.
In response, the Trust contended that preconditions of Section 3819 applied because Section 5.3(c) failed to “affirmatively disavow” them. The Trust based this argument primarily on the meaning of the prefatory phrase appearing in Section 3819(a) and (c), which provides: “Except as otherwise provided in the governing instrument.” This phrase had been interpreted in a prior Court of Chancery decision to mean that “in the absence of language in the governing instrument . . . to the contrary,” the DSTA’s default statutory provisions apply. Cargill, Inc. v. JWH Special Circumstance LLC, 959 A.2d 1096, 1116 (Del. Ch. 2008). The Trust, relying on this interpretation, argued that the language of Section 5.3(c) was not “contrary” to Section 3819 because it did not “expressly disclaim” the preconditions and defenses contained in Section 3819.
The Trust also relied upon Section 18-305 of the LLC Act and Section 17-305 of DRULPA for support of its position. These sections of the LLC Act and DRULPA set forth the right to inspect books and records of a Delaware LLC or a Delaware LP. Sections 18-305 and 17-305 are nearly identical to Section 3819 of the DSTA, but do not contain the same prefatory clause as Section 3819. Based upon this distinction, the Trust argued that “unlike the LLC Act and [DRULPA], the [DSTA] does provide a series of default provisions for a books and records action, each of which the governing document must expressly alter.”
Finally, the Trust argued that even if GA had a contractual right to inspect the Requested Information under the Trust Agreement, it was not entitled to inspect the Requested Information because the purpose of the inspection was improper. The Trust argued that this common law defense, known as the contractual “improper purpose defense,” was applicable because GA was seeking to inspect the Requested Information for a personal reason harmful to the interests of the Trust.
Court’s Analysis
At the outset of its analysis, the court noted that in the LLC and LP context, “a contractual books and records right provided in an [LLC’s] or [LP’s] governing instrument [is] independent from the relevant default statutory right.” In the same context, “providing an entity’s owners with an unconditional contractual right to inspect that entity’s books and records has the practical impact of rendering the relevant statutory preconditions and defenses inapplicable to that independent contractual right.” Although these principles had only been relied upon in the LLC and LP contexts, the court determined that they applied equally to statutory trusts because the DSTA shares the same policy of maximizing freedom of contract as the LLC Act and DRULPA. The court then turned to the parties’ arguments to determine whether Section 5.3(c) created an unconditional contractual right to inspect the Requested Information.
First, the court rejected the Trust’s contention that the prefatory phrase found in Section 3819 required an express disclaimer in the Trust Agreement of Section 3819’s preconditions and defenses. Rather, the Court found that to disclaim default provisions of the DSTA, the Trust Agreement need only contain contractual language “contrary” to the statutory language. The court determined that Section 5.3(c), which expressly permitted beneficial owners of the Trust to “inspect, examine and copy the Trust’s books and records,” subject only to the condition that such actions be taken “during normal business hours,” was clearly contrary to Section 3819.
Additionally, the court observed that although Section 18-305 and Section 17-305 do not contain the same prefatory clause as Section 3819, the LLC Act and DRULPA include provisions that expressly permit the respective entity’s governing instrument to limit an owner’s right to inspect the entity’s books and records. Specifically, Section 18-305(g) of the LLC Act and Section 17-305(g) of DRULPA allow an LLC or an LP to restrict a member’s or partner’s right to inspect any of the books and records of the LLC or LP. Notably, Section 3819 of the DSTA contains no such provision. The court accounted for this distinction by concluding that the prefatory phrase in Section 3819 served the same purpose as Section 18-305(g) and Section 17-305(g). In other words, the court found that the prefatory phrase in Section 3819 permits the governing instrument of a statutory trust to limit the right of beneficial owners to inspect the books and records of the statutory trust.
Finally, the court noted that the “improper purpose defense” had only ever been applied in the LP context and that its application in the statutory trust context was an “open issue.” Nevertheless, the court determined that it need not address the issue because even if the defense was applicable, the Trust failed to prove that releasing the Requested Information to GA would cause the Trust actual harm.
Takeaways
Governing Instrument of a Statutory Trust Trumps the Default Provisions of the DSTA
Similar to a Delaware LLC or LP, a statutory trust is primarily a creature of contract, governed first by its respective trust agreement and secondarily by statute. In lieu of applying the statutory defaults of the DSTA, Delaware courts will defer to the parties’ rights as agreed upon in a trust agreement. Grand Acquisition illustrates that when addressing an issue related to the freedom to contract in the statutory trust context, Delaware courts may look to, and directly apply, LLC and LP precedents to render a decision. Practitioners must be cognizant of this possibility and consult Delaware LLC and LP law when drafting the governing instrument of a statutory trust.
“Contrary” Language Need Not Be an Express Disclaimer of a Statutory Default
A contractual right or obligation in a statutory trust’s governing instrument that is “contrary” to a statutory default of the DSTA will displace that statutory default. Grand Acquisition makes clear that contractual language need not expressly disclaim or affirmatively disavow a statutory default to be considered “contrary.” Rather, “contrary” language encompasses a broader spectrum, which includes language that is incompatible or inconsistent with a statutory default. Thus, if the intent of the contractual provision is to merely clarify or create conditions in addition to a specific statutory right, the governing instrument must expressly state such purpose.
Statutory Defaults Should Be Expressly Incorporated into the Trust’s Governing Instrument
Parties seeking to form a statutory trust subject to certain default provisions of the DSTA must carefully draft the Trust’s governing instrument to exclude any and all provisions that may be considered “contrary” to those statutory defaults. However, relying on what the parties perceive to be the absence of any term “contrary” to the relevant statutory defaults is an uncertain endeavor. By doing so, the parties leave open the door for a court to interpret whether any term of the governing instrument is “contrary” to the statutory default. For the avoidance of doubt, parties should expressly incorporate into the statutory trust’s governing instrument the default provisions of the DSTA that they wish to apply.
It is Unclear to What Extent LLC and LP Precedents Will Apply in the Statutory Trust Context
In Grand Acquisition, the Delaware Court of Chancery applied established principles of LLC and LP law to determine that the terms of the Trust Agreement trumped the default rules of the DSTA. However, when asked to confirm the application of the contractual “improper purpose defense” to a statutory trust, the court avoided doing so despite the defense being applicable in the LP context. Thus, although the Grand Acquisition decision demonstrates that LLC and LP precedents may be applied to contractual issues involving a statutory trust, the extent of their application is not entirely clear.
Significantly, the DSTA does not preempt common law principles related to trusts. In fact, Section 3809 of the DSTA explicitly subjects Delaware statutory trusts to trust common law unless otherwise provided in the statutory trust’s governing instrument or the DSTA. The interplay between the application of trust common law and LLC and LP precedents to Delaware statutory trusts is an interesting issue that should be monitored as statutory trust law continues to evolve.
Conclusion
The Court of Chancery’s decision in Grand Acquisition illustrates the analysis Delaware courts will undertake in order to determine whether the statutory framework of the DSTA has been displaced by a trust’s governing instrument. This analysis may include application of LLC and LP precedents due to the DSTA’s shared policy of maximizing freedom of contract and the lack of case law involving Delaware statutory trusts. As in the realm of Delaware LLCs and LPs, it is the governing instrument of the statutory trust that controls when a conflict arises with the DSTA. Accordingly, practitioners seeking to maintain statutory defaults must take care to ensure that the statutory framework of the DSTA will apply by omitting any language to the contrary in the trust’s governing instrument or by expressly incorporating the desired DSTA default provisions.