August 15, 2017

DELAWARE INSIDER: USACafes: A Return

Aaron M. Nelson

It is often noted that alternative entities (e.g., limited partnerships (LPs), limited liability companies (LLCs)) are creatures of contract. Fisk Ventures LLC v. Segal et al., 2008 WL 1961156, at *8 (Del. Ch.) (“[L]imited liability companies . . . are creatures . . . of contract, those duties or obligations must be found in the LLC Agreement or some other contract.”).

At the same time, over 25 years ago, during the formative years of the law regarding alternative entities, the Delaware Court of Chancery posed the following hypothetical in the seminal case of In re USACafes, L.P. Litigation:

Consider, for example, a classic self-dealing transaction: assume that a majority of the board of the corporate general partner [of a limited partnership] formed a new entity and then caused the general partner to sell partnership assets to the new entity at an unfairly small price, injuring the partnership and its limited partners. Can it be imagined that such persons have not breached a duty to the partnership itself? And does it not make perfect sense to say that the gist of the offense is a breach of the equitable duty of loyalty that is placed upon a fiduciary?

600 A.2d 43, 49 (Del. Ch. June 7, 1991), appeal refused sub nom. Wyly v. Mazzafo, 602 A.2d 1082 (Del. 1991) (TABLE). Not suffering from subtlety, the court relied on “general [equitable] principles and trust law” to hold that the individuals who controlled the general partner of a limited partnership (either directly or indirectly) owed a fiduciary duty of loyalty to the limited partnership and its limited partners.

Stated differently, the duty of loyalty owed by the human controllers of an entity-managed LLC or LP is extra-contractual and stems from traditional equitable duties under common law. This was a dramatic change in the law, which previously only permitted finding liability against the human controllers of a corporate general partner under a veil-piercing theory, as opposed to the theory that they owed a direct fiduciary duty to the limited partnership and its limited partners. See Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 2000 WL 1476663, at *20 (Del. Ch.) (stating that, before USACafes: “Only if there had been abuse of the corporate form by the owners of the corporate general partner that would justify veil piercing would the limited partners be able to look beyond the corporate partner to others for redress.”).

This article argues in favor of a return to the pre-USACafes state of the law, because the equitable aims of USACafes and the contractarian nature of alternative entities are not inherently in tension. Who owes fiduciary duties to an alternative entity should be determined solely by looking at the operating agreement, not “[by] disregard[ing] a negotiated agreement among sophisticated parties. . . .” R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318, at *6 (Del. Ch.). Courts should reserve their equitable powers for the remedy stage, invoking veil piercing or joint and several liability as necessary to address the concerns raised in USACafes—just as they did before. Such an approach will return the law to a state of clarity.

The Operating Agreement Should Control Who Owes Fiduciary Duties

“Delaware is a freedom of contract state, with a policy of enforcing the voluntary agreements of sophisticated parties in commerce.” Personnel Decisions, Inc. v. Bus. Planning Sys., Inc., 2008 WL 1932404, at *6 (Del. Ch.). As such, it is the express legislative policy of the Delaware Limited Liability Company Act (the “LLC Act”) “to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” 6 Del. C. § 18-1101(b). Members thus enjoy tremendous freedom to organize their business and affairs in the way that they see fit. This includes deciding who or what is to serve as the manager of the LLC. Section 18-401 provides that “[a] person may be named or designated as a manager of the limited liability company.” Section 18-101(12) defines “Person” as “a natural person, partnership (whether general or limited), [or a] limited liability company [among other entities].” Thus, the LLC Act expressly provides for an entity-managed LLC.

Section 18-1101(c) states that the LLC agreement can expand, restrict, or eliminate the fiduciary duties owed by the manager “or to another person that is a party to or is otherwise bound by a limited liability company agreement. . . .” Accordingly, the members could agree that a controller of the entity manager owes fiduciary duties to the LLC, or could specifically elect to eliminate any such duties.

Our Supreme Court has recently reminded us that: “[I]nvestors in [LLC] agreements must be careful to read those agreements and to understand the limitations on their rights,” The Haynes Family Trust v. Kinder Morgan G.P., Inc., 2016 WL 912184, at *1 (Del.) (ORDER), and further that, “[i]nvestors must appreciate that with the benefits of investing in alternative entities often comes the limitation of looking to the contract as the exclusive source of protective rights.” Dieckman v. Regency GP LP, 155 A.3d 358, 366 (Del. 2017); but see, Leo E. Strine, Jr., & J. Travis Laster, The Siren Song of Unlimited Contractual Freedom (Robert W. Hillman & Mark J. Loewenstein eds., 2015) (“But because bargaining, at best, occurs only sometimes . . . the practical alternatives for a skeptical investor are often stark: invest without adequate protection against self-dealing or avoid the asset class altogether”). Indeed, “investors can no longer hold the general partner to fiduciary standards of conduct, but instead must rely on the express language of the partnership agreement to sort out the rights and obligations among the general partner, the partnership, and the limited partner investors.” Dieckman, 155 A.3d at 366. As a result, the contractual nature of LLCs supports the argument that the LLC agreement should control when determining who owes what fiduciary duties.

Equitable Principles Under Common Law

At the same time, LLCs are not “purely contractual,” because an “LLC has powers that only the State of Delaware can confer.” In re Carlisle Etcetera LLC, 114 A.3d 592, 606 (Del. Ch. 2015). Accordingly, “the State of Delaware retains an interest in having the Court of Chancery available when equity demands. . . .” Indeed, “equity backstops the LLC structure,” because Section 18-1104 states that: “In any case not provided for in this chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.” Thus, USACafes’ hypothetical conjures up the equitable maxims of “equity will regard substance over form” and “[e]quity always attempts to . . . ascertain, uphold, and enforce rights and duties which spring from the real relations of parties.” Monroe Park v. Metro. Life Ins. Co., 457 A.2d 734, 737 (Del.1983). At bottom, USACafes is premised on the notion that those who control the entity manager must be viewed as one in the same as the entity they control. Martin v. D.B. Martin Co., 88 A. 612, 615 (Del. Ch. 1913) (“For the protection of the rights of stockholders of the dominant, or parent company, and for righting of wrongs done them by means of the control of the dominant, or parent, company . . . the latter are to be treated as agents of the former, or even as identical with each other.”). Accordingly, the nature of alternative entities and the equitable principles discussed above appear to be in tension. See Feeley v. NHAOCG, LLC, 62 A.3d 649, 669 (Del. Ch. 2012) (“The Delaware alternative entity statutes highlight the tension between corporate separateness and the outcomes achieved in equity by imposing fiduciary duties on those actually in control.”).

Addressing the Tension

Indeed, much ink has been spilled over USACafes ignoring the “bedrock” principle of corporate separateness (even though there are many equitable exceptions); disregarding black letter contract law (same); or placing directors “in the situation of having potentially conflicting and irreconcilable fiduciary duties” to different entities. Bay Ctr. Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451, at *9 & n.44 (Del. Ch.) (citations omitted). These critiques have some validity, but they cannot be premised on the notion that equity is powerless to act or that the equitable aims of USACafes are invalid. Carlisle Etcetera, 114 A.3d at 606. There is no perfectly drafted LLC agreement and therefore there will always be gaps to fill and situations when a court will need flexibility to address the situation. Schoon v. Smith, 953 A.2d 196, 204–05 (Del. 2008) (“[T]he Chancellor always has had, and always must have, a certain power and freedom of action, not possessed by the courts of law, of adapting the doctrines which he administers.”); see also Huatuco v. Satellite Healthcare, 2013 WL 6460898, at *7 (Del. Ch.) (balancing equitable concerns in the context of the agreed upon bargain), aff’d, 93 A.3d 654 (Del. 2014).

But that flexibility—which is codified in Section 18-1104—is also limited by Section 18-1104 to “case[s] not provided for in this chapter”—meaning that equitable considerations have no place in resolving matters expressly provided for in the LLC Act, or by extension, an LLC agreement. As discussed above, the LLC Act provides the members of an LLC with the express authority to limit fiduciary duties to an entity manager. “If the parties have agreed how to proceed under a future state of the world, then their bargain naturally controls.” Lonergan v. EPE Holdings, LLC, 5 A.3d 1008, 1018 (Del. Ch. 2010). Indeed, “investors must rely on the express language of the [operating] agreement to sort out the rights and obligations. . . .” Dieckman, 155 A.3d at 366. Rather than engrafting the duty of loyalty onto the human controllers of entity managers, when the duties of the entity managers themselves are subject to modification or elimination by the LLC agreement, the equitable aims of USACafes are better served at the remedy stage through veil piercing or joint and several liability—a court’s traditional equitable powers. Keenan v. Eshleman, 2 A.2d 904, 908 (Del. 1938) (affirming order of joint and several liability because, “[t]he conception of corporate entity is not a thing so opaque that it cannot be seen through.”); Gotham Partners, 2000 WL 1476663, at *20.

That approach better balances the contractarian policy goals of the alternative entity statutes and the Court of Chancery’s constitutional authority to “extend those doctrines to new relations, and shape . . . remedies to new circumstances, if the relations and circumstances come within the principles of equity. . . .” Schoon, 953 A.2d at 204–05.

Conclusion

The Delaware Supreme Court has never expressly adopted (or rejected) the reasoning of USACafes. See Feeley, 62 A.3d at 671 (“The Delaware Supreme Court indisputably has the authority to revisit this Court’s approach and address the tensions created by USACafes.”). Returning the law to the pre-USACafes state of play will allow both the contractarian goals of the alternative entity statutes and the Court of Chancery’s equitable aims to work harmoniously.

For defense counsel, this presents an opportunity to raise the issue in the appropriate case and potentially obtain clarity in our law.

Aaron M. Nelson

Associate, Heyman Enerio Gattuso & Hirzel LLP

Aaron M. Nelson is an associate at Heyman Enerio Gattuso & Hirzel LLP in Wilmington, Delaware, where he practices corporate, alternative entity, and complex commercial litigation, including business divorce cases involving the dissolution of privately held business entities.