Fiduciary Duty Default Standards Are Applicable to LLCs -- Delaware Chancery's Reasoning

Peter J. Walsh, Jr., T. Brad Davey, Thomas A. Mullen, and David B. DiDonato of Potter Anderson & Corroon LLP

Original Title: Auriga Capital Corp. v. Gatz Properties, LLC, C.A. No. 4390-CS (Del. Ch. Jan. 27, 2012) (Strine, C.)

In this opinion, the Delaware Court of Chancery found that a majority owner and manager of a limited liability company breached his contractual and fiduciary duties when he attempted to obtain the ownership interests of the minority members in bad faith. In doing so, the Court held that traditional fiduciary duties apply in a limited liability company context unless a limited liability company agreement provides otherwise.

The company at issue was Peconic Bay, LLC, a Delaware limited liability company ("Peconic Bay" or the "Company"). The manager of the Company was defendant Gatz Properties, LLC, a Delaware limited liability company ("Gatz Properties"), which was managed, controlled, and partially owned by defendant William Gatz ("Gatz"). Gatz was the sole actor on behalf of Gatz Properties, and therefore, essentially acted as the manager of Peconic Bay. Gatz and his family also held the majority voting control over the Company, while numerous other investors (the "Minority Members") owned the remaining interests.

Gatz and his family leased a valuable piece of property to Peconic Bay to operate a golf course (the "Lease"). The Company then sublet the property to American Golf Corporation ("AG") for the same purpose (the "Sublease"). Five years into the 35-year Sublease, Gatz realized that AG would have to exercise its right to terminate the Sublease ten years into the endeavor because AG could not make a profit. Gatz knew that a replacement strategy for the AG contract was necessary for the Company to remain viable. Instead of trying to find a new sublessee or a new investment strategy, however, Gatz failed to take any steps to protect the interests of the Company and the Minority Members. Through numerous misrepresentations and bad faith acts, Gatz tried to buy out the Minority Members for a low price to become the sole owner of the Company. The Minority Members eventually sued for damages, arguing that Gatz breached his contractual and fiduciary duties through his course of conduct.

In analyzing the plaintiffs' claims, the Court of Chancery first discussed what duties Gatz owed to the members of the Company. The Court held that the traditional fiduciary duties of care and loyalty apply in a limited liability company context as long as the members do not contract them away. After reviewing Peconic Bay's operating agreement (the "LLC Agreement"), the Court found that the LLC Agreement did not displace these duties and Gatz, therefore, owed the members of the Company the fiduciary duties of care and loyalty. In addition, the Court found that Section 15 of the LLC Agreement provided a contractual duty not to deal with affiliates of the members or managers unless the deal was approved by the non-affiliated members or gave the Company a price as favorable as it would have received from an arms-length third party.

The Court then applied these contractual and fiduciary duties to the facts and found that Gatz breached these duties on four separate occasions. The first breach occurred when Gatz failed to take any good faith steps to address the loss of AG as a sublessee. Faced with the possibility of losing the Company's primary source of revenue, the Court stated that a responsible fiduciary would have made a good faith effort to find a new sublessee, explore new profitable business models, or find a buyer to acquire Peconic Bay. The second breach came when Gatz turned away a credible buyer, RDC Group, Inc. ("RDC"), that was willing to purchase the Lease and Sublease for an amount equal to the members' investments in Peconic Bay. Specifically, Gatz misrepresented his intention not to sell the Company's assets, refused to provide material information to RDC and dissuaded RDC from making an offer to buy the Company's assets in excess of the Company's debt. The Court stated that a reasonable fiduciary would have instead made a good faith effort to explore the possibility of selling the Lease and Sublease to make up for the loss of the Company's primary revenue source.

The third breach occurred when Gatz played "hardball" with the Minority Members in an attempt to buy out their interests. Gatz did so by providing misleading and incomplete information to the Minority Members regarding RDC's offers to buy the Company's assets. Instead of informing the Minority Members that RDC offered enough money for the Minority Members to get a return of their investments, Gatz only informed them of its lower offers. He did so to make the Minority Members believe that the Company was worth less than its actual value, so Gatz could make a low-ball offer to buy out their interests. As such, the Court found that Gatz breached his duties of loyalty and care to the Minority Members.

The fourth breach came when Gatz ran a "sham" auction to sell the Company in light of the coming expiration of AG's Sublease. The Court found that Gatz failed to make a genuine effort to obtain the best price for the Company so that he could purchase the Company for a low price. Specifically, Gatz hired an inexperienced auctioneer when experienced auctioneers were available, allowed for only 90 days to market the auction, made no effort to contact known golf course brokers, managers, or operators of the auction, did not inform RDC of the auction, and used essentially worthless advertisement efforts to sell the Company. The Court, therefore, held that Gatz breached his fiduciary duties to the Company. In addition, when Gatz bought the Company at auction for a low price, the Court found that Gatz breached his contractual duty under Section 15 of the LLC Agreement to obtain a price as favorable as it would have received from an arms-length third party. The burden was on Gatz to prove that he obtained a fair price, which he could not do because of his bad faith efforts to market the auction.

In his defense, Gatz argued that Section 16 of the LLC Agreement exculpated Gatz for his conduct. Section 16 provided that Gatz would only be liable for a breach of a fiduciary duty if the breach was in bad faith, or the result of gross negligence, willful misconduct, or willful misrepresentation. Further, to be protected by this provision, Gatz's actions must have been "on behalf of the Company." The Court concluded that the provision did not exculpate Gatz because (i) the auction violated Section 15 of the LLC Agreement and, therefore, was not an act "on behalf of the Company," and (ii) Gatz's actions were taken in bad faith. Finally, because of the bad faith actions taken by Gatz and his counsel, the Court of Chancery awarded the plaintiffs one-half of their reasonable attorneys' fees and costs.

Delaware Case Law Relevant to Venture Capital Community

In this buzz article Potter Anderson & Corroon LLP attorneys will provide an update on decisions of the Delaware Court of Chancery and the Supreme Court of Delaware that are particularly relevant to the venture capitalist community. These courts are among the most influential tribunal in the world regarding corporate matters and alternative entities and therefore contribute significantly to shaping the law that affects sophisticated venture capitalist transactions.

Peter J. Walsh, Jr., Partner, Corporate Group,

Mr. Walsh is a corporate and commercial litigator. He has first-chaired many trials in the Delaware courts, and has successfully argued cases before the Supreme Court of Delaware and in the United States Court of Appeals for the Third Circuit. He regularly handles Delaware Court of Chancery proceedings, including stockholder class and derivative actions, summary proceedings pursuant to the General Corporation Law of the State of Delaware, and hostile takeover proceedings. Mr. Walsh also frequently counsels officers and directors, committees of the board and the Delaware corporations they serve in matters of Delaware corporate law, primarily as such matters bear upon ongoing or anticipated litigation.

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T. Brad Davey, Partner, Corporate Group,

Mr. Davey's practice focuses primarily on business and corporate litigation in the Delaware Court of Chancery. Mr. Davey represents directors, stockholders and special committees in corporate governance and mergers and acquisition litigation involving a broad range of industries including communications, software, energy, private equity and financial institutions.

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Thomas A. Mullen, Partner, Business Group,

Mr. Mullen's practice focuses on business transactions, particularly the structure and use of Delaware corporations, partnerships, limited liability companies and statutory trusts. Mr. Mullen's practice includes counseling corporations, investors, directors and board committees on matters involving the General Corporation Law of the State of Delaware and related fiduciary duty issues arising in a variety of transactions and circumstances, including mergers and acquisitions, defensive planning, recapitalizations and liquidations. Mr. Mullen also advises on the use of Delaware LLCs, partnerships and statutory trusts in a broad range of transactions, including structured financings, formation of private equity funds and joint ventures, and mutual fund reorganizations. He frequently provides legal opinions concerning Delaware business entity statutes and corporate law issues.

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David B. DiDonato, Associate, Corporate Group,

Mr. DiDonato's practice involves counseling Delaware corporations on corporate law and governance issues. His practice also focuses on corporate and commercial litigation in the Delaware Court of Chancery.

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Potter Anderson & Corroon LLP

Potter Anderson & Corroon LLP represents Fortune 500 companies, some of the largest national law firms, and individuals in connection with complex corporate and commercial litigation in the Delaware Court of Chancery and Supreme Court of Delaware while also counseling such clientele on corporate law and governance issues under Delaware law.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Potter Anderson & Corroon LLP. This work reflects the law at the time of writing.

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