Challenging Traditional Thought: Chief Justice Steele’s Proposition on Default Contractual Duties for Delaware Limited Liability Companies Tests Delaware Jurists and Practitioners’ Presumptions That All Business Entities Must Necessarily Be Formed With Fiduciary Duties
Professor Ann E. Conaway·
I agree with Chief Justice Myron T. Steele in his article, Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies, that the proper default rule for Delaware limited liability companies (“LLCs”) formed under the Delaware Limited Liability Company Act (“DLLCA” or “Act”) is the contractual duty of good faith and fair dealing. As his history as Vice Chancellor of the Delaware Court of Chancery and Justice of the Delaware Supreme Court, before taking the helm as Chief Justice has proven, Myron T. Steele is a judicial scholar of rare business prescience. Because Chief Justice Steele willingly examines Delaware’s popular alternative entity statutes with exceptional rigor and demand is laudable and demands reasoned – not kneejerk – legal reaction and examination. It is my hope in this article to set forth rational, reasoned principles supporting the Chief Justice’s article. I invite each reader to set aside bias, pre-conceived legal opinions, and rote legal training and to listen. Hearing each legal argument and searching for– not assuming – the most appropriate answer to the question of default duties is our quest.
Unlike my “bomb-throwing” colleagues who mask legal arguments behind clever rhetoric, my opinion is based upon the construction of DLLCA, the lack of extant common law at the enactment of DLLCA, the absence of vicarious liability for members or managers of a Delaware LLC, and the ability of contract policing techniques to render “equity” in the circumstance of an unsophisticated, unrepresented party to a Delaware LLC agreement.
I. The Infrastructure of the DLLCA
A. Freedom of Contract
The DLLCA is unique among Delaware’s unincorporated entity acts. The Delaware General Assembly adopted the Act in 1992 as the last of Delaware’s preeminent unincorporated acts. Like the Delaware Revised General Partnership Act (“DRUPA”), and the Delaware Revised Limited Partnership Act (“DRULPA”), DLLCA contains the signature Delaware provision that provides:
“It is the policy of this chapter to give maximum effect to the principle of freedom of contract and to the enforceability of limited liability agreements.”
At the time of the enactment of this contractarian provision, the Delaware General Assembly made clear that: (1) limited liability companies were contractual in nature; and (2) contractual principles were to be given dominance above tort-based, fiduciary principles like those applied by the Delaware Court of Chancery for almost one hundred years in the corporate domain.  Otherwise, the statutory language, “freedom of contract, coupled with “maximum enforceability of limited liability agreements” is unnecessary to the Act. In other words, unlike any other Delaware act, “freedom of contract” has a clear and intended meaning within DLLCA.
Freedom of contract in the context of a member-managed LLC, the default organization under DLLCA, is reasonable since a member must enter into an LLC agreement in order to form a Delaware LLC. Contract law does not impose fiduciary duties between parties to a bargain. The suggestion/assumption by my colleagues that every business organization is formed with fiduciary duties is silly. This legal position reflects rote application of business governance principles and ignores the unique structure of Delaware’s Act. Just as parties negotiating the purchase and sale of a business may bargain in self-interest, so may investors. The obvious benefit of a contractual, rather than a statutory, entity is that the bargained-for entity does not presumptively require fiduciary duties in a contractarian jurisdiction. On the contrary, no “contract or agreement” among the owner/s of a corporation is necessary to form a corporate entity – only the filing of a certificate of incorporation. Thus, the statutory language of DLLCA, as well as that in DRUPA and DRULPA, is clearly differentiated from any statutory, or common, law in the realm of corporations.
In addition, the provision for “freedom of contract” does not exist as a Delaware statutory corporate governance policy. Tort-based fiduciary duties that drive corporate internal affairs reflect the separateness between corporate managers and the accountability the managers owe to their indirect residual owners. These corporate fiduciary duties derive their authority from the common law as interpreted under general authority provisions of the Delaware General Corporation Law (“DGCL”).
The Delaware statutory provision enabling “freedom of contract” manifested clear legislative intent and signaled a unique beacon for Delaware. Foremost, in an entity context, “freedom of contract” signifies to a reviewing court that a Delaware LLC is a bargained-for, contractual entity where terms are not uniformly set by statute, but rather are dictated by the parties and the marketplace. In this sense, parties may choose a lesser bargain in a difficult market in the hope that the first bargain will lead to a second on better terms in the future. Second, freedom of contract also represents that parties may bargain in self-interest or freely waive self-interest, if desired. Third, contractual freedom and its duty of good faith and fair dealing (that attaches to the performance of actual and not missing terms) most importantly permit parties to determine for themselves whether to contract or to walk away from the bargaining table due to unfair or untenable terms. This latter contractual tenet is known as “freedom from [judicial] contract.” Finally, “freedom of contract” does not impose fiduciary duties except in the instance of the unusual relationship where one party reposes trust and confidence in another and the other party knows of this special reliance. In the aggregate, statutory “freedom of contract” clearly calls for default contractual duties.
B. Linkage and the Common Law
In addition, DRULPA specifically “links” to the Delaware Uniform Partnership Act (“DUPA”) which, when enacted, “dragged along” the common law of general partnerships. Therefore, a court faced with the issue of whether tort-based fiduciary duties exist under DRULPA is required to interpret the “linkage” provision in DRULPA that provides:
“In any case not provided for in this chapter, the Delaware Uniform Partnership Law in effect on July 17, 1999 (cites omitted) and the rules of law and equity, including the Law Merchant, shall apply.”
The essential common law of general partnerships that transferred into DUPA, and thus into the “linkage” provisions, was that pronounced in the seminal case of Meinhard v. Salmon. In the Meinhard case, the defendant, approximately four months before the expiration of a 20-year lease, executed a new lease with the lessor without first disclosing the new lease to his “coadventurer.” Justice Cardozo, writing for the majority, found the non-disclosure to be a breach of “the duty of finest loyalty.” Justice Cardozo seemed not to like the fact that the defendant managed the venture and had bargained for day-to-day control of the leased property. Importantly, Justice Cardozo states that he need not decide that if defendant had disclosed the opportunity for the new lease and then competed and won the opportunity whether a breach would have occurred.
As examined in a prior writing, the “duty of loyalty” in Meinhard did not arise under the existing statute at the time – UPA (1914). However, a reference in the case notes the actions of the defendant in his capacity as an agent. Under the Restatement (Second) of Agency, however, the duty of care is not the same as a corporate fiduciary duty of care. The Restatement (Second) of Agency does, however, articulate a duty of loyalty. If the Restatement (Second) of Agency is the source of Justice Cardozo’s “duty of finest loyalty” then the duty’s application is limited to actions by a partner with third parties – as were the facts in the case that so held. The duty of loyalty would not attach to partners or co-venturers inter sese. Yet, without any serious examination of Meinhard or the foundation of its holding, subsequent courts have applied the “duty of finest loyalty” with unrestrained judicial abandon for decades.
The DLLCA, however, has no linkage provision. All answers regarding “fiduciary duties” are contained in Act. The DLLCA includes no standards of conduct within its provisions. However, DRUPA clearly provides standards of conduct for partners in a Delaware general partnership. Thus, when the Delaware General Assembly saw fit to incorporate standards of conduct within an unincorporated act, it did so in an obvious and unmistakable manner. Standards of conduct, or tort-based fiduciary duties, are wholly absent within DLLCA.
In addition to the nonexistence of fiduciary standards in DLLCA, at the time of its enactment, there was no extant common law of fiduciary duties for limited liability companies. The DLLCA is a hybrid entity and is unique in this respect from all Delaware unincorporated organizations. The only provision of DLLCA that raises a hint of duties is § 18-402 that provides:
“Unless otherwise provided in a limited liability company agreement, each member and manager has the authority to bind the limited liability company.”
Section 18-402 does not use the term “agent” to describe the authority of the member and manager. However, it seems logical that the “authority to bind the limited liability company” refers to acts regarding third parties and thus can be assumed to relate to agency authority. The Restatement (Third) of Agency imposes fiduciary duties on agents with respect to their principals – here, the LLC. However, even in its broadest interpretation, this single reference to “binding” the entity cannot bootstrap itself into a general argument for default fiduciary duties inter sese.
C. Section 18-1101(c) – The Modification or Elimination of Duties in a Delaware LLC Agreement
In the 1992 version of the DLLCA, parties to a Delaware LLC agreement could:
“[E]xpand or restrict duties (including fiduciary duties) owed by a person or member to each other or the entity or to another person, provided that the limited liability agreement did not eliminate the implied contractual covenant of good faith and fair dealing.”
In 2004, the General Assembly amended the language “expand or restrict,” when used to describe the contractual parameters of duties, to make clear that “restrict” included “eliminate.”
Some commentators may suggest that the parenthetical language of § 18-1101(c) is conclusive evidence that fiduciary duties were intended by the General Assembly as default fiduciary obligations. This conclusion is presumptive and incorrect for three reasons.
First, the structure of the opening sentence to § 18-1101(c) suggests that duties do not exist. For example, § 18-1101(c) provides: “to the extent that duties exist . . . “, they may be modified or eliminated. In the DGCL at § 102(b)(7), the Delaware General Assembly stated that a corporation could amend its certificate of incorporation to include:
“A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a directors: (i) For any breach of the director’s duty of loyalty to the corporation or its stockholders….”
As evidenced by the language of § 102(b)(7) of the DGCL, when the Delaware General Assembly intended to refer to extant fiduciary duties, it clearly knew how to do so. By comparison, the language of the DLLCA § 18-1101 does not refer to any fiduciary duties owed by or to any person.
Second, at § 18-402 of DLLCA, each member or manager of a Delaware LLC may “bind” the limited liability company. To the extent the member or manager exercises “agency” authority in “binding” the LLC, agency law imposes certain fiduciary duties upon the agent to the principal – here, the LLC. Certainly, § 18-1101(c) permits parties to modify or eliminate any fiduciary duty arising under agency, not LLC, law.
Finally, contract law recognizes one exception to the rule that no fiduciary duties exist in a bargained-for exchange. That exception arises where one party reposes special trust and confidence in another, and the other party knows and accepts this special relationship. Again, in the circumstance of full knowledge and consent by contracting parties, § 18-1101(c) permits the modification, and possible elimination, of a “special” contractual fiduciary duty.
In each of these examples, the language of § 1101(c) illustrates that no fiduciary duty is created between and among members and managers inter sese or between members and managers and the LLC. The statutory provision merely provides that, to the extent that duties (including fiduciary duties) exist by way of other law, those duties are subject to modification and elimination. Section 1101(c) does not enable fiduciary duties. If the statutory provision were meant to be enabling, the General Assembly was quite knowledgeable in 2004 as to how to draft standards of conduct as it did in 2001 in DRUPA at § 15-404.  The General Assembly obviously chose not to do so in § 18-1101(c).
II. When Are Fiduciary Duties Necessary?
- A. General Rule
Common law fiduciary duties are imposed where parties are in a special relationship and one party has superior knowledge or control over another. A classic example is that of a trustee over the res of a trust with residual beneficiaries who cannot either control the trustee or safeguard trust res. In this case, the trustee is held to a very strict standard of safeguarding trust assets for the benefit of trust beneficiaries.
Another example is that developed by the common law of publicly-traded corporations. In a publicly-owned corporation, shareholders/owners exercise their right to elect directors at an annual meeting. In general, directors will thereafter manage the business and affairs of the corporation until the next annual election of directors. In order to assure that directors are accountable to shareholders during the course of each year, corporate common law developed tort-based fiduciary duties that directors must satisfy or suffer litigation at the hands of shareholders. These fiduciary duties are the duties of care and loyalty – recognizing that good faith is a component of these duties.
B. No Default Duties Are Warranted in a Delaware LLC
In the scheme of corporate governance, fiduciary duties are logical. A corporation is a creature of statute and is formed by a filing and not by an agreement of owners. As noted before, a Delaware corporation does not operate under a philosophy of “freedom of contract” – especially in the context of Fortune 500 corporations where an “agreement of shareholders” would be nonsensical. Recognizing, then, that corporations and LLCs exist as diverse paradigms and seek to achieve divergent legal stratagems, to argue that fiduciary duties exist in corporations and therefore should survive in all other limited liability entities is irrational and lacks a searching inquiry. The presumption that all business entities necessarily exist with fiduciary duties ignores DLLCA, its legislative purpose, and the absence of any common law for the LLC.
In a general partnership, fiduciary duties were deemed necessary since partners could create vicarious liability against other partners even though innocent partners rarely had knowledge of the misconduct of the tortfeasor partner. Standards of conduct were adopted by Delaware in the DRUPA. Similarly, in a limited partnership, the common law developed fiduciary duties based upon the statutory structure of a limited partnership. Unlike the general partnership, the Delaware limited partnership, by statute, requires two persons – at least one general partner and one limited partner. The general partner has the same powers as a general partner in a general partnership and the limited partner may not participate in control of the limited partnership. Therefore, like the corporation with separation of control and management, the limited partnership common law imposed a fiduciary duty upon the general partner as the statutory person in control of the entity to the exclusion of the limited partner.
The Delaware LLC, on the other hand, is unlike both the Delaware general and limited partnerships. Statutorily, then, by far the most compelling reason against imposing a default fiduciary duty is that one is not needed. In a Delaware LLC, the default entity is member-managed. In a member-managed LLC, no member has liability for LLC obligations and no member can create vicarious liability for other members. Thus, unlike a general partnership where partners can create vicarious liability against other partners, the parallel is not true for a member-managed LLC. In addition, in an LLC each member bargains for whatever economic and voting rights the deal dictates. Those rights range from non-economic rights, non-voting rights, and economic rights based upon capital contributed, to per capita voting rights. It is an inaccurate assumption that every member-managed Delaware LLC is organized and capitalized in the same manner. Without some compelling evidence of a default legal infrastructure in DLLCA that indicates that members who, under a scheme of freedom of contract, always find themselves in an undesired, “frozen-out” situation, imposition of fiduciary duties necessarily alters the parties’ bargain. Therefore, reading the clear intent of the General Assembly’s provision for “freedom of contract,” the only appropriate conclusion is that adoption of default fiduciary duties counteracts free will as well as parties’ ability to tailor their deals according to specific desires, including self-dealing. The application of default fiduciary duties affronts an obvious State policy of contractual freedom and will result in rampant judicial interference in bargained-for exchanges, market inefficiency, increased agency costs, and the loss of Delaware’s preeminence in the field of LLCs.
III. Saving Unsophisticated, Unrepresented and Ignorant parties From the Bargains They Make
Some commentators allege that fiduciary duties are necessary in every business organization that potentially involves unsophisticated or unrepresented parties who are unable to “bargain” for “fair” contract terms. There are several reasons that this argument fails.
First, in the seminal Delaware case of Nixon v. Blackwell, involving the application of the “entire fairness” doctrine, the Delaware Supreme Court succinctly stated:
“[The plaintiffs’] argument takes the following form: fiduciary principles require fair conduct; equal treatment is fair conduct; hence, fiduciary principles require equal treatment. The conclusion does not follow. The argument depends on an equivalence between equal and fair treatment. To say that fiduciary principles require equal treatment is to beg the question whether investors would contract for equal or even equivalent treatment.”
For the same reason stated in Nixon, it is a faulty assumption that even unsophisticated investors would bargain for “fair” or even “equal” treatment if a first “unfair” agreement placed them in a position for a future opportunity for a second “fair” agreement.
Second, as noted in Nixon, contract principles also do not impose a “fairness” or “equality” standard for parties to a bargain. Just as in the above example, to require a “fair” bargain between arm’s length parties nullifies each party’s ability to negotiate for those terms that are most advantageous to one party and to “give up” those terms that have lesser significance. In a down economy, many investors are willing to negotiate on terms today that they would not have accepted three years ago – does this fact make the contract unfair? A contract is a bargain sought and returned; each promise exchanged in return for the other. If both parties seek a bargained-for exchange, the courts should enforce the exchange without reference to “equality” or “fairness” – the contract is the parties’ deal.
In the event a sophisticated party uses sharp practices against a party of lesser mental agility, contract law offers policing techniques to unwind the damage. For example, if economic duress is present, a court may reform the contract. Unconscionability is another judicial device for not enforcing terms that are shocking to the judicial conscience. Other policing devices include failure of assent, interpretation against the drafter, adhesion contracts, mutual mistake, impracticability, or frustration of purpose.
The contractual duty of good faith and fair dealing is available for the enforcement and performance of agreed to terms – not the implication of missing terms. The duty of good faith and fair dealing is also not a freestanding, independent duty separate from a breach of underlying contract terms. Where the duty of good faith and fair dealing consistently arises in entity law is typically in the interpretation of “satisfaction” or “discretion” clauses. Thus, parties may choose to bargain for one side to have “full discretion” in managing the business except to the extent the “discretion” impacts the withdrawal of the other party’s funds after a specified interval. In this circumstance, the parties have shifted all managerial decisions to one person with the limited exception noted. In the same manner, an investor could bargain for the payment of specific management fees if a fund is performing to the investor’s “satisfaction.” In the latter example, the investor holds no management power, but does retain all authority over the payment of management fees. Historically, “satisfaction” and “discretion” clauses shift the balance of control absolutely from one side to another unless exceptions are drafted. Parties bargain for these “control” devices and may enforce them in self-interest – just as they were negotiated.
Finally, parties are free intentionally to breach a contract – especially a losing contract – and not pay punitive damages. The breach may be willful, intentional, and thus arguably in “bad faith.” However, because contract law compensates the injured party with a suit for damages, no “extra” reparation will be awarded for the “bad faith” breach. The economics of the rules are sound. If a party finds itself in a 15-year contract at a market price that is now increasing at an unforeseen rate, the losing party should be free to breach the contract, cut its losses, and pay the contract damages owed to the non-breaching party. Even though the breach is intentional, the non-breaching party is fully compensated by a money award and the losing party has mitigated its losses. The “bad faith” breach is paid. No punitive damages are necessary since the breach was economically sound and “societal penance” or “moral reforms” are illogical concepts in contract law absent an accompanying tort.
There is no historical or common law that suggests fiduciary duties arise in member-managed LLCs – the default entity under DLLCA. This fact is true around the United States as well. But the Delaware Act is extremely unique. The DLLCA was drafted to include a STATE policy of “freedom of contract.” Only two other Delaware acts embody this policy. In one of those acts, DRUPA, the Delaware General Assembly codified standards of conduct for general partners – possibly due to the issue of vicarious liability; possibly due to the extant common law of partnerships. In the second act, DRULPA, a linkage provision sends a reviewing court to DUPA and the common law of general partnerships.
Structurally, only DLLCA has: (1) freedom of contract; (2) no linkage to another act with pre-existing common law; (3) no standards of conduct; and (4) no common law. The DLLCA is a hybrid act that must be interpreted by Delaware jurists, academics and practitioners as an independent act, linked to no other Delaware entity legislation either by way of common law or statutory device.
In addition, due to the flexible nature of the Delaware LLC, there is no “default” organizational infrastructure that warrants the imposition of fiduciary duties. Even in a manager-managed LLC, the manager may well be an employee and not a party to the LLC agreement. The term “manager” in an LLC may cover many forms of “management.” Without a default statutory structure that requires investor protection, default fiduciary duties undercut parties’ bargained-for agreements. Sophisticated deals will leave Delaware if courts can reform transactions on an ad hoc basis.
As for ignorant and unsophisticated parties, neither entity nor contract law requires “equal” nor “fair” deals since investors likely don’t bargain in this manner. In the event foul play or “inequity” arises in the context of a contract, courts have an arsenal of equitable contract remedies to reform, unwind, assess damages or enter a judgment suitable to the circumstances. The contractual duty of good faith and fair dealing, however, is not a “contractual fiduciary duty” in disguise and should not be used by courts as shorthand for a fiduciary duty.
- · Professor of Law, Widener University School of Law, Wilmington, Delaware. All rights reserved. © Ann E. Conaway 2011.
 16 Am. Bus. L. 221 (2009).
 Del. Code Ann. tit. 6, §§ 18-101 to 18-1109 (1992) (short form Delaware Limited Liability Company Act).
 Del. Code Ann. tit. 6, § 15-103(d).
 Del. Code, Ann. tit. 6, § 17-1101(c).
 Del. Code Ann. tit., 6, § 18-1101(b). The Delaware Statutory Trust Act refers the practitioner and court to trust, rather than contract, law. See Del. Code Ann., tit. 8, § 3809.
 See. e.g., In re Walt Disney Litig., 2005 Del. Ch. LEXIS 113 (Aug. 9, 2005)
 Del. Code Ann. tit. 6, § 18-201(a)(“In order to form a limited liability company, 1 or more authorized persons must execute a certificate of formation. The certificate shall be filed in the office of the Secretary of State. . . . “); Del. Code Ann., tit. 6, § 18-201(d)(“A limited liability company agreement shall be entered into or otherwise existing either before, after or at the time of the filing of a certificate of formation, . . . .”).
 Del. Code Ann. tit. 8, § 102(a),(b)(No shareholders/owners exist at the time of the filing of a certificate of incorporation).
 Del. Code Ann. tit. 8, §§ 141(a)(general authority of the board of directors); §142(officers); § 144 (interested transactions).
 Del. Code Ann., tit. 6, § 17-1105.
 164 N. E. 545 (N.Y. 1928)(Not applying UPA).
 Ann E. Conaway, The Multi-Facets of Good Faith in Delaware: A Mistake in the Duty of Good Faith and Fair Dealing; A Different Partnership Duty of Care; Agency Good Faith and Damages; Good Faith and Trust Law, 10 Del. L. Rev. 89 (2008).
 Del. Code Ann. tit. 6, § 15-404.
 Del. Code Ann., tit. 6, § 18-1101(c).
 Id. (2005).
 Del. Code Ann. tit. 8, § 102(b)(7)(i).
 Delaware adopted its Revised Uniform Partnership Act, effective June 1, 2001. See Del. Code Ann. tit. 6, §§ 15-101 to -1210 (2005). The Act was based upon the National Conference of Commissioners on Uniform State Laws (NCCUSL). Revised Uniform Partnership Act of 1997. In DRUPA, general standards for partner’s conduct are set forth at Del. Code Ann. tit. 6, § 15-404. A Delaware partnership agreement may provide for the limitation or elimination of all liability for breach of contract or breach of fiduciary duty other than liability for an act or omission that constitutes a bad faith violation of the implied contractual duty of good faith and fair dealing. Del. Code Ann. tit., 6, § 15-103(f).
 The other issue posed by any argument suggesting default fiduciary duties is what fiduciary duties would apply? The LLC is a hybrid entity with the default organization being member-managed. If default duties are being sought, then partnership duties such as those set forth in DRUPA § 15-404 are the logical default choice. However, there is presently in Delaware’s Court of Chancery cases in which the court has applied corporate duties without any reasoning or explanation. As noted by the Delaware Supreme Court in CML V v. Bax, 28 A.3d 1037 (Del. 2011), corporations and LLCs are different types of entities and operate under different sets of rules. This reasoning by the Delaware Supreme Court should apply equally to any attempted application of fiduciary principles in the context of LLCs or other alternative entities.
 Del. Code Ann., tit. 8, § 141(a).
 See In re Walt Disney Litig., 2005 Del. Ch. LEXIS 113 (Aug. 9, 2005).
 Stone v. Ritter, 911 A.2d 362 (Del. 2006).
 Del. Code Ann., tit. 6, § 18-404.
 Del. Code Ann., tit. 6, § 17-101(9).
 Del. Code Ann., tit. 6, § 17-403(a).
 Del. Code Ann., tit. 6, § 17-303(a).
 Del. Code Ann., tit. 6, § 18-303.
 626 A, 2d 1366 (Del. 1992).
 Restatement (Second) of Contracts § 17, § 79.
 Id. at § 208.
 Id. at § 205. Compare § 204.
 See, e.g., Paige Capital Mgmt., LLC v. Lerner Master Fund, LLC, 2011 Del. Ch. 116 (Aug. 8, 2011).