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Carter G. Bishop: Are Delaware LLC Members Status Fiduciaries Imbued With Loyalty?

Are Delaware LLC Members Status Fiduciaries Imbued With Loyalty?

 

Professor Carter G. Bishop

Suffolk University Law School

 

It is a daunting task to develop only two pages of commentary regarding Delaware LLC fiduciary duty jurisprudence. Delaware statutory law articulates a clear relationship between the LLC Act and a limited liability company agreement by authorizing the complete elimination of any member, manager or other person’s fiduciary duties, including loyalty, while preserving only the implied contractual covenant of good faith and fair dealing.[1] As a result, the Act is simply a set of default rules that may be varied by the agreement with a single admonition against contractual bad faith.

A sound of silence exists between the Act’s default rules and the express provisions of the agreement. The Act expressly declares that void is filled by implied good faith designed in spirit to protect the reasonable expectations of parties to the agreement. But is there more? Specifically, does the fiduciary duty loyalty also fill the void by expanding the protections available under the good faith? This answer is clouded by equivocal judicial history generally recognizing common law loyalty springing from fiduciary relationships created by the parties. [2]

Since the power of a person to bind another is the hallmark of an agency relationship,[3] it is simple enough to argue the duty of loyalty[4] springs from that fiduciary relationship under Delaware common law.[5] On the other hand, Delaware law is designed to grant maximum effect to freedom of contract[6] in part by broadly construing statutory law and narrowly construing common law.[7]

In this highly charged context, it is fair to ask whether the common law fiduciary duty of loyalty undermines the statutory respect for the power of the limited liability agreement by implying loyalty obligations the parties did not reasonably expect. Is it appropriate for judicial implications of loyalty duties exceeding the reasonable expectations protected by good faith? In a thoughtful inquiry, Chief Justice Steele argues loyalty does not have a viable role.[8] Rather, he argues that under Delaware law contract is supreme, contractual good faith is the sole limit on selfish behavior, and the common law implied duty of loyalty is a poor ex post proxy to protect an ex ante unexpressed contractual expectancy.[9]  Chief Justice Steele relies on contractual supremacy under Delaware statutory law, the failure of Delaware law to positively state fiduciary duties,[10] and the law of economics suggesting that a corporate fiduciary model is inappropriate because all the parties chose a Delaware LLC contractarian model.[11]

Stated this way, implying additional loyalty duties beyond those reasonably expected under good faith is more likely to frustrate the original intent of the parties than fulfill it. Unlike a pure agency relationship but like a contractual relationship, parties are expected to behave selfishly. The larger question is the legal limit of selfish behavior, especially when that conduct unduly prefers the interest of the actor at the expense of other LLC members.

Contract law provides a limit to selfish behavior. A contract party may not act to deprive the other party their reasonable expectations. A film studio may not fail to exercise legitimate subjective dissatisfaction by simply not even considering film proposals by the other party.[12] But a party may fail to exercise a put option on its LLC interest even though exercising or eliminating the put may have benefited the other party.[13]

What is to be made from this patchwork? Contractual self-interested behavior is assumed, tolerated and constrained only by contractual good faith and fair dealing designed to protect the reasonable expectations of the other party arising from duties expressed in the contract.[14] The judicial search must be confined to finding a derivative expressed contractual intent rather than an implied fiduciary intent. In Delaware, a party to a limited liability company agreement need only search the agreement for implied rights. Anything else merely dresses a breach of contract claim in fiduciary duty clothing[15] and risks total frustration rather then fulfillment of contractual intent. It also sacrifices predictability. Specifically, when a party affirmatively exercises a right expressed in the limited liability agreement, they may do so perfectly selfishly unless to do so contravenes a reasonable expectation of the other party. When a party exercises selfish conduct not addressed by the agreement, the other party may not rely on an implied duty of loyalty to block the exercise. This paradigm, like contract law, forces the parties to actually efficiently bargain for express limitations on selfish behavior or expect it. If reasonably expected, the courts should not condemn the conduct. In Delaware, contractual freedom comes a duty to “scriven with precision.”[16] A duty of loyalty should not be implied to add protections not safeguarded by the reasonable expectations of the parties under good faith. Judicial review should begin and end with a fair understanding of the terms of the agreement and the resulting reasonable expectation of the parties. Specifically, like a contract, the parties to an LLC agreement should expect self interested behavior when not limited by the express or implied understanding of the agreement.

 


[1]DEl. CODE ANN., tit. 6 § 18-1101(c). The Act preserves both the “duty” of good faith as well as “liability” for bad faith breaches of the agreement. Compare DEl. CODE ANN., tit. 6 §§ 18-1101(c) and (e).

[2] Lerner v. Westreich, 819 N.Y.S. 2d 210, 213 (Sup. Ct. 2006) (“Delaware courts have found that a manager of a limited liability corporation owes a fiduciary duty of loyalty to the LLC, its investors and his fellow managers under the common law.”) and VGS, Inc. v. Castiel, 2000 WL 1277372, *4 (Del. Ch. Ct. Aug. 31, 2000), aff’d, 781 A.2d 696 (Del. 2001) (LLC managers breached their duty of loyalty by secretly orchestrating a squeeze-down merger of the LLC).

[3] RESTATEMENT (THIRD) OF AGENCY § 1.01 (2006).

[4] RESTATEMENT (THIRD) OF AGENCY §§ 8.01-8.05 (2006) (material benefit, adverse party, competition and use of property including confidential information).

[5] RESTATEMENT (THIRD) OF AGENCY § 8.01 (2006).

[6] DEl. CODE ANN., tit. 6 § 18-1101(b).

[7] DEl. CODE ANN., tit. 6 § 18-1101(a).

[8] Myron T. Steele, “Freedom of Contract and Default Contractual Duties In Delaware Limited Partnerships and Limited Liability Companies,” 46 Am. Bus. L. J. 221,  (2009).

[9] Id at 236.

[10] Id at 242.

[11] Id.

[12] Locke v. Warner Bros., Inc., 57 Cal. App. 4th 354 (Ct. App. 1997).

[13] Fisk Ventures, LLC v. Segal, 2008 Del. Ch. LEXIS 158, at * 37-38 (De. Ch. May 7, 2008).

[14] Fisk Ventures, LLC v. Segal, 2008 Del. Ch. LEXIS 158, at * 37-38 (De. Ch. May 7, 2008).

[15] Id at 41.

[16] Willie Gary, LLC v. James & Jackson LLC, 2006 WL 75309 (Del. Ch. Jan. 10, 2006) (interpreting agreement that provided generally for arbitration while allowing claims for judicial injunctive and dissolution relief and stating “[w]ith the contractual freedom granted by the [Delaware] LLC Act comes the duty to scriven with precision.”).