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Louis G. Hering: Commentary on Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies

Introduction.  I am very pleased to participate in the on-line symposium discussing certain of the issues raised by Chief Justice Myron T. Steele in his article Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies[1] (hereinafter, “Freedom of Contract”) and in the following note I make some brief observations on the role of default fiduciary duties in the operation of Delaware limited partnerships (“Delaware LPs”) formed under the Delaware Revised Uniform Limited Partnership Act[2] (the “DRULPA”) and Delaware limited liability companies (“Delaware LLCs”) formed under the Delaware Limited Liability Company Act[3] (the “DLLCA”).[4]  I begin by noting that I am only addressing transactions involving sophisticated parties and I assume that default fiduciary duties should apply among unsophisticated parties or transactions involving passive investors.[5]  Thus, the focus of my discussion is whether, as a matter of law and sound and efficient public policy, default fiduciary duties should apply to the relationships of sophisticated parties who are actively involved in the formation of Delaware LPs and Delaware LLCs.

The Legal Basis for the Imposition of Default Fiduciary Duties – Delaware LPs.  The seminal case of Boxer v. Husky Oil Company,[6] provides a logical starting point for the analysis of the application of default fiduciary duties to a general partner of a Delaware LP although it should be noted that the limited partnership in question in the Boxer case was actually a Colorado limited partnership.[7]  In the Boxer case, the Court first considered Section 403(a), a so called “linkage” provision, of the Uniform Limited Partnership Act, the predecessor to the Revised Uniform Limited Partnership Act upon which the DRULPA is based and which the Court noted was then in effect in both Colorado and Delaware.[8]  Section 403(a) is referred to as a “linkage” provision because it linked the Uniform Limited Partnership Act to the Uniform Partnership Act.  As the Court noted in Boxer, Section 403(a) provided that “[e]xcept as provided in this Act or in the partnership agreement, a general partner of a limited partnership has the rights and powers and is subject to the restrictions of a partner in a partnership without limited partners.”[9]  The Court then referred to the Uniform Partnership Act, which it noted had also been adopted in both Delaware and Colorado, and which made a partner accountable as a fiduciary.  The Court quoted Section 21 of the Uniform Partnership Act as follows:

Partner Accountable as a Fiduciary

(a) Every partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.

The Court concluded that “[w]hen the provisions of the Uniform Partnership Act and the Uniform Limited Partnership Act are read together, it is clear that the general partner in a limited partnership owes a fiduciary duty to the limited partners.”[10]  The Court also noted that a partner owed a fiduciary duty to the other partners at common law, citing, among other authorities, Meinhard v. Salmon.[11]  Citing further New York authority, the Court concluded that the “fiduciary duty of partners is often compared to that of corporate directors.”[12]  Since the Boxer case, the Delaware courts have consistently held that general partners of a Delaware limited partnership owe fiduciary duties to the partnership and its limited partners and that such duties are generally analogous to the fiduciary duties of corporate directors.[13]

Delaware LLCs.  In contrast to a Delaware LP, the basis for the application of default fiduciary duties to members and managers of a Delaware LLC is less clear.  Although the DLLCA is based in large part on the DRULPA and has a provision comparable to DRULPA Section 17-1105, that section simply refers to the rules of law and equity, including the law merchant, to govern any cases not provided for in the DLLCA.[14]  Absent is any reference to the Delaware Uniform Partnership Law.  Notwithstanding this omission, the Delaware Court of Chancery has, on several occasions, found that members and managers of a Delaware LLC owe the LLC and its members fiduciary duties.[15]  Presumably, the courts that have found these duties have done so based on DLLCA Section 18-1104 and the equitable and other Delaware legal principles relating to the application of fiduciary duties.[16]  Nor is it necessarily surprising that a court of equity would impose some type of default fiduciary duties when reviewing an entity created under a statute that very closely follows the DRULPA and that is often structured in a manner similar to a limited partnership (where the manager or managing member would be analogous to the general partner and the non-managing members to limited partners) or to a general partnership (where the members would be analogous to the general partners and share the management of the entity) or to a corporation (where a board of managers would function like a board of directors and the members would be passive investors like shareholders) – each of which is an entity to which fiduciary duties attach.  However, while these legal concepts may provide a basis for the imposition of fiduciary duties on members and managers of a Delaware LLC, it is important that any such imposition be done advisedly and with an appreciation of its implications and effects.  As the Delaware Supreme Court noted in Wal-Mart Stores, Inc. v. AIG Life Insurance Company,[17] “it is vitally important that the exacting standards of fiduciary duties not be extended to quotidian commercial relationships.”[18]  Therefore, if one were to conclude that there is a basis to apply default fiduciary duties to the relations of partners of a Delaware limited partnership and members and managers of a Delaware LLC, the question is then, from a policy standpoint including an appreciation of the costs of the application of these duties and the reasonable expectations of the parties to the subject transactions, should these duties be applied and, if so, how?

How should default fiduciary duties be applied?  I note at this juncture that both the DRULPA and DLLCA now make clear that fiduciary duties can be eliminated,[19] and the case law indicates, consistent with my experience in practice, that parties to complex limited partnership and limited liability company agreements understand the way in which to contract out of the application of default fiduciary duties.[20]  Thus, when the parties to complex limited partnership and limited liability company agreements have expressly stated their intention to eliminate fiduciary duties, under the DRULPA and DLLCA these provisions will be given effect.  What of the situation, however, where the parties do not expressly restrict or eliminate fiduciary duties?  In such a case, I would suggest that the standard articulated by then-Vice Chancellor Strine in R.S.M. Inc. v. Alliance Capital Management Holdings L.P.,[21] provides a useful guide.  In Alliance Capital, the Court held:

[O]ur courts have thus far adhered as a general matter to a close examination of whether the application of default fiduciary duties can be reconciled by a practical and efficient operation of the terms of the limited partnership agreement.  Where such a reconciliation is possible, the courts will apply default fiduciary duties in the absence of clear contractual language disclaiming their applicability.  But where the use of default fiduciary duties would intrude upon the contractual rights or expectations of the general partner or be insensible in view of the contractual mechanisms governing the transaction under consideration, the court will eschew fiduciary concepts and focus on a purely contractual analysis of the dispute.  Put somewhat differently, the irreconcilability of fiduciary duty principles with the operation of the partnership agreement can itself be evidence of the clear intention of the parties to preempt fiduciary principles.[22]

In support of this principle, the Court cited several cases where it had previously declined to impose fiduciary obligations that would have had an effect inconsistent with the terms and spirit of the contract at issue.[23]  In my view, a strict application of this principle would eliminate much of the inefficiency and frustration of expectations that could arise if traditional fiduciary duties were superimposed over fully negotiated contractual provisions and would be, I believe, consistent with the Chief Justice’s analysis of Chancellor Chandler’s holding in Fisk Ventures, LLC v. Segal,[24] that “in an agreement that fully fleshes out the conduct of the parties, no default duties should be assumed.”[25]   

In this connection, I think it is helpful to consider the hypothetical posed by the Chief Justice in Freedom of Contract.   In the hypothetical the Chief Justice posits, we have an agreement that does not provide for the explicit elimination of fiduciary duties and one party engages in clearly self-interested conduct.  What should the result be?  I believe that the Alliance Capital standard would be helpful in answering this question.  Under this standard, I would suggest, if as a general matter the agreement permitted comparable self-dealing transactions, then application of the Alliance Capital standard would suggest that similar self-dealing conduct, although not specifically authorized, would be consistent with the expectations of the parties.  However, if the contract at issue generally proscribed self-dealing transactions, then, even if the transaction at issue did not fall within the proscribed list, application of a default fiduciary duty that prohibited the attempted self-dealing conduct would again seem to be consistent with the contractual rights and expectations of the parties.  To this extent, I believe this rule is similar to the standard that the Chief Justice refers to from the Cooter and Ulen textbook as a rule for determining default terms, namely: “Impute the terms to the contract that the parties would have agreed to if they had bargained over all the relevant risk.”[26]

This analysis is similar to the application of the implied covenant of good faith and fair dealing and the doctrine of supplying an omitted essential term, both of which are discussed by the Chief Justice in Freedom of Contract.[27]  However, in its most recent pronouncement on the implied covenant, the Delaware Supreme Court stated that the “implied covenant only applies to developments that could not be anticipated, not developments that the parties simply failed to consider.”[28]  In most cases, parties to a contract could have anticipated most developments so that under this standard there is very little room for the application of the implied covenant.  In contrast, if the standard is, as the Cooter and Ulen quote suggests, what would the parties have agreed to if they had bargained over the relevant risk, then I would think, considering the hypothetical, if the parties generally permitted self-dealing conduct, they would permit the further self-dealing conduct at issue and if they generally prohibited self-dealing conduct, they would prohibit it.

Turning briefly to a few of my experiences in practice, I have seen sophisticated parties negotiating limited liability company agreements specifically contract for fiduciary duties, often by reference to corporate duties.  I have seen the default duties restricted but then left in place in their restricted form.  I have worked on transactions where the default duties are eliminated but replaced with a fiduciary-like contract standard requiring actions to be in the best interests of the LLC and its members, and I have seen the default fiduciary duties eliminated and replaced with a contractual standard such as a duty to act in a manner that does not constitute gross negligence or willful misconduct.  From a drafting standpoint, I would say that the most difficult drafting exercise involves an elimination of all fiduciary duties and their replacement by a contract-type standard such as gross negligence rather than a fiduciary standard such as the best interest of the entity.  As a practical matter, when drafting management provisions for a complex undertaking where there is no generalized standard of required conduct, it is often necessary to include long and detailed lists of permitted and prohibited conduct and, as a drafter, I am often concerned that matters will come up that we have not anticipated.  Not surprisingly, my clients are typically in favor of the elimination of fiduciary duties when they are considering their duties, but take a more sanguine approach when the same standard is applied to the other side.  One mechanism that is often relied upon when duties are eliminated is to include a long list of actions that require the consent of both sides.  While this is certainly a possible approach, I cannot help but think that, at least in some circumstances, it may be less efficient than having one party with the authority generally to manage the entity, but subject to an obligation to do so in the best interest of the entity and all of its owners.  Certainly, the approach requiring unanimous consent on a large number of matters can require frequent meetings of the parties and would, I think, also be more likely to lead to situations where the parties may require consideration for the giving of consent[29] or may not be able to come to an agreement on some required matter thus giving rise to potential deadlock and the dissolution of the common enterprise.[30]  Furthermore, while I have not done an economic analysis of the effect of the application of default fiduciary duties, it would seem to me that application of these duties as articulated in the Alliance Capital case would both give the parties the benefit of their bargain and discourage them from attempting actions that although not anticipated and therefore not specifically addressed in the agreement, would violate its spirit and the reasonable expectations of the parties.  This in turn should result in a better understanding by the parties of their rights and duties in both anticipated and unanticipated situations and, therefore, limit disputes and the attendent litigation costs.  Finally, I believe that contracts such as limited partnership agreements and limited liability company agreements that involve the operation of an ongoing entity can often be fundamentally different from the universe of contracts that do not involve the operation of entities.  The traditional principles of contract construction and freedom of contract no doubt apply to these entities so that to the extent a limited partnership agreement or limited liability company agreement specifically addresses the conduct of the parties, those provisions should certainly be given effect.  However, to the extent there are gaps, and in my experience there are often gaps, I do not think the implied covenant of good faith and fair dealing is the best means of filling these gaps when the parties have not clearly manifested their intention to displace fiduciary duties.

ENDNOTES:


[1]           46 AM. BUS. L.J. 221 (2009).

[2]           DEL. CODE ANN. tit. 6, § 17-101 et seq. (2011).

[3]           DEL. CODE ANN. tit. 6, § 18-101 et seq. (2011).

[4]           I would like to thank my colleague, Brian McBrearty, for his valuable research contributions to this paper.

[5]           In this regard, I note that the Chief Justice indicated in his article that he would “focus only on sophisticated parties entering into a Delaware LLC.”  STEELE, supra note 1, at 241 n.71.  He added that he did not imply that his analysis would apply to all members, specifically passive investors who were not involved in the formation of the LLC.  Id.

[6]           429 A.2d 995 (Del. Ch. 1981).

[7]           It is interesting to note that William T. Allen represented the plaintiffs in Boxer, E. Norman Veasey represented the defendants and then-Vice Chancellor Hartnett presided – three names that need no introduction to all who have studied the development of corporate and alternative entity law in Delaware.

[8]           Boxer, 429 A.2d at 997.

[9]           Unif. Limited Partnership Act § 403(a) (1976).  While Section 403(a) addressed specific linkage with regard to the rights, powers and restrictions of a general partner of a limited partnership, Section 1105 of the Uniform Limited Partnership Act addressed general linkage by stating that in any case not provided for in the Uniform Limited Partnership Act “the provisions of the Uniform Partnership Act govern.”

[10]          Boxer, 429 A.2d at 997.

[11]          Id. (citing 164 N.E. 545 (1928)).

[12]          Id.

[13]          Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 170 (Del. 2002) (“[A] general partner owes the traditional fiduciary duties of loyalty and care to the limited partnership and its partners . . . .”); Wallace ex. rel. Cencom Cable Income Partners II, L.P. v. Wood, 752 A.2d 1175, 1180 (Del Ch. 1999) (“Unquestionably, the general partner of a limited partnership owes direct fiduciary duties to the partnership and to its limited partners.”); In re Boston Celtics Limited Partnership Shareholders Litig., C.A. No. 16511, 1999 WL 641902, at *4 (Del Ch. August 6, 1999) (“It is well settled that, unless limited by the limited partnership agreement, the general partner of a Delaware limited partnership . . . , like the directors of a Delaware corporation, ha[s] the fiduciary duty to manage the partnership in the partnership’s interests and the interests of the limited partners.”).

The Delaware version of the Uniform Limited Partnership Act at issue in the Boxer case was replaced by the DRULPA in 1982, but the linkage provisions carried over in Section 17-403 of the DRULPA and Section 17-1105 of the DRULPA, which states that “[i]n any case not provided for in this chapter, the Delaware Uniform Partnership Law in effect on July 11, 1999 (6 Del.C. § 1501, et seq.) and the rules of law and equity, including the Law Merchant, shall govern.”  In addition, Section 1521 of the Uniform Partnership Law, which is the provision setting forth the duties of a general partner of a general partnership and thus the section to which Section 17-403(a) refers, is the same as it was in 1981 when it was referenced by the Court of Chancery.

[14]          DEL. CODE ANN. tit. 6, § 18-1104 (2011).

[15]          Kelly v. Blum, C.A. No. 4516-VCP, 2010 WL 629850, at *10 (Del. Ch. February 24, 2010) (“Delaware cases interpreting Section 18-1101(c) have concluded that, despite the wide latitude of freedom of contract afforded to contracting parties in the LLC context, in the absence of a contrary provision in the LLC agreement, LLC managers and members owe traditional fiduciary duties of loyalty and care to each other and to the company.”) (internal quotation marks omitted); Lola Cars Int’l Ltd. v. Krohn Racing, LLC, C.A. Nos. 4479-VCN, 4886-VCN, 2010 WL 3314484, at *7 (Del. Ch. August 2, 2010) (concluding that manager of Delaware limited liability company “was bound by the traditional duties that otherwise govern the conduct of corporate fiduciaries” where parties had not agreed to modify duties of manager); Bay Ctr. Apartments Owner, LLC v. Emery Bay PKI, LLC, C.A. No. 3658-VCS, 2009 WL 1124451, at *8 n.33 (Del. Ch. April 20, 2009) (“The LLC cases have generally, in the absence of provisions in the LLC agreement explicitly disclaiming the applicability of default principles of fiduciary duty, treated LLC members as owing each other the traditional fiduciary duties that directors owe a corporation.”).

[16]          See J. Leo Johnson, Inc. v. Carmer, 156 A.2d 499, 502 (Del. 1959) (“The relationship of joint adventurers is fiduciary in character and imposes upon all of the participants the utmost good faith, fairness and honesty in dealing with each other with respect to the enterprise.”); Prestancia Mgmt. Group, Inc. v. Virginia Heritage Foundation, II LLC, C.A. No. 1032-S, 2005 WL 1364616 at *6 (Del. Ch. May 27, 2005) (“A fiduciary relationship is a situation where one person reposes special trust in and reliance on the judgment of another or where a special duty exists on the part of one person to protect the interests of another.  The relationship connotes a dependence.  The traditional relationships recognized by equity as ‘special’ are express trustees and corporate officers and directors.  Delaware has recognized several other relationships which also carry the ‘special’ nature of a fiduciary relationship, including: general partners; administrators or executors; guardians; and, in special circumstances, joint venturers or principals and their agents.”); In re USA Cafes, L.P. Litig., 600 A.2d 43, 48 (Del. Ch. 1991) (“I understand the principle of fiduciary duty, stated most generally, to be that one who controls property of another may not, without implied or express agreement, intentionally use that property in a way that benefits the holder of the control to the detriment of the property or its beneficial owner.”); see also RESTATEMENT (THIRD) OF AGENCY § 8.01 cmt. b (2006) (“The general fiduciary principal [set forth in § 8.01] facilitates a principal’s ability to exercise control over an agent because it provides a benchmark standard against which the agent must interpret manifestations by the principal, either the principal’s initial statement of authority to the agent or interim instructions that the principal subsequently provides to the agent.  An agent is not free to exploit gaps in the principal’s manifestations by taking action that is self-interested or otherwise fails to serve interests of the principal that the agent knows or should know.”); RESTATEMENT (SECOND) OF AGENCY § 13 cmt. b (1958) (“The fact that an agent is subject to these fiduciary duties distinguishes him from other persons who have power to affect the interests of others; and the understanding that one is to act primarily for the benefit of another is often the determinative feature in distinguishing the agency relation from other relations.”).

[17]          901 A.2d 106 (Del. 2006).

[18]          Wal-Mart Stores, Inc., 901 A.2d at 114 (quoting Wal-Mart Stores, Inc. v. AIG Life Insurance Co., 872 A.2d 611 (Del. Ch. 2005)).

[19]          DEL. CODE ANN. tit. 6, § 17-1101(d) (2011); DEL. CODE ANN. tit. 6, § 18-1101(c) (2011).

[20]          See Brinckerhoff v. Enbridge Energy Co., Inc., C.A. No. 5526-VCN, 2011 WL 4599654, at *8-9 (Del. Ch. September 30, 2011) (finding default fiduciary duties eliminated in favor of contractual duty to act in good faith); Lonergan v. EPE Holdings LLC, 5 A.3d 1008, 1017 (Del. Ch. 2010) (noting that plaintiff alleged breaches of the implied covenant of good faith and fair dealing because limited partnership agreement eliminated fiduciary duties pursuant to § 17-1101(d) of DRULPA); In re Atlas Energy Resources LLC, Unitholder Litigation, C.A. No. 4589-VCN, 2010 WL 4273122, at *9 (Del. Ch. October 28, 2010) (finding that limited liability company agreement eliminated default fiduciary duties of directors and officers in favor of good faith standard).

[21]          790 A.2d 478 (Del. Ch. 2001).

[22]          Alliance Capital, 790 A.2d at 497-98.

[23]          Id. at 498 n.27.

[24]          C.A. No. 3017-CC, 2008 WL 1961156 (Del. Ch. May 7, 2008).

[25]          STEELE, supra note 1, at 230.

[26]          Id. at 236 (quoting Robert Cooter & Thomas Ulen, Law and Economics 201 (3d ed. 2000)).

[27]          Id. at 234, 238 n. 63.

[28]          Nemec v. Shrader, 991 A.2d 1120, 1126 (Del. 2010).

[29]          See, e.g., Related Westpac LLC v. JER Snowmass LLC, C.A. No. 5001-VCS, 2010 WL 2929708, at *4 (Del. Ch. July 23, 2010) (noting that member who had right to consent to certain material actions pursuant to provisions of limited liability company agreement had conditioned such consent on other members providing certain commercial benefits to it).

[30]          See, e.g., Vila v. BVWebties LLC, C.A. No. 4308-VCS, 2010 WL 3866098, at *7 (Del. Ch. October 1, 2010) (“This case is one in which an LLC has two managers whose agreement is contractually required for [the company] to move forward with a properly authorized strategy. Neither manager can act in isolation for [the company] without the assent of the other. This sort of deadlock has classically provided the basis for a dissolution in the corporate context when a joint venture with two coequal shareholders faces a deadlock . . . .”).