Waivers and Their Consequences: An Analysis of the Limitation of Fiduciary Duties in Delaware LLC Bankruptcies.

• Author: McNeill, R. Stephen
• Position: Limited liability companies

1. INTRODUCTION

   Many bankruptcy professionals may not be aware that a limited liability company ("LLC") formed under Delaware law has the flexibility to eliminate all fiduciary duties owed by its management and members in its operating agreement. Recognizing this flexibility, the Delaware Supreme Court has held that well-established corporate fiduciary law may not always apply to LLCs. This article provides an overview of the structure of these business entities and the fiduciary duties owed in both contexts. From there, the article discusses in detail whether creditor claims for breach of those fiduciary duties may be pursued in bankruptcy cases.

2. LLCS AND CORPORATIONS--SIMILARITIES AND DIFFERENCES

   Delaware corporations and LLCs are both commonly-used business entities that offer their equity holders various tax advantages and protections from personal liability. Corporations existed in some form in Delaware dating back to the late eighteenth century when Delaware ratified its first constitution, allowing Delaware corporate law to be shaped by centuries' worth of common law. (1) In contrast, LLCs are a relative newcomer in the business entity space, arriving on the scene in 1992 as a product of statutory creation. (2)

   A. Structure

   A Delaware corporation must implement and adhere to numerous corporate formalities. These requirements are set forth in the General Corporation Law of the State of Delaware (the "DGCL"). (3) Its structure generally features shareholders, a board of directors, and officers. The rights, duties and restrictions of these parties are governed by the corporation's certificate of incorporation and bylaws. Shareholders acquire ownership interests by purchasing shares of stock in the corporation. (4) Shareholders can be natural persons or entities. While they may provide direction in certain areas of governance and decision-making, such as electing directors to the board, shareholders typically do not have a say in the day-to-day operation of the corporation. The board governs the corporation's affairs and guides the officers who are responsible for daily management of the business. Unlike shareholders, directors and officers must be natural persons. (5)

   The rights, duties and restrictions of members, managers and other related parties in an LLC are governed by a certificate of formation and an operating agreement, which provide significant flexibility in how the LLC governs its affairs. An LLC can have a single member that also manages the company. It can also have two or more members, as well as a non-member manager. It can have members who do not hold any equity interest in the company (unlike a shareholder of the corporation). (6) An LLC can also have one or more members or managers that are entities, rather than natural persons. Despite this freedom to adopt a variety of structures, LLCs may choose to adopt corporate (or corporate-style) formalities. For example, an LLC can opt to have officers whose duties are derived from their corporate counterparts or have a board of managers that resembles a corporate board of directors.

   Equity in an LLC is comprised of limited liability company interests, which are similar to shares in a corporation, although typically far less numerous and not publicly traded. Equity holders in LLCs are often referred to as members, but they may go by other titles as set forth in the operating agreement. Unlike a corporation, an LLC may be controlled (and managed) by the same entity that has ownership interest in the company. In other words, an LLC may have a sole member who holds all of the company's limited liability company interests (similar to the sole shareholder of a corporation) and also has the power to manage the company (similar to a corporation's board of directors).

   B. Fiduciary Duties

   Largely due to the differences discussed above, as well as the relatively recent creation of LLCs as a business entity structure, the development of Delaware fiduciary duty law in the LLC context has evolved differently from those duties under corporate law, where the corporate fiduciary duty law is significantly more developed. Indeed, over the years, the concept of fiduciary duties in corporate law has become almost mainstream. Even in non-legal conversations, there is a general awareness of the two fiduciary duties: the duty of loyalty and the duty of care. This section provides a preliminary overview of fiduciary duties for both business models under Delaware law.

   1. General Corporate Fiduciary Duties Owed to Equity Holders

      It is "well established" that the directors of Delaware corporations owe fiduciary duties to the corporation and its shareholders. (7) A fiduciary duty analysis typically considers the duties of loyalty and care. (8) The duty of loyalty requires directors to act in the best interests of the corporation and its stockholders and prohibits self-dealing or self-interested transactions. (9) Generally speaking, the duty of care requires directors to remain reasonably informed in their oversight of the corporation. (10) This duty requires a range of behavior, including involvement in the decision-making process by regularly attending board meetings, engaging experts to advise on transactions, and reading and evaluating reports on the company's financials and business operations. (11) The duty to act in good faith is central to many fiduciary duty analyses. (12) In Stone v. Ritter, (13) the Delaware Supreme Court clarified that "although good faith may be described colloquially as part of a 'triad' of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty." (14)

      A relatively recent trend has been to allow a corporation, in its certificate of incorporation, to waive a director's personal liability for breaching a key component of the duty of loyalty as it relates to corporate opportunities. (15) Since 2000, a Delaware corporation's certificate of incorporation and bylaws may expressly allow directors to engage in other business transactions or activities that are competitive with the corporation's business and to deprive the corporation of a corporate opportunity. (16) Similarly, a Delaware corporation's organizational documents may also include exculpatory clauses that shield a director from liability to the corporation and its shareholders for breaches of certain fiduciary duties, or aspects thereof. (17) "The totality of these limitations or exceptions [in [section] 102(b)(7) of the DGCL] ... is to ... eliminate ... director liability only for 'duty of care' violations." (18) Absent these waivers and exculpatory provisions, however, directors owe traditional fiduciary duties by default (19) and these fiduciary duties may not be fully waived. (20)

   2. General LLC Fiduciary Duties to Members

      Similar to a corporate board of directors, the managers and managing members of Delaware LLCs also owe default fiduciary duties to the company and toward each other. (21) The Delaware Court of Chancery has long accepted the proposition that managers of a limited liability company owe fiduciary duties to the limited liability company and its members in the absence of modifications to such fiduciary duties in the operating agreement. (22) However, the Delaware Supreme Court was hesitant to find that traditional fiduciary duties were owed by default in LLCs. (23) In Auriga Capital Corp v. Gatz Properties, LLC, (24) then-Chancellor Strine found that an LLC manager had breached his fiduciary duties to the company, and stated that "because the LLC Act provides for principles of equity to apply, because the LLC managers are clearly fiduciaries, and because fiduciaries owe the fiduciary duties of loyalty and care, the LLC Act starts with the default that managers of LLCs owe enforceable fiduciary duties." The Delaware Supreme Court affirmed the Court of Chancery's finding that the LLC manager had breached his fiduciary duties, but criticized its extension of "default" fiduciary duties, declaring that the Court of Chancery's "statutory pronouncements" on this subject were mere dictum. (25) In response to these cases, the Delaware General Assembly enacted legislative amendments codifying the Court of Chancery's dictum as law. (26)

      Notwithstanding the amendment establishing default fiduciary duties in LLCs, the LLC Act allows an operating agreement to completely waive default fiduciary duties. Section 18-1101(e) of the LLC Act provides as follows:

      A limited liability company agreement may provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a member, manager or other person to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement; provided, that a limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing. (27) Parties to an LLC agreement owe common law fiduciary duties unless such duties are expressly waived in the operating agreement. Such a waiver eliminates any claim for a breach of those duties. (28) However, the implied covenant of good faith and fair dealing can never be waived. (29)

   3. Corporate Fiduciary Duties Owed to Creditors

      Although a corporation's board of directors owes fiduciary duties to shareholders, it ordinarily does not owe any fiduciary duties to the corporation's creditors. This default rule changes when a corporation becomes insolvent.

      In Geyer v. Ingersoll, (30) the Delaware Court of Chancery stated the "general rule is that directors do not owe creditors duties beyond the relevant contractual terms absent 'special circumstances ... e.g...