Allows Claims for Breach of the Implied Covenant of Good Faith and Fair Dealing and Breach of Fiduciary Duty to Proceed

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1 Milbank May 14, 2009 Corporate Governance Group Client Alert Bei j i n g Fr a n k f u r t Ho n g Ko n g Lo n d o n Lo s An g e l e s Mu n i c h Ne w Yo r k Si n g a p o r e To k y o Wa s h i n g t o n, DC Delaware Court of Chancery Refuses to Dismiss Claims Brought Against LLC s Managing Member and the Individual Who Controlled the Managing Member Allows Claims for Breach of the Implied Covenant of Good Faith and Fair Dealing and Breach of Fiduciary Duty to Proceed In a previous Client Alert 1, we discussed the decision of the Delaware Court of Chancery in Fisk Ventures, LLC v. Segal 2 dismissing claims brought by one member of a limited liability company ( LLC ) against the other members following a series of disputes over the operation and direction of the LLC. Among other claims, the disgruntled LLC member alleged that the other members breached both the implied covenant of good faith and fair dealing (the Implied Covenant ) contained in the LLC operating agreement, as well as their fiduciary duties. Treating the LLC operating agreement as any other contract, and recognizing the flexibility provided in the Delaware Limited Liability Company Act (the LLC Act ) to limit the fiduciary duties of LLC members, the Court stated that in the context of limited liability companies, which are creatures not of the state but of contract, the duties and obligations alleged to have been breached must be found in the LLC agreement. With respect to the alleged breach of the Implied Covenant, the Court found the terms of the LLC operating agreement to be unambiguous and observed that this was just another in a long line of cases in which a plaintiff has tried, unsuccessfully, to argue that the implied covenant grants [him] a substantive right that [he] did not extract during negotiation. With respect to the alleged breach of fiduciary duty, the Court observed that the LLC Agreement, in accordance with Delaware law, greatly restricts or even eliminates fiduciary duties. 1 See our previous Client Alert entitled Delaware Chancery Court Grants Dismissal of Fiduciary Duty Claims Raised Against Members of a Limited Liability Company (June 2, 2008). 2 C.A. No CC (Del.Ch. May 7, 2008). Please feel free to discuss any aspect of this Client Alert with your regular Milbank contacts or with any of the members of our Corporate Governance Group, whose names and contact information are provided at the end of this alert. In addition, if you would like copies of our other Client Alerts, please visit our website at and choose the Client Alerts & Newsletters link under Newsroom/Events. This Client Alert is a source of general information for clients and friends of Milbank, Tweed, Hadley & McCloy LLP. Its content should not be construed as legal advice, and readers should not act upon the information in this Client Alert without consulting counsel Milbank, Tweed, Hadley & McCloy LLP. All rights reserved. Attorney Advertising, prior results do not guarantee a similar outcome.

2 Where a Delaware court finds ambiguity in an LLC operating agreement, however, the result can be very different, as demonstrated in the recent ruling of the Delaware Court of Chancery in Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC. 3 In this case, Vice Chancellor Strine refused to dismiss an action arising from the failure of a condominium development project brought by Bay Center Apartments Owner, LLC ( Plaintiff ) against several defendants ( Defendants ): the LLC established to carry out the project, Emery Bay Member, LLC ( Emery Bay ), Alfred E. Nevis ( Nevis ) and various entities owned and managed by Nevis, including the managing member of Emery Bay, Emery Bay PKI, LLC ( PKI ). Plaintiff alleged that it suffered investment losses as a result of Defendants breach of contract, breach of the Implied Covenant, breach of fiduciary duty and fraud. Particularly noteworthy is the Vice Chancellor s discussion of Plaintiff s allegations that (i) PKI, the managing member of Emery Bay, breached the Implied Covenant contained in Emery Bay s LLC operating agreement, and (ii) Nevis and the other Defendants breached fiduciary duties owed to the other member of Emery Bay, Plaintiff. Background In November 2005, Plaintiff and PKI formed Emery Bay for the purpose of developing a condominium project in Emeryville, California. PKI, whose sole member was Nevis, was granted considerable authority to manage Emery Bay s affairs, and the LLC operating agreement contemplated that Nevis, although not himself a member of Emery Bay, would play a major role in PKI s exercise of this authority. PKI also agreed to make up any capital shortfall if the initial capital contributions of the parties proved to be inadequate. Rather than carry out many of its duties as managing member of Emery Bay directly, PKI caused Emery Bay and certain subsidiaries of Emery Bay to enter into a series of support agreements with affiliates of PKI. Emery Bay s LLC operating agreement, however, did contain language to the effect that PKI was required to cause its affiliates to perform their obligations under these support agreements. Finally, Nevis personally guaranteed repayment of a construction loan obtained by Emery Bay from a third-party bank. Within two years of its formation, Emery Bay ran into financial trouble and defaulted on its bank debt. The bank brought suit, and a California state court appointed a receiver to manage Emery Bay s affairs. The receiver prepared a report revealing extensive mismanagement on the part of Defendants, which detailed not only lack of oversight of the project, but also intentional misuse of projects funds and property for the benefit of Defendants. In March 2008, Plaintiff brought suit against Defendants on a variety of theories. In addition to asserting contract claims against PKI for direct breaches of the LLC operating agreement, Plaintiff claimed, in the alternative, that even if PKI was not obligated by the explicit terms of the LLC operating agreement to ensure performance of the support agreements by its affiliates, it nevertheless breached the Implied Covenant contained in the LLC operating agreement by failing to do so. Plaintiff also asserted that Nevis, PKI and the other entities controlled by Nevis breached fiduciary duties owed to Plaintiff and committed, or aided and abetted the commission of, acts of common law fraud. Defendants filed a motion to dismiss all counts other than the breach of contract claim. The Court denied this motion in its entirety. 3 C.A. No VCS (Del. Ch. Apr. 20, 2009). 2

3 The Court s Analysis The Implied Covenant At the outset of its analysis of Plaintiff s Implied Covenant claim, the Court characterized this claim as part of Plaintiff s efforts to, in essence, hold PKI secondarily liable for the alleged breaches of the support agreements by its affiliates despite the fact that PKI was not a signatory. According to the Court, Plaintiff felt compelled to bring this claim due to the ambiguity that exists in the LLC Agreement as to who was responsible for the bulk of the conduct alleged in Plaintiff s complaint. Therefore, assuming for purposes of the motion to dismiss that PKI was not directly obligated under the LLC operating agreement to ensure performance by its affiliates under the support agreements, the Court declared that the pertinent question was whether that obligation can be implied in the LLC Agreement. This, according to the Court, was a close question. Recognizing that Delaware courts have invoked the Implied Covenant sparingly when parties have crafted detailed, complex agreements, the Court nevertheless noted that Delaware courts have recognized the occasional necessity of implying contract terms to ensure the parties reasonable expectations are fulfilled. The Court recognized just such an occasional necessity in the facts before it. As the managing member under the LLC operating agreement, PKI had the obligation to manage Emery Bay, and as the entity which controlled the Nevis affiliates who were parties to the support agreements, PKI had the discretion to cause [the support agreements] to be performed. As such, according to the Court, PKI was required to carry out these functions in good faith, meaning that PKI could not engage in arbitrary or unreasonable conduct that had the effect of preventing Bay Center from receiving the fruits of the bargain. Because, in the Court s view, Plaintiff pled sufficient facts from which it can reasonably be inferred that PKI s decision not to cause performance of the [s]upporting [a]greements was not in good faith, the Court refused to dismiss Plaintiff s claim that PKI had breached the Implied Covenant. Breach of Fiduciary Duty The Court began its analysis of Plaintiff s breach of fiduciary duty claims against Nevis and his controlled entities by addressing the threshold question whether the Emery Bay LLC operating agreement eliminated fiduciary duties, as Defendants claimed. In this regard, the Court noted that LLCs are creatures of contract, and the LLC Act gives members of an LLC wide latitude to order their relationships, including the flexibility to limit or eliminate fiduciary duties. The Court also noted, however, that in the absence of a contrary provision in the LLC agreement, the manager of an LLC owes the traditional fiduciary duties of loyalty and care to the members of the LLC. 4 Because the Emery Bay LLC operating agreement contained two separate and seemingly contradictory provisions with respect to the fiduciary duties owed by one member to the other, and the parties had taken starkly opposite positions with respect to these provisions, the Court was compelled to resolve this apparent 4 The Court noted in a footnote that [t]he 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. In the same footnote, the Court also observed that when LLC case law is lacking, this court often looks for help by analogy to the law of limited partnerships, under which the general partner of a Delaware limited partnership owes the traditional fiduciary duties of loyalty and care to the Partnership and its partners. The Court, however, did not address this apparent anomaly or the differences, if any, between the traditional fiduciary duties in the corporation and limited partnership contexts. 3

4 paradox. One provision stated that [t]he Members shall have the same duties and obligations to each other that members of a limited liability company formed under the Delaware Act have to each other, while the other stated that [e]xcept for any duties imposed by this Agreement... each Member shall owe no duty of any kind towards the Company or the other Members. Relying on the rule of contract construction that given ambiguity between potentially conflicting terms, a contract should be read so as not to render any term meaningless, the Court determined that the former provision expressly imposes the default fiduciary duties on PKI, while the latter eliminates only those that are not traditional fiduciary duties or are not otherwise not expressly contemplated in the LLC Agreement. On this basis, the Court was prepared to assume, for the purposes of this motion to dismiss, that the LLC Agreement requires Emery Bay s members to act in accordance with traditional fiduciary duties. 5 Having determined for purpose of the motion before it that the Emery Bay LLC operating agreement did impose fiduciary obligations on its members, the Court proceeded to analyze the specific claims of breach of those duties by the various Defendants. The Court had little difficulty in refusing to dismiss the claimed breach on the part of PKI, given its position as the managing member of Emery Bay and the number of facts [alleged by Plaintiff] from which it can be inferred that PKI breached its duties. By contrast, the analysis with respect to Nevis, who was neither a member nor an officer of Emery Bay and thus beyond the normal scope of those who owe fiduciary duties in the corporate context, was less straightforward. Nevis was accused by Plaintiff of having caused Emery Bay to use its cash resources to advantage Nevis at the expense of Plaintiff. Citing the line of cases beginning with In Re USACafes, L.P. Litigation 6 for the proposition that those affiliates of a general partner who exercise control over the partnership s property may find themselves owing fiduciary duties to both the partnership and its limited partners, and relying on the analogy between the limited partnership form and the LLC form, 7 the Court also refused to dismiss the breach of fiduciary duty claims against Nevis. In this vein, the Court noted that while USACafes does not apply to all affiliates in all circumstances, it does apply to someone such as Nevis who himself exerted direct control over Emery Bay s property. The Court also observed that while controlling affiliates do not have the full range of traditional fiduciary duties, such duties do include, as articulated in USACafes, the duty not to use control over the partnership s property to advantage the corporate director at the expense of the partnership. Conclusion The contrasting results in the motions to dismiss in Fisk Ventures and Bay Center demonstrate the obvious, but oft-neglected, importance of clear and unambiguous drafting of LLC operating agreements. Although Delaware courts will respect the plain meaning of contract terms and refrain from imposing implied duties or fiduciary concepts to expand the rights and obligations of parties to an unambiguous LLC operating agreement, the courts will not hesitate to intervene when the agreement contains ambiguities and the facts are particularly egregious. In addition, the imposition of fiduciary duties on Nevis, whose only relationship with Emery Bay was as the sole owner of its managing member, sends a strong message that an individual cannot completely avoid incurring some fiduciary duties simply by acting through an LLC. 5 In support of its conclusion, the Court also noted that the interpretive scales also tip in favor of preserving fiduciary duties under the rule that drafters of chartering documents must make their intent to eliminate fiduciary duties plain and unambiguous A.2d 43 (Del. Ch. 1991). 7 Although the Court admitted that no court had yet decided whether USACafes and its progeny are applicable to the affiliates of an LLC s managing member, it was prepared to rely on the ruling in USACafes on the basis that in the absence of developed LLC case law, this court has often decided LLC cases by looking to analogous provisions in limited partnership law. 4

5 Please feel free to discuss any aspect of this Client Alert with your regular Milbank contacts or with any of the members of our Corporate Governance Group, whose names and contact information are provided below. Beijing Units 05-06, 15th Floor, Tower 2 China Central Place, 79 Jianguo Road, Chaoyang District Beijing , China Anthony Root aroot@milbank.com Edward Sun esun@milbank.com Frankfurt Taunusanlage Frankfurt am Main, Germany Norbert Rieger nrieger@milbank.com Hong Kong 3007 Alexandra House, 18 Chater Road Central, Hong Kong Anthony Root aroot@milbank.com Joshua Zimmerman jzimmerman@milbank.com London 10 Gresham Street London EC2V 7JD, England Stuart Harray sharray@milbank.com Thomas Siebens tsiebens@milbank.com Los Angeles 601 South Figueroa Street Los Angeles, CA Ken Baronsky kbaronsky@milbank.com Neil Wertlieb nwertlieb@milbank.com Munich Maximilianstrasse 15 (Maximilianhoefe) Munich, Germany Peter Nussbaum pnussbaum@milbank.com New York One Chase Manhattan Plaza New York, NY Scott Edelman sedelman@milbank.com Roland Hlawaty rhlawaty@milbank.com Thomas Janson tjanson@milbank.com Robert Reder rreder@milbank.com Alan Stone astone@milbank.com Douglas Tanner dtanner@milbank.com Singapore 30 Raffles Place, #14-00 Chevron House Singapore David Zemans dzemans@milbank.com Naomi Ishikawa nishikawa@milbank.com Tokyo 21F Midtown Tower, Akasaka, Minato-ku Tokyo Japan Darrel Holstein dholstein@milbank.com Bradley Edmister edmister@milbank.com Washington, DC International Square Building, 1850 K Street Washington, DC Glenn Gerstell gerstell@milbank.com 5