Business Law Articles
Written By: Roger J. Brothers Esq. and Dominic V. Signorotti, Esq.
Buchman Provine Brothers Smith LLP
Walnut Creek, California
A recent decision by a Delaware court imposes new fiduciary duties on Delaware limited liability company ("LLC") managers. As a result, existing Delaware LLCs should review their operating agreements, investor agreements and compensation agreements in order to ensure that managers are not subject to unintended or unexpected personal liabilities.
In Auriga Capital Corp. v. Gatz Properties, LLC, a Delaware Chancery Court held for the first time that Delaware LLC managers are fiduciaries who owe the traditional fiduciary duties of loyalty and care to LLC members. If a manager breaches these fiduciary duties, he/she may be held personally liable. This decision expands both the duties owed by LLC managers to LLC members, as well as the liability exposure of managers with respect to their management of a LLC under Delaware law.
In Auriga, defendant William Gatz was the controlling member and manager of Peconic Bay, LLC ("Peconic Bay" or the "Company"). The plaintiffs were the minority members of the Company. Peconic Bay was formed to hold a long-term lease on a parcel of land in Long Island that it hoped to lease and develop into a golf course. The land was owned by Gatz. Peconic Bay borrowed $6 million, secured by the land, and built a golf course. In 1998, it subleased the course to a third-party golf course operator, American Golf Corporation. The sublease was for a 35-year term, but American Golf had an option to terminate the lease as early as 2010.
Almost from the beginning of the sublease, American Golf failed to produce sufficient cash flow to cover its operating expenses. As a result, the golf course fell into a state of disrepair. Gatz was aware of American Golf's issues, and by 2005 knew that it was nearly certain that American Golf would exercise its option to terminate the sublease in 2010. Yet, Gatz neglected to relay this information to Peconic Bay's minority members. Instead, Gatz commissioned an appraisal of the property, and learned that it was worth significantly more if used for residential development rather than as a golf course. Again, Gatz kept this information from the minority members.
In 2007, Gatz was approached by RDC Golf Group, Inc. ("RDC") with an offer to purchase Peconic Bay's ground lease and the sublease for $3.75 million. This offer was subsequently raised to $4.15 million. At this time, Peconic Bay had debt of $5.4 million; which was something else that Gatz failed to disclose to RDC. Both of RDC's offers were rejected by Peconic Bay's minority members, because the offers would each render the Company insolvent. Gatz requested and received authority from the minority members to make a counteroffer of $6 million. RDC responded that it would consider a price "well north" of $6 million. However, Gatz did not share this information with the minority members. Instead, Gatz made an offer to the minority members to purchase their collective interests for $5.6 million, based on the implication that RDC's highest offer was $4.15 million. The minority members rejected this offer.
In December, 2008, Peconic Bay had approximately $1.4 million in cash on hand. The Court noted that with this money, Peconic Bay could have covered its debt payments for at least three (3) more years. Nevertheless, Gatz informed the minority members that he was putting Peconic Bay up for auction. Gatz hired a novice auctioneer with no experience in golf course auctions. The auctioneer did an incredibly poor job of advertising the auction, and as a result, no third-party offers were made for Peconic Bay. Rather than cancel the auction, Gatz proceeded to purchase the entirety of Peconic Bay for $50,000, plus an assumption of its bank debt. Gatz kept the $1.4 million in cash on hand, and paid each of the minority members the sum of $20,985.
The minority members sued Gatz, arguing that he breached his contractual and fiduciary duties. The Court agreed, and held that Gatz breached his fiduciary duties of loyalty and care by engaging in bad faith and grossly negligent conduct. For the first time, the Court found that the Delaware LLC Act imposed fiduciary duties of loyalty and care on LLC managers. On this basis, the Court awarded the minority members damages equal to the full amount of their original capital contribution plus 10%. In addition, the Court awarded the minority members prejudgment, compounded, monthly interest, and one-half of their requested attorneys' fees, based on Gatz's bad faith conduct.
The Auriga case raises important issues for California residents who are considering the formation of a LLC. One traditional advantage of Delaware LLCs was the fact that its law and courts are often perceived as more "manager-friendly" than those in California. Based on Auriga, this appears to no longer be the case. The Auriga case creates fiduciary obligations for managers of Delaware LLCs that appear to be on par with those imposed under California law (see, Corporations Code § 17153). As a result, one of the traditional advantages of incorporating in Delaware (i.e., the absence of the imposition of fiduciary duties on LLC managers) no longer exists, and individuals may wish to give California a second look when deciding under which jurisdiction they should form their LLC.
With respect to existing Delaware LLCs, a number of precautions should be taken in response to the Auriga case. With respect to manager-managed LLCs, managers should consider eliminating (or at least reducing) the fiduciary duties owed by them to the LLC members. As the Auriga court acknowledged, an operating agreement for a Delaware LLC may alter and/or eliminate altogether a manager's fiduciary duties toward the members under Delaware law. (6 Del. Code Ann. § 18-1101(c).) California law allows similar limitations to be created in an operating agreement.
On the other hand, LLC members may wish to expressly impose the fiduciary duties of loyalty and care on LLC managers via the operating agreement, whether forming the LLC under California or Delaware law.
Both Delaware and California LLCs should consider further the benefits of procuring financing via debt versus equity. If the LLC is funded by investors who receive equity in exchange for their investment, the manager(s) will owe fiduciary duties to those investors (who are now LLC members) in the absence of specific provisions in the operating agreement which eliminate those duties. In contrast, if the LLC is funded via creditors extending debt, then no fiduciary duties will be owed by the manager(s). However, if the debt is structured as convertible debt, which may be converted to equity, fiduciary duties will be owed upon the conversion, unless expressly eliminated in the operating agreement.
Another issue to consider concerns profit participation for executives and employees. If executives and/or employees are provided with profit participation in the form of equity in the LLC, the manager(s) will likely owe fiduciary duties to those executives and employees (who are now members) which otherwise would not exist. As such, LLC managers may wish to consider extending profit participation to such executives and employees in the form of increased salary and/or bonuses, in order to eliminate the risk of establishing a new fiduciary obligation. Out of an abundance of caution, any such profit participation, salary increases and/or bonuses should expressly state that they do not create or otherwise constitute equity interests in the LLC, and that they do not create any fiduciary duties in favor of the executive and/or employee.
Given the new issues brought to light by the Auriga case, it is now more important than ever to ensure that your LLC is structured in such a fashion that the manager's duties and obligations are clearly defined and set forth in the LLC operating agreement. In addition, investment and compensation structures should be fine-tuned such that they do not create unintended, or unexpected, liabilities for LLC managers.