Delaware Courts and the Continued Erosion of Fiduciary Duties

In the world of fiduciary duties for corporate directors, Delaware courts diminish them case by case.  Take a look at the evisceration of the duty of loyalty with respect to decisions on executive compensation.  (Returning Fairness to Executive Compensation). 

With respect to other types of entities, such as limited liability companies, the courts have been provided a helping hand by the state legislature.  Thus, § 18-1101 provides that the operating agreement can eliminate the traditional fiduciary duties of mangers (the duty of care and loyalty) but not the duty of good faith and fair dealing, an implied clause in contracts.  As the provision provides:

• (c) To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) 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, the member's or manager's or other person's duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.

Most states do not allow the elimination of fiduciary duties (although my home state of Colorado does).  This type of provision puts pressure on courts to add meaning to the notion of "good faith and fair dealing."  The provison varies from state to state but in Delaware, the court has held that it means:

• "Stated in its most general terms, the implied covenant requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain. Thus, parties are liable for breaching the covenant when their conduct frustrates the overarching purpose of the contract by taking advantage of their position to control implementation of the agreement's terms."

Dunlap v. State Farm, 878 A.2d 434, 442 (Del. 2005)(internal quotations and citations omitted).  These provisions are often used, for example, in cases where terms such as quantity are open ended and prevent one party from acting in a manner inconsistent with the expectation of the parties.

Effectively, therefore, the Delaware (and Colorado) legislature have left as a floor for the protection of investors not traditional fiduciary duties associated with managers of entities but some type of implied contractual provision.  At the same time, the legislature did not make clear how this contractual provision was meant to operate in the LLC context.  Must, for example, it be tied to specific language or provisions in the operating agreement or can it be more generally about investor expectations on how the LLC will be managed? 

With this in mind, we turn to Wood v. Baum, a case already discussed on this Blog (in a series of posts and in naming it one of the most anti-shareholder cases decided by Delaware courts in 2008).  But we return to it (in part because it was assigned to students to read) with some new insight.  The provision in the operating agreement of the relevant company waived all fiduciary duties for officers and directors excepting only "fraudulent or illegal conduct of such person."  In addition, however, the officers and directors were subject to, as the statute requires, the duty of good faith and fair dealing. 

The Delaware Supreme Court predictably upheld dismissal of the case, agreeing that plaintiffs had not alleged facts that would show fraud or illegal conduct by the officers and directors.  When it came to the duty of good faith and fair dealing, the Court had this to say:

• the Complaint does not purport to allege a "bad faith violation of the implied contractual covenant of good faith and fair dealing." The implied covenant of good faith and fair dealing is a creature of contract, distinct from the fiduciary duties that the plaintiff asserts here.  The implied covenant functions to protect stockholders' expectations that the company and its board will properly perform the contractual obligations they have under the operative organizational agreements. Here, the Complaint does not allege any contractual claims, let alone a "bad faith" breach of the implied contractual covenant of good faith and fair dealing. Nor, as discussed above, does the Complaint contain any particularized allegations that the defendants acted with the requisite scienter (in "bad faith").

In other words, the Court tied the obligation of good faith and fair dealing to obligations contained in the operating agreement, not to a more generalized notion of the obligations of directors.  In this case, the complaint included allegations that the directors caused the company to make charitable contributions to non-profit organizations that could then be used to make debt service payments.  In other words, the charitable contributions were designed to mask nonperforming loans.  As paragraph 47 of the complaint described:  

• "Defendants caused the Company to expend additional assets in order to avoid loss recognition and maintain control over defaulted loans so that the individual Defendants could personally derive benefit from the Company's control over such assets.  Throughout the relevant period, the Defendants caused the Company to make numerous charitable contributions to non-profit borrowers so that they could, in turn, make debt service payments on bonds owed by the non-profit borrowers to the Company.  This had the affect of both artificially lowering the purported amount of defaulted loans, thereby enhancing the appearance of the tax-exempt bond portfolio, and further enabling the Company to maintain control over such debt and the entities who were the borrowers of such debt who were thereafter obligated to maintain their allegiance to the Defendants and the management companies controlled by certain of the Defendants who were the actual beneficiaries of the 'Charitable Contributions' from the Company.  In essence, Defendants directed the Company to make 'charitable contributons' to the defaulted borrowers who then passed along the 'contributions' in the form of debt payments and payments to management companies controlled by certain of the Defendants." 

It's one thing to conclude that plaintiffs have not alleged sufficient facts to meet the pleading threshold for these types of allegations.  But that's not what the Court did here.  Instead, the Court more or less said that even if the allegation had been sufficiently substantiated in the Complaint, the allegation itself was insufficient to be a violation of the duty of good faith and fair dealing since "the Complaint does not allege any contractual claims."  Somehow allegations of deliberate concealment of non-performing loans was not sufficiently "contractual" to trigger the duty of good faith and fair dealing. 

This case makes it clear that the Delaware courts have no intention of making the duty of good faith and fair dealing any kind of meaningful limitation on management behavior.  Management will apparently be able to engage in false disclosure and unfair treatment of investors yet not violate this contractual obligation.  It should be clear from Wood v. Baum that Investors investing in LLCs formed in Delaware and that have waived fiduciary duties should expect no meaningful protections and do so at their own peril.  Caveat Emptor.

For materials filed in this case go to the DU Corporate Governance web site.

Comments

[E. M. Heppenstall]

Against the backdrop of the several cases on fiduciary duty erosion one may infer that not all is lost, since a few cases suggest that a delaware court will set aside an action that may be technically legal but basically unfair. See, e.g., Schnell c. Chris Craft Industries, Inc., 285 A. 2d 437; VGS, Inc. v. Castiel,Court of Chancery, No. 17995, 2000 Del. Ch. LEXIS 122 (8/31.2000).