United States: Fiduciary Duties In Limited Liability Company Acquisition Vehicles

2013 change in Delaware law inadequately addressed in many private equity deals

In most private equity and other leveraged buyout transactions, the acquiring group will create a new legal entity (NewCo) to serve as the acquisition vehicle. NewCo will consolidate capital from the various debt and equity investors, acquire and manage the target business, and facilitate the distribution "waterfall" upon an exit.

In the last fifteen years, the limited liability company has become increasingly popular as an investment vehicle for acquisition transactions. Certain types of investors (e.g., tax-exempt or non-U.S. persons) still prefer to own equity in C-corporations. However, for many others, the LLC form is preferred. The LLC offers an appealing hybrid of the pass-through taxation and flexibility of partnerships and the limited liability of corporations.

Despite the increasing prevalence of the LLC in leveraged buyout transactions, certain fundamental elements of the LLC structure are frequently mishandled. In particular, we have found that members' and managers' fiduciary duties are often erroneously or inadequately addressed. This article briefly summarizes this issue. Although each of the 50 states provides for its own state-specific form of LLC, this article focuses on limited liability companies formed under Delaware law. Due to its well-developed legal framework, experienced judiciary and discretion with respect to publicly available information, Delaware is the jurisdiction of choice for forming sophisticated investment entities.

Under Delaware's corporation law, directors and controlling stockholders have fiduciary duties to the corporation's stockholders, including the duty of loyalty and the duty of care. These duties have been refined through decades of judicial interpretation. In the LLC context, the relative youth of the Delaware LLC Act means that the fiduciary duties of members and managers in LLCs are not nearly as well defined. Although Delaware courts have addressed a spate of cases on this topic in recent years, judicial interpretation has generally been inconclusive.

However, in 2013 the Delaware legislature amended Section 18-1104 of the Delaware LLC Act to clarify that fiduciary duties apply in the LLC context unless expressly limited by the LLC operating agreement. Although future Delaware judicial decisions will likely result in the evolution of these duties, the statutory change is a significant leap towards clarifying this issue. As a result of this change, private equity sponsors and other parties that control LLC acquisition vehicles are subject to the duties of loyalty and care in their dealings with the minority. These duties may come into play in a variety of situations, particularly in cases where the sponsor may be perceived as acting it its own interests to the detriment of the other investors.

For example, fiduciary duties may be implicated in decisions involving the pursuit of corporate opportunities, the payment of management fees or the sale process upon an exit. If the sponsor or controlling investor fails to satisfy these duties, it could be subject to a claim by the other stakeholders.

Section 1101(c) of the Delaware LLC Act permits an LLC operating agreement to expand, restrict or eliminate fiduciary duties of the members or manager (except for the implied contractual covenant of good faith and fair dealing). This is a significant difference from the Delaware corporation law, which does not permit fiduciary duties to be waived.1 Section 1101(c) allows parties to an LLC agreement to renounce virtually all fiduciary duties. With a blanket waiver, the members and managers of the LLC would only be subject to the contractual restrictions set forth in the operating agreement (along with the implied contractual covenant of good faith and fair dealing).

Unless the sponsor has specifically breached a provision of NewCo's operating agreement, a waiver of fiduciary duties should be a significant impediment to minority members pursuing a claim based on a sponsor's unfair acts or self-dealing. For example, in Wiggs v. Summit Midstream Partners, LLC2, Energy Capital Partners, a private equity group based out of New Jersey, owned a controlling interest in a family of Delaware LLCs involved in the development of natural gas gathering systems. The company awarded incentive equity interests in the venture to a number of senior officers. These incentive interests were designed to participate in distributions once ECP's capital had been returned and a hurdle rate achieved. The operating agreements afforded ECP great leeway in operating the company. ECP ultimately caused the company to engage in a refinancing and other transactions that specifically benefitted ECP. ECP's actions were not prohibited by the operating agreements. However, these transactions had the additional effect of hurting the chances that the officers' incentive units would be "in the money" upon a sale of the company. The officers filed suit against ECP, alleging a breach of ECP's fiduciary duties (among other claims). In dismissing the fiduciary duty claims, the Delaware Chancery Court relied on a broad waiver of fiduciary duties in the pertinent LLC operating agreement that "specifically eliminates any fiduciary duties on the part of [ECP]".

In our experience, however, blanket waivers of fiduciary duties of the type at issue in Wiggs are frequently omitted from LLC operating agreements. These omissions may be due to oversight on the part of sponsor's counsel or leverage on the part of non-controlling investors. In any event, without a waiver, default fiduciary duties apply. Any limitation on the fiduciary duties owed by a sponsor or controlling investor to the other members must usually be deduced from the "limitation of liability" and "indemnification" sections of the operating agreement, assessed against the backdrop of the Delaware LLC Act. These sections often address the impact of the managers' or members' "bad faith", "good faith", "willful misconduct", "negligence", "scope of authority" and other standards of conduct. However, the "limitation of liability" and "indemnification" sections frequently do not harmonize, and often conflict. Moreover, we regularly see operating agreements that ignore the impact of fiduciary duties imposed by the statute. In many cases, the operating agreement is at best murky as to the duties owed by the sponsor or controlling investor to the other stakeholders of NewCo. As a result, the sponsor or controlling investor may have a different level of exposure to the other members than is expected or intended.

To address this issue, NewCo's operating agreement should have carefully crafted "limitation of liability" and "indemnification" sections. These sections must work together and with any other sections of the operating agreement that arguably impose standards of conduct or other fiduciary obligations on the sponsor or a controlling investor. Further, these provisions must take into account the fiduciary duties that are overlaid by the Delaware LLC Act. Any waivers of fiduciary duties must be clear and explicit. The operating agreement might also address in detail certain aspects of fiduciary duties that might be especially relevant to a particular transaction. For example, the agreement could cover management's obligations with respect to corporate opportunities, or the conflict of interest to which a private equity group's board appointees is inherently subject.

Previously published in the July 15, 2015 issue of the Delaware Business Court Insider © 2015 ALM Media Properties, LLC.


1 Section 102(b)(7) of the Delaware General Corporation Law permits a corporation to exculpate directors from liability in certain instances, although liability resulting from a breach of a director's duty of loyalty is explicitly carved out from this provision.

2 C.A. No. 7801-VCN (Del. Ch. Mar 28, 2013).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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