Limited liability companies ("LLCs") in Delaware and most other states have the option to specify in their operating agreements that their managers owe no fiduciary duties to other members or the company. But even when LLCs take advantage of that flexibility and adopt such a provision, the expectation of many is that there are still some duties that managers will owe to members in running the company. Indeed, all LLC agreements in Delaware and most other states contain an implied covenant of good faith and fair dealing. A recent Delaware decision (Miller v. HCP & Co., 2018 WL 656378 (Del. Ct. Ch. Feb. 1, 2018)), however, clarifies that courts in that state will enforce an LLC's exclusion of fiduciary duties even in the face of allegations that the managers undertook to enrich themselves directly at the expense of other members. Applying traditional tools of contract interpretation, the court established that the members plainly intended to restrict the application of fiduciary duties and that any other result would be inconsistent with the members' intent. Members who claimed to be harmed were left with no remedy.
The original owners of Trumpet Search, LLC ("Trumpet") founded the company to provide clinical services to persons with autism and other developmental disabilities. In late 2014, HCP & Co., a Chicago-based private equity firm, formed entities to purchase an interest in the company and became Trumpet's largest member. As part of its investment, HCP gained the right to appoint the majority of Trumpet's board. In May 2016, in need of additional cash, Trumpet's members entered into a revised operating agreement that created new ownership units, and the operating agreement set out a distribution waterfall for returns on capital investment in the event of a sale. The operating agreement stated that the new units would be entitled to a first-in-line, first-priority return of 200% of their capital contribution before any other members received any return. HCP purchased more than 80% of the new units.
The agreement also provided that if a majority of the board approved a sale of all of Trumpet's ownership units to an independent third party, each member was obligated to consent. (If a member refused to consent, the agreement provided that the board would be appointed attorney-in-fact so that the board had authority to sign on the objecting member's behalf any documentation necessary for the sale.) The revised operating agreement also explicitly waived all fiduciary duties that might otherwise be owed by Trumpet's members and board. Like all contracts in Delaware, though, the operating agreement subjected Trumpet's members to an implied covenant of good faith and fair dealing.
In December 2016, seven months after the new operating agreement was signed, Trumpet's board met to consider an offer from MTS Health Partners, L.P. ("MTS"), for the sale of Trumpet, which HCP, through its majority interest on the board, was planning to accept. Though Delaware generally imposes a duty on boards and managers to take affirmative steps to determine whether a proposed sales price adequately reflects a company's market value, HCP had not undertaken any market evaluation process to determine whether the offer reflected Trumpet's market value. The non-HCP-appointed board members objected and claimed the offer substantially undervalued the company. HCP agreed to allow these board members to contact other possible purchasers, but under narrow time restrictions. In February 2017, another potential purchaser, FFL Partners LLC ("FFL"), sent a letter of interest in purchasing Trumpet for a price that was $15M to $25M higher than MTS's offer. Significantly, while accepting MTS's offer would yield benefit almost exclusively for HCP's units, the FFL letter of interest offered the prospect of substantial return for all of Trumpet's members. The minority of Trumpet's board urged HCP's appointed board members to explore FFL's interest before selling.
HCP's board majority, however, elected to proceed with the firm offer from MTS. Minority members immediately sued to attempt to block the transaction, claiming HCP had breached its obligation to act in good faith by not pursuing the FFL opportunity or otherwise assessing Trumpet's value in the market. The Delaware Court of Chancery rejected the members' argument. The court noted that the members had agreed in their amended operating agreement to waive fiduciary duties. The court also determined that the operating agreement expressly addressed the possible sale of the company, vesting the board with "sole discretion" to decide how to manage a sales process. The operating agreement also included restrictions on how the board would be permitted to act in response to conflict-of-interest offers. Considering these provisions, the court then held that the operating agreement's implied covenant of good faith and fair dealing, while still in place, should not be used by courts to contravene what it perceives to be the intentions of the parties. "When an LP [or LLC] agreement eliminates fiduciary duties as part of a detailed contractual governance scheme, Delaware courts should be all the more hesitant to resort to the implied covenant."
As the court went on to explain, "The Court does not derive implied obligations from its own notions of justice or fairness. Instead, it asks what the parties themselves would have agreed to had they considered the issue in their original bargaining positions at the time of contracting." The court determined that the parties had expressed their intentions plainly, and they did so in a manner to permit the majority to strike the deal without concern for minority interests. Doing so would effectuate a bargain different from what was struck when the LLC agreement was signed, amended presumably to attract the additional capital. When the majority acts in a manner permitted by the LLC agreement, Delaware courts will not step in to protect minority owners:
[I]f the Plaintiffs had wanted protection from self-interested conduct by the Defendants, they could easily have drafted language requiring the Board to implement a sales process designed to achieve the highest value reasonably available for all of Trumpet's members. The Plaintiffs also could have sought other protections, such as a minimum sales price, a majority-of-the-minority sales provision, or a period during which sales were prohibited. Such a contract would, of course, have been less attractive to investors. Instead, the Plaintiffs struck an investor-friendly bargain with which they are now dissatisfied. But "[p]arties have a right to enter into good and bad contracts[;] the law enforces both."
The Delaware Supreme Court recently affirmed the Court of Chancery's decision, though in doing so it adopted a more expansive interpretation of the implied covenant. While Trumpet's board had "sole discretion" to manage the sales process, the operating agreement "did not relieve the board of its obligation to use that discretion consistently with the implied covenant of good faith and fair dealing." Nevertheless, the Supreme Court concluded that the implied covenant would not supplant an express waiver of fiduciary duties and require the board to comply with fiduciary requirements to "market-check" sales offers. (Miller v. HCP Trumpet Investments, LLC, 2018 WL 4600818 (Del. Sept. 20, 2018)).
The message of the Delaware courts in this case is clear: If LLC members elect to permit their company's managers to operate without owing fiduciary duties, those members should not expect courts to rely on inherent notions of fairness and implied duties applicable to all contracts to overturn self-interested conduct, even if that conduct is potentially egregious. LLC members must use the LLC agreement itself to establish the managers' duties to provide protection for their interests and rights.
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