March 12, 2018

Fiduciary Duties: LLC Members Get Only What They Bargain For

This Fried Frank memo reviews the Delaware Chancery Court’s recent opinion in Miller v. HCP (Del. Ch.; 2/18) – in which the Court refused to impose a duty on an LLC’s board to maximize value in a sale favored by its controlling member. Here’s an excerpt summarizing the case:

Under the LLC operating agreement’s “waterfall” provisions governing the allocation of proceeds on a sale of the company, the controller was entitled to receive almost all of the proceeds of any sale up to $30 million and almost none of any proceeds above that amount (which, the court acknowledged, created little incentive for the board to negotiate a price higher than $30 million).

The buyer initially offered $31 million and ultimately increased the price to $43 million (after the company had received a competing offer for $36 million and an unsolicited indication of interest that valued the company at $50-$60 million—neither of which the controller-allied board members pursued). Only $48,000 of the $13 million price increase was allocated to the plaintiff (who was a co-founder of the company), with the balance being allocated to other minority stockholders who had priority over the plaintiff in the waterfall. Under the waterfall, the plaintiff was entitled to an allocation of significant proceeds on a sale only if the price reached $60 million.

The plaintiff claimed that an open auction process would have resulted in a much higher sale price that would have made proceeds available to all of the Trumpet preferred unitholders. Although, under the LLC operating agreement, all fiduciary duties of the board to the LLC members and of the LLC members to one another were waived, and the board was granted “sole discretion” to approve a sale to an unaffiliated third party, the plaintiff contended that, based on the contractual implied covenant of good faith (which adheres to every contract and cannot be waived), the board was obligated to seek to maximize the price. The court disagreed and granted the motion of the controller and the controller-allied board members to dismiss the case.

While Delaware permits LLCs to waive fiduciary duties in their operating agreements, the implied covenant of good faith continues to apply to all contracts, including  LLC agreements.  But Vice Chancellor Glasscock noted that the covenant of good faith is a gap filler, and a court needs to determine whether there are any gaps to fill before invoking it. Citing prior Delaware authority, he concluded that there wasn’t one here:

“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.” The reason is that an alternative entity agreement that waives all fiduciary duties “implies an agreement that losses should remain where they fall” rather than being shifted after the fact through fiduciary duty review.

John Jenkins