In recent years, the tension between fiduciary duty principles and contract rights, particularly with respect to fiduciary duties in unincorporated entities, has received a great deal of attention from the members of the Delaware judiciary in their written opinions and in extrajudicial commentary.
On the one hand, many decisions of the Court of Chancery have held that fiduciary duties apply in unincorporated entities unless specific language eliminates those duties. On the other, Chief Justice Myron T. Steele wrote an article in the 2009 American Business Law Journal that stated, "Delaware courts should not apply default fiduciary duties even if the parties have not specifically provided for the elimination of fiduciary duties."
Although the Delaware Supreme Court has not yet directly addressed whether fiduciary duties apply to unincorporated entities by default, it has held — in the 2010 case Nemec v. Shrader — that the exercise of contractual rights is not subject to fiduciary duties.
The tension between fiduciary duties and contract principles in unincorporated entities was visited again in the Court of Chancery's recent opinion in Paige Capital Management LLC v. Lerner Master Fund LLC. Although the court's opinion addressed many factual and legal issues, the facts of Paige as they relate to fiduciary duty issues are straightforward.
Michele and Christopher Paige, wife and husband, sought to enter the world of hedge fund management. They recruited Lerner Master Fund LLC, the investment arm of the Lerner family, founders of MBNA and current owners of the NFL's Cleveland Browns and English Premier League's Aston Villa Football Club, to provide the hedge fund with $40 million in "seed money" so that the Paiges could use the Lerners' investment to attract other qualified investors. The Lerner group became a limited partner of the hedge fund, but also signed a separate agreement with additional terms and conditions that were applicable to the Lerners' investment. Pursuant to this side agreement, the Lerners were not permitted to remove their investment from the hedge fund for three years, unless, among other things, the Paige entities breached the contract or a fiduciary duty. In exchange, the Lerners received reduced management fees, incentive payments and other benefits.
The hedge fund agreement itself, an agreement of limited partnership, permitted limited partners to withdraw funds, but provided that if the withdrawal requests were greater than 20 percent of the hedge fund's total asset value, the general partner (controlled by the Paiges) "will reduce on a pro-rata basis" the amounts requested to be withdrawn, so that not more than 20 percent is withdrawn during any single withdrawal period. This "gate provision" was part of the agreement.
The mandatory language of the gate provision was modified, however, by Section 8.02(d) of the partnership agreement, which stated: "The general partner, in its sole discretion, may waive or modify the conditions relating to withdrawals for limited partners that are employees or affiliates of the general partner or the [Paige Capital Management, the investment adviser] relatives of such persons, and for certain large or strategic investors."
The Lerners, having learned that the Paiges made no investments, did not recruit any additional investors and the only additional investment was $40,000 from Michele Paige herself, demanded return of their investment on the third anniversary of the Lerners' investment. The Paiges returned only 20 percent of the investment, arguing that the gate provision applied to the Lerners' investment. Because there were no other investors in the hedge fund, applying the gate provision to the Lerners' investment would allow the Paiges to continue to earn management fees for a longer period of time.
The court initially determined that pursuant to Section 8.02(d) of the partnership agreement, the parties' side letter modified the terms of the gate provision, so the gate provision did not apply to the Lerners' investment. The court then found that even if the gate provision did apply to the Lerners' investment, it was a breach of fiduciary duty by the general partner not to waive that provision as to the Lerners.
The parties agreed that the Lerners were a "large or strategic investor," so they fell within the category of investors for which the general partner could waive or modify the conditions to withdraw from the hedge fund. The Paiges argued that because Section 8.02(d) gave the general partner "sole discretion" to determine whether to "waive or modify the conditions relating to withdrawal," the agreement takes precedence over any default fiduciary duty and permits the general partner to act in its own self-interest, without consideration of the hedge fund and its investors. The court disagreed for two reasons.
First, the court noted that many agreements grant general partners "sole discretion" and then define "sole discretion" to mean that the general partner need not consider any other interests. Without such a definition, providing that the general partner may act in its sole discretion means only that the general partner need not consult with any other party before deciding the matter. Because the limited partnership agreement of the hedge fund did not define "sole discretion," the court concluded Section 8.02(d) must mean only that the general partner could decide on its own. (Note to drafters of LLC and LP agreements — be sure to define "sole discretion" properly if you intend to permit a general partner or manager to act in its own interest).
Second, the court supported its conclusion with a decision from Steele, who was sitting by designation on the Court of Chancery in its 2001 case Cantor Fitzgerald L.P. v. Cantor. In Cantor Fitzgerald, Steele wrote that "any 'sole and absolute discretion granted by a particular provision is subject to the global requirement that every partner abide by its duty of loyalty ... and ... exercise good faith in making all determinations and judgments,'" and that the "sole discretion" in a partnership agreement meant only that the general partner did not need to seek approval or guidance of others.
Finally, the court stated that its conclusion that the general partner's exercise of discretion under Section 8.02(d) was subject to fiduciary duties was consistent with the basic requirement that "any contractual displacement of the fiduciary duties of loyalty and care be made with clarity."
Having reached this conclusion, the court found that the failure to waive the gate provision would be a breach of fiduciary duty because it is a self-interested decision that benefits only the general partner at the expense of, and with no benefit to, the investors.
Interestingly, the court did not even discuss Nemec, if only to distinguish it. Moreover, the court chose a decision by the chief justice sitting by designation in the Court of Chancery to support his holding that exercise of "sole discretion" by a general partner of a limited partnership is bounded by fiduciary duties of loyalty and good faith. This is, of course, not to say that Nemec is not distinguishable, or that the court's reliance on Cantor Fitzgerald is inappropriate. The point of this article is to point out how the Court of Chancery appears to be on a collision course with at least the views of the chief justice on the application of fiduciary duties in unincorporated entities.
Since 2009, in cases such as Bay Center Apartments Owner v. Emery Bay PKI, Kelly v. Blum and In re Atlas Energy Resources LLC Unitholder Litigation, the Court of Chancery consistently has held that managers of LLCs and general partners of LPs are subject to traditional fiduciary duties in the absence of clear language eliminating such duties.
Steele, in his own right, has authored scholarly articles and given public speeches indicating that his personal view, although not necessarily that of the entire Supreme Court, is the opposite — default fiduciary duties should not apply unless specifically included in an LLC or LP agreement. Like two fighters sizing up their opponents, the Court of Chancery and the Supreme Court have been dancing around the issue without a real opportunity to resolve it. While there is no guarantee of an appeal, the Court of Chancery's holding in Paige may provide the Supreme Court with the opportunity to opine on the issue.