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Self-Dealing Conduct Supporting Fiduciary-Duty Claims Was Covered by Contractual Duties Imposed in the LLC Agreement

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May 24, 2018
Albert Manwaring IV

The Delaware Limited Liability Company Act’s policy is to give the maximum effect to the principle of freedom of contract in LLC operating agreements. The act permits parties to eliminate common-law fiduciary duties, and replace them with contractual duties that are often more limited in scope than default common-law fiduciary duties. While parties may not eliminate the implied covenant of good faith and fair dealing in an operating agreement, the implied covenant only operates to imply terms essential to fill gaps necessary to meet the reasonable expectations of the parties as reflected in the express terms of the operating agreement.

The Delaware Court of Chancery has cautioned that when an operating agreement eliminates, or replaces common-law fiduciary duties as part of a contractual corporate governance scheme, “Delaware courts should be all the more hesitant to resort to the implied covenant.” The reason lies in the act’s policy of freedom of contract: the elimination or replacement of default common-law fiduciary duties in an operating agreement “implies an agreement that losses should remain where they fall” in the agreement, rather than being shifted after the fact through fiduciary-duty review under the guise of the implied covenant. Moreover, because of the primacy of contract over fiduciary law in Delaware, fiduciary-duty claims arising from the same facts that underlie contractual duties are superfluous, and thus, foreclosed. In sum, when a dispute arises over the conduct of a manager or LLC’s board, the Court of Chancery is often left to interpret only the express terms of the operating agreement to determine whether the contractual duties imposed cover or prohibit the conduct challenged in the dispute.

In its recent decision, MHS Capital v. Goggin, C.A. No. 2017-0449-SG (Del. Ch. May 10, 2018) (Glasscock, V.C.), the Court of Chancery held that contractual duties imposed on the defendant manager in the operating agreement covered the plaintiff’s claim against the manager for self-interested transactions in breach of the operating agreement. Pursuant to contractual duties imposed by the express terms of the operating agreement, the manager was required to “discharge his … duties in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner [he] reasonably believes to be in the best interests of the [LLC].” The court reasoned that the contractual obligation “to act in good faith and in a manner he ‘reasonably believes to be in the best interests of the [LLC]’” unequivocally covered the manager’s alleged self-dealing theft of business opportunities from the LLC for himself and his “cronies,” and also his misuse of LLC funds to pay his personal legal expenses. The court noted, however, that how the manager’s contractual duty of “good faith and ordinary care” worked together with an exculpatory provision in the operating agreement, barring monetary damages against the manager regardless of any breach of his contractual duties, was unclear. Thus, the court’s determination of relief was premature in the motion to dismiss, and left for a later decision on a developed evidentiary record.

The court subsequently dismissed the plaintiff’s implied covenant, fiduciary duty, and fraud claims based on the express contractual duties, covering the challenged conduct, under the operating agreement. On the implied covenant claim, the court reasoned that the claim rested on the same conduct “explicitly addressed” in the operating agreement, and thus, there was no gap for the implied covenant to fill. Similarly for the plaintiff’s fiduciary duty claim, the court found that all of the conduct that “could conceivably form the basis for a fiduciary duty claim” was “covered by the duties spelled out in the operating agreement,” and the fiduciary duty claim sought the same remedies as the contract claim. Thus, there was no independent basis for the fiduciary duty claim apart from the contract claim, which made the fiduciary duty claim duplicative of the contract claim, and superfluous due to the primacy of contract over fiduciary law in Delaware. Lastly, the court found that the plaintiff’s fraud claim, which essentially alleged that the manager never intended to perform his contractual duties under the operating agreement, violated the well-established principle that “a plaintiff cannot ‘bootstrap’ a claim for breach of contract into a claim of fraud merely by alleging that a contracting party never intended to perform its obligations.”

Practice Point

In MHS Capital, the operating agreement defined contractual duties of the manager in terms that equated with the otherwise applicable default common-law fiduciary duties of loyalty and care. While parties may eliminate common-law fiduciary duties, and replace them with contractual duties that are more limited in scope than default common-law fiduciary duties, parties should carefully define the specific duties and covered conduct in the operating agreement. In sum, a clear manifestation of the parties’ reasonable expectations in the operating agreement will reduce the risk of a judicial interpretation that negates the parties’ objective to limit the scope of default common-law fiduciary duties.

Delaware Business Court Insider, May 23, 2018

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