New Delaware Ruling Highlights Unintended Consequences of Excluding Officers from Fiduciary Duty Waivers
Delaware law provides parties with significant flexibility to restrict or eliminate fiduciary duties in LLC agreements. Sophisticated parties regularly take advantage of this flexibility by eliminating fiduciary duties of members and directors of LLCs. These same parties, however, often choose not to extend these waivers to officers of the LLCs, often stemming from a desire to ensure that officers still have a fiduciary duty to be loyal to the LLC. A new ruling from the Delaware Court of Chancery highlights the unintended consequences of excluding officers from the scope of the fiduciary duty waiver.
In Cygnus Opportunity Fund, LLC, et al. v. Washington Prime Group, LLC, et al.,[1] the Court denied dismissal of claims alleging that company officers breached their fiduciary duties by failing to provide adequate information to minority investors in connection with a tender offer by the controlling member and a subsequent squeeze-out merger. In addition, the Court allowed the survival of claims against the officers, the board and the controlling investor, asserting a breach of the covenant of good faith in connection with the transactions.
Cygnus illuminates two key tensions (also examined here, here, and here): (i) the tension between the officers’ duties owed to the board of managers versus its fiduciary duties owed to the members and (ii) the tension between freedom of contract when drafting LLC agreements versus the backstop of the implied covenant of good faith and fair dealing. These facts are worth keeping in mind when drafting LLC agreements with fiduciary duty waivers and provisions that grant full discretion to one of the parties. Below we break down the Court’s analysis and key takeaways.
Factual Background
This case arose in connection with a squeeze-out merger that eliminated the minority investors in Washington Prime Group, LLC (the “Company”), a Delaware limited liability company. The Company’s limited liability company agreement (the “LLC Agreement”) provided for a structure that mimicked a corporation, with a board of managers and officers.[2] Under the terms of the LLC Agreement, a squeeze-out merger required either approval of a minority-approved independent manager or approval of a majority the minority members.[3]
The controlling investor (the “Controller”) initially launched a two-tiered tender offer to purchase the minority holders’ shares for $25.75 in cash if they tendered in the initial two-weeks, and $25.00 in cash thereafter. No recommendation was made by the Controller or the board in connection with the tender offer, and no financial information was provided to the minority investors.[4]
When the tender offer closed, one of the minority investors asked for the contact information for the minority-approved independent manager. This request for information was rejected.[5]
Several months thereafter, the Company informed the minority investors that each of their shares had been converted into the right to receive $27.25 in cash in a squeeze-out merger.[6] The investors were provided with 8 pages of disclosure, which plaintiffs alleged was missing key material information, including information about the negotiations of the minority-approved independent manager and the Controller, and the fairness opinion received in connection with the squeeze-out merger.[7]
One of the minority investors contacted Company counsel for information about the squeeze-out merger, though the response added nothing beyond what had already been disclosed.[8] Another minority investor formally demanded information about the squeeze-out merger, which the Company rejected on the grounds that the investor no longer had any interest in the Company and thus no longer had informational rights.[9]
The minority investors sued the members of the board, the officers and the Controller. Among other claims, the plaintiffs alleged breaches of fiduciary duty against each of the defendants for failing to provide material information in connection with the transactions, and against the board members and the Controller for approving an unfair transaction. The plaintiffs also asserted a claim against all defendants for breach of the implied covenant of good faith and fair dealing and against the board member and Controller for aiding and abetting breaches of fiduciary duty by the officers.[10] The defendants filed motions to dismiss these claims. At the motion to dismiss stage, the Court accepts all well-pled facts as true, and draws all inferences in favor of the plaintiff.[11]
The Decision
First, the Court quickly dismissed the breach of fiduciary duty claims against the Board and the Controller, noting that the LLC Agreement contains a plain and unambiguous fiduciary duty waiver for both the Board and the Controller.[12]
Next, the Court analyzed the breach of fiduciary duty claims against the Company’s officers. Unlike the Board and the Controller, the officers did not benefit from any fiduciary duty waiver, since the waiver explicitly excluded Company officers.[13]
The Court denied dismissal of the breach of fiduciary duty claims against the officers for failing to provide adequate disclosure in connection with the tender offer and merger. Analyzing Delaware case law, the Court concluded the officers may have had a duty of disclosure that is analogous to the duties owed by company directors, which, depending on the circumstances, may require disclosure in connection with a tender offer. The Court also held that, as fiduciaries, the officers may have had a duty to inform the minority holders of the material facts surrounding the squeeze-out merger, regardless of whether or not their approval is required.[14]
Notably, the Court noted that officers’ fiduciary duty of disclosure owed to the minority investors is in significant tension with the officers’ duty of obedience to the board. Underscoring this “conundrum,”[15] the Court explained that officers, as agents of the Board, may not act contrary to the board’s directives. Even so, officers do not have a duty to comply with directives that they have reason to know would expose them to criminal or civil liability, including with “directives that the officer[s] ha[ve] reason to believe would constitute a breach of fiduciary duty.”[16] Here, the Court noted that “[i]t is reasonably conceivable that a duty of disclosure could exist in connection with a severely underpriced tender offer such that fiduciaries for the entity and its investors would have a duty to say something.”[17]
The Court also denied the dismissal of the claim against all the defendants for breach of the implied covenant of good faith and fair dealing in connection with (i) failing to disclose information about the tender offer and the squeeze-out merger, (ii) seeking approval by the minority-approved independent manager of the squeeze-out merger, rather than a vote by the minority investors, and (iii) providing very low consideration in connection with the squeeze-out merger.[18]
The Court noted the freedom of contract inherent in the LLC Agreement, and the need for courts to avoid using the implied covenant to “re-write”[19] the agreements between the parties. Nevertheless, the Court reasoned that on the facts of these claims, the implied covenant applied. In denying dismissal of claim (i), the Court cited the Delaware Supreme Court case Dieckman v. Regency GP LP[20] for the proposition that while a limited liability agreement may eliminate the duty of disclosure, the implied covenant of good faith “obligated the defendants to provide truthful and accurate disclosure of material information.”[21]
In denying dismissal of claim (ii), the Court noted that even when a contract grants full discretion to one party, the implied covenant constrains that parties’ ability to act.[22] The plaintiffs alleged that the minority-approved independent manager was incapable of acting independently of the Controller, pointing to his refusal to speak with one of the plaintiffs and his purported dependence on private equity firms like the Controller. The Court asserted that it is reasonably conceivable that the parties would not have agreed that approval by the minority-approved independent manager would have been appropriate in circumstances when the independent manager was not independent and in circumstances when the disclosure and price were inadequate.[23] So, when the board had discretion to choose between the two paths to approve the transaction, the implied covenant requires them to exercise the discretion reasonably.
In denying dismissal of claim (iii), the Court similarly maintained that it is reasonably conceivable that the consideration was so low that it violated the implied covenant.[24]
Finally, the Court denied dismissal of aiding and abetting claims against the Board and the Controller relating to the breach of fiduciary duty claims against the officers.[25] Though the Court deferred ruling on these claims until the trial, the claims’ survival to trial significant undermines the benefit of fiduciary duty waivers in the first instance.
Key Takeaways
- When drafting LLC agreements, practitioners should consider the potential consequences of excluding officers from fiduciary duty waivers.
- The Cygnus Court’s ruling appears to be an unintended consequence of carving officers out of the fiduciary duty waiver, which generally serves to ensure officers have a fiduciary duty to the company and do not engage in self-dealing.
- As seen in this ruling, carving out the officers from the waiver both opens the officers up to fiduciary duty breach claims by any member, and even may expose the controllers and the boards to claims of aiding and abetting breaches of fiduciary duty that they themselves are expressly protected against.
- From the perspective of a controlling holder, a waiver of fiduciary duties should be clear and broad. If officers are to be carved out of fiduciary duty waivers, drafters should still consider waiving officers’ fiduciary duties of care (similar to the scope of exculpation of corporate officers now permitted under Section 102(b)(7) of the Delaware General Corporation Law) and making clear that officers owe any remaining fiduciary duties only to the company, rather than to all of its members. Drafters should also consider making clear that only the board can assert claims for breach of these duties and should eliminate the ability of members to enforce such claims through a derivative action.
- If not beneficiaries of a fiduciary duty waiver, officers of Delaware LLCs should be aware of the potential for claims against them.
- In these circumstances, in connection with a significant event, such as a merger, officers must take reasonable steps to disclose material information to holders, even in circumstances where a controller or board may be reluctant to provide information.
- Even if an LLC agreement grants full discretion to one of the parties, the implied covenant of good faith and fair dealing remains a backstop against the exercise of that discretion.
- Cygnus provides another important reminder that not all obligations may be contracted away in an LLC agreement. A party granted full discretion to act must still act in the spirit of good faith.
[1] C.A. No. 2022-0718-JTL (Del. Ch. 2023).
[2] Id. at 2.
[3] Id.at 3-4.
[4] Id. at 5-7.
[5] Id. at 6-7.
[6] Id. at 7.
[7] Id.
[8] Id. at 8.
[9] Id.
[10] Id. at 8-10.
[11] Id. at 10.
[12] Id. at 10-11.
[13] Id. at 12.
[14] Id. at 12-28.
[15] Id. at 17.
[16] Id., citing Goldstein v. Denner, 2022 WL 1671006, at *52 (Del. Ch. May 26, 2022).
[17] Id. at 17.
[18] Id. at 33-43.
[19] Id. at 34, citing Nemec v. Shrader, 991 A.2d 1120, 1125 (Del. 2010).
[20] 155 A.3d 358 (Del. 2017).
[21] Cygnus, C.A. No. 2022-0718-JTL at 39, citing Dieckman, 155 A.3d at 367-68.
[22] Id. at 40.
[23] Id. at 41.
[24] Id. at 43.
[25] Id. at 47.
