Managers of Delaware LLCs Owe Fiduciary Duties to LLC Members by Default

A Delaware court has held that, in the absence of contrary language in an LLC operating agreement, the manager of a Delaware limited liability company owes fiduciary duties to the members of the limited liability company.

The court’s holding is significant because the Delaware Supreme Court has refused to expressly hold that such fiduciary duties apply. In fact, as recently as November 2012, the Delaware Supreme Court found that a lower court’s reference to fiduciary duties applying to LLC managers was “dictum without any precedential value.” Nevertheless, the lower courts in Delaware have not given up on the idea on imposing equitable fiduciary duties on LLC managers or managing members. As a result, until a final, express decision is rendered by the Delaware Supreme Court, real estate developers, operators, and investors should consult with counsel regarding fiduciary duties that may be imposed in the absence of other express language in their operating agreements.

The most recent case is Feely v. NHAOCG LLC (Del. Ch., CA No. 7304-VCL, 11/28/12). In Feely, the court allowed a fiduciary duty claim to move forward in a busted real estate development deal. The plaintiff, a member of the LLC, claimed that the manager “failed miserably” in his management role and his skills as a financier “proved to be illusory.” At the time of formation of the LLC, the manager told the members that he was “extremely well-connected in the world of financing” and that he had an extensive “book of business” that he would be able to employ to seek out and secure sources of debt and equity financing.

The plaintiff further alleged that a development project in Florida failed due to gross negligence, when the manager failed to provide the entire deposit called for by the written purchase agreement for the property and failed to fix the mistake during the cure period, even after the LLC’s counsel flagged the issue. The seller declared a default under the real estate purchase agreement and cancelled the contract. As a result, the LLC forfeited a portion of its deposit, became obligated to reimburse a co-investor for its investment, suffered financing penalties, and lost the fees that would have been earned had the deal closed. Finally, the plaintiff asserted that the manager of the LLC began “negotiating student housing deals for his own account” instead of presenting them to the members of the LLC.

The defendant manager argued that LLCs are creatures of contract and the managing member of the LLC owes only the duties expressly stated in the operating agreement. However, the court disagreed with the defendant manager’s theory. “Numerous Court of Chancery decisions hold that managers of an LLC owe fiduciary duties,” the court stated, “unless those duties are eliminated, restricted, or otherwise displaced by express language in the LLC operating agreement.” While the Delaware Supreme Court has not yet finally determined whether LLC managers owe fiduciary duties — and in fact had found that a lower court’s decision that such fiduciary duties were “dictum without any precedential value” — the court nevertheless reasoned “the long line of Chancery precedents holding that default fiduciary duties apply to the managers of an LLC . . . are appropriately viewed as stare decisis by this Court.” The court thus held: “Like the Delaware General Corporation Law, the LLC Act does not explicitly provide for fiduciary duties of loyalty or care; consequently, the traditional laws of law and equity govern.” The court goes on to say that the managing member of an LLC is vested with discretionary power to manage the business of the LLC and easily fits the definition of a fiduciary.

The court also dismissed an argument that the LLC’s operating agreement spoke to the issue of fiduciary duties, reasoning that an exculpation clause that shielded the manager “against liability for certain types of claims” did not “restrict, modify, or eliminate fiduciary duties.” The plain language of the provision eliminated monetary liability unless, among other things, “the act or omission is attributed to gross negligence [or] willful misconduct or fraud . . . .” As a result, the manager owed fiduciary duties to the other member of the LLC and may be held liable for damages if gross negligence or willful misconduct can be shown in the manager’s dealings in the real estate deal.

Delaware limited liability companies are often used as the entity of choice in real estate transactions in California and elsewhere. If a real estate developer or operator is the managing member of an LLC, it will be important to state in the operating agreement the extent of any fiduciary duties owed to the other members of the LLC when discharging its active responsibilities. The more clear the agreement, the better the understanding among the parties as to each party’s obligations under the LLC’s operating agreement. Without clear drafting, general equitable fiduciary duties under common law will apply, meaning that a body of case law will determine the parties fiduciary rights and responsibilities. Similarly, real estate investors that are “silent members” of an LLC or who typically only get involved in “major decisions” will want to have a very clear understanding of the duties owed in the transaction. Sometimes a fiduciary relationship will make sense for both the “sweat equity” and “money” in a transaction; in other situations fiduciary relationships are not necessary for one or more parties if each party’s rights and obligations are spelled out clearly. In either case, consulting with counsel will help to make sure that the parties are on the same page.