In resolving this dispute between the controlling member-manager and the minority investors of a Delaware Limited Liability Company ("LLC"), we interpret the LLC's governing instrument (the "LLC Agreement") as a contract that adopts the equitable standard of entire fairness in a conflict of interest transaction between the LLC and its manager. We hold that the manager violated that contracted-for fiduciary duty by refusing to negotiate with a third-party bidder and then, by causing the company to be sold to himself at an unfair price in a flawed auction that the manager himself engineered. For that breach of duty the manager is liable. Because the manager acted in bad faith and made willful misrepresentations, the LLC Agreement does not afford him exculpation. We
I. FACTUAL AND PROCEDURAL HISTORY
In 1997, Gatz Properties, LLC and Auriga Capital Corp., together with other minority investors,
The instrument that governed Peconic Bay was the Amended and Restated Limited Liability Company Agreement (the "LLC Agreement"). The Gatz family and their affiliates controlled over 85% of the Class A membership interests, and over 52% of the Class B membership interests of Peconic Bay. The LLC Agreement requires that 95% of all cash distributions first be made to the Class B members until they recoup their investment. Thereafter, the cash distributions are to be made to all members pro rata.
The LLC Agreement designated Gatz Properties as manager. Gatz Properties was managed and controlled by William Gatz ("Gatz"), who also managed, controlled, and partially owned Gatz Properties.
Beginning January 1, 1998, Gatz Properties leased the family property to Peconic Bay under a Ground Lease that ran for an initial 40-year term, with an option to renew for two ten-year extensions. The Ground Lease limited the property's use to a high-end, daily fee, public golf course. The LLC Agreement contemplated that a third party would operate the golf course. (Peconic Bay could not operate the golf course itself without majority membership interest approval.) To finance the golf course construction, Peconic Bay borrowed approximately $6 million, evidenced by a Note secured by the property. The LLC Agreement contemplated that Gatz Properties, as manager, would collect rent from the third-party golf course operator, make the required payments on the Note, and then distribute the remaining cash as the LLC Agreement provided.
On March 31, 1998, Peconic Bay entered into a sublease (the "Sublease") with American Golf Corp., a national golf course operator. The Sublease ran for a term of 35 years, but granted American Golf an early termination right after the tenth year of operation. Under the Sublease, American Golf would pay rent to Peconic Bay, starting at $700,000 per year and increasing annually by $100,000, until leveling out to $1 million per year in 2003. American Golf would also pay additional rent amounting to 5% of the revenue from its golf course operations. Under the Ground Lease between Gatz Properties and Peconic Bay, the revenue-based portion of the rent would "pass through" directly to Gatz Properties.
The golf course's operations were never profitable. Both sides characterized American Golf as a "demoralized operator" that neglected maintenance items to the extent that the poor condition of the course adversely affected revenue. By at least 2005, Gatz knew that American Golf would elect to terminate the Sublease in 2010. Anticipating that, in 2007 Gatz commissioned an appraisal that valued the land with the golf course improvements at $10.1 million, but at a value 50% higher — $15 million — as vacant land available for development. By mid-2009, again in anticipation of the sublease's termination, Gatz Properties had set aside almost $1.6 million in cash under Section 11 of the LLC Agreement, which authorized the manager to retain distributions reasonably necessary to meet present or future obligations.
In August 2007, Matthew Galvin, on behalf of RDC Golf Group, Inc. ("RDC"), contacted Gatz and expressed an interest in acquiring Peconic Bay's long-term lease. Galvin asked Gatz to permit RDC to conduct basic due diligence, and told Gatz that he was willing to enter into a confidentiality agreement. Gatz refused to provide the requested due diligence information, and moreover, criticized Galvin's gross revenue projections of $4 million as overly optimistic.
Nevertheless, Galvin submitted a nonbinding letter of intent to Gatz, offering to acquire the Peconic Bay Ground Lease and the Sublease, exclusive of other assets and liabilities, for $3.75 million. Gatz put the Galvin offer to a membership vote, knowing that the offer would be rejected not only because it would render Peconic Bay insolvent,
On January 22, 2008, Galvin proposed a "Forward Lease" whereby RDC would take over the Sublease from American Golf if American Golf exercised its 2010 early termination option. RDC would maintain the Sublease's noneconomic features, but would renegotiate the rent terms. Again, Gatz made no response. The reason is that Gatz himself wanted to acquire the Sublease and Peconic Bay's other assets.
The proof is that one week earlier, on January 14, 2008, Gatz had written to Peconic Bay's minority investors and offered to purchase their interests for a "cash price equal to the amount which would be distributed for those interests as if [Peconic Bay's] assets sold for a cash price of $5.6 million as of today." Gatz characterized his offer as equivalent to a sale price of over $6 million, by not having to pay certain related closing costs and prepayment penalties that would result if the buyer were a third party. The Gatz letter then informed the minority investors that "[n]egotiations with RDC have broken off with their best offer of $4.15 million being rejected. Offering a counter proposal of $6 million to RDC as Bill Carr suggested did not receive majority approval from the members." What Gatz did not tell the minority investors was that Galvin had expressed an interest in negotiating an offer "north of $6 million," and that Gatz had never responded. As his "bottom line," Gatz offered the minority members $734,131, conditioned on their unanimous acceptance.
All but one of the minority members rejected that offer. Gatz then changed strategy and hired Laurence Hirsh to appraise the property, but without giving Hirsh complete information. Gatz did not inform Hirsh of Galvin's $4.15 million offer, of Galvin's gross revenue projections of $4 million which implied a value of $6 to 8 million, or that American Golf was a "demoralized operator." As a result, Hirsh relied solely on American Golf's historical financials and data from comparable courses in the geographic area. On that basis Hirsh appraised Peconic Bay's leasehold, as of June 2008, at $2.8 million as a daily fee golf course, and at $3.9 million as a private golf course. Relying on Hirsh's appraisal as proof that Peconic Bay had no net positive value, Gatz then made a new offer to the minority members on August 7, 2008. This time Gatz offered to pay 25% of each member's capital account balance. In connection with that offer, Gatz also retained Blank Rome LLP
On December 8, 2008, Gatz formally proposed to sell Peconic Bay at auction and informed the minority members that Gatz Properties intended to bid. Exercising their majority voting power, the Gatz family and their affiliates approved Gatz's auction proposal. By this point, Peconic Bay had almost $1.4 million in cash reserves and debt service of about $520,000 per year.
Assisted by Blank Rome, Gatz next hired an auctioneer in February 2009. Although Gatz claimed to have considered three different auction firms, he hired Richard Maltz of Maltz Auctions, Inc. ("Maltz"). Maltz specialized in "debt related" sales and conducted the majority of its work in connection with bankruptcy court proceedings, but had never auctioned off a golf course. Gatz and Maltz entered into an agreement in late May 2009, whereby the golf course would be marketed for 90 days, after which the auction would take place on August 18, 2009. As actually carried out, the marketing effort consisted of small-print classified advertisements in general circulation newspapers and in a few magazines, online advertisements on websites, and direct mailings. At trial, Maltz was unable to produce documents or testimony evidencing the content of the direct mailings. The Court of Chancery found no credible evidence that any golf course brokers, managers, or operators had ever been contacted. The court also found that Gatz had not informed Maltz about the RDC bids or suggested that Maltz contact Galvin.
Due diligence materials, which the trial court described as "less than optimal," were made available to potential bidders on or about July 16, 2009, for a $350 fee.
In 2009, Auriga brought a Court of Chancery action against Gatz. Auriga then moved to enjoin the Auction from taking place, but the court denied the injunction
On August 18, 2009, the day of the auction, Maltz informed Gatz that he (Gatz) would be the only bidder. Gatz then proceeded to bid and then to purchase Peconic Bay for $50,000 cash plus assumption of the LLC's debt. The minority members collectively received $20,985. Maltz received $80,000 for his services. At trial Gatz admitted that "had there been another bidder at the Auction, he `might have bid higher' than $50,000."
In 2010, Auriga and the remaining LLC minority members brought this Court of Chancery action for money damages. After a trial, the court ruled in favor of Auriga, holding that Gatz had breached "both his contractual and fiduciary duties" to Peconic Bay's minority members.
On July 20, 2012, Gatz Properties filed a voluntary Chapter 11 petition in the United States Bankruptcy Court for the Eastern District of New York. On September 12, 2012, the Bankruptcy Court granted, among other things, a motion for relief from the automatic stay, thereby enabling this Court to proceed with the appeal.
II. STANDARD OF REVIEW
This case raises issues of contract interpretation that we review de novo.
A. Did Gatz Owe Fiduciary Duties To The Other Members Of Peconic Bay?
The pivotal legal issue presented on this appeal is whether Gatz owed contractually-agreed-to fiduciary duties to Peconic Bay and its minority investors. Resolving that issue requires us to interpret Section 15 of the LLC Agreement, which both sides agree is controlling. Section 15 pertinently provides that:
The Court of Chancery determined that Section 15 imposed fiduciary duties in transactions between the LLC and affiliated persons. We agree. To impose fiduciary standards of conduct as a contractual matter, there is no requirement in Delaware that an LLC agreement use magic words, such as "entire fairness" or "fiduciary duties." Indeed, Section 15 nowhere expressly uses either of those terms. Even so, we construe its operative language
We conclude that Section 15 of the LLC Agreement, by its plain language, contractually adopts the fiduciary duty standard of entire fairness, and the "fair price" obligation which inheres in that standard. Section 15 imposes that standard in cases where an LLC manager causes the LLC to engage in a conflicted transaction with an affiliate without the approval of a majority of the minority members. There having been no majority-of-the-minority approving vote in this case, the burden of establishing the fairness of the transaction fell upon Gatz. That burden Gatz could easily have avoided. If (counterfactually) Gatz had conditioned the transaction upon the approval of an informed majority of the nonaffiliated members, the sale of Peconic Bay would not have been subject to, or reviewed under, the contracted-for entire fairness standard.
Gatz's admissions in the pleadings and during his cross examination at trial confirm
Equally if not more illuminating is Gatz's trial testimony during cross examination. When asked, "Would you agree Gatz Properties owed fiduciary duties to the members of Peconic Bay?", Gatz answered unequivocally "Yes."
We therefore uphold the Court of Chancery's determination that Gatz breached his contractually adopted fiduciary duties to the minority members of Peconic Bay. Although the trial court reached that conclusion after first having determined that Delaware's LLC statute imposed "default" fiduciary duties — a conclusion that we address elsewhere in this Opinion — we affirm the court's holding that Gatz was subject to fiduciary duties and that he breached them. We do that exclusively on contractual grounds, however.
Entire fairness review normally encompasses two prongs, fair dealing and fair price.
The trial judge found facts, solidly grounded in the record, that firmly support his conclusion that Gatz breached his contracted-for duty to the LLC's minority members. Regarding price, the court found that "Peconic Bay was worth more than what Gatz paid."
The court also found as fact that had "Gatz dealt with Galvin with integrity in 2007, it seems probable that Peconic Bay could have been sold in a way that generated to the Minority Members a full return of their invested capital ($725,000) plus a 10% aggregate return ($72,500)."
As for fair dealing, the Court of Chancery did not "view the Auction process as generating a price indicative of what Peconic Bay would fetch in a true arms-length negotiation."
These conclusions flow persuasively from the evidence of record. Gatz's decision to auction off Peconic Bay as a distressed property — as opposed to engaging
We are satisfied that Gatz failed to carry his burden of proving that he discharged his contracted-for entire fairness obligation. Accordingly, we affirm that court's determination of liability solely on contractual grounds.
B. Does Section 16 Of The LLC Agreement Exculpate Gatz?
Although the trial court's adjudication subjects Gatz to liability under Section 15 of the LLC Agreement, another provision, Section 16, permits both exculpation and indemnification of Peconic Bay's manager in specified circumstances. Gatz, however, did not cause those circumstances to come about. Having failed to satisfy the criteria of Section 16, Gatz was not eligible for exculpation or indemnification, and the Court of Chancery properly so held.
Section 16 of the LLC Agreement pertinently provides:
Gatz was not entitled to exculpation because the Court of Chancery properly found that he had acted in bad faith and had made willful misrepresentations in the course of breaching his contracted-for fiduciary duty. Consequently, Section 16 of the LLC Agreement provides no safe harbor. We highlight the most egregious instances below.
This Court and the Court of Chancery have defined "bad faith" in the corporate fiduciary duty of loyalty context as (among other things) a failure "to act in the face of a known duty to act," which demonstrates
Likewise, the factual findings support the court's conclusion that Gatz conducted the Auction in bad faith. Gatz decided to pursue an auction process on distressed sale terms, rather than a broker-led process based on a fully developed analysis of strategic alternatives.
Further, that court correctly found that Gatz's offer to Peconic Bay's minority members in 2008 "contained incomplete and misleading information about the RDC negotiations."
Those findings support the court's determination that Gatz acted in bad faith and made willful misrepresentations. We therefore uphold the trial court's finding that Section 16 of the LLC Agreement does not immunize Gatz from liability for his conduct.
C. Unnecessary Construction Of LLC Statute To Provide Default Fiduciary Duties
At this point, we pause to comment on one issue that the trial court should not have reached or decided. We refer to the court's pronouncement that the Delaware Limited Liability Company Act imposes "default" fiduciary duties upon LLC managers and controllers unless the parties to the LLC Agreement contract that such duties shall not apply. Where, as here, the dispute over whether fiduciary standards apply could be decided solely by reference to the LLC Agreement, it was improvident and unnecessary for the trial court to reach out and decide, sua sponte, the default fiduciary duty issue as a matter of statutory construction. The trial court did so despite expressly acknowledging that the existence of fiduciary duties under the LLC Agreement was "no longer contested by the parties."
First, the Peconic Bay LLC Agreement explicitly and specifically addressed the "fiduciary duty issue" in Section 15, which controls this dispute. Second, no litigant asked the Court of Chancery or this Court to decide the default fiduciary duty issue as a matter of statutory law. In these circumstances we decline to express any view regarding whether default fiduciary duties apply as a matter of statutory construction. The Court of Chancery likewise should have so refrained.
Third, the trial court's stated reason for venturing into statutory territory creates additional cause for concern. The trial court opinion identifies "two issues that would arise if the equitable background explicitly contained in the statute were to be judicially excised now."
Fourth, the merits of the issue whether the LLC statute does — or does not — impose default fiduciary duties is one about which reasonable minds could differ. Indeed, reasonable minds arguably could conclude that the statute — which begins with the phrase, "[t]o the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties)"
Having found that the defendants had breached a contracted-for fiduciary duty arising from equity, and that the LLC Agreement did not dictate otherwise, the Court of Chancery awarded equitable damages as a remedy.
Conscience and reason appropriately circumscribed the trial court's award of damages in this case. The law requires the trial judge to weigh the evidence, including the credibility of live witness testimony.
The trial court determined that if Gatz had engaged with Galvin in 2007, as Gatz's contracted-for entire fairness duty required, Peconic Bay could probably have been sold at a price that returned to the minority investors both their initial capital ($725,000) plus a 10% aggregate return ($72,500).
The Court of Chancery arrived at a damage award of $776,515, which represented a full return of the minority members' capital contributions plus a 10% aggregate return, less the $20,985 the minority members received at the Auction. That award is slightly less than the amount a sale in 2007 for $6.5 million would have yielded.
E. Attorneys' Fees
Gatz's final claim of error attacks the trial court's award of attorneys' fees. We review an award of attorneys' fees for
"Under the American Rule, absent express statutory language to the contrary, each party is normally obliged to pay only his or her own attorneys' fees."
In this case, the Court of Chancery made specific findings that detailed Gatz's bad faith conduct throughout the course of the trial. Even so, the court awarded plaintiffs only one-half of their reasonable attorneys' fees and costs because of Auriga's own "less than ideal" litigation efforts.
For the foregoing reasons, the judgment of the Court of Chancery is AFFIRMED.
The trial court also interpreted our decision in Saliba as holding that traditional fiduciary duties exist unless the contracting parties expressly modify or eliminate them in their operating agreement. Auriga, 40 A.3d at 854, 855 n. 65 (citing Saliba, 13 A.3d at 756). That misreads Saliba's holding. In Saliba our task was to interpret the intent of the parties as expressed in their operating agreement. There, the parties agreed that under the operating agreement, fiduciary duties applied. Saliba, 13 A.3d at 756 ("[T]he parties here agree that the Lingos [as managers] owe fiduciary duties of loyalty and care to the members of Del Bay."). In that circumstance, we do not look behind their in-court representations. See Stroud v. Grace, 606 A.2d 75, 87 n. 2 (Del. 1992) ("Plaintiffs do not specifically contest this aspect of the Vice Chancellor's ruling on appeal and effectively waive that claim."). Similarly, where, as here, the LLC Agreement expressly imposes a contractual obligation of entire fairness, it is unnecessary to look beyond the contract language to determine whether default fiduciary duties exist as a matter of statutory law.
See Myron T. Steele & J.W. Verret, Delaware's Guidance: Ensuring Equity for the Modern Witenagemot, 2 VA. L. & BUS. REV. 189 (2007) (discussing the role of extrajudicial activities in guiding Delaware law); see also Lawrence A. Hamermesh, The Policy Foundations of Delaware Corporate Law, 106 COLUM. L.REV. 1749, 1759-62, 1788 (2006) (describing how the members of the Delaware Court of Chancery and Delaware Supreme Court develop corporate law outside of the courtroom as well as cataloguing appearances by Delaware judges at public forums on corporate law).
817 A.2d 160, 175 (Del.2002).