In transactions where a majority of directors or a controlling stockholder stands on both sides, the Delaware courts apply the entire fairness standard of review. That standard also applies in the limited liability company or limited partnership context where the parties adopt that standard by contract. While the two prongs of this nonbifurcated standard are well known — fair dealing and fair price — not that many cases have been tried and resulted in a Court of Chancery opinion that is then subject to review by the Delaware Supreme Court.
Gatz Properties v. Auriga Capital, No. 148, 2012 (Del. Supr. Nov. 7, 2012), is the most recent post-trial entire fairness decision by the Delaware Supreme Court. The court’s affirmance that the contract at issue adopted the entire fairness standard for affiliated transactions, that fiduciary duties had been breached, that the limited liability company agreement provided no exculpation and that the lower court properly determined damages provides important guidance to practitioners for transactions subject to entire fairness review.
LLC AGREEMENT CONTAINS ENTIRE FAIRNESS STANDARD
Gatz involved Peconic Bay LLC, a Delaware LLC whose governing agreement contained the following provision:
"Neither the manager nor any other member shall be entitled to cause the company to enter into any amendment of any of the initial affiliate agreements which would increase the amounts paid by the company pursuant thereto, or enter into any additional agreements with affiliates on terms and conditions which are less favorable to the company than the terms and conditions of similar agreements which could then be entered into with arms-length third parties, without the consent of a majority of the non-affiliated members (such majority to be deemed the holders of 66-2/3 percent of all interests which are not held by affiliates of the person or entity that would be a party to the proposed agreement)." (Emphasis added.)
The Supreme Court agreed with the lower court that the provision imposed fiduciary duties in transactions between the LLC and affiliated persons. The court noted that it had held similarly in the partnership context in Gotham Partners v. Hallwood Realty Partners, 817 A.2d 160, 171 (Del. 2002). The lesson for practitioners is that words like "entire fairness" or "fiduciary duties" need not be used for the court to conclude that the parties’ choice of operative language reflects "an explicit contractual assumption by the contracting parties of an obligation subjecting the manager and other members to obtain a fair price for the LLC in transactions between the LLC and affiliated persons." The court went on to say that "viewed functionally, the [italicized] language is the contractual equivalent of the entire fairness equitable standard of conduct and judicial review."
FAILURE TO PROVE SALE REFLECTED A FAIR PRICE
The plaintiffs’ complaint attacked the managing member’s failure to sell the LLC’s principal asset, a golf course, for a fair price or following a fair process. The LLC was owned by the Gatz family, one of whose members ran the entity, Gatz Properties LLC, which managed the LLC. The LLC leased the golf course to a golf course operator pursuant to a 10-year lease. The operator failed to run the LLC profitably and it was apparent a new operator would have to be selected or another action would have to be taken when the lease expired. Eventually, Gatz Properties sold the property in an auction in which it was the only bidder. The minority members received a total of approximately $21,000. Among the facts that persuaded the trial court that the transaction was unfair was that the managing member had turned down a potential bid at a price north of $6 million seven months prior to the expiration of the operating lease, yet eventually purchased the golf course himself following a flawed auction for nominal value plus assumption of the LLC’s $5.4 million debt. The Supreme Court found the trial court had properly relied on the plaintiffs’ expert witness’ discounted cash-flow analysis, which valued the property at $8.9 million. The Supreme Court also upheld the lower court’s determination that the auction process was a sham. Among the factors supporting this conclusion was that it was unnecessary to auction the property as a distressed sale as opposed to an orderly auction with a broker experienced in the golf course industry. Further, the record reflected no outreach to industry players, a failure to inform the auctioneer of the possible interest of a bidder who had expressed a willingness to bid more than $6 million, a rushed timeframe and unfair auction terms. Thus, the Supreme Court upheld the lower court’s finding that "the auction was not a process that anyone acting with minimal competency and in good faith would have used to obtain fair value for Peconic Bay."
BAD FAITH PRECLUDES EXCULPATION OR INDEMNIFICATION
As with most LLC agreements, this one contained indemnification and exculpation clauses. The Supreme Court upheld the trial court’s determination that the managing member was not entitled to either because he had acted in bad faith and had willfully misrepresented facts while breaching his contracted-for fiduciary duties. The same facts that supported the breach supported the finding of bad faith, leading the lower court to conclude that the managing member’s actions were "consistent with those of someone who was hoping that Peconic Bay would simply revert back to his family’s ownership once Peconic Bay’s primary source of revenue ran dry, without regard for the interests of the minority members." The misrepresentation was based on the managing member’s failure to communicate to the minority members, in connection with an offer he had made for his family’s company to purchase Peconic Bay for $5.6 million, that a third-party bidder had expressed a willingness to bid more than $6 million.
COURT OF CHANCERY PROPERLY CALCULATED DAMAGES
In affirming the lower court’s damages award, returning to the minority investors their initial capital ($725,000) plus a 10 percent aggregate return ($72,500), the Supreme Court affirmed the Court of Chancery’s determination that, had the managing member properly engaged with the initial bidder in 2007, Peconic Bay could have been sold for a price that would have generated this amount for the minority members. The 2007 bidder’s statement of a willingness to bid more than $6 million, plus the plaintiffs’ expert witness report that valued the LLC at $8.9 million, supported this determination.
TRIAL COURT’S DETERMINATIONS AFFIRMED
While much attention has focused on the Supreme Court’s disavowal of the precedential value of the lower court’s dictum that managers of Delaware limited liability companies have fiduciary duties where the governing instrument is silent (an issue that remains for future determination by the Delaware Supreme Court), the Supreme Court otherwise affirmed in all respects the trial court’s determinations. Practitioners who counsel clients in conflict-of-interest transactions would be well served by a careful review of the facts and circumstances that led the lower court to conclude that the parties had contracted for fiduciary duties and an entire fairness standard in affiliated transactions, that the managing member had failed to prove that it paid a fair price to acquire the LLC, that the managing member’s bad faith precluded exculpation and that therefore it was responsible for damages equal to almost 40 times what it paid in the flawed auction plus interest compounded monthly.