Delaware law has long permitted parties to a contract to limit remedies for a breach of that contract. But many attorneys believed that no matter what the contract said, a remedy for acting in bad faith still survived and permitted a suit to enforce that remedy. That is still true, but only barely. For, as a recent Court of Chancery decision shows, even a claim for acting in bad faith may be severely limited.
This legal result began by at least by 2002. In that year, the Delaware Supreme Court suggested in Gotham Partners v. Hallwood Realty Partners, 817 A. 2d 160 (Del. 2002), that perhaps the parties to a limited partnership might be able to contract away "traditional notions of fiduciary duties." The Delaware General Assembly readily agreed, by amending the Delaware Limited Partnership Act to expressly permit waivers of any fiduciary duties owed by a general partner to the limited partner investors. Only the duty to act in good faith could not be waived under the Limited Partnership Act or the Limited Liability Company Act.
Soon, clever drafters sought to even limit the duty to act in good faith and to abolish any fiduciary duties by entity controllers to their investors. First, as Gotham Partners suggested, limited partnership agreements and limited liability operating agreements began to expressly state that the general partner as manager only had the duty to act in good faith and did not have any other duties, including any fiduciary duty. Then, drafters went even further and defined "good faith" as a subjective belief that any transaction was in the best interests of investors. Further, any controller was deemed to act in good faith if a transaction, even a self-dealing transaction, was approved by a "conflicts committee" of "independent" members.
What exactly does this mean in the real world in terms of investor protections from abuse by a controller of the investment? The recent decision in Gerber v. EPE Holdings, Del. Ch. C.A. 3543-VCN (January 18, 2013), provides an answer: not much protection at all. Briefly, in Gerber, the plaintiff investor alleged that Dan Duncan controlled the management of Gerber’s investment in EPE GP Holdings LP. Joel Gerber claimed that Duncan caused EPE to buy assets also controlled by Duncan for more than $500 million more than they were worth. That self-dealing transaction was approved by a conflicts committee that did not engage any independent advice on the fairness of the purchase. Indeed, the purchase price was effectively 100 percent more than Duncan had paid for those same assets just two years prior.
Significantly, the Gerber decision was on a motion to dismiss the complaint. That meant that the facts alleged by Gerber in his complaint had to be taken as true, for purposes of deciding if Gerber had alleged enough facts to state a valid claim. Thus, the court’s decision to dismiss Gerber’s complaint shows the strength of the contractual exculpation clauses in the EPE partnership agreement.
The court reasoned that the conflicts committee had independent numbers because they meet the tests of independence established by the New York Stock Exchange rules, as adopted in the partnership agreement. Next, the court concluded that the agreement’s standard exculpation language excluded any fiduciary duty owed by the controller to Gerber. That left only the duty to act in good faith. The court then held that the agreement defined "good faith" as a subjective belief the transaction was fair to EPE. Finally, the court concluded that the absence of independent advice and a deal price with a 100 percent price increase over two years did not in themselves show the conflicts committee approved the transaction in bad faith. After all, it was still possible the price was fair and Gerber did not allege facts to show the committee had at least some reason to think the price was unfair.
It is hard to quarrel with the Gerber decision. It stated Delaware law correctly. The complaint was factually weak. Indeed, the court itself pointed out that Gerber failed to plead facts otherwise apparently available that tended to show the price for the purchased assets exceeded the price for similar assets in the market and that one investment banker had analyzed the price and concluded it was too steep. Had Gerber pled that those facts were known to the conflicts committee, he might have been able to defeat the motions to dismiss. Therefore, the Gerber decision may be characterized as just a bad case on its merits that should have been dismissed.
But there are at least two lessons from Gerber. First, when faced with a partnership or limited liability agreement that excludes fiduciary duties for its managers, simply complaining a transaction is unfair does not state a valid claim. Instead, a plaintiff needs to allege facts that tend to show the managers knew the transaction was unfair but approved it anyway. Ignorance alone on the part of the managers may not be enough to show they knowingly acted in bad faith. Their subjective beliefs are what count. Of course, they cannot believe what any reasonable person would know to be false, but that may be a tough point to establish.
Second, investors in Delaware limited partnerships and limited liability companies get exactly what the operating agreements provide, and no more. These entities are not the same as Delaware corporations where controllers and managers have fiduciary duties to the entities and their investors. If you invest in such alternative entities as limited partnerships and LLCs, you need to either get a return that compensates for the risk you run of unfair management or bargain for better investor protection.