Lewis Lazarus, Morris James

Under Delaware law, the members of a limited liability company may eliminate or modify the common-law fiduciary duties of loyalty and care in their operating agreement. When they do so, Delaware courts will analyze any alleged management misconduct under the standard of conduct to which the parties agreed. In MKE Holdings v. Schwartz, C.A. No. 2018-0729-SG (Del. Ch. Sept. 26, 2019), the Delaware Court of Chancery found the managers' contractual duty to be a narrow one: act with a good-faith belief that their conduct was in or not opposed to the LLC's best interests. It then dismissed a complaint alleging breach of duty by the managers for the plaintiffs' failure to allege facts making it reasonably conceivable that the defendants breached the contractual standard. The case reflects the Court of Chancery's application of contract principles to assess whether the defendants may have breached the duties to which parties in an LLC have agreed.

Court Finds Parties Eliminated Common-Law Fiduciary Duties

In MKE Holdings, the plaintiffs brought derivative claims against the managers of a Delaware LLC, alleging that they had violated the LLC's operating agreement and their fiduciary duties by making acquisitions that would benefit them personally, as well as by compensating themselves excessively. The defendants sought dismissal on the ground that their conduct did not violate the operating agreement. In construing the LLC's operating agreement, the Court of Chancery determined that the parties had eliminated the common-law duties of care and loyalty, and explicitly permitted the managers to engage in self-interested transactions, as long as the transactions were done in good faith (i.e., not in bad faith).

If this case involved the conduct of directors of a Delaware corporation, a claim that the directors caused the corporation to acquire an entity so that the defendants or their affiliates would earn a substantial fee in a self-dealing transaction likely would subject the transaction to a high level of scrutiny. Directors of a Delaware corporation cannot waive the duty of loyalty. Where, as here, parties to an LLC agreement modify or eliminate the duty of loyalty, the task for a reviewing court is to determine the extent to which the parties did so and the contractual standard they did impose on the managers. Here, although certain language in the operating agreement appeared to suggest that the parties had adopted a simple negligence standard of conduct, the court found otherwise in construing the contract as a whole. A reading of the parties' operating agreement that they intended to subject managers to liability for simple negligence was "nonsensical" because "It would eviscerate, and make surplus, the good faith standard and conflict-waiver provisions of the operating agreement. No reasonable drafter, or reader, would construe an explicit waiver of all duties but good faith—including a waiver of conflict and gross negligence—to be contingent on the actor avoiding simple negligence."

Court Finds Plaintiffs Failed to Plead Violation of Contractual Standard of Conduct

Bad faith, under the LLC operating agreement in this case, would be the managers entering into a transaction not reasonably believing that it was in or not opposed the LLC's best interests. The court found plaintiffs had failed to allege facts permitting an inference of bad faith because, among other reasons, the controlling entity the managers allegedly were acting to benefit owned 70% of the LLC and would suffer the most injury by the misconduct plaintiff had alleged.

Lessons Learned

This case provides an example of how difficult it is for a plaintiff in a limited liability company to state a claim where the parties have eliminated common law fiduciary duties and expressly permitted interested parties to make decisions that benefit themselves. Delaware courts hold parties in unincorporated entities to the contractual standards of their foundational agreements. Unless a plaintiff can plead facts making it reasonably conceivable that the defendants have breached the agreed-upon contractual standard, a Delaware court, construing the agreement as a whole, will dismiss the complaint.