The general policy of the Delaware Limited Liability Company Act (the “Act”) is “to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”[1] Specifically, with respect to duties, the Act provides that to the extent law or equity would impose a fiduciary or other duty on a member or manager of an LLC, that duty may be “restricted or eliminated by provisions in the limited liability company agreement.”[2] This flexibility makes LLCs an especially attractive vehicle for private equity investors, in particular with respect to allowing management and other minority holders to participate in an investment.
An LLC agreement, however, cannot eliminate the implied covenant of good faith and fair dealing that inheres in all contracts under Delaware law.[3] As a result, for private equity funds and other controlling investors, a lurking concern has been whether the implied covenant potentially provides a mechanism for a minority investor to undermine or change the terms of an LLC agreement, including through the imposition of otherwise waived fiduciary duty-like obligations.
Miller v. HCP & Company
Recently, in Miller v. HCP & Company,[4] the Delaware Court of Chancery allayed this concern to a significant extent when it rejected an attempt to use the implied covenant to impose a duty on an LLC board to maximize value in connection with a sale of the LLC.
In Miller, the controlling private equity investor held a preferred equity interest and had the right to appoint a majority of the board. The LLC agreement included an explicit waiver of fiduciary duties, and provided that the board had sole discretion as to the manner of any sale of the LLC to an unaffiliated third party and all members could be dragged-along in any such sale.
When the board agreed to a transaction that resulted in a full payout to the private equity investor and limited payouts to the minority, plaintiffs argued that the incentive created by the private equity investor’s preferred equity mandated application of the implied covenant to require that any sale be pursuant to an auction so that maximum value for the LLC be obtained. Vice Chancellor Glasscock granted defendants’ motion to dismiss the complaint.
According to the court, application of the implied covenant “must address ‘developments or contractual gaps that the asserting party pleads neither party anticipated,’” and that “the implied covenant does not ‘establish a free-floating requirement that a party act in some morally commendable sense.’ Instead ‘good faith’ in the implied covenant context entails ‘faithfulness to the scope, purpose, and terms of the parties’ contract.’”[5] The court noted that, despite creating an incentive for the controlling private equity firm to pursue a transaction that would maximize its own return regardless of the impact on the other investors, the members explicitly “eschewed fiduciary duties, and gave the Board sole discretion to approve the manner of the sale.”[6] As a result, there was no “gap” in the contractual terms that required application of the implied covenant of good faith and fair dealing.[7] The court thus “reject[ed] the Plaintiffs’ attempt to ‘re-introduce fiduciary review through the backdoor of the implied covenant.’”[8]
In re Oxbow Carbon
Although Miller is reassuring in that, in the absence of a “gap” in the contractual terms, the court was reluctant to introduce obligations into the LLC agreement, plaintiffs and courts can be quite creative in asserting the implied covenant. Vice Chancellor Laster’s 177-page opinion in In re Oxbow Carbon LLC Unitholder Litigation,[9] decided eleven days after Miller, reminds practitioners that, Miller notwithstanding, they ought to tread carefully in the drafting and application of LLC agreements.
In 2007, Crestview Partners and Load Line Capital purchased an approximately one-third equity interest in Oxbow, an energy business controlled by William I. Koch. The revised LLC agreement negotiated by Koch and the new investors included complex provisions regarding the minority investors’ ability to force a sale of Oxbow. After a long and somewhat sordid history together, Crestview determined to exercise its right to force a sale of the LLC contrary to Koch’s wishes, and litigation regarding the exit sale provisions ensued.
The litigation would turn on whether two Koch-controlled holders who owned an aggregate of 1.4% of the Oxbow equity (the “1.4% Holders”) had the power to block the proposed Crestview sale. Because the 1.4% Holders had received their interests years after the other members and the other members had been receiving regular distributions in the interim, the exit sale provisions’ minimum aggregate return requirement would not be satisfied with respect to the 1.4% Holders. Koch argued that, therefore, Crestview could not force the sale of Oxbow. Crestview argued in response that the 1.4% Holders could be left behind in the sale, or alternatively, they could be separately topped-up to satisfy the minimum aggregate return requirement.
On a motion for summary judgment, the Vice Chancellor agreed with Koch’s reading of the exit sale provisions. Pursuant to the LLC agreement, the member exercising the exit sale right could “not require any other Member to engage in such Exit Sale unless the resulting proceeds to such Member … equal at least 1.5 times such Member’s aggregate Capital Contributions.”[10] Because “Exit Sale” was defined as a transfer of all but not less than all of the equity interests in Oxbow, the court determined that any member who would not receive 1.5 times their capital from an exit sale, such as the 1.4% Holders, had the right to block an exit sale entirely. The LLC agreement further provided that in an exit sale the same terms and conditions must apply to each member and that proceeds must be distributed on a pro rata basis. The court concluded that this language precluded the separate topping-off of any member to satisfy the 1.5x return threshold.
Summary judgment on the language of the LLC agreement might have been a solid win for Koch, but the Vice Chancellor seemed less than wholly satisfied with that outcome. He remarked, “I recognized … that this reading produced a harsh result by effectively blocking an Exit Sale, and I observed that the implied covenant of good faith and fair dealing might have a role to play.”[11] At trial, it took center stage.
In his post-trial opinion, the Vice Chancellor, echoing Miller, noted that “[w]hen a party asserts an implied covenant claim, the court ‘first must engage in the process of contract construction to determine whether there is a gap that needs to be filled.’”[12] The implied covenant may be used only when ‘“the contract is truly silent with respect to the matter at hand.’”[13] Unlike Miller, however, the court found its gap. In particular, the Vice Chancellor focused on the admission of the 1.4% Holders.
Like many LLC agreements, the Oxbow agreement empowered the board to determine the terms and conditions on which the LLC would admit new members. Unfortunately for Koch, the Oxbow board was quite sloppy in admitting the 1.4% Holders. Perfunctory resolutions were adopted that did not specify the rights of the 1.4% Holders as members.[14] The board also did not attend to the existing equity holders’ pre-emptive rights, and ignored that, in light of their affiliation with Koch, the Oxbow LLC agreement required a supermajority vote of the board (including the Crestview-appointed director) for admission of the 1.4% Holders. The court held that given that the board did not specify the rights and obligations of the 1.4% Holders, “[t]he gap therefore remains open for the implied covenant to fill.”[15] And “[t]he Supermajority Vote requirement meant that [Crestview] could have blocked the issuance and forced a negotiation.”[16]
The court then envisioned how such a negotiation would have played out had it occurred at the time of the admission of the 1.4% Holders. The Vice Chancellor pointed out that, over several years, Koch and his legal advisors assumed the LLC agreement permitted the separate topping-off of the 1.4% Holders so that the minimum return threshold could be met, and it was only after the commencement of litigation that they asserted the LLC agreement required all holders receive the same consideration in an exit sale. He further noted that Crestview and Load Line “proved at trial that they never would have consented to admitting the [1.4% Holders] had they understood it would reset [the minimum return hurdle].”[17] Based on this, the Vice Chancellor posited that in the hypothetical negotiation the parties would have compromised by amending the LLC agreement’s exit sale provisions to permit the 1.4% Holders to be separately topped-off to meet the minimum return requirement.[18] The court concluded that, despite its holding with respect to the language in the LLC agreement, “[i]ssues of compelling fairness call for deploying the implied covenant to fill the gap created when the Company admitted the [1.4% Holders]. Without it, the fortuitous admission of the [1.4% Holders] guts the Exit Sale Right and enables the majority member to defeat a commitment he made in 2007 and would otherwise have to fulfill.”[19] The Vice Chancellor thus determined to “incorporate” a separate right to top-off the 1.4% Holders.[20]
In re Oxbow Carbon was a hard case, and one can easily imagine it going the other way. The Vice Chancellor found on summary judgment, and then affirmed following trial, that the language of the LLC agreement precluded a separate top-off of the 1.4% Holders. That finding alone may have been enough to end the controversy in favor of Koch, as the court itself acknowledged that the implied covenant ‘“cannot be invoked where the contract expressly covers the subject at issue.’”[21] The Vice Chancellor also could have found that the interpretation of the provisions by Koch and his advisors over time was irrelevant in light of the contractual language. He may also have relied on the fact that plaintiffs were sophisticated investors represented by capable counsel and extensively negotiated the language of the LLC agreement; that plaintiffs had representatives on the board when the 1.4% Holders were admitted as members; that plaintiffs treated the 1.4% Holders as members for several years; and that plaintiffs failed to complain about the circumstances of the admission of the 1.4% Holders until after litigation was commenced. All of those factors may have justified a finding for the defendants. But, despite all the precedents that counsel caution in its application,[22] In re Oxbow Carbon teaches that the implied covenant of good faith and fair dealing presents a tantalizing temptation for disgruntled minority investors, and occasionally, judges, and thus, it remains a significant peril for drafters of LLC agreements.
Lessons for Practitioners
Miller and In re Oxbow Carbon provide several lessons with respect to the drafting and application of LLC agreements:
- Clear and Comprehensive Waivers of Duty. From the perspective of a controlling holder, a waiver of fiduciary duties should be clear and broad. And, in light of Miller, it seems a bit of redundancy does not hurt in this regard. There, the fiduciary duty waiver was likely enough to preclude use of the implied covenant to impose a Revlon-like duty on the controlling holder, but the court nonetheless relied in part on the fact that the LLC agreement also specified that the manner of sale of the LLC was in the discretion of the board. As a result, in addition to including a broad waiver of duties, if there are particular issues of concern, a controller may want to specifically (and perhaps redundantly) call them out in the agreement.
- Specify Minority Rights. From the perspective of a minority holder, the cases demonstrate that it is no easy task to use the implied covenant to introduce protections into an LLC agreement. Although the Vice Chancellor managed to do so in In re Oxbow Carbon it did take him 177 pages to get it done. Minority holders, therefore, should carefully consider the specific protections they require, and those protections should be clearly delineated in the LLC agreement.
- Company Formalities. In re Oxbow Carbon serves as a stark reminder that, despite the fact that LLCs generally require fewer formalities than corporations, failure to observe those formalities, particularly with respect to the admission of members and the issuance of units, may later surface as an unwelcome surprise. Prior to taking significant action, the LLC agreement should be reviewed for requirements, the necessary procedures should be carefully followed, a record of such actions should be kept, and related documents, such as resolutions, should be detailed, clear and accurate.
- Interpreting the Agreement. An interesting aspect of In re Oxbow Carbon is the court’s reliance on the interpretation of the LLC agreement by Koch and his counsel over time. As a result, that case counsels that before communicating advice outside the circle of privilege or taking action based on that advice, practitioners should be mindful that advice regarding an LLC agreement and the implementation of that advice as a course of dealing may impact the interpretation of the agreement in a future dispute.
[1] 6 Del. C. Section 18-1101(b).
[2] 6 Del. C. Section 18-1101(c).
[3] Id.
[4] Miller v. HCP & Company, C.A. No. 0291-SG, 2018 WL 656378 (Del. Ch. February 1, 2018).
[5] Id. at *9 (citations omitted).
[6] Id. at *2.
[7] Id.
[8] Id. at *13 (citations omitted).
[9] In re Oxbow Carbon LLC Unitholder Litigation, C.A. No. 12447-VCL, 2018 WL 818760 (Del. Ch. February 12, 2018).
[10] Id. at *1.
[11] Id. at *3.
[12] Id. at *58 (citations omitted).
[13] Id. (citations omitted).
[14] Id. at *61.
[15] Id. at *62.
[16] Id.
[17] Id. at *63.
[18] Id. at *64.
[19] Id. at *3.
[20] Id.
[21] Id. at *58 (citations omitted).
[22] Id. at *59 (“Invoking the doctrine is a ‘cautious enterprise.’”).