Tag: Private Equity

LLC Fiduciary Duties in Delaware Private Equity and Venture Capital

Posted on by Justin Taylor

In its January 27th decision of Auriga Capital Corp. v. Gatz Properties, LLC, the Delaware Chancery Court put to rest any ambiguity in its reading of the Delaware LLC Act as it applies to establishing default fiduciary duties in the LLC context. (1) Although the topic had been addressed in a number of recent cases, none approached the depth and breadth of analysis exhibited by the Court in Auriga. (2) In his opinion, Chancellor Strine definitively establishes that a manager or member of an LLC owes the default duties of care and loyalty to all other members, unless an LLC agreement effectively expands, limits, or eliminates these duties.

Auriga Capital v. Gatz Properties

The dispute in Auriga centered on Gatz Properties, LLC’s management of property held by Peconic Bay, LLC. William Gatz, as the sole actor for Gatz Properties, formed Peconic Bay with Auriga Capital Corporation in order to develop land held by the Gatz family into a golf course. Peconic Bay then leased the golf course land from Gatz Properties. While the LLC Agreement required dual class majority approval for any “major decision affecting the company,” Gatz was effectively able to approve his own decisions as Manager without interference from minority members due to majority control of both the A and B Peconic share classes by Gatz Properties and the Gatz family.

Gatz made and approved such a “major decision” when he chose to perform a sale of Peconic, which ultimately led to a dispute with Auriga and other minority owners of Peconic Bay. In 2010, after the underperforming golf course operator with a sublease on the property chose to exercise its early termination option, Gatz turned away a serious bidder for Peconic Bay and orchestrated a sham auction. Gatz was the only bidder for the company, and purchased Peconic Bay at an unfairly low price. The minority members, whose invested capital amounted to $725,000, received a paltry $20,985 distribution from the sale. This led them to file suit and claim Gatz breached his fiduciary duties.

At trial, Gatz raised various defenses. However, of particular interest was his assertion that the LLC Agreement of Peconic Bay “displaced any role for the use of equitable principles in constraining the LLC’s manager,” and thus removed his actions from any fiduciary duty analysis. The Court rejected this argument, however, and affirmatively determined the existence of default restrictions on the actions of a managing member of an LLC beyond the requirements of good faith and fair dealing.

Existence of Default Duties

Like the Delaware General Corporation Law (“DGCL”), the LLC Act (the “Act”) does not plainly state the fiduciary duties of care and loyalty apply by default to managers and members of an LLC. However, unlike the DGCL, 6 Del. C. § 18-1104 of the Act provides an explicit default application of the “rules of law and equity.” Do those rules of law and equity include the duties of care and loyalty? Footnote 34 of Auriga explains they do.

That § 18-1101(c) provides for the contracting out or modification of fiduciary duties implies these duties exist by default. The Court goes on to explain that when §§ 1101(c) and 1104 are read together, these sections establish that when a manager or member would traditionally owe fiduciary duties, they are a fiduciary and are subject to the express right of the parties to contract out of those duties. So far as a manager or member would not owe fiduciary duties under traditional equitable principles, they do not owe any in the LLC context. This is not by operation of the Act, but by those same traditional equitable principles. The Act does not create a broader range of duties.

The Court also pointed to the 2004 amendment of the Act (in addition to the amendment of Delaware Revised Uniform Limited Partnership Act (“DRULPA”)) by the Delaware Legislature. The amendments were instigated by a Delaware Supreme Court holding in Gotham Partners L.P. v. Hallwood Realty Partners L.P, which questioned the extent to which default duties could be completely eliminated in the partnership context. (3) Both the Act and DRULPA were reworded to permit the complete elimination of fiduciary duties, as well as full contractual exculpation for breaches (through the introduction of §18-1101(e) for LLCs).

The Court in Auriga reasoned if the “equity backdrop” did not apply to LLCs then: 1) the amendment would have provided that members and managers owed no duties to the LLC other than those set forth by agreement or in the statute; 2) the General Assembly would have eliminated or modified the default application of the rules of law and equity in §18-1104; and 3) the General Assembly would not have provided for the elimination and exculpation of something if that something did not exist. These factors combined with the case law establishing the existence of default duties in the LLC setting and the policy concerns surrounding displacement of a widespread investor belief in the same, firmly established, in the Court’s mind, the alignment of those holdings and the legislature’s intent.

Outcome of Auriga

The Court determined, and Gatz conceded, as an LLC manager without clear and unambiguous elimination or modification in the LLC Agreement, Gatz owed the other members of Peconic Bay the fiduciary duties of care and loyalty. The Court then determined that:

“Gatz breached his fiduciary duty of loyalty and his fiduciary duty of care by: (1) his bad faith and grossly negligent refusal to explore any strategic alternatives for Peconic Bay from the period 2004-2005 forward when he knew that American Golf would terminate its lease; (2) his bad faith refusal to consider RDC’s interest in a purchase of Peconic Bay or a forward lease; (3) his bad faith conduct in presenting the Minority Members with misleading information about RDC‟s interest and his own conduct in connection with his buyout offers in 2008; and (4) his bad faith and grossly negligent conduct in running a sham Auction process that delivered Peconic Bay to himself for $50,000. The results of this conduct left the Gatz family with fee simple ownership of the Property again, a Property that had been improved by millions of dollars of investments and now contained a clubhouse and first-class golf course. The Minority Members got $20,985.” (4)

Chancellor Strine awarded the minority members what they should have received in a fair auction: their initial investment of $725,000 and a 10% return. He deemed this “a modest remedy and the record could support a higher one.” Additionally, because the “record is regrettably replete with behavior by Gatz and his counsel that made this case unduly expensive for the Minority Members to pursue,” Strine required Gatz to pay one half of the minority’s attorneys’ fees and costs. If the manager or a member of an LLC wants a lesson on what not to do, this case is a very instructive read.

Key Takeaways for Private Equity and Venture Capital

In reflecting on Auriga, drafters and parties to LLC Agreements should find some comfort in the relative certainty the holding provides. In drafting their LLC Agreements for Management Company, General Partner, and Portfolio LLCs, parties should ensure their Agreements clearly and unambiguously reflect their intentions as to the types and extent of duties they intend to apply between members and management. Some key takeaways include:
• The traditional duties of loyalty and care apply by default to Delaware LLCs.
• A manager of a Delaware LLC is a fiduciary and subject to those default duties.
• Such duties may be altered or eliminated and liability exculpated by clear and explicit agreement under the LLC Agreement.
• Evaluation of fiduciary duty claims “cannot occur without a close examination of the LLC agreement itself.”
• The duties of good faith and fair dealing, as they exist independently from the duty of loyalty, apply to all LLCs and cannot be contracted around.
• LLC agreements in existing Private Equity and Venture Capital investments should be evaluated for clarity in any desired modification of fiduciary duties, with necessary amendments made to bring them in line with the intentions of the parties to the agreement in light of the Court’s clarifications.

1- Auriga Capital Corp. et al v. Gatz Properties, LLC et al, C.A. 4390-CS (Del. Ch. Jan. 27, 2012).
2- See Kelly v. Blum, 2010 WL 629850 (2010), Bay Ctr. Apartments, 2009 WL 1124451 (2009).
3- Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160 (Del. 2002).
4- Auriga, C.A. 4390-CS at 62.

Private Equity Firms Continue to Utilize Material Adverse Effect Provisions as a Device to Force Sellers to Renegotiate Agreements

Posted on by Daryl L. Saylor

A Material Adverse Effect (“MAE”) is a provision that is included in a negotiated agreement to allocate risk between a buyer and seller during the period separating signing and closing. A pro-buyer MAE will provide the buyer with the ability to walk away from a transaction if there is a material adverse effect; whereas, a pro-target MAE will make closing of the deal fait accompli.

An example of the standard MAE is: “There shall not have occurred a Material Adverse Effect on the Company.” Consequently, the provision acts as a mechanism to protect the buyer from the occurrence of unknown events, which threaten the long-term health of the seller’s business. Sellers, however, will want to attenuate the provision’s applicability by requiring there to be certain carve-outs. For example, the seller may exclude from the definition of a MAE “Acts of God, earthquakes, hostilities, acts of sabotage or terrorism or military actions or any escalation or material worsening of any such hostilities, acts of sabotage or terrorism or military actions.”1 Otherwise buyers would be able to walk away from a deal under their own economic discretion.

Indeed, the chronological progression of MAE disputes have become all too predictable over the course of the past decade: (1) a buyer and seller reach a negotiated agreement that includes a MAE; (2) the buyer walks away from the agreement claiming that there has been a material adverse effect as a result of a change to the sellers business, assets, liabilities, operations, conditions or prospects; (3) the seller files suit asserting that the buyer improperly terminated the binding agreement; and (4) instead of progressing through trial, the buyer and seller renegotiate the purchase price (or some other remedy that is favorable to the buyer’s position), resulting in a settlement and dismissal of the lawsuit.

This is precisely what happened in In re Innkeepers USA Trust v. Cerberus Series Four Holdings2, which follows the recent trend of private equity firms using MAEs as an effective tool to force renegotiation and strike better deals for its stakeholders.3 Innkeepers filed suit against Cerberus and Chatham on August 29, 2011 for walking away from its $1.12 billion deal to purchase multiple hotels owned by Innkeepers. In Cerberus’ answer, it claimed there was a material adverse effect because of the “adverse changes in the debt and equity markets.” Nevertheless, the parties reached a settlement agreement on October 19, 2011, which resulted in a decrease of the purchase price by $180 million.

By settling the case, the judiciary– in this instance, the United States Bankruptcy Court for the Southern District of New York – is once again left unable to interpret another MAE provision. Such judicial interpretation is important for elucidating MAEs and clarifying when a buyer can successfully invoke a material adverse effect to walk away from a negotiated agreement. A small number of cases involving the interpretation and application of MAEs have been litigated from start to finish.4 To date, the Delaware courts have never found there to be a material adverse effect in the specific context of a merger agreement.

The question, therefore, is what is a MAE’s true purpose? This is a valid query since, in most cases, invoking a material adverse effect will be futile due to the fact that a court is highly unlikely to find that one has occurred. In a recent survey, Nixon Peabody identified that the use of MAEs in publically filed agreements consisting of asset purchases, stock purchases, and merger agreements, increased from 93% to 96% between June 1, 2010 and May 31, 2011.5

This undoubtedly demonstrates that, post the financial turbulence in 2007-2009, buyers, such as Cerberus and Chatham, are still negotiating for MAEs to use as leverage – in effect, arming themselves with a quasi-mulligan to renegotiate the agreement. Forcing a seller to litigate whether the buyer is entitled to invoke a material adverse effect is extraordinarily costly.

Consider the magnitude of the expense a seller would incur if it were to engage in full-scale discovery to prove the non-existence of a material adverse effect. There would be depositions of integral executives, which would contribute to a lack of productivity and presumably decrease the value of the firm; there would be a battle of highly expensive experts explaining, in their opinion, why or why not a material adverse effect occurred to the target; and there would be an unimaginable amount of documents produced in order to prove or disprove the claim. Therefore, in most cases, the economically prudent firm will simply renegotiate the purchase price to save the headache, expense, and, not to mention, expedite the efficient closing of the transaction so that new strategies can be effectively implemented.

Although Nixon Peabody reports that the current economic environment provides attractive sellers with a lot of leverage in the negotiation of MAEs (which is evidenced by the 23% increase in the use of definitional carve-outs), firms, such as Cerberus and Chatham, are still able to utilize MAEs as leverage to renegotiate deals. It is worthwhile to note that Inkeepers was in Chapter 11 during the negotiations; therefore, it certainly was in a weak position and not an attractive target. The actual MAE was heavily favored toward Cerberus. Nevertheless, the case demonstrates that MAEs continue to be of value to buyers.

A significant portion of the MAE puzzle remains to be filled-in by the courts. As a result, many questions persist: How much longer will targets endure this strategy? Are targets utterly defenseless? Are there any defensive measures that sellers can adopt to counter its inherent vulnerability? If one thing is for certain, however, firms such as Cerberus and Chatham are still negotiating for MAEs and reaping the economic benefits.

1 See, e.g., Weil Briefing: MAC/MAE Provisions. ↵
2 In re Innkeepers USA Trust v. Cerberus Series Four Holdings, Case No. 11-02557. ↵
3 Such as Bain Capital’s acquisition of Home Depot’s wholesale supply unit or KKR and Goldman Sachs termination of the transaction with Harman International and taking it private. ↵
4 IBP, Inc. v. Tyson Foods, Inc. 789 A.2d 14, 54-55 (Del. Ch. 2001) (where the Delaware Chancery Court, applying New York law, stated that MAE clauses are to be construed narrowly against the party invoking the clause); Genesco v. Finish Line, Inc., No. 07-2137-II(III) (Tenn. Ch., Dec. 27, 2007) (where the Tennessee Court of Chancery found that the buyer failed to demonstrate the existence of a MAE because the genesis of the target’s financial deterioration was the result of general economic conditions, which was expressly carved-out); Hexion Specialty Chemical, Inc. v. Huntsman Corp., 965 A.2d 715, 738-739 (Del. Ch. 2008) (where the Delaware Chancery Court stated that the party claiming the material adverse effect bears a heavy burden of proof and emphasized that successfully demonstrating one has occurred is extremely difficult). ↵
5 Nixon Peabody’s 10th Annual “Study of Current Negotiation Trends Involving Material Adverse Change Clauses in M&A Transactions”. ↵

Emerging Markets Provide Potential Gains and Headaches for Private Equity Firms

Posted on by Mark Franke

Dealbook reported this week that emerging market opportunities are beginning to bear fruit, noting that China boasts three of the largest markets for I.P.O.’s and the fastest growing markets for deals are Ukraine, Thailand, and Chile. Private equity firms like the Carlyle Group and Blackstone have committed significant capital to acquiring stakes in companies abroad and have set up offices in many emerging economic nations to capitalize on the shift of opportunity from the developed world to these untapped frontiers. Wall Street is responding to the sluggish growth at home by turning its eyes abroad, but these opportunities can bring headaches.

Putting aside the administrative costs and barriers to entry of working with foreign governments and in new, sometimes recalcitrant, markets, one major legal problem that arises when an American firm buys stakes in a foreign company is the need to comply with the Foreign Corrupt Practices Act (FCPA). Under this act, a U.S.-based company may not use bribes to “obtain or retain” business.

Private equity funds all offer substantially the same things: capital infusions and management expertise. While name recognition and a good track record may go a long way, the terms of the deals between companies and private equity firms are almost always on substantially similar terms, and the firms exert control over the companies in substantially similar ways—20% cut of the net profits as carried interest upon exit, preferred stock and management control by seeking board placements and various other mechanisms to mitigate downside exposure and maximize upside gains. Why should a company in a foreign jurisdiction respond to a bid from one private equity firm over another? In many cultures, gifts are an expected part of business transactions, and it is a natural impulse to try to grease the wheels of a negotiation. Indeed, a common practice on Wall Street in domestic deals is to do just that. A dinner here, a Broadway show there. Why not? Because the S.E.C. and D.O.J. say you can’t.

There are ways that skilled lawyers could exploit the margins of meaning in the language of the FCPA, contracting the scope of the word “bribe” so as not to capture the activity of their client. But this opportunity would only be meaningful in the context of defending an enforcement action, and private equity firms, like any rational actor, want to avoid litigation. It is risky business to depend on a creative argument from a verbal technician where the act may be questionable. The issue is not whether the act is an actual bribe, but whether the agencies will pursue an enforcement action. The agencies have lawyers too, and those lawyers spend their days scouring filings for suspicious activities and get paid to show how an act fits within the scope of the language. Moreover, beyond litigation costs, who wants to be on the S.E.C’s or D.O.J.’s bad side?

Consequently, when engaging in a deal abroad, especially in nations known for corruption, firms are having to spend more and more on FCPA compliance. While this is good news for law firms (FCPA compliance is a huge cash cow), the robust enforcement of the act is leading to astronomical costs that could arguably be stifling foreign investment. Certainly, American ideals require that firms act with integrity abroad, but with compliance costs going through the roof, at some point firms are likely to accept the cost of being on the bad side of U.S. Government and take the risk of losing a suit. In a world of rational economic actors, the loudest input in a firm’s decision is cost.

In the meantime, however, while costs of either option are comparable, firms will likely choose to comply. There is talk in Washington to make compliance less onerous, but with the election season in full swing, who knows when that will happen.