March 30, 2011
Different Fiduciary Obligations for LLC Managers and Corporate Directors
Lewis Lazarus recently posted Directors Designated By Investors Owe Fiduciary Duties to the Company as a Whole and Not to the Designating Investor at the Delaware Business Litigation Report. In his article, he explained
[The Delaware] cases teach that directors designated by particular stockholders or investors owe duties generally to the company and all of its stockholders. Where the interests of the investor and the company and its common stockholders potentially diverge, the directors cannot favor the interests of the investor over those of the company and its common stockholders.
Professor Bainbridge weighs in (here), agreeing that the above is the general rule, but that in some cases that may not be best. He gives a few examples, such as a struggling company granting a union nominee a board position or a time when preferred shareholders can elect a board majority because no dividends were paid for a sufficient period of time. He then notes that a director's "sponsor might reasonably expect the directors not just to 'advocate' for the shareholder's position, but to vote for it and take other action." Professor Bainbridge concludes that he still doesn't "think the sponsor should be able to punish the directors for failing to" vote as the sponsor desired and that such cases should be viewed "contextually."
This all got me thinking about VGS, Inc. v Castiel, 2000 WL 1277372 (Del. Ch.), which I recently covered in class. That case involved a manager-managed LLC, with a three-person Board of Managers. Castiel named himself and Quinn to the Board, and Sahagen added himself. Sahagen and Castiel got into a feud, and Quinn defected to Sahagen's side. Quinn and Sahagen then merged the LLC into VGS, Inc., without notice to Casteil, via written consent. (This case is also a great lesson into the perils of poor drafting.)
Despite the plain language of the LLC agreement, the court bails out Castiel (and his lawyers) finding that
As the majority unitholder, Castiel had the power to appoint, remove, and replace two of the three members of the Board of Managers. Castiel, therefore, had the power to prevent any Board decision with which he disagreed.
. . . .
Notice to Castiel would have immediately resulted in Quinn's removal from the board and a newly constituted majority which would thwart the effort to strip Castiel of control. Had he known in advance, Castiel surely would have attempted to replace Quinn with someone loyal to Castiel who would agree with his views.
This is not how we tend to react in the corporate context. Sponsors generally can't bind directors to a specific vote, and they don't usually require notice of a director's intended votes. Think Ringling Bros-Barnum & Bailey Combined Shows v. Ringling, 53 A.2d 441 (Del. Sup. Ct. 1947); McQuade v. Stoneham, 263 NY. 323 (1934); or even perhaps Ramos v. Estrada, 8 Cal. App. 4th 1070 (1992).
In VGS, it seems to me the court should have determined this action was improper (if it was) because Sahagan and Quinn were acting in a way that implicates a conflict of interest and that they were inappropriately taking something that wasn't theirs. That is, it was an act of fraud, self-dealing, or a conflict of interest. At least then Quinn and Sahagan could defend their decision-making process and the decision itself.
I have been working on a short piece arguing that the courts may be developing rules that respect LLCs as unique entities. Professors Ribstein and Bainbridge, among others, have long advocated that courts apply rules appropriate for LLCs rather than blindly adopting corporate or partnership rules, and I would advocate a similar position here. In VGS, however, my decision would place far more weight on the contract itself and respect the powers granted to the board. That is, I might allow Castiel the authority he sought and was granted in this case in the LLC context, even though that power is in conflict with general corporate law directors' rules. But, I would only grant the power if Castiel expressly acquired that power on the front end. Here, Castiel did not, and absent fraud or self-dealing, I think he should have lost.