PEs, Delaware Entities and Anomalies

The formal title of this blog site is Law and Other Anomalies.  An anomaly is something that is incongruous and inconsistent.  Welcome to Delaware business law.

Let us say your are a fund investing in a Delaware corporation; you have preferences in the waterfall and the power to trigger a sale through board control or contract.  You trigger a sale and by definition you are getting a preference in the proceeds.  You run the risk of breaching your fiduciary duty to the minority, and deal terms likely are subject to fairness review under the “heightened fairness standard.”  Those of us in the business are aware of the complex charts that have been published trying to explain the various levels of review and approval that interested parties must go through to navigate safely the corporate fiduciary duties of the majority or the control parties or the favored parties, in order to avoid a claim of breach of duty.  And this is true even though Delaware, in closely held smaller enterprises, is less wedded to treating small companies as if the players owed each other the same high standard of loyalty as is owed in simple partnerships.

Same facts but let’s swing over to an LLC.  The standard paper for an LLC will have the same business terms but also will state that all fiduciary duties are waived and that the fund may well have discretion to call for a sale in its own judgment.  Such waivers of duties are not unusual in LLCs.

In claims brought against controlling investors in a Delaware LLC by junior investors, objecting to a sale that paid out the controlling interests but left virtually nothing for the junior tier, recognizing that the language of the Operating Agreement waived fiduciary arguments, the plaintiffs asserted a claim under the general contractual doctrine of breach of the obligation of good faith and fair dealing in the operation of any contract.

In a February decision (Miller v HCP), the Delaware Chancery Court threw out the claim.  Their decision basically was “can’t you plaintiffs read English?”  Fiduciary duties were waived.  It was clear on the face of the paper that the controlling parties could trigger a sale and be paid first.  And the argument that there is an obligation of good faith and fair dealing applies only if unexpected events arise which would work an unfairness.  Nothing unexpected here: it is all spelled out in the Operating Agreement you signed.

An argument can be made that the difference in result based on the choice of entity type is anomalous; the entity type should be driven by other business and tax considerations.  Further, in order to stimulate capital formation it is likely that the best rule is the LLC rule and that one ought to be able to draft effectively into corporate documents the same result you get with an LLC.  There are no doubt situations which create abuse and one would draft very carefully, but the ability of investment funds (for example) to obtain contractual leverage for their money should not depend on the type of entity — in a rational system.

As a side-note: I have written in the last year or so about the problems of the Delaware law in dealing with authorizing the sale of a corporate business, for which I respectfully direct you to my CV at my firm’s website;  at that point you can link to the relevant articles. http://www.duanemorris.com.

Forgive another side-note: when I first encountered the concept of an anomaly it was many years ago as an astronomy major in college; the concept if I recall correctly had to do with degrees of arc for the apogee or perigee of a body from its primary.  Understanding astronomy was difficult but at least there were logical answers — unlike Delaware business law on occasion.


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