In re Atlas Energy Resources, LLC, Unitholder Litigation: The Delaware Court of Chancery Discusses Fiduciary Duties and the Implied Covenant of Good Faith and Fair Dealing in a Case Involving a Publicly Traded Limited Liability Company
November 8, 2010
Publication| Limited Liability Company & Partnership Advisory
In Atlas, the Delaware Court of Chancery considered issues relating to the modification and elimination of fiduciary duties in a limited liability company agreement and the implied covenant of good faith and fair dealing in connection with a challenged merger.
The defendants in Atlas, which consisted of various directors and officers of Atlas Energy Resources, LLC, a publicly traded Delaware limited liability company (“Energy”), and Energy’s controlling unitholder, Atlas America, Inc., a Delaware corporation (“America”), sought to dismiss claims brought against them for breach of their fiduciary duties to Energy’s minority unitholders in connection with a merger involving Energy and America.
Energy was created to (A) own and operate the natural gas and oil assets and the investment partnership assets management business of America and (B) develop natural gas production in the Marcellus Shale, a gas-rich geological formation located in parts of the Appalachian Mountains from Virginia to New York. The challenged merger transaction contemplated Energy surviving a merger, pursuant to which Energy’s public unitholders would receive 1.16 shares of America in exchange for their units in Energy and Energy would become a wholly owned subsidiary of America. At the time the merger was announced, America (together with a wholly owned subsidiary of America) controlled more than 48 percent of Energy’s voting interests.
Recognizing the potential conflicts of interest in pursuing the merger, Energy’s board of directors had formed a special committee (the “Energy Special Committee”) to consider the merger, as well as certain other strategic alternatives for Energy. Energy retained legal and financial advisors, and over several weeks the parties negotiated, and eventually agreed upon, the terms of the merger. The plaintiffs challenged the merger, alleging breach of fiduciary duties to Energy’s minority unitholders. They argued that the merger should be reviewed, and found lacking, under the entire fairness standard. The plaintiffs claimed, inter alia, that the merger undervalued Energy’s units because it failed to include a premium for the elimination of cash distributions to Energy’s unitholders and to account fully for the value of the Marcellus Shale assets. Furthermore, the plaintiffs alleged that America and certain of Energy’s directors and officers dictated the terms of the merger (including the absence of a “majority of the minority” condition to approving the merger) and limited the information available to the Energy Special Committee.
In its analysis, the Court first emphasized that limited liability companies are creatures of contract designed to afford the maximum amount of freedom of contract to the parties involved and acknowledged that “parties to a limited liability company agreement can contractually expand, restrict, modify or fully eliminate the fiduciary duties owed by the company or its members, subject to certain limitations.” The Court stated that “in the absence of explicit provisions in a limited liability company agreement to the contrary, the traditional fiduciary duties owed by corporate directors and controlling shareholders apply in the limited liability company context.”
In addressing the claims brought against America, the Court quoted Kelly v. Blum, noting that “‘in the absence of provisions in the LLC agreement explicitly disclaiming the applicability of default principles of fiduciary duty, controlling members in a manager-managed LLC owe minority members the traditional fiduciary duties that controlling shareholders owe minority shareholders.’” In analyzing the terms of Energy’s limited liability company agreement (the “Energy LLC Agreement”), the Court focused on a provision of the Energy LLC Agreement that addressed the resolution of a potential conflict of interest “between any Affiliate of [Energy], on the one hand, and [Energy] . . . , on the other.” The Court found that such provision did not, by its terms, apply to conflicts of interest arising between America and Energy’s unitholders. Therefore, the Court distinguished such provision from that which was challenged in Lonergan v. EPE Holdings LLC, 2010 WL 3987173 (Del. Ch. Oct. 11, 2010). Furthermore, the Court found that a separate provision of the Energy LLC Agreement that eliminated the fiduciary duties of Energy’s directors and officers also did not, by its terms, apply to Energy’s members, further distinguishing this case from Lonergan.
As a result, the Court found that the Energy LLC Agreement did not eliminate America’s fiduciary duties, and as such, America owed Energy’s minority unitholders the same fiduciary duties that a controlling shareholder would owe minority shareholders in the corporate context. The Court held that the entire fairness doctrine was applicable in this situation, and found that the plaintiffs’ allegations regarding fair price and fair dealing adequately suggested that the merger was not entirely fair to Energy’s public unitholders. The Court therefore denied the defendants’ motion to dismiss the plaintiffs’ claim against America for breach of fiduciary duty.
In analyzing the plaintiffs’ claims against Energy’s directors and officers, the Court found the language of the Energy LLC Agreement to “unambiguously eliminate the traditional fiduciary duties of Energy’s directors and officers.” As a result, the directors and officers owed only those duties set forth elsewhere in the Energy LLC Agreement or imposed by the implied covenant of good faith and fair dealing.
The Court considered a provision of the Energy LLC Agreement that imposed a contractually defined duty of good faith on Energy’s directors and officers, which required them, when making a determination or taking or declining to take any action, to believe that such determination or taking or declining to take such action was in Energy’s best interest. The plaintiffs contended that such contractual and subjective definition of good faith was unenforceable, alleging that it eliminated the implied covenant of good faith and fair dealing. The Court reaffirmed that the implied covenant of good faith and fair dealing is “‘a limited and extraordinary remedy’” meant to protect a party from arbitrary conduct that was objectively unanticipated by the terms of the contract and that “frustrates the ‘fruits of the bargain that the asserting party reasonably expected’” (quoting Nemec v. Shrader). Citing to Lonergan, the Court stated that “where the parties have contractually agreed to eliminate fiduciary duties, they may not invoke the implied covenant as a back door through which such duties may be reimposed after the fact.” The Court held that the implied covenant of good faith and fair dealing was not applicable. Furthermore, in analyzing the various directors’ and officers’ actions in connection with the merger, the Court held that the claims made by the plaintiffs against them did not allege “the type of subjective bad faith required to state a claim” under any duty imposed by the Energy LLC Agreement. As a result, the Court granted the defendants’ motion to dismiss the claims against Energy’s directors and officers.
The Court’s ruling in Atlas further highlights Delaware’s strong policy in favor of freedom of contract in limited liability company agreements and provides another example of the importance of carefully drafting limited liability company agreements.
Richards, Layton & Finger was involved in Atlas, but the views expressed herein are those of the writers and not necessarily those of Richards Layton or its clients.