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Paige Capital Management, LLC, et al. v. Lerner Master Fund, LLC, et al., C.A. No. 5502-CS (Del. Ch. August 8, 2011)

August 8, 2011

In this opinion, the Delaware Court of Chancery refused to permit management of a hedge fund (the “Paige Fund”) to utilize the provisions of the partnership agreement of the Paige Fund’s Delaware investment vehicle to restrict the withdrawal by the Paige Fund’s only outside investor of its entire capital investment finding, among other things, that imposing such restrictions was a breach of a separate agreement entered into with such investor as well as a breach of fiduciary duty by management of the Paige Fund.

In October 2007, an investment vehicle controlled by a wealthy family (the “Lerner Fund”) invested $40 million of “seed” capital with a hedge fund manager starting the Paige Fund as her first such fund. The Lerner Fund entered into a Partnership Agreement (the “Partnership Agreement”), as a limited partner of the Delaware limited partnership (the “Partnership”) which was one of the vehicles through which the Paige Fund’s investments would be administered. At such time, the Lerner Fund also entered into a Revenue Sharing Agreement (the “Seeder Agreement”) with entities acting as the general partner and the investment manager of the Paige Fund. The Partnership Agreement governed the rights of all limited partners, including the Lerner Fund, with respect to their investments. The Seeder Agreement governed the relationship between the aige Fund and the Lerner Fund with respect to management fees, incentive fees, and withdrawal rights, and did not apply to any other limited partners. Importantly, the Paige Fund failed to attract any additional investors as limited partners. The only limited partners ever admitted were the Lerner Fund and the individual managing the Paige Fund, who invested $40,000, representing just .1% of the total amount invested. The Lerner Fund invested the remaining 99.9%. This action arose as a result of the Lerner Fund’s request to withdraw its capital from the Paige Fund three years after its original investment pursuant to the Seeder Agreement, and the refusal by the general partner and manager of the Paige Fund to honor such withdrawal request.

The contractual interpretation of the Partnership Agreement and the Seeder Agreement with respect to the Lerner Fund’s right to withdraw its capital was the fundamental legal issue the Court dealt with in this case. Because New York law governed the Seeder Agreement, and the primary contract-law issue on which the parties sought the Court’s guidance was the effect of the Seeder Agreement on the Partnership Agreement, the Court based its contract-law analysis on New York law. In construing the disputed Partnership Agreement and Seeder Agreement withdrawal provisions in favor of the Lerner Fund, the Court used several New York law principles of contract interpretation that closely correspond to their Delaware counterparts. Those principles include that contracts must be read as a whole, giving effect to every provision; where there is more than one agreement that governs a relationship, the court may look for a “collective design” appearing in all such agreements; and the more specific agreement generally trumps the more general.

The specific provisions at issue in the Seeder Agreement unequivocally provided that the Lerner Fund could withdraw its capital, without penalty, three years after its original seed investment. However, the Partnership Agreement contained a “Gates Provision.” That provision generally permitted the general partner to limit the amount that the limited partners collectively could withdraw during each six-month period to 20% of the capital invested by all limited partners. Notably, the Partnership Agreement expressly permitted the general partner to waive withdrawal restrictions for “certain large or strategic investors,” a category into which the Lerner Fund, as the only outside investor, undoubtedly fell. Nonetheless, in response to the Lerner Fund’s request to withdraw its capital on the third anniversary of its investment pursuant to the Seeder Agreement, the general partner invoked the Gates Provision of the Partnership Agreement and thereby refused to allow the withdrawal of over 20% of such capital. The Paige Fund and its principals essentially argued that the Gates Provision could be invoked notwithstanding the seemingly conflicting provisions of the Seeder Agreement because the Partnership Agreement was not “amended” by the provisions of the Seeder Agreement relating to withdrawal of capital. The Lerner Fund’s main argument was that no amendment was necessary because the Partnership Agreement permitted the general partner to waive the Gates Provision and it specifically did so with respect to the Lerner Fund in the Seeder Agreement. Treating the Seeder Agreement similarly to a “side letter” between an investor and an investment fund, the Court agreed with the Lerner Fund that the Seeder Agreement’s specific provisions regarding the ability of the Lerner Fund to withdraw its capital after three years should be interpreted as superseding the Partnership Agreement’s Gates Provision, and that the refusal by the Paige Fund to return the Lerner Fund’s capital was a breach of contract.

The Lerner Fund also argued that the refusal by the Partnership’s general partner to return the Lerner Fund’s capital was a breach of fiduciary duty. The Lerner Fund posited that because the Partnership Agreement provided the general partner with the right to waive the restrictions imposed by the Gates Provision (assuming it applied), the general partner should have in good faith returned its capital and that the refusal to do so was motivated solely by management’s own self-interested purposes. As the Court explains at great length, the principals of the Paige Fund stood to collect management fees for so long as they retained the Lerner Fund’s capital. Upon the return of that capital, the Paige Fund’s sole remaining asset would have been the .1% capital invested by management, and the Paige Fund would no longer have constituted a viable investment fund.

The Paige Fund principals argued that the individual serving as the managing member of the Partnership’s general partner did not owe fiduciary duties because she was not herself the general partner. To that end, the Court held, pursuant to the USACafes, L.P. Litigation (In re USACafes, L.P. Litig., 600 A.2d 43 (Del. Ch. 1991) case and its Delaware progeny, that the Paige Fund manager, as the managing member of the entity serving as the general partner of the Partnership, in exercising control over the Partnership’s property, owed fiduciary duties directly to the Partnership and the Lerner Fund, as a limited partner of the Partnership. It is notable that the Court refused to hold the Paige Fund manager’s husband liable for breach of fiduciary duty even though the record showed that he exercised some control over the Partnership. The refusal of the Court to do so was based on the fact that the Paige Fund manager’s husband was not an officer, director or member of the general partner of the Partnership.

Another counter-argument advanced by the Paige Fund against the Lerner Fund’s allegation of breach of fiduciary duty was that the Partnership Agreement contractually modified and limited any such duties, as permitted by the Delaware Revised Uniform Limited Partnership Act (“DRULPA”). The Paige Fund contended that such a modification was effected by the Partnership Agreement providing the general partner with the “sole discretion” to waive the restrictions in the Gates Provision. In choosing not to waive such restriction, the Partnership’s general partner argued, it was merely exercising such sole discretion as had been authorized by the Partnership Agreement. The Court disagreed with this argument. The Court cited prior Delaware cases interpreting such language in the alternative entity context as holding that, without additional clarifying language in the Partnership Agreement regarding the meaning of “sole discretion,” a fiduciary would not be relieved of its duty to act in an impartial manner. Such clarifying language accepted by Delaware courts as modifying a fiduciary’s duty of loyalty in past cases has provided that in making decisions in its sole discretion a fiduciary like the general partner need not consider other interests, including those of limited partners. Without such additional language, the Court found that it was more reasonable to interpret “sole discretion” as simply meaning that no other consent besides the general partner’s was necessary to waive the Gates Provision. In addition, the Court rejected the Paige Fund’s reliance on Section 17-1101(e) of DRULPA, which provides:

    Unless otherwise provided in a partnership agreement, a partner or other person
    shall not be liable to a limited partnership or to another partner or to another  
    person that is a party to or is otherwise bound by a partnership agreement for
    breach of fiduciary duty for the partner’s or other person’s good faith reliance on
    the provisions of the partnership agreement.

The Court held that, with respect to Section 17-1101(e) “to exculpate a fiduciary for breach of fiduciary duty for making a good faith, but erroneous, determination that the partnership agreement allowed the fiduciary to advance its self-interest over the best interests of the investors would seem to extend the statute’s reach beyond its sensible borders.” Accordingly, the Court found that the Partnership’s general partner and individual manager had breached fiduciary duties by favoring their own interests (and not even their own interests in their capacity as an investor) over those of the investors in the Paige Fund (i.e., the Lerner Fund) in invoking the Gates Provision and thereby refusing to allow the return of capital to the Lerner Fund.

In the Court’s 101 page opinion, it also ruled against the Paige Fund and its principals with respect to several claims made by them. Such claims include that the Lerner Fund breached an implied contractual covenant of good faith and fair dealing, that the Lerner Fund defamed the Paige Fund principals, and that the Paige Fund principals were entitled to indemnity for their legal expenses. The Court ultimately ordered the Paige Fund and its principals to return the Lerner Fund’s capital with interest, to pay back any management fees earned on the Lerner Fund’s capital after the third anniversary of the original investment date, and to repay the Partnership for any fees and expenses advanced by the Paige Fund related to the litigation.

The full opinion is available here