Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC et al., C.A. No. 3658-VCS (Del. Ch. April 20, 2009)

Plaintiff Bay Center Apartments Owner, LLC (“Bay Center”) and defendant Emery Bay PKI, LLC (“PKI”), as members, formed Emery Bay Member, LLC (“Emery Bay”), a Delaware limited liability company, in connection with a project to convert certain apartment buildings in Emeryville, California into condos (the “Project”). Bay Center’s limited liability company agreement (the “LLC Agreement”) provided that PKI would be the managing member and, in that capacity, expressly gave PKI the power and authority to take actions in connection with the Project. Due to mismanagement and poor financial performance the Project failed. Partly as a result of such failure, Bay Center filed suit against each of PKI, Emery Bay, an affiliate of PKI named Emery Bay ETI, LLC (“ETI”), and Alfred E. Nevis (“Nevis”). Nevis controlled PKI, Emery Bay and ETI.

The day-to-day management of the Project at the center of this case was entrusted by PKI to ETI as the “Development Manager.” Under the LLC Agreement, PKI, as managing member, had the ability to cause ETI, as its affiliate, to become the Development Manager under a separate Development Management Agreement (the “Management Agreement”) to which PKI was not a party. With respect to PKI, however, as managing member pursuant to the LLC Agreement, as stated by the Delaware Court of Chancery “at the very least, PKI had the power and authority to make sure that [the Management Agreement] was performed, regardless of what entity served as the Development Manager.” The Management Agreement and certain loan documents for a $110 Million loan (the “Loan”) were attached as exhibits to the LLC Agreement and allegedly incorporated by reference into the LLC Agreement. Nevis personally guaranteed the repayment of the Loan.

Bay Center alleged breach of contract, breach of the implied contractual covenant of good faith and fair dealing, breach of fiduciary duty, common law fraud, and aiding and abetting breach of fiduciary duty and fraud. Defendants moved for dismissal of each claim, except the breach of contract claims, under Court of Chancery Rule 12(b)(6). The Court denied the motion with respect to all claims for which defendants sought dismissal.

A. The Implied Contractual Covenant of Good Faith and Fair Dealing

Bay Center’s claim that defendants breached the implied covenant of good faith and fair dealing was in the alternative to its claim for breach of contract. Under its breach of contract claim, which was not at issue in the motion to dismiss, Bay Center alleged that PKI had an express obligation under the LLC Agreement to cause its affiliate, ETI, to perform the management obligations under the Management Agreement. As described above, PKI had the power and authority to cause performance of the Management Agreement. Defendants argued that the grant of this power under the LLC Agreement did not necessarily obligate PKI to take action with respect to the Management Agreement. Notably, the Court found that, based on the implied covenant of good faith and fair dealing, the discretion to cause performance of the Management Agreement, in conjunction with the obligation to manage Emery Bay, could result in an implied duty on PKI to affirmatively act to cause such contractual performance. In reaching its decision, the Court stated that, among other things, PKI’s decision to not pursue claims against ETI for failure to perform under the Management Agreement was not in good faith because Nevis controlled both parties to that agreement and PKI.

B. Fiduciary Duties

The Delaware LLC Act gives parties to a limited liability company agreement the ability to restrict or eliminate fiduciary duties and the liability for the breach thereof. This right is limited only by a prohibition on the elimination of the implied contractual covenant of good faith and fair dealing. Bay Center argued that the LLC Agreement preserved the traditional fiduciary duties of loyalty and care owed by a manager of an LLC to its members. As support, Bay Center pointed to the provision of the LLC Agreement providing “[e]ach Member agrees that, to the fullest extent permitted by the Delaware Act and except as otherwise expressly provided in this Agreement or any other agreement to which the Member is a party: . . . [t]he Members shall have the same duties and obligations to each other that members of a limited liability company formed under the Delaware Act have to each other.” The defendants, however, argued that fiduciary duties had been eliminated by the LLC Agreement and, as support, pointed to another provision of the LLC Agreement providing that “[e]xcept for any duties imposed by this Agreement . . . each Member shall owe no duty of any kind towards the Company or the other Members in performing its duties and exercising its rights hereunder or otherwise.” Applying the standards of Rule 12(b)(6) the Court ruled that this claim could not be dismissed against PKI because defendants’ interpretation of the LLC Agreement was not the only reasonable one in light of the seemingly contradictory provisions. The Court repeated what Delaware Courts have stated in numerous other cases – when attempting to eliminate fiduciary duties drafters of governing instruments like the LLC Agreement must do so with plain and unambiguous provisions.

The Court also refused to dismiss Bay Center’s claim that Nevis breached its fiduciary duties to Bay Center. The Court analyzed the claim against Nevis under the In re USACafes, L.P Litigation line of cases because Nevis was not a traditional fiduciary, as he was not a member, manager or officer of Emery Bay. In re USACafes and its progeny essentially stand for the proposition that parties with managerial control over an entity (a “Parent”) that itself controls another entity (a “Sub”) may owe direct fiduciary duties not only to the Parent and its equity owners but also to the Sub and its  equity owners since such parties ultimately possess managerial control over the Sub’s property. It was undisputed by defendants that Nevis, as the controlling person of PKI, also exerted direct control over Emery Bay’s property. The Court found that Bay Center’s allegations against Nevis created a reasonable inference that Nevis exercised his control to avoid personal liability at the expense of Bay Center.  While the Court does not seek to define the specific duties encompassed by the In re USACafes line of case, it notes that the scope of such duties have thus far been limited to merely avoiding the use of control over a subsidiary entity’s property to advantage the controlling person or entity at the expense of the subsidiary, and the Court states it is able to deny the motion to dismiss in this matter on that very basis. The Court’s finding of sufficient allegations that PKI and Nevis had fiduciary duties and that those duties were breached led it to also deny defendants’ motion to dismiss the claims of aiding and abetting breach of fiduciary duty.

C. Fraud

Bay Center’s common law fraud claims were based on 1) an alleged failure of PKI and Nevis to disclose severe problems with the Project and its financing, and 2) active concealment of material information by PKI and Nevis from Bay Center. The Court held that PKI and Nevis, as fiduciaries, had a duty to disclose all material information within their control by analogizing their roles in Emery Bay to those of directors of a Delaware corporation. A corporation’s board of directors has such a duty when the board seeks shareholder action or shareholders have the right to take action. The LLC Agreement required Bay Center’s consent to certain actions related to the Loan, however, in six out of the seven instances where such actions were taken by PKI, Bay Center was neither informed of even basic facts nor was its consent obtained. The common law fraud claim survived due to the sufficient allegations of a failure to disclose material information. Bay Center’s claims based on active concealment, however, were dismissed. Because Bay Center sufficiently alleged that Nevis personally participated in the asserted fraud, the Court also allowed the fraud claims based on failure to disclose to go forward against Nevis. The alternative claim that Nevis aided and abetted PKI’s fraud was also allowed to proceed.

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