2012 Choice of Jurisdiction Considerations: Texas vs. Delaware

The University of Texas School of Law Presented: LLCs, LPs, and Partnerships July 11, 12-13, 2012 Austin, TX 2012 Choice of Jurisdiction Considerations: Texas vs. Delaware Recent Developments Regarding Fiduciary Duties in Unincorporated Entities and How They May Affect Choice of Jurisdiction and Drafting Cliff Ernst Author contact information: Cliff Ernst Graves Dougherty Hearon & Moody, A Professional Corporation 401 Congress Avenue, Suite 2200 Austin, Texas 78701 cernst@gdhm.com 512-480-5672 Continuing Legal Education 512-475-6700 www.utcle.org

2012 Choice of Jurisdiction Considerations: Texas vs. Delaware Recent Developments Regarding Fiduciary Duties in Unincorporated Entities and How They May Affect Choice of Jurisdiction and Drafting Table of Contents I. Introduction... 1 II. What is a Fiduciary?... 2 III. Meinhard v. Salmon... 2 IV. Examining the Statutes... 4 Page A. Texas Statutes... 4 B. Delaware Statutes... 7 V. Case Law and Recent Developments in Delaware... 10 A. Gotham Partners Case... 10 B. Amendments to the Delaware Statutes... 10 C. Justice Steele s Article... 11 D. The Court Responds... 12 E. The Requirement of Good Faith... 15 VI. Texas Case Law... 17 VII. Examples of Contract Provisions Dealing with Duties... 19 A. Texas LP Competing Business... 19 B. Delaware LLC Forced Sale of Company Assets... 19 C. Delaware LP Replace Fiduciary Duty with Best Interests... 20 D. Delaware LP No Duties Absent Fraud, etc... 20 E. Delaware LLC No Fiduciary Duties... 20 F. Delaware LP Discretion Implies No Duties... 21 G. Delaware LLC No Duties; Good Faith Reliance on Experts... 22 VIII. Summary and Conclusions... 23 i

2012 Choice of Jurisdiction Considerations: Texas vs. Delaware Recent Developments Regarding Fiduciary Duties in Unincorporated Entities and How They May Affect Choice of Jurisdiction and Drafting Cliff Ernst Graves, Dougherty, Hearon & Moody, A Professional Corporation Austin, Texas Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the disintegrating erosion of particular exceptions.... Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court. 1 -- Benjamin Cardozo, Chief Judge, New York Court of Appeals I. Introduction This paper will focus on recent developments in the law regarding the duties of the management of limited liability companies and partnerships, particularly limited partnerships, 2 and the impact these developments may have on (i) choice of jurisdiction when a lawyer advises clients about whether to form an entity under the laws of Texas or the laws of Delaware and (ii) drafting and negotiating the organization agreement. We will begin with an examination of the development and history of the these duties, which began as a common law concept. We will 1 Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545, 546 (N.Y. 1928). 2 General and limited partnerships and limited liability companies are often referred to alternate entities or alternative entities (because they are alternatives to the traditional corporation) or unincorporated entities. In this paper such terms are used interchangeably. 1

review and compare the relevant Texas and Delaware statutory provisions. Then we will examine recent developments in Delaware pertaining to this area of the law. We will end by examining some examples of contractual provisions drafted with these developments in the law taken into consideration. II. What is a Fiduciary? Let us begin by considering what the term fiduciary means. Merriam-Webster s Dictionary defines a fiduciary as one that holds a fiduciary relation or acts in a fiduciary capacity, 3 which is not particularly helpful. The following definitions are more helpful: A person to whom property or power is entrusted for the benefit of another. 4 An individual, corporation or association holding assets for another party, often with the legal authority and duty to make decisions regarding financial matters on behalf of the other party. 5 In layman s terms, a fiduciary is a person or entity who takes care of money or other property for another person or entity. Fiduciary duties arise as a matter of common law when certain relationships exist such as attorney-client, trust-trustee and partnership relationships. 6 In 1928, in a case called Meinhard v. Salmon 7, Benjamin Cardoza, then the Chief Judge of the Court of Appeals of New York, found that this duty arises in the context of a real estate joint venture. In doing so, he created one of the most famous and durable articulations of the duty, which is quoted at the beginning of this article. III. Meinhard v. Salmon While Meinhard v. Salmon 8 was decided in 1928, it involved an agreement that had been made twenty-six years earlier in 1902. That agreement was between Walter J. Salmon and Morton Meinhard to form a venture to own and develop real estate in New York City, not unlike the arrangement that many modern practitioners draft and negotiate legal documents for every week. 3 http://www.merriam-webster.com/dictionary/fiduciary. 4 Dictionary.com http://dictionary.reference.com/browse/fiduciary. 5 InvestorWords.com http://www.investorwords.com/1932/fiduciary.html. 6 Insurance Co. of North America v. Morris, 981 S.W.2d 674, 678 (Tex. 1998). 7 164 N.E. 545 (N.Y. 1928). 8 Id. 2

The parties agreed to share the start-up costs of the venture fifty/fifty. Mr. Salmon was the organizer of the venture, generated the business opportunity that would become the venture s investment and source of income, and agreed to manage the venture. The agreement provided that profits would be split sixty/forty for the first five years of the venture, in recognition of Mr. Salmon s finding the opportunity and taking on the obligation to manage the venture. After the first five years, profits would be split fifty/fifty for the remaining fifteen-year term of the venture. Losses were to be shared fifty/fifty throughout the term. The business of the venture would be to lease and operate a building located at the corner of Fifth Avenue and 42 nd Street in New York City. In 1902 that part of New York City was being transformed from a residential area to a commercial area. Across the street from the property, construction was commencing on the then new main building of the New York Public Library. Construction of the new Grand Central Terminal would begin two blocks to the east the following year. The property was occupied by an eight-story hotel called the Bristol Hotel. The business plan for the venture was to convert the Bristol Hotel to office space. The Bristol Hotel was converted by the venture to the Bristol Building and although the venture was marked by disagreements between the venturers from almost the beginning of the project and experienced losses in its first years, it was ultimately very successful. Each investor received profits in excess of $500,000 from an initial investment of $40,000. 9 At the end of the initial lease, without telling Mr. Meinhard, Mr. Salmon as manager entered into discussions with the landlord for a new lease to a company owned by Salmon individually (not by the venture). The footprint of the new lease would be expanded to include adjoining land owned by the landlord. The Bristol Building would be torn down and replaced with a skyscraper that would cover the expanded footprint. The new lease would be for a term of twenty years with three twenty-year renewal terms. The rent would be $350,000 per year, rising to $475,000 per year (compared with rent of $55,000 per year under the old lease.) As part of the transaction, Salmon agreed to provide a construction guaranty. The original plan was for a 25-story building, which was increased to a 59-story building that still stands today. It was one of the tallest buildings in midtown Manhattan at the time it was built. Salmon entered into the new lease without Meinhard s knowledge. Upon learning of the new lease, Meinhard sued Salmon alleging breach of fiduciary duty and demanding that the new lease be held in trust as an asset of the Salmon-Meinhard venture. The trial court awarded Meinhard a twenty-five percent interest in the new arrangement. Both sides appealed and the appellate division of the New York Supreme Court increased Meinhard s interest to fifty percent. The appeal by Salmon to the New York Court of Appeals, the highest court in the New York 9 For a detailed history and description of the litigation between Salmon and Meinhard and the venture and the parties involved, see Robert B. Thompson, The Story of Meinhard v. Salmon and Fiduciary Duty s Punctilio, Vanderbilt University Law School Public Law and Legal Theory Working Paper Number 08-44, available at http://ssrn.com/abstract=1285705. 3

system, gave the chief judge of that court, Benjamin Cardozo, the opportunity to write the paragraph appearing at the beginning of this paper. The Court of Appeals awarded Meinhard fifty percent of the corporation that Salmon had formed to hold the new lease, minus one share to give Salmon control. In hindsight it was a hollow victory for Meinhard. The building on the site, known as 500 Fifth Avenue, opened in 1931 during the Great Depression. Only a few floors were rented when the building opened and Meinhard s financial participation ultimately benefited Salmon because Meinhard had to fund his share of operating losses, which otherwise would have been funded by Salmon alone. When Meinhard died two years later, his liability on the lease was two-thirds of the debt of his estate. There was subsequent litigation related to the property that was settled by a sale of the Meinhard interest in the building back to Salmon. Salmon still controlled the building when he died in 1953. Even though this case may not have worked out well for Mr. Meinhard and his heirs, in the end it became the seminal case on the duty owed in partnerships, joint ventures and many other business arrangements. A July 2012 search in WestlawNext found 4,348 citations to the case in judicial decisions, administrative law decisions, secondary sources, trial documents and arbitration awards. IV. Examining the Statutes Against the background of numerous cases applying the common law of fiduciary duty in business transactions, the Texas legislature and the Delaware legislature have codified the duties of partners of partnerships and managers and members of limited liability companies. A. Texas Statutes. The Texas Business Organizations Code (the TBOC ) is the Texas statute that governs entities formed in Texas, including general and limited partnerships and limited liability companies. The hub provisions of the TBOC (Chapters 1 through 12) apply to all such entities. Chapter 101 of the TBOC contains provisions that apply specifically to limited liability companies and Chapters 151 through 154 apply to partnerships. TBOC Chapter 153 applies specifically to limited partnerships. It is interesting to note that the provisions of the TBOC that deal with the duties of partners do not use the term fiduciary. TBOC 152.204 provides: BOC 152.204. GENERAL STANDARDS OF PARTNER S CONDUCT (a) A partner owes to the partnership, the other parties, and a transferee of a deceased partner s partnership interest as designated in Section 152.406(a)(2): (1) a duty of loyalty; and 4

(2) a duty of care. (b) A partner shall discharge the partner s duties to the partnership and the other partners under this code or under the partnership agreement and exercise any rights and powers in the conduct or winding up of the partnership business: (1) in good faith; and (2) in a manner the partner reasonably believes to be in the best interest of the partnership. (c) A partner does not violate a duty or obligation under this chapter or under the partnership agreement merely because the partner s conduct furthers the partner s own interest. (d) A partner, in the partner s capacity as a partner, is not a trustee and is not held to the standard of a trustee. The duty of loyalty is further defined in TBOC 152.205, which provides: BOC 152.205. PARTNER S DUTY OF LOYALTY A partner s duty of loyalty includes: (1) accounting to and holding for the partnership property, profit, or benefit derived by the partner: (A) in the conduct and winding up of the partnership business; or (B) from use by the partner of partnership property; (2) refraining from dealing with the partnership on behalf of a person who has an interest adverse to the partnership; and (3) refraining from competing or dealing with the partnership in a manner adverse to the partnership. 5

The duty of care is further defined in TBOC 152.206, which provides: BOC 152.206. PARTNER S DUTY OF CARE (a) A partner s duty of care to the partnership and the other partners is to act in the conduct and winding up of the partnership business with the care an ordinarily prudent person would exercise in similar circumstances. (b) An error in judgment does not by itself constitute a breach of the duty of care. (c) A partner is presumed to satisfy the duty of care if the partner acts on an informed basis and in compliance with Section 152.204(b). These statutory duties are made applicable to a general partner of a partnership by TBOC 153.152, which provides in relevant part: BOC 153.152. GENERAL POWERS & LIABILITIES OF GENERAL PARTNER (a) Except as provided by this chapter, the other limited partnership provisions, or a partnership agreement, a general partner of a limited partnership: (1) has the rights and powers and is subject to the restrictions of a partner in a partnership without limited partners; and (2) has the liabilities of a partner in a partnership without limited partners to the partnership and to the other partners.... While it may be less than obvious, the phrase is subject to the restrictions of a partner in a partnership without limited partners means that a general partner has a duty of loyalty and duty of care to the limited partners. The courts have had little trouble reaching this conclusion. 10 Note that the first part of TBOC 153.152 includes the language [e]xcept as provided by... a partnership agreement.... This suggests that a limited partnership agreement could 10 See e.g. Hughes v. St. David s Support Corp., 944 S.W.2d 423 (Tex. App. Austin 1997, writ denied). 6

eliminate entirely the duty of loyalty and duty of care owed by a general partner under Texas law. As will be discussed later in the paper, the Delaware legislature and courts have taken steps to make it clear that Delaware law does allow this result. A recent Texas case 11 discussed later in this paper reached the conclusion that the parties to a Texas limited partnership could eliminate fiduciary duties by contract, but did so without mentioning TBOC 153.152. Interestingly, the portion of the TBOC dealing with limited liability companies 12 does not contain provisions establishing duties owed by managers or members of Texas limited liability companies. However, this portion of the TBOC dealing specifically with limited liability companies (Chapter 101) does contain the following provision regarding expansion or restriction of duties: BOC 101.401. EXPANSION OR RESTRICTION OF DUTIES & LIABILITIES The company agreement of a limited liability company may expand or restrict any duties, including fiduciary duties, and related liabilities that a member, manager, officer, or other person has to the company or to a member or manager of the company. B. Delaware Statutes. The duties of a partner in a Delaware partnership are specifically denominated as fiduciary duties and are set out in Section 15-404 of the Delaware Revised Uniform Partnership Act 13 : 15-404. General standards of partner s conduct (a) The only fiduciary duties a partner owes to the partnership and the other partners are the duty of loyalty and the duty of care set forth in subsections (b) and (c). (b) A partner s duty of loyalty to the partnership and the other partners is limited to the following: (1) to account to the partnership and hold as trustee for it any property, profit or benefit derived by the partner in the conduct or winding up of the partnership business or affairs or 11 Strebel v. Wimberly, No. 01-10-00227-CV, 2012 WL 112253 (Tex. App. Hous. (1 Dist.)). 12 TEX. BUS. ORG. CODE 101.001 et seq. 13 6 DEL. CODE 15-404 (2006). 7

derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity; (2) to refrain from dealing with the partnership in the conduct or winding up of the partnership business or affairs as or on behalf of a party having an interest adverse to the partnership; and (3) to refrain from competing with the partnership in the conduct of the partnership business or affairs before the dissolution of the partnership. (c) A partner s duty of care to the partnership and the other partners in the conduct and winding up of the partnership business or affairs is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law. (d) A partner does not violate a duty or obligation under this chapter or under the partnership agreement solely because the partner s conduct furthers the partner s own interest.... These duties apply to a general partner of a Delaware limited partnership by virtue of Section 17-403(a) of the Delaware Limited Partnership Act, 14 which provides: 17-403. General powers and liabilities (a) Except as provided in this chapter or in the partnership agreement, a general partner of a limited partnership has the rights and powers and is subject to the restrictions of a partner in a partnership that is governed by the Delaware Uniform Partnership Law.... 14 6 DEL CODE 17-403(a) (2006). 8

Section 17-1101(d) of the Delaware Limited Partnership Act, 15 adopted in its current form in 2004, provides: 17-1101. Construction and application of chapter and partnership agreement... (d) To the extent that, at law or in equity, a partner or other person has duties (including fiduciary duties) 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, the partner s or other person s duties may be expanded or restricted or eliminated by provisions in the partnership agreement; provided that the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing.... Similar to the TBOC, the Delaware Limited Liability Company Act does not specify the duties owed by managers or members, but it does contain the following provision regarding expansion, contraction or elimination of duties in 18-1101: 16 18-1101. Construction and application of chapter and limited liability company agreement... (c) To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member s or manager s or other person s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.... 15 6 DEL. CODE 17-1101(d) (2010). 16 6 DEL. CODE 18-1101(c) (2010). 9

V. Case Law and Recent Developments in Delaware A. Gotham Partners Case. The recent developments in Delaware law relevant here began in 2002 with Gotham Partners, L.P. v. Hallwood Realty Partners, L.P. 17 That case arose prior to the adoption of the versions of 17-1101 of the Delaware Limited Partnership Act and 18-1101 of the Delaware Limited Liability Company Act quoted above. Gotham Partners was part of a series of lawsuits related to a tender offer for units of limited partnership interest in Hallwood Realty Partners, L.P., a publically traded Delaware limited partnership. Plaintiff Gotham Partners, L.P. as the holder of units in Hallwood alleged that the tender offer was unfair because the purchaser (the parent company of the general partner) paid an unfairly low price for the units to acquire control over the partnership. Gotham Partners asserted claims for breaches of traditional common law fiduciary duty and contractually based fiduciary duties. 18 The trial court sustained the contractual fiduciary duty claims but dismissed the common law duty claims. In doing so, the trial court stated that the Delaware statute at the time authorized the elimination of all fiduciary duties by contract. The appellate court labeled this ruling as dicta and then stated that the Delaware statue allowed the expansion or restriction of fiduciary duties by contract, but not the elimination of fiduciary duties entirely, stating in our jurisprudence scrupulous adherence to fiduciary duties is normally expected. 19 B. Amendments to the Delaware Statutes. In 2004 the Delaware General Assembly amended the Delaware Limited Partnership Act and the Delaware Limited Liability Company Act to add the words or eliminated to the existing provisions permitting parties to the governing agreement of an unincorporated entity to restrict duties by contract. The revised language for limited partnerships now reads as follows: the partner s or other person s duties may be expanded or restricted or eliminated by provisions in the partnership agreement 20 17 817 A.2d 160 (Del. 2002). 18 Id. at 166. 19 Id. at 167. 20 6 DEL. CODE 17-1101(d) (2010) (emphasis added). 10

The revised language for limited liability companies now reads as follows: the member s or manager s or other person s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement... 21 C. Justice Steele s Article. In 2007 Myron T. Steele, Chief Justice of the Delaware Supreme Court, published an article in the Delaware Journal of Corporate Law. In this article, entitled Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnership and Limited Liability Companies, 22 Justice Steele surveyed the history of recent Delaware fiduciary duty cases involving unincorporated entities, concluding that Delaware courts had erroneously borrowed the concept of fiduciary duties based upon status (such as directors and shareholders of a corporation) and applied it to entities created by contract (specifically limited partnerships and limited liability companies). He noted that the 2004 amendments to the Delaware Limited Partnership Act and the Delaware Limited Liability Company Act described above were directly in response to the Gotham Partners case. 23 While Justice Steele did not quibble with the concept that traditional fiduciary duties will exist if the parties do not provide otherwise in the governing agreement, Justice Steele concluded that the law of the land in Delaware after the enactment of the 2004 amendments (if not before) was that partners in a limited partnership and the managers and members in a limited liability company could completely eliminate by agreement any common law fiduciary duties. The August 2004 amendment should put the Delaware Supreme Court on notice that, except where the parties to an LLP or LLC agreement do not address fiduciary duties, parties to limited partnership and limited liability company agreements will normally seek to craft their own status relationship by contract. In these cases, the courts must recognize that the contracting parties have not superimposed upon their relationship a set of duties and liabilities drawn from common law fiduciary duty with its complex overlay of levels of scrutiny. The General Assembly recognized the greater desirability, if not flexibility, of allowing parties to define their respective duties and liabilities by contract. 24 21 6 DEL. CODE 18-1101(c) (2010) (emphasis added). 22 32 Del. J. Corp. L. 1 (2007) 23 Id. at 13. 24 Id. at 23. 11

D. The Court Responds. After the publication of Justice Steele s article, it was only a matter of time before the Delaware courts would have a chance to revisit the issue. 25 One such chance came in January of this year (2012) with the case of Gerber v. Enterprise Products Holdings, LLC. 26 The Gerber case involved a complicated set of facts involving three back-to-back transactions. The first transaction was a purchase made by a Delaware limited partnership called Enterprise GP Holdings L.P. ( Holdings LP ) of a Texas oil and gas company called Texas Eastern Products Pipeline Company, LLC ( Teppco ) for $1.1 billion. In the second transaction, Holdings LP sold its interest in Teppco for $100 million to a third company called Enterprise Products Partners, L.P. ( Products LP ), also a Delaware limited partnership. In the third transaction, Holdings LP was merged into a subsidiary of Products LP, the purchaser of Teppco. (See the illustration below.) 25 In 2006, in the case of Douzinas v. American Bureau of Shipping, Inc., 888 A.2d 1146 (Del. Ch. 2006), the Delaware Chancery Court stated that contractual freedom [is] recognized as central to the Delaware Limited Liability Company Act, which permits the contractual elimination of default principals of fiduciary duty. Id. at 1150. However, the Douzinas case did not turn on provisions of a limited liability company agreement eliminating fiduciary duty, but rather turned on the interpretation and application of mandatory arbitration provisions in the company agreement. An interesting side observation for Texas practitioners related to the Douzinas case is the choice of law provision in the company agreement. The limited liability company involved in the case was organized as a Delaware limited liability company, but the company agreement provided that the agreement would be governed by the laws of the State of Texas, except where the Delaware Limited Liability Company Act requires the application of Delaware law. The court recognized and gave effect to this odd choice of law provisions and interpreted the mandatory arbitration provision under the laws of the State of Texas. Id. at 1148. 26 Gerber v. Enterprise Products Holdings, LLC, No. 5989-VCN, 2012 WL 34442 (Del. Ch. 2012). 12

Prior to the merger, Holdings LP was a publically traded limited partnership. Gerber was a holder of limited partnership units in Holdings LP. He attempted to bring a class action lawsuit on behalf of the public unitholders of Holdings LP challenging the second and third transactions. Gerber claimed, among other things, that the disposition of the oil and gas company was a breach of duty by the general partner of Holdings LP. He based this claim on the fact that Teppco and the general partner of Holdings LP and the general partner of Products LP were all affiliated with and controlled by an individual named Dan L. Duncan and his family. He alleged that the transaction involved an improper conflict of interest. He also complained that the merger price was unfair because it did not take into account the claim related to the undervalued sale of Teppco. In essence, Gerber s version of the facts was that (i) Duncan sold Teppco to a company he controlled for $1.1 billion; (ii) Duncan then caused the buyer, which he controlled as general partner, to sell the same asset for $1 billion less to another company he also controlled as general partner; and (iii) he merged away the unaffiliated limited partners of the seller in a transaction that also ignored the improper $1 billion loss on the Teppco sale. The court ruled against Gerber on his claims of conflicts of interest. In reaching this conclusion, the court relied upon 17-1101 of the Delaware Limited Partnership Act that permits a partnership agreement to expand, restrict of eliminate the duties (including fiduciary duties) that any person may owe to either the limited partnership of any other party to the limited partnership agreement. 27 The court then quoted the following provisions of the Holdings LP limited partnership agreement: 27 Id. at *6. 13

Unless otherwise expressly provided in this Agreement, whenever a potential conflict of interest exists or arises between the General Partner or any of its Affiliates, on the one hand, and the Partnership or any Partner, on the other hand, any resolution or course of action by the General Partner or its Affiliates in respect of such conflict of interest shall be permitted and deemed approved by all Partners, and shall not constitute a breach of this Agreement or of any agreement contemplated herein or therein, or of any duty stated or implied by law or equity, if the resolution or course of action in respect of such conflict of interest is (i) approved by Special Approval, (ii) approved by the vote of a majority of the Units excluding Units owned by the General Partner and its Affiliates, (iii) on terms no less favorable to the Partnership than those generally being provided to or available from unrelated third parties or (iv) fair and reasonable to the Partnership, taking into account the totality of the relationships between the parties involved (including other transactions that may be particularly favorable or advantageous to the Partnership. 28 The court found that because the transaction had been approved by Special Approval (defined as approval by the general partner s audit and conflicts committee), the requirements of the contractual provision had been met and denied the claim. The court then made this pronouncement, in line with the position taken by Justice Steele in his 2007 Article: Alternate entity legislation reflects the Legislature s decision to allow such ventures to be governed without the traditional fiduciary duties, if that is what the partnership agreement or other governing document provides for, and allows conduct that, in a different context, would be sanctioned. Ultimately, the investor, who is charged with having assessed and accepted the risks of putting his money in any entity without the comfort afforded by fiduciary duties, is left with contractual protections, either those that are expressed or those that are within the implied covenant of good faith and fair dealing. 29 Texas courts that have applied Delaware law have also ruled that under Delaware law an unincorporated entity may restrict or wholly eliminate any duties that might otherwise be owed 28 Id. at *7. 29 Id. at *9. 14

to that company, including fiduciary duties. 30 It is interesting to note that apparently Texas courts stated that this was the law in Delaware before Delaware courts did. Also note that this issue often arises in the context of a bankruptcy proceeding in which the creditors are asserting a breach of fiduciary duty claim. Such claims are not discharged in bankruptcy due to Section 523(a)(4) of the Bankruptcy Code, 31 which excepts from discharge a debt from fraud or defalcation by a fiduciary (i.e. failure to fulfill a fiduciary duty). E. The Requirement of Good Faith. One final concept to mention regarding the Delaware law in this area relates to the implied contractual covenant of good faith and fair dealing. The provisions of the Delaware Limited Partnership Act and the Delaware Limited Liability Company Act that allow elimination by contract of fiduciary duties state that an entity s governing document may not eliminate the implied contractual covenant of good faith and fair dealing. 32 Because this language includes the word contractual, in his 2007 article Justice Steele cites this language as additional indicia that the legislature intended that issues of duty be determined in accordance with the contractual obligations and not principals of common law fiduciary duty. 33 Justice Steele also argues that the courts should look to the cases dealing with good faith issues in contractual settings rather than the enigmatic good faith fiduciary duty at common law. 34 In the Gerber case, the Delaware Chancery Court was required to deal with the issue of an implied covenant of good faith and fair dealing. The facts underlying the claim and the court s analysis are complicated. The conflicts of interest provision in the limited partnership agreement (quoted above) established four alternative standards of review: (i) approval by the general partner s audit and conflicts committee; (ii) approval by a majority of the Units of limited partnership interest of Holdings LP; (iii) on terms no less favorable than available from an unrelated third party; or 30 See e.g. In re Heritage Organization, L.L.C., *11 (Bkrtcy N.D. Tex. 2008). 31 11 U.S.C. 523(a)(4). 32 6 DEL. CODE 17-1101(d) (2010) and 6 DEL. CODE 18-1101(c) (2010). 33 Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 Del. J. Corp. L. 1, 14 (2007). 34 Id. at 32. 15

(iv) fair and reasonable taking into account the totality of the relationships among the parties involved. Holdings LP bought the oil and gas company for $1.1 billion and sold it to an affiliate (Products LP) for $100 million. Plaintiff Gerber alleged that because of this disparity in price, the transaction could never be approved under the standards listed as (ii), (iii) and (iv) above. He alleged that the general partner of Holdings LP knew this and its decision to have the transaction approved by the audit and conflicts committee under (i) was in bad faith (i.e. a breach of the implied covenant of good faith and fair dealing). In addressing the claim, the court considered another provision of the limited partnership agreement which stated: [The General Partner] may consult with legal counsel, accountants, appraisers, management consultants, investment bankers and other consultants and advisors selected by it, and any act taken or omitted to be taken in reliance upon the opinion (including an Opinion of Counsel) of such Persons as to matters that the General Partner reasonably believes to be within such Person s professional or expert competence shall be conclusively presumed to have been done or omitted in good faith and in accordance with such opinion. 35 In planning the sale of Teppco to Products LP, the board of directors of the general partner of Holdings LP retained Morgan Stanley & Company to render an opinion as to whether the sale price was fair financially to Holdings LP and its public unitholders. Morgan Stanley rendered an opinion that it was. 36 The court made a factual finding that the General Partner relied upon the Morgan Stanley fairness opinion in deciding to have the audit and conflicts committee approve the transaction instead of using one of the other three specified approval processes. It found no breach of a duty of good faith by the General Partner because under the limited partnership agreement the general partner had an express contractual right to rely upon the opinion of any expert and thereby [can] be conclusively presumed to have acted in good faith. 37 The case of K-Sea Transportation Partners L.P. Unitholders Litigation, 38 which was decided after the Gerber case, also involved the implied contractual covenant of good faith and 35 Gerber v. Enterprise Products Holdings, LLC, 2012 WL 34442, *8 (Del. Ch. 2012). 36 Id at *2. 37 Id at *9. 38 No. 6301 VNP, 2012 WL 1142351 (Del. Ch. 2012). 16

fair dealing, which cannot be eliminated by contract according to the Delaware Limited Partnership Act. 39 The K-Sea case involved claims by the public unitholders of a Delaware limited partnership against the general partner of the partnership in connection with a merger transaction. In accordance with the limited partnership agreement, the terms of the merger were approved by the Conflicts Committee based upon a fairness opinion rendered by an investment banking firm. To prove bad faith the plaintiff offered evidence that (i) the general partner refused to consent to the merger until it was offered $18 million for a profits interest it held that had been valued at $100,000 and (ii) 15,000 phantom units that vested upon the closing of the merger were granted to each of members of the Conflicts Committee during the merger negotiations, which incentivized them to approve the merger. 40 The court admitted that these actions could support a claim for bad faith, but still ruled against the plaintiffs because a fairness opinion was obtained in accordance with the partnership agreement. Together, these allegations could support an inference that [the General Partner] unreasonably exploited the [Limited Partnership Agreement s] limited duties to extract a personal gain that did not advance a proper Partnership purpose and, thus, failed to act in good faith. Section 7.10(b) of the [Limited Partnership Agreement], however, directly addresses good faith. As mentioned above, Section 7.10(b) entitles [the General Partner] to a conclusive presumption of good faith whenever it acts in reliance on an expert opinion as to matters it reasonably believes to be within the expert s professional competence. VI. Texas Case Law There are no published opinions yet by the Texas courts considering whether duties of loyalty and care may be contractually altered under the authority of TBOC 153.152, which provides that a Texas limited partnership agreement may alter the rights and powers of a partner (without specifically mentioned the duties of loyalty and care). Nor are there any published opinions considering TBOC 101.401, which provides that a Texas limited liability company agreement may expand or restrict any duties, including fiduciary duties. However, as mentioned earlier, in the case of Strebel v. Wimberly 41 decided in January of this year (2012) by the Houston District of the Texas Court of Appeals, the court held that a contractual disclaimer of fiduciary duty in a Texas limited partnership agreement foreclosed 39 6 DEL. CODE 17-1101. 40 6301 VNP, 2012 WL 1142351, *10 (Del. Ch. 2012). 41 No. 01-10-00227-CV, 2012 WL 112253 (Tex. App. Hous. (1 Dist.) 2012). 17

recovery by a limited partner who was claiming that the controlling member of the general partner breached fiduciary duties owed to the limited partner. 42 Somewhat ironically, the Strebel case involved a business set up by Mr. Strebel and Mr. Wimberly to advise others on how structure their businesses. The business of Mr. Strebel and Mr. Wimberly began as a Delaware limited liability company formed in 2003 owned fifty percent by each. In 2005 the business was restructured by the formation of a Texas limited partnership and the transfer of the company s business including client contracts to the new limited partnership. The existing limited liability company became the general partner of the new limited partnership. The company agreement of the limited liability company was amended to, among other things, name Strebel as the Managing Member and CEO of the general partner. The amended company agreement also contained the following provisions: [T]he Managers shall have fiduciary duties to the Company and the Members equivalent to the fiduciary duties of directors of Delaware corporations [and the] Members shall have fiduciary duties to the Company comparable to stockholders of Delaware corporations. 43 The limited partnership agreement of the new Texas limited partnership, however, took a very different approach. The court noted the following regarding the limited partnership agreement: The LP Agreement provides that the General Partner will have no duties (including fiduciary duties) except as expressly set forth in th[e] Agreement. No other provision in the agreement imposes fiduciary duties upon the general partner. 44 Wimberly complained that various actions taken by Strebel as the Managing Member and CEO of the general partner constituted breaches of fiduciary duties, especially the reduction of the percentage interest of Wimberly in the partnership, which had the effect of increasing the share of the profits paid to Strebel and his affiliates. The company agreement of the general partner included provisions stating that actions taken by the company as the partner of any affiliated entities were Major Decisions that required company board approval. Wimberly argued that because of the Major Decisions provisions and because the entities were created together with the intention that they be operated as one business, 45 the company agreement 42 Id at *14. 43 Id. at *5. 44 Id. at *6. 45 Id. at *13. 18

standard of care provisions should apply, not the no duties language in the limited partnership agreement. The court disagreed and found that the no duties language controlled. 46 The case also includes a detailed analysis of the duties that a limited partner owes to another limited partner, including analysis of two recent unreported cases considering this issue. VII. Examples of Contract Provisions Dealing with Duties Against the background of this law allowing the parties to replace the common law duties contractually, it is interesting and instructive to examine contract provisions intended to have this effect. 47 A. Texas LP Competing Business. Below is an example of a provision from a Texas limited partnership agreement intended to limit the duty of loyalty with regard to potentially competing business: Competing Business. Notwithstanding anything to the contrary contained in or inferable from this Agreement, the Texas Business Organizations Code or any other statute or principle of law, the Partners and their Affiliates shall not be prohibited or restricted from investing in or conducting, and may invest in and/or conduct, businesses of any nature whatsoever, including the ownership and operation of facilities similar to the Project. The investing in or conducting of any such business by a Partner or any Affiliate thereof shall not give rise in the other Partners or the Partnership to any claim for an accounting or any right to claim any interest therein, to claim the profits therefrom or to participate therein, even if such investment or business is of a character which, if presented to the Partnership, could be undertaken by the Partnership. B. Delaware LLC Forced Sale of Company Assets. The provisions below were included in the company agreement of a Delaware limited liability company under which the investor member had a right to force a sale of company assets: Modification Liability. The Managing Member expressly agrees that with respect to the exercise of the Investor Member s right under [provisions of the Agreement permitting the Investor 46 Id. at *14. 47 Drafters should be certain that any agreement used by them is appropriate for the particular transaction. The sample provisions presented herein are for illustration purposes only and should not be taken as an indication that the provisions are or are not market standard. 19

Member to force a sale of Company assets], Investor Member shall have no fiduciary duty whatsoever to the Managing Member and that with respect to the exercise of any unilateral or approval right granted to Investor Member, the Investor Member may exercise such right and grant or deny such approval as determined by the Investor Member in its sole and absolute discretion. C. Delaware LP Replace Fiduciary Duty with Best Interests. In K-Sea Transportation Partners L.P. Unitholders Litigation 48 described above, the court quoted the partnership agreement provisions below, which it found replaced the general partner s fiduciary duties with the requirement that the general partner have reasonable belief that its actions were in the best interests of the partnership. Any standard of care and duty imposed by this Agreement or under [any provisions of the Delaware Limited Partnership Act] or any applicable law, rule or regulation shall be modified, waived or limited, to the extent permitted by law, as required to permit [the General Partner] to act under this Agreement and to make any decision pursuant to the authority prescribed in this Agreement, so long as such action is reasonably believed by [the General Partner] to be in, or not inconsistent with, the best interests of the Partnership. 49 D. Delaware LP No Duties Absent Fraud, etc. The following partnership agreement provisions were quoted in a recent Texas case involving an alleged breach of fiduciary duty by the general partner of a Delaware limited partnership: Exculpation. [T]o the extent that, at law or in equity, any General Partner Party has duties (including fiduciary duties) and liabilities relating thereto... to any Partner, such General Partner Party shall not be liable for monetary or other damages to... such Partner for... losses sustained or liabilities incurred by the Partnership or such Partner as a result of any act or omission of such General Partner Party, if such General Partner Party acted without fraud, bad faith, gross negligence, or willful misconduct. 50 E. Delaware LLC No Fiduciary Duties. The following provisions were included in the company agreement of a Delaware limited liability company. The provisions were quoted in 48 No. 6301 VNP, 2012 WL 1142351 (Del. Ch. 2012). 49 Id. at *8. 50 In re Park Central Global Litigation, 2010 WL 3119403, *11 (N.D. Tex. 2010). 20

In re Heritage Organization, L.L.C., 51 a Texas bankruptcy case considering breach of fiduciary duties claims against the company s manager: The Manager shall not be required to exercise any particular standard of care, nor shall he owe any fiduciary duties to the Company or the other Members. Such excluded duties include, by way of example, not limitation, any duty of care, duty of loyalty, duty of reasonableness, duty to exercise proper business judgment, duty to make business opportunities available to the company, and any other duty which is typically imposed upon corporate officers and directors, general partners or trustees. The Manager shall not be held personally liable for any harm to the Company or the other Members resulting from any acts or omissions attributed to him. Such acts or omissions may include, by way of example but not limitation, any act of negligence, gross negligence, recklessness, or intentional misconduct. 52 In re Heritage is worthy of study by a practitioner charged with the task of drafting language to limit duties. In that case the court analyzed not just the language quoted above, but sections of the LLC agreement dealing with the duties and responsibilities of the president and the secretary and other provisions of the agreement that might not, at first blush, appear to the limitation of duty provisions. F. Delaware LP Discretion Implies No Duties. The K-Sea case 53 also included an example of interesting language, quoted below, providing that any time the general partner was authorized to take action under the partnership agreement in its sole discretion or discretion, and whether the agreement used those words or not, then the general partner could act without any fiduciary duties. Whenever this Agreement provides that [the General Partner] is permitted or required to make a decision (i) in its sole discretion or discretion, [the General Partner] shall be entitled to consider only such interests and factors as it desires and shall have no duty or obligation to give any consideration to any interest of, or factors affecting, the Partnership [or] any Limited Partner [and] (ii) it may make such decision in its sole discretion 51 No. 04-35574-BJH-11, 2008 WL 5215688 (Bkrtcy N.D. Tex. 2008). 52 Id. at *11. 53 No. 6301 VNP, 2012 WL 1142351 (Del. Ch. 2012). 21

(regardless of whether there is a reference to sole discretion or discretion ). 54 G. Delaware LLC No Duties; Good Faith Reliance on Experts. Set forth below are provisions from the governing agreement of a stock and bond portfolio fund organized under the laws of Delaware. The provisions are intended to define and limit the duties and liabilities of the fund manager and include detailed provisions specifically allowing the manager to rely on experts: Powers. The Managers have the power to construe and interpret this Company Agreement and to act upon any such construction or interpretation. Any construction or interpretation of this Company Agreement by the Managers and any action taken pursuant thereto and any determination as to what is in the interests of the Company and the Members made by the Managers in good faith shall, in each case, be conclusive and binding on all Members and all other Persons for all purposes. In construing the provisions of this Company Agreement, the presumption shall be in favor of a grant of power to the Managers. Except as required by federal law including the 1940 Act, neither the Managers nor any officer of the Company shall owe any fiduciary duty to the Company or any Series or Class or any Member. Limitation of Liability. To the fullest extent permitted by law, a Manager shall be liable to the Company and to any Member solely for his or her own willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of his or her office of Manager, and shall not be liable for errors of judgment or mistakes of fact or law. The Managers shall not be responsible or liable in any event for any neglect or wrongdoing of any officer, agent, employee, Manager, advisor, sub-adviser or Principal Underwriter of the Company. Managers Good Faith Action, Expert Advice, No Bond or Surety. The exercise in good faith by the Managers of their powers and discretions hereunder shall be binding upon everyone interested. The Managers may rely in good faith upon advice of counsel or other experts with respect to the meaning and operation of this Company Agreement and their duties as Managers hereunder, and shall be under no liability for any act or omission in accordance with such advice; provided the Managers shall be 54 Id. at *7. 22