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First Department Affirms that an LLC’s Operating Agreement Trumps Delaware Law

A unanimous panel of the Appellate Division, First Department recently affirmed a ruling by the Commercial Division dismissing causes of action against the ACE Group International LLC (“AGI”) brought by the estate of the deceased majority owner of AGI, Alexander Calderwood (the “Estate”).  The decision in Estate of Alexander Calderwood v. ACE Group International LLC, No. 650150/15 (App. Div. 1st Dep’t Dec. 14, 2017), primarily rested on the principle of Delaware business law that parties are free to set the terms of a limited liability company’s operations through contract.  As a result, the panel rejected the Estate’s arguments that provisions in Delaware’s Limited Liability Company Act (“LLC Act”) overrode contrary terms of AGI’s operating agreement (“LLC Agreement”), and affirmed the dismissal of the Estate’s claims. 

AGI is a Delaware limited liability company that managed the Ace brand of boutique hotels.  AGI’s founder and majority owner, Alexander Calderwood, died unexpectedly in 2013.  The Estate requested access to AGI’s books and records in order to ascertain the value of Calderwood’s interest in the company, but AGI failed to provide the information.  The Estate also received a buy-out offer from Ecoplace LLC, which owned a 33.33% interest in AGI.  After refusing the offer, the Estate sued AGI, Ecoplace, and Ecoplace’s owner, Stefanos Economou.  The Estate alleged multiple causes of action, including seeking declarations that the Estate is a member of AGI with full membership rights and that the defendants owe the Estate fiduciary duties.  The defendants moved to dismiss, among others, the claims for declarations that the Estate is a member of AGI and that the defendants owe the Estate fiduciary duties for failure to state a claim.  Justice Shirley Kornreich of the Commercial Division dismissed the complaint, and the Estate appealed.

The core issue on appeal was whether or not the Estate, as successor to a deceased member, was now a member of AGI and entitled to full membership rights.  The defendants argued that the LLC Agreement, not the LLC Act, controlled whether the Estate was a member of AGI.  The LLC Agreement provided that, in the event of the death of a member, the successor would be treated only as an assignee of the deceased member’s interest and not as a full member of the LLC, and expressly limited the rights of any successor solely to the right of distribution absent a waiver by the remaining members.  The Estate sought to rely on a provision of Delaware’s LLC Act, 6 Del. CODE. § 18-705, which provides that the personal representative of a deceased member may exercise all the rights of the deceased member.  The Estate argued that this provision overrode the terms of the LLC Agreement, which contained a choice-of-law provision selecting Delaware law. 

In rejecting the Estate’s position, the First Department looked to how the LLC Act has been viewed by Delaware courts, which have interpreted the Act as giving the parties to an LLC agreement substantial authority in setting up the operation of the LLC and which generally find that the terms of LLC agreements control when they conflict with the LLC Act.  The LLC Act primarily provides “gap-filling provisions” that govern when an LLC agreement is silent.  Since AGI’s LLC Agreement already addressed the rights of successors, there was no need to look to the provisions of the LLC Act.  Nor did Section 18-705’s lack of language stating that it could be overridden by an LLC agreement make that provision mandatory, as the Estate argued, since Delaware courts have already rejected that argument with regard to provisions of the LLC Act.  The  First Department  ultimately concluded that neither the language of the LLC Agreement nor policy considerations regarding protection of the rights of successor members required deviating from well-settled Delaware law that LLC’s are first and foremost governed by the terms of their LLC agreements.  The panel concluded that the language of AGI’s LLC Agreement was clear that successors do not inherit the rights of a full member, and thus modified the judgment below to grant a declaratory judgment that the Estate is not a member of AGI. 

The First Department’s decision that the Estate was not a member of AGI also contributed to the panel’s rejection of the Estate’s claim that the defendants’ owed it fiduciary duties.  The Estate argued that Ecoplace, as the new managing member of AGI, owed the Estate default fiduciary duties because the Estate was now bound by the LLC Agreement.  In support, the Estate cited Sections 18-1104 and 18-1101of the LLC Act and Delaware case law to argue that a managing member of an LLC owes fiduciary duties to those who are “bound” by an LLC agreement, absent an express disclaimer.  The panel rejected the Estate’s interpretation of Delaware law, concluding that Delaware law was not clear whether the LLC Act imposes default fiduciary duties at all, and in any event, fiduciary duties would not extend to a successor and non-member such as the Estate.  As with the issue of membership, the First Department modified the order below to grant a declaratory judgment that the defendants do not owe fiduciary duties to the Estate.  The panel then affirmed the dismissal of the other remaining claims by the Estate, relying in part on its rulings that the Estate is not a member of AGI and is not owed fiduciary duties.

The First Department’s decision in Estate of Calderwood demonstrates the importance that Delaware business law places on parties’ ability to craft their own rules through LLC agreements so as to suit their needs.  Delaware’s LLC Act provides guidance and default rules, but the operating agreement is king.

By Matthew Funk and Stephen P. Younger