Contributions

Challenging USACafes Liability of a Fiduciary Entity’s Controllers

By Natalie Noble1

In In re USACafes, L.P. Litigation, the Delaware Chancery Court held generally that when a business entity (a “fiduciary entity”) exercises control over another business entity (the “beneficiary entity”), those persons exercising control over the fiduciary entity owe a fiduciary duty to the beneficiary entity and its owners.2 Although the holding of USACafes specifically addressed fiduciary duties owed to a limited partnership (LP),3 its doctrine has been applied more broadly. Since its inception in 1991, courts have applied USACafes doctrine to a variety of multi-layered, parent-subsidiary business structures involving corporations, general partnerships, LLCs, and LPs.4 The doctrine is founded on general equitable principles deriving from trust law: those who have control over the property of a beneficiary owe a fiduciary duty to act in the best interest of the property’s true owners.5 Viewed exclusively from this perspective, USACafes doctrine makes sense. However, viewed more expansively, it creates friction with the corporate law principles of legal separateness and limited liability, under which owners of a business are not personally liable for the obligations of the business entity.6 It also creates tension with ordinary contract law by extending liability outside the agreement between the business entity and its investors. Finally, USACafes creates a fiduciary relationship between a general partner and limited partner investors, which may interfere with the general partner’s traditional fiduciary duty to its shareholders.

As a result, USACafes doctrine has been the subject of criticism from practitioners, academics, and judges.7 Moreover, despite being over a quarter-century old, it has not been explicitly approved by the Delaware Supreme Court. The time is therefore ripe for this doctrine to be reconsidered. This Contribution will argue that the USACafes doctrine should be abandoned because it discourages freedom of contract, dissuades investors from financing new enterprises, and contravenes bedrock doctrines of corporate law.

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The existence of USACafes stems from a rift between the law governing corporations and the law governing alternative entities such as LPs and Limited Liability Companies (LLCs). Under corporate law, the controllers of a corporation must be “natural persons.”8 By contrast, under alternative entity law, the general partner of an LP or the managing member of an LLC may be a natural person or a legal person (that is, another legal entity).9 Whether the entity is a corporation, LLC, or LP, the legal or natural manager of the business owes a fiduciary duty to act in the best interest of the business and its owners.10 However, when the person owing the duty is a legal entity rather than a natural person, the question arises whether the individuals controlling the entity also owe a duty directly to the beneficiary entity and its owners.11 This is the question addressed by USACafes.

In USACafes, the Delaware Chancery Court held that, where a legal entity is the general partner of an LP, the directors of the general partner owe a fiduciary duty directly to the LP and to the limited partners of the LP. The case involved a corporate general partner, itself owned by two shareholders, that owned 47% of the LP’s . The unaffiliated LP unitholders sued the directors of the general partner for breach of fiduciary duty, alleging they accepted individual side payments in exchange for selling the LP’s assets to a third-party purchaser.12 The directors moved to dismiss the limited partners’ claim. They argued that, although the general partner owed fiduciary duties to the LP and its limited partners, the directors did not personally owe such duties to the LP and its limited partners.13 The basis for this argument is the fundamental corporate law doctrine of legal separateness, which conceives of a business entity as a separate legal entity from its controllers.14 Surprising many,15 the Delaware Chancery Court departed from this fundamental principle and denied the defendants’ motion to dismiss.16 Chancellor Allen justified this departure by referencing trust law, under which “one who controls property of another may not, without implied or express agreement, intentionally use that property in a way that benefits the holder of the control to the detriment of the property or its beneficial owner.”17

Focusing on control as the essential component, courts have expanded this far-reaching equitable principle to include a variety of business structures and entities. For example, in Wallace v. Wood, the Delaware Chancery Court ruled that fiduciary duties may attach to the parent of a corporate general partner, thus extending USACafes to cover controlling shareholders.18 USACafes doctrine has also been applied where the general partner of an LP is an entity other than a corporation. In Bigelow/Diversified Secondary Partnership Fund, the Delaware Chancery Court found that, when the general partner of an LP is itself a general partnership, the partners of that general partnership (as well as entities and individuals affiliated with that partnership) may owe a fiduciary duty to the LP and its limited partners.19 Similarly, in Paige Capital Management, the Delaware Chancery Court interpreted USACafes to impose fiduciary duties on the manager of an LLC that was the general partner for the LP.20 More recently, the Delaware Chancery Court held that, when one LLC is managed by another LLC, the sole member of the managing LLC owes fiduciary duties to the subsidiary LLC.21

Despite this expansion, several judicial opinions have criticized the doctrine. For example, Chief Justice Strine has called the doctrine a “less venerable but largely unquestioned precedent,”22 “a bit of an oddment [of] our alternative entity law,”23 and a “step . . . taken . . . without much analysis.”24 Moreover, although Chief Justice Strine expanded the doctrine in Bay Center Apartments, he did so because, “[i]importantly, the defendants [did] not challenge the general applicability of the doctrine in the LLC context.”25 Similarly, Vice Chancellor Laster noted that there are “good reasons to question the entity-piercing implications of USACafes” and thus its “continuing persuasiveness . . . .”26 From this, the Vice Chancellor thought the Delaware Supreme Court may eventually reject the doctrine.27

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The USACafes doctrine creates an “unorthodox”28 default rule. Under it, unless the LLC or LP agreement explicitly includes controllers in a fiduciary waiver provision, they are automatically subject to liability.29 The alternative default rule would exclude the controllers from liability unless the parties choose to extend fiduciary duties beyond the fiduciary entity to its controllers.30 This is in line with the concept of legal separateness, which considers controllers as independent from the affiliated legal entity. At issue in the debate surrounding USACafes is which of these default rules should govern. Accepting the USACafes default rule would be problematic for three reasons.

First, USACafes doctrine discourages freedom of contract and makes the law governing LPs and LLCs difficult to predict. Delaware’s LLC statute and LP statute emphasize that the relationship among parties to LLCs and LPs is primarily contractual in nature.31 Under ordinary contract law principles, only the contractual parties owe legal duties to one another arising from the contract.32 Therefore, individuals that are not party to the contract should not owe legal duties to the contract parties. In the context of LPs, this principle means that where the general partner of an LP is an entity, only that entity would owe legal duties to the LP and its limited partners, because only that entity is a party to an agreement creating that relationship. The controllers of the general partner entity would owe no such duties, since they are not formally parties to the agreement.33 Similarly, applied to LLCs, individuals exercising control over an LLC manager entity would not owe fiduciary duties if they are not parties to the agreement.

However, USACafes doctrine runs contrary to this principle by recognizing the fiduciary liability of individuals not party to the contract. Recently, Vice Chancellor Laster critiqued USACafes doctrine by suggesting that the Delaware Supreme Court might hold that, when parties freely bargain for an entity to serve as the fiduciary, “that entity is the fiduciary, and the parties cannot later circumvent their agreement by invoking concepts of control.”34 When individuals outside of the contractual agreement can be subject to liability, it discourages parties from defining the contours of liability ex ante. Instead, it makes liability contingent on courts’ case-by-case factual assessments of the extent to which directors controlled the managing entity. This system stands in contrast to the purpose of Delaware law governing LPs and LLCs: “. . . to give the maximum effect to the principle of freedom of contract.”35 Moreover, it creates unpredictability in how the doctrine applies to LPs and LLCs.

Second, USACafes doctrine contravenes traditional principles of corporate law and discourages investment of capital in new enterprises. According to the principle of limited liability as applied to corporations, LLCs, and LPs, the managers of a business are not personally liable for the debts and obligations of the entity.36 Since the entity is a legal person separate from its directors, those obligations belong to the entity alone.37 As Chief Justice Strine recently noted, this principle encourage wealth-creation for society by allowing investors to cabin their risk when they invest capital in new enterprises.38 This is particularly important in unpredictable sectors such as real estate and healthcare. However, USACafes doctrine disregards the formality of limited liability for reasons of equity.39 It is admittedly true that USACafes is not the only instance in which equity takes precedence over traditional principles of corporate law. For example, courts sometimes pierce the corporate veil to hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts.40 However, the normal corporate veil-piercing remedy requires plaintiffs to show some serious injustice involving “fraud or something like fraud.”41 Mere “domination and control” over an entity is not sufficient to justify piercing.42

This stands in stark contrast to USACafes doctrine, which only requires control – and not serious injustice – to establish liability.43 Moreover, because courts are “not particularly exacting in finding control for such purposes,”44 USACafes doctrine enables a comparatively “odd pattern of routine veil piercing.”45 In a prior decision, then-Chancellor Strine questioned this pattern in the context of an LP with a corporate general partner: “why [are] investors in the limited partnership not required, in the absence of a reason for veil piercing, to look solely to the entity they knew was their fiduciary for relief[?]”46 Aside from allusions to equity,47 courts have not clarified why veil-piercing rules should be adjusted in the context of USACafes.48 This is made more puzzling by the fact that USACafes doctrine benefits “voluntary, essentially contractual, creditors of the fiduciary entity.”49 Such creditors had the opportunity to protect themselves ex ante by extending liability beyond the fiduciary entity.50 Therefore, common sense and academic consensus51 suggest that these sophisticated creditors are the least deserving beneficiaries of the judicial decision to pierce the corporate veil.52 Given the importance of the limited liability principle as a catalyst for investment and the lack of judicial justification for USACafes doctrine, the doctrine should be abandoned.

Third, USACafes doctrine creates internal conflicts for the principle of fiduciary duty.53 Usually, the controllers of a corporation only owe fiduciary duties to the corporation and its shareholders.54 However, under USACafes, if the corporation is also the general partner of an LP, the controllers also owe fiduciary duties to the limited partners of the LP. When the interests of these two groups inevitably conflict, the corporation is put in an “awkward position”55 of responding to two sets of contrary duties. The idea that corporate directors should “serve multiple masters” in this sense has been disparaged as encouraging litigation and impeding accountability to any one set of interests.56 However, under USACafes doctrine, this is exactly what corporate directors must do.

For these three reasons, the default rule should align with traditional principles of corporate law and contract law rather than USACafes doctrine. Establishing a default rule that respects the limited liability principle does not negate the equity concerns motivating the decision in USACafes. Without USACafes, parties would still be entitled to pierce the corporate veil in cases involving serious injustice. They would also be free to bargain for extended legal duties to the controllers of a fiduciary entity during contract negotiations. Granted, a change in the default rule might have adverse consequences for those who relied on USACafes by leaving their LLC or LP agreement silent regarding controllers’ duties.57 However, given that the doctrine has been frequently critiqued by judges and has not yet been accepted by the Delaware Supreme Court, it is unlikely that parties have intentionally relied on USACafes doctrine.

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USACafes doctrine sets forth a controversial default rule that creates tension with bedrock principles in contract and corporate law. Because it fosters uncertainty and discourages investment in new businesses, it should be abandoned in favor of a rule that recognizes the separateness of legal entities and their controllers. This alternative default rule would allow for controller liability in extreme cases and preserve parties’ freedom to impose fiduciary duties on controllers through ex ante bargaining.

Notes:

1. Natalie Noble is a 3L at New York University School of Law. This piece is a commentary on the 2017 Problem at the Ruby R. Vale Interschool Corporate Moot Court Competition held in Wilmington, Delaware. The issue in the problem dealt with whether fiduciary duties should be extended to the board of directors of the parent company of a general partner of a limited partnership. The views expressed in this article do not necessarily represent the views of the author on this point of law. Rather, this article is a distillation of one side of an argument assigned to the team the author represented at the Vale Interschool Corporate Moot Court Competition.  For another commentary from this competition, see The Future of Dead-Hand Proxy Puts in Delaware: Alive and Well or Dead on Arrival? by Caitlin Millat.
2. In re USACafes L.P. Litig., 600 A.2d 43, 48 (Del. Ch. 1991) (Allen, C.). See also Moshen Manesh, The Case Against Fiduciary Entity Veil Piercing, 72 Bus. Law. 61 (2017).
3. USACafes, 600 A.2d at 48.
4. Manesh, supra note 2, at 63 (“[C]ourts have applied USACafes in a variety of contexts and through various multi-tiered, parent-subsidiary business structures involving corporations, general partnerships, LLCs as well as LPs.”).
5. USACafes, 600 A.2d at 48 (“While I find no corporation law precedents directly addressing the question whether directors of a corporate general partner owe fiduciary duties to the partnership and its limited partners, the answer to it seems to be clearly indicated by general principles and by analogy to trust law. I understand the principle of fiduciary duty, stated most generally, to be that one who controls property of another may not, without implied or express agreement, intentionally use that property in a way that benefits the holder of the control to the detriment of the property or its beneficial owner.”).
6. See, e.g., Rev. Unif. Ltd. Liab. Co. Act. § 303(a)(2) (Unif. Law. Com’n 2006) (“The debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise . . . do not become the debts, obligations, or other liabilities of a member or manager solely by reason of the member acting as a member or manager acting as a manager.”); Manesh, supra note 2, at 73 (“For corporations, LLCs, and LPs . . . owners and managers of the business are not personally liable for the debts and obligations of the entity.”).
7. See, e.g., Martin I. Lubaroff & Paul M. Altman, Lubaroff & Altman on Delaware Limited Partnerships §§ 11.2.5 (1995 & 2011 Supp.); Leo E. Strine, Jr. & J. Travis Laster, The Siren Song of Unlimited Contractual Freedom, in Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations 11, 21 (Robert W. Hillman & Mark J. Loewenstein eds., 2015).
8. See, e.g., Del. Code Ann. tit. 8, § 141(b) (2015).
9. Feeley v. NHAOCG, LLC, 62 A.3d 649, 669 (Del. Ch. 2012) (“Other Delaware alternative entity statutes, including the LLC Act and the Delaware Statutory Trusts Act . . . permit entities to serve in managerial roles, and adopt the same policy of maximizing freedom of contract.”) (footnote omitted).
10. Manesh, supra note 2, at 65 (“In all cases, whether the entity is a corporation, LLC, or LP, the legal or natural persons managing a business owe fiduciary duties to the business and its owners.”) (footnote omitted).
11. Id. at 66 (“But the question naturally raised when the person who stands in a fiduciary position is not a natural person, but instead a legal entity, is whether, in addition to this fiduciary entity, the individuals controlling the fiduciary entity also owe a fiduciary duty directly to the beneficiary entity and its owners?”).
12. In re USACafes L.P. Litig., 600 A.2d 43, 46 (Del. Ch. 1991) (Allen, C.).
13. Id. at 47.
14. See, e.g., 18 Am. Jur. 2d Corporations § 2 (2016) (“A corporation is a legal entity with an identity or personality separate and distinct from that of its owners and its shareholders and must be thought of without reference to the members who comprise it.”); Manesh, supra note 2, at 72 (“A fundamental principle of entity law is that of legal separateness—that a business entity is a legal person, separate and distinct from the entity’s owners and managers) (footnote omitted).
15. See, e.g., Russell C. Silberglied & Blake Rohrbacher, TOUSA, USACafes, and the Fiduciary Duties of a Parent’s Directors Upon a Subsidiary’s Insolvency, 2011 Norton’s Ann. Surv. of Bankr. L. 33, 51 (2011) (“USACafes came as a bit of a surprise to many practitioners . . . .”); Manesh, supra note 2, at 67.
16. USACafes, 600 A.2d at 56.
17. Id. at 48.
18. Wallace ex rel. Cencom Cable Income Partners II, Inc. v. Wood, 752 A.2d 1175, 1182 (Del. Ch. 1999).
19. Bigelow/Diversified Secondary P’ship Fund 1990 v. Damson/Birtcher Partners, Civ.A. No. 16630-NC, 2001 WL 1641239, at *8 (Del. Ch. Dec. 4, 2001).
20. Paige Capital Mgmt., LLC v. Lerner Master Fund, LLC, C.A. No. 5502-CS, 2011 WL 3505355, at *29-30 (Del. Ch. Aug. 8, 2011).
21. Bay Ctr. Apartments Owner, LLC v. Emery Bay PKI, LLC, C.A. No. 3658-VCS, 2009 WL 1124451, at *9 & n.44 (Del. Ch. Apr. 20, 2009). See also Feeley v. NHAOCG, LLC, 62 A.3d 649, 671 (Del. Ch. 2012) (applying Bay Center Apartments and confirming the relevance of USACafes doctrine to LLCs under principles of stare decisis).
22. Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., C.A. No. 15754, 2000 WL 1476663, at *19-20 (Del. Ch. Sept. 27, 2000).
23. Paige Capital Mgmt., 2011 WL 3505355, at *30.
24. Id.
25. Bay Ctr. Apartments Owner, 2009 WL 1124451, at *9.
26. Feeley v. NHAOCG, LLC, C.A. No. 7304-VCL, 2012 WL 966944, at *8 (Del. Ch. Mar. 20, 2012).
27. Feeley v. NHAOCG, LLC, 62 A.3d 649, 671 (Del. Ch. 2012).
28. Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., C.A. No. 15754, 2000 WL 1476663, at *19-20 (Del. Ch. Sept. 27, 2000).
29. Manesh, supra note 2, at 90 (“The fiduciary duty owed by a controller under USACafes will apply unless waived or modified by the terms of the agreement governing the beneficiary entity.”) (footnote omitted).
30. Id. at 91 (“Judicial abandonment of the doctrine would not radically alter the existing legal landscape. It would simply flip the default rule for alternative entities from one that is “unorthodox” to one that is more in accord with other fundamental principles of law and equity.”) (footnote omitted).
31. See Del. Code Ann. tit. 6, § 17-1101(c) (2015) (governing LPs); id. § 18-1101(b) (governing LLCs) (stating that it is the statutes’ “policy . . . to give the maximum effect to the principle of freedom of contract.”).
32. Manesh, supra note 2, at 78 (“Of course, under ordinary contract law principles, only the parties to a contract owe legal duties to one another arising from the contract.”).
33. Id.
34. Feeley v. NHAOCG, LLC, 62 A.3d 649, 671 (Del. Ch. 2012).
35. See Del. Code. Ann. tit. 6, § 17-1101(c) (2015) (governing LPs); id. § 18-1101(b) (governing LLCs); Manesh, supra note 2, at 78.
36. See, e.g., Manesh, supra note 2, at 73.
37. Id.
38. See BASF Corp. v. POSM II Props. P’ship, L.P., C.A. No. 3608-VCS, 2009 WL 522721, at *8 n.50 (Del. Ch. Mar. 3, 2009).
39. Manesh, supra note 2, at 73.
40. See, e.g., 18 Am. Jur. 2d Corporations § 48 (2016); Manesh, supra note 2 at 74.
41. Mobil Oil Corp. v. Linear Films, Inc., 718 F. Supp. 260, 268 (D. Del. 1989).
42. See, e.g., Otokumpu Eng’g Enters., Inc. v. Kvaerner EnviroPower, Inc., 685 A. 2d 724, 729 n.2 (Del. 1996).
43. In re USACafes L.P. Litig., 600 A.2d 43, 48 (Del. Ch. 1991) (Allen, C.).
44. Manesh, supra note 2, at 75. See also Bigelow/Diversified Secondary P’ship Fund 1990 v. Damson/Birtcher Partners, Civ.A. No. 16630-NC, 2001 WL 1641239, at *8 (Del. Ch. Dec. 4, 2001).
45. See Strine & Laster, supra note 5, at 21.
46. Paige Capital Mgmt., LLC v. Lerner Master Fund, LLC, C.A. No. 5502-CS, 2011 WL 3505355, at *30 (Del. Ch. Aug. 8, 2011).
47. See Feeley v. NHAOCG, LLC, 62 A.3d 649, 668 (Del. Ch. 2012) (asserting equity as the basis for attaching liability to controllers)
48. Manesh, supra note 2, at 76.
49. Id.
50. Id.
51. See, e.g., Mark J. Loewenstein, Veil Piercing to Non-Owners: A Practical and Theoretical Inquiry, 41 Seton Hall L. Rev. 839, 846 (2011); Stephen M. Bainbridge, Abolishing Veil Piercing, 26 J. Corp. L. 479, 507-09 (2001).
52. Manesh, supra note 2, at 76-77.
53. Id. at 80.
54. See, e.g., Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986).
55. Gelfman v. Weeden Investors, L.P., 792 A.2d 977, 992 n.24 (Del. Ch. 2001).
56. Manesh, supra note 2, at 81.
57. Id. at 91 n.195.