Use Of Delaware Corporate Law Authorities In Connection With The Resolution Of Issues Relating To Delaware Alternative Entities, Including Limited Partnerships, Limited Liability Companies and Busines


Copyright© 1998 Martin I. Lubaroff

All rights reserved.

INTRODUCTION

An "alternative entity," be it a general partnership, limited partnership, limited liability partnership, limited liability limited partnership, limited liability company or statutory business trust, is a form of business entity distinctly different from a corporation, which frequently has very different purposes. One of the attractions of using an alternative entity, as opposed to a corporation, is the ability to define specifically in that entity's governing instrument the terms of a specific transaction and to tailor the structure of the entity to the needs of the "deal" at hand. The governing instrument of such an alternative entity is, at its most basic level, a contract between the parties to that governing instrument, whether they are partners in a partnership, members and managers in a limited liability company or trustees and beneficiaries in a statutory business trust. In fact, in Delaware, several of the statutes governing such alternative entities contain a section providing that maximum effect should be given to the principle of freedom of contract and to the enforceability of the agreements governing alternative entities.

In maximizing freedom of contract and giving effect to the statutory bias in favor of enforcing the agreements governing alternative entities, a question arises concerning to which authorities it is appropriate to refer in analyzing issues concerning alternative entities. Fundamentally, the topic to which this paper relates is an examination of the extent to which Delaware courts are looking to and drawing from corporate law authorities, and specifically the General Corporation Law of the State of Delaware (the "GCL"), in deciding such issues. As this paper will demonstrate, Delaware courts are indeed looking to and drawing from corporate law authorities in a variety of contexts, but they are not viewing such corporate law authorities as being automatically binding on questions arising in connection with alternative entities. Rather, the approach embraced by the Delaware courts in examining issues concerning alternative entities has been to ascertain first whether there is an answer within the governing documents or law (i.e., in the agreement or statute governing the alternative entity), and then, if necessary, looking to traditional alternative entity authorities to interpret the documents or the law. If no answer is found within the body of alternative entity law, the courts then consider whether similar issues have been addressed in the corporate context and, if so, whether the corporate precedent provides an answer which is appropriate for use in an alternative entity context. The Delaware courts are thereby drawing upon the body of Delaware corporate law as an aid in analyzing alternative entity questions without sacrificing the freedom and flexibility which an alternative entity offers. The courts use this procedure more or less strictly, depending upon how appropriate the use of a corporate precedent is in resolving a particular alternative entity question. The courts have, however, recognized that the application of corporate precedent to an alternative entity issue is not automatic. Rather, the application of the precedent in an alternative entity context must be found to make sense. How the courts have answered alternative entity questions by looking at corporate law will be examined with particular reference to selected subject areas.

INDEMNIFICATION

One area that is always a topic of interest to corporate practitioners is the indemnification of the directors and officers of a corporation. Section 145 of the GCL has detailed provisions relating to indemnification. It permits, inter alia, a corporation to indemnify any person who was a party to any action, suit or proceeding by virtue of that person's status as a director, officer, employee or agent of the corporation, so long as such person "acted in good faith and in a manner reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, has no reasonable cause to believe that such person's conduct was unlawful." 8 Del. C.

§ 145(a). To the extent that a present or former director or officer of a corporation is "successful on the merits or otherwise" in any action, suit or proceeding to which § 145 of the GCL applies, indemnification of such person is mandatory. See 8 Del. C. § 145(c).

To what extent should the standards governing indemnification under the GCL be relevant to the alternative entity statutes? A contrast of § 145 of the GCL with each of § 17-108 of the Delaware Revised Uniform Limited Partnership Act, 6 Del. C. § 17-101, et seq. (the "LP Act"), § 18-108 of the Delaware Limited Liability Company Act, 6 Del. C. § 18-101, et seq. (the "LLC Act"), and § 3817 of the Delaware Business Trust Act, 12 Del. C. § 3801, et seq. (the "Business Trust Act"), suggests that reference to corporate indemnification may not be appropriate. Each of the alternative entity statutory provisions provides that "subject to such standards and restrictions, if any, as are set forth [in the governing instrument of the applicable alternative entity, such entity] shall have the power to indemnify and hold harmless [any partner, member, manager, trustee, beneficial owner or other person] from and against any and all claims and demands whatsoever." The broadly stated language of the quoted indemnification provisions demonstrates that a premium is placed on the ability of the parties to agreements governing alternative entities to permit contractually indemnification in any manner they see fit. For example, unlike § 145 of the GCL, on their face, the alternative entity statutory provisions do not prevent an alternative entity from providing indemnification if the person seeking indemnification did not act in good faith or in a manner reasonably believed to be in or not opposed to the interests of the alternative entity, nor, again, on their face, unlike § 145 of the GCL, do they mandate indemnification under certain circumstances. The statutes appear to be conceptually different from the GCL, which suggests that analogies to indemnification under the GCL may not be controlling in the alternative entity context.

This conclusion was borne out in a case decided under the LP Act, in which the Court of Chancery, in addressing the permissible scope of a limited partnership's indemnification provision, found that the permitted scope of indemnification under the LP Act was different from the scope of indemnification under the GCL. In Delphi Easter Partners Limited Partnership v. Spectacular Partners, Inc., C.A. No. 12409, Allen, C., 1993 WL 328079 (Del. Ch. Aug. 3, 1993), Chancellor Allen was called upon to determine whether the defendants in litigation seeking the dissolution of a limited partnership were entitled to receive indemnification for the legal expenses they incurred in their defense. The Court noted that in construing, under the LP Act, contractual language which confers a right of indemnification a court should interpret the language of the limited partnership agreement so as to achieve, when possible, the beneficial purposes that indemnification can afford. Id. at *2. A large part of the Court's focus in its discussion of indemnification was on the importance of the governing instrument of the limited partnership. Id. at *2-3, 8. The Court noted that § 17-108 of the LP Act is "broadly enabling." Id. at *2. The Court also noted that § 17-108 of the LP Act is "broader than the statutory indemnification provision applicable to corporations, [and, in fact,] defers completely to the contracting parties to create and delimit rights and obligations with respect to indemnification and advancement of expenses. The statute itself creates no rights to indemnification." Id. at *2. Thus, having decided, at least implicitly, that it would be inappropriate to analogize to corporate law, the Court looked to the limited partnership agreement itself and found that the parties seeking indemnification met the requirements for indemnification contained in the limited partnership agreement and, therefore, were entitled to receive it.

How would a cases relating to indemnification be decided under § 18-108 of the LLC Act or § 3817 of the Business Trust Act, given the similarity which the statutory language of § 17-108 of the LP Act bears to each of § 18-108 of the LLC Act and § 3817 of the Business Trust Act? The most likely answer is that a court applying either of those statutory provisions would reach a conclusion similar to that of the Delphi court as to the appropriateness of applying § 145 of the GCL. Although there has been no reported case addressing § 18-108 of the LLC Act, a recent opinion from the Court of Chancery, addressing the issue of indemnification under a business trust agreement and § 3817 of the Business Trust Act, came to the conclusion that a comparison of the GCL and the Business Trust Act "illustrates the fact that the two statutes are simply too different to draw any conclusions from a comparison of their various provisions." See Nakahara v. The NS 1991 American Trust, C.A. No. 15905, Chandler, C., 1998 Del. Ch. LEXIS 50 at *37-38 (Del. Ch. Mar. 20, 1998).

In Nakahara, the managing trustees of a Delaware business trust sought advance indemnification from the trust under an advancement provision in the trust's governing instrument. A beneficiary of the trust's parent trust objected to advancement on the ground that the Business Trust Act does not permit business trusts to advance litigation expenses to trustees and, even if it does, the managing trustees had not satisfied the pre-conditions set forth in the business trust's governing instrument. Id. at *1-2. The beneficiary argued that because the Business Trust Act, unlike § 145(e) of the GCL, does not by its terms empower a business trust to make advancements, it must be presumed that the Delaware General Assembly intended by its silence to prohibit business trusts from making advancements. Id. at *29. While acknowledging that one could presume that the General Assembly was aware of § 145(e) of the GCL when it drafted § 3817 of the Business Trust Act, the Court found it unacceptable to required the General Assembly to harmonize the language of all Delaware statutes containing provisions that grant a right of indemnification or advancement to business organizations. "[I]t is too high a burden to expect the General Assembly to maintain constant vigilance over the exact wording of all statutes addressing similar issues. Furthermore, this is not what Delaware law requires." Id. at *34.

The Court went on to find that, given the many differences between the GCL and the Business Trust Act, the Business Trust Act's failure to mention advancement in § 3817 does not indicate an intent to prohibit business trusts from making advancements. Id. at *38-39. The Court, citing to the Business Trust Act's policy to give maximum effect to the principle of freedom of contract, noted that the Business Trust Act was intended to be far more flexible than the GCL, giving greater freedom to business trusts in establishing their governance structure. Id. at *40. The Court contrasted the general language of § 3817 of the Business Trust Act with § 145 of the GCL, which, unlike the Business Trust Act, lays out express limitations on who can be indemnified and under what circumstances that indemnification may occur. Id.

More importantly, however, the Court then expressly analogized § 3817 of the Business Trust Act to § 17-108 of the LP Act. Citing Chancellor Allen's decision in Delphi, the Court noted that while the LP Act, like the Business Trust Act, makes no mention of advancement, the Delphi court assumed without discussion that the LP Act authorizes advancement in addition to indemnification. Id. at *42-43. "[W]hile the GCL is construed narrowly by the courts, [the LP Act and the Business Trust Act] were intended by the Legislature to be construed flexibly. . . . Clearly the Legislature intended to provide Delaware business trusts and limited partnerships wide latitude in the drafting of their governing instruments." Id. at *43. Finding that the Business Trust Act does not prohibit the inclusion of advancement provisions in a business trust's governing instrument, the Court then found that the managing trustees were, under the terms of the trust agreement, entitled to receive advancement. Id. at *68. However, because the managing trustees engaged in inequitable conduct in withdrawing funds to pay litigation expenses notwithstanding the existence of a standstill agreement prohibiting such an action, the Court refused to grant the managing trustees advancement of their litigation expenses. Id. at *82-83.

From an examination of both the Delphi and Nakahara opinions several general conclusions can be reached. First, Delaware courts are recognizing that alternative entities are creatures of contract and, as such, primary consideration must be given to their governing instruments and to the principles of freedom of contract and maximum enforceability of those governing instruments. Second, the courts are recognizing that, in many respects, the alternative entity statutes are materially and conceptually different from the GCL. Third, the courts are examining analogous provisions of the corporate law in resolving alternative entity issues but, having recognized that the alternative entity statutes are different from the GCL, they are being careful in drawing analogies to the GCL, and will not do so when, as with indemnification, such an analogy is inappropriate.

BOOKS AND RECORDS

Issues surrounding access to a business' books and records have always been a fertile ground for litigation. This area of the law has also proven to be fertile ground for analogies between corporate and alternative entity law. Each of the LP Act, the LLC Act and the Business Trust Act, like the GCL, provides the "owners" of the relevant entities access to the records and to certain other information of the entity.

Each of § 17-305 of the LP Act, § 18-305 of the LLC Act and § 3819 of the Business Trust Act highlight the contractual nature of the entities that they govern, specifically that a limited partner's, limited liability company member's or a beneficial owner's right to access will be "subject to such reasonable standards ... as may be set forth in a [limited partnership agreement, limited liability company agreement or trust agreement]." Each of the statutes also gives discretion to release information to those responsible for the management of the alternative entity. All three of the statutes require that a reasonable demand be made in writing, stating the purpose for which the information is sought. Such purpose must be "reasonably related to the [partner's, member's, or beneficial owner's] interest" as a partner, member, or beneficial owner of the entity.

Compare the foregoing with § 220 of the GCL, which grants discretion to the corporation, or its agent, to refuse a stockholder permission to inspect records. Further, § 220 requires that the stockholder make written demand, stating the purpose for which inspection is sought. Such purpose, upon oath, must be "proper," defined as "a purpose reasonably related to [the seeker's] interest as a stockholder." Unlike the dissimilarity between § 145 of the GCL and each of the alternative entities statutes' indemnification provisions, the similarity between

§ 220 of the GCL and each of the alternative entity statutes' books and records provisions is quite striking and suggests use of corporate precedent in resolving issues and in interpreting the statutes may be appropriate. With respect to issues arising under the LP Act that have already been addressed in the corporate arena, the Court of Chancery has, in fact, made reference to the above described similarities.

In In re Paine Webber Limited Partnerships, C.A. No. 15043, Jacobs, V.C., 1996 WL 535403 (Del. Ch. Sept. 17, 1996), plaintiffs sought a court-ordered list of the names, addresses, and ownership interests of a limited partnership's limited partners. In the Court's opinion, Vice Chancellor Jacobs noted that the plaintiffs' claim of right to the lists was two-fold, that is, a claim of right by statute, under § 17-305 of the LP Act, and by contract, under the limited partnership agreement. (Note, once again, that the Court looked first to an alternative entity agreement and the statute before examining the applicability by analogy of corporate law authorities.) Turning to the statutory claim under § 17-305 of the LP Act, the Court put special emphasis on its requirement that the purpose for which the information is sought be "reasonably related to the limited partner's interest as a limited partner." Id. at *2. The Court ruled that the plaintiffs' purpose, to give the lists to a future investment fund in exchange for an interest in that fund, was commercial, personal and unrelated to their interests as limited partners, and therefore insufficient under § 17-305 of the Act. Id. at *2-4. Under § 220 of the GCL, "the corporate analogue to § 17-305," the Court noted that such a reason would be considered improper and saw no reason not to apply the same standard to a § 17-305 case, finding that the plaintiffs had failed to demonstrate their entitlement to the lists under § 17-305 of the LP Act. Id. at *4-5.

Turning to the plaintiffs' contractual claim, the Court found nothing in the agreement required a showing of proper purpose. Paying particular attention to the LP Act's policy of giving maximum effect to the enforceability of the parties' agreement, the Court refused to read a proper purpose standard into an agreement that contained no such clause. Id. at *5. Not only would such an action contradict the expressed purpose of the LP Act, it would also be inconsistent with the existing corporate precedent. Id. The Court also cited Ostrow v. Bonney Forge Corp., C.A. No. 13270, Allen, C., 1994 WL 114807 (Del. Ch. April 6, 1994), in which the Court recognized and enforced a stockholders agreement which gave the stockholders a contractual right to access the books and records of the corporation that was independent of their right under § 220 of the GCL, and found such a contractual right to be analogous to a limited partner's right under a limited partnership agreement. Id. The Court also cited Schwartzberg v. CRITEF Assocs. L.P., 685 A.2d 365 (Del. Ch. 1996), as support for its holding that the Court should not read a "proper purpose" requirement into a limited partnership agreement that grants access to the partnership's books and records without such a showing. Paine Webber, C.A. No. 15043, 1996 WL 535403 at *5. See also Schwartzberg, 685 A.2d at 375-77.

Adding to the theme, in Gotham Partners v. Hallwood Realty, C.A. No. 15578, Steele, V.C., 1998 Del. Ch. LEXIS 69 (Feb. 6, 1998), the Court of Chancery recently reaffirmed the relationship between § 17-305 of the LP Act and § 220 of the GCL. Faced with the question of whether the Court should allow a plaintiff to tack additional claims onto a § 17-305 action, the Court noted that the legislative history of the LP Act suggests that § 17-305 was patterned after

§ 220 of the GCL. Id. at *14. Examining the amendments made to § 17-305 since its inception, and finding that developments in corporate law were the genesis of those changes, the Court found that "§ 220 case law embodies the most logical and meaningful source from which to seek precedent relevant to this dispute." Id. at *18. Finding that a books and records action under the GCL is a limited-purpose action, one which does not permit the tacking on of additional claims, the Court applied the corporate analogy and rejected the plaintiff's attempt to add claims to the § 17-305 action. While there have been no corresponding actions interpreting § 18-305 of the LLC Act or § 3819 of the Business Trust Act, the similarity of those provisions to § 17-305 of the LP Act suggests that a § 220 corporate analogy would apply with equal force.

FIDUCIARY DUTIES

It is well settled that the directors and officers of a corporation owe fiduciary duties to the corporation and its stockholders. Those duties can take the form of general duties to act within their power and authority, or can be more specific, such as the duty of loyalty that directors owe in discharging their management functions. The GCL mentions the fiduciary duties of directors and officers in several provisions, and those duties have been defined in relevant case law. See, e.g., 8 Del. C. § 141; Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1280 (Del. 1989); Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. 1939). Delaware courts have said for quite some time that a general partner owes fiduciary duties to limited partners. See, e.g., Boxer v. Husky Oil Co., 429 A.2d 995 (Del. Ch. 1981); see also KE Property Management Inc. v. 275 Madison Management Corp., C.A. No. 12683, Hartnett, V.C., 1993 WL 285900 (Del. Ch. July 27, 1993) (holding that a limited partner may, under appropriate circumstances, owe fiduciary duties to a general partner). It is another thing to determine what those fiduciary duties actually are, as well as the extent to which the parties to an alternative entity agreement may contractually define the scope of those duties and the extent to which such definition may differ from accepted corporate norms.

The first step in examining fiduciary duties in the alternative entity arena, and their relationship to fiduciary duties in a corporate setting, is to reemphasize the contractual nature of an alternative entity agreement and the policy of each of the LP Act, the LLC Act and the Business Trust Act to give maximum effect to the principle of freedom of contract and to the enforceability of agreements. Such policies are intended to give parties the broad latitude, with the needs of a particular transaction in mind, to define the standards of conduct and duties of care and loyalty which are to apply to a specific transaction.

The second step is to note that each of the LP Act, the LLC Act and the Business Trust Act include provisions which are relevant to a court's consideration of fiduciary duties as they relate to alternative entities:

To the extent that, at law or in equity, a [partner, member, manager, trustee or other person] has duties (including fiduciary duties) and liabilities relating thereto to [a limited partnership or another partner, a limited liability company or another member or manager, or a business trust or a beneficial owner], (1) any such [partner, member, manager, trustee or other person] acting under a [limited partnership agreement, limited liability company agreement or business trust agreement] shall not be liable to [the limited partnership, the limited liability company or the business trust] or to any such [other partner, other member or manager, or beneficial owner] for the [partner's, member's, managers, trustee's or other person's] good faith reliance on the provisions of the [limited partnership agreement, limited liability company agreement or business trust agreement], and (2) the [limited partner's, member's, manager's, trustee's or other person's] duties and liabilities may be expanded or restricted by provisions in a [limited partnership agreement, limited liability company agreement or business trust agreement].

See 6 Del. C. § 17-1101(d) (limited partnerships); 6 Del. C. § 18-1101(c) (limited liability companies); 12 Del. C. § 3806(c)-(d) (business trusts). See also 6 Del. C. § 17-403 (providing that, except as provided otherwise in the LP Act or in a partnership agreement, a general partner is subject to the same duties as a partner in a general partnership).

In applying the foregoing statutory provisions to actual cases, Delaware's courts are doing a good job of recognizing that the LP Act, the LLC Act and the Business Trust Act all permit parties broad latitude in defining fiduciary duties. At the same time, the courts are recognizing that Delaware's corporate law is a source of standards and information relating to fiduciary duties. For example, in United States Cellular Investment Co. of Allentown v. Bell Atlantic Mobile Systems, Inc., 677 A.2d 497 (Del. 1996), the plaintiff-limited partner alleged a breach of contract and a breach of fiduciary duty through the usurpation by the defendant-general partner of an opportunity belonging to the partnership. Under the terms of the partnership agreement, the limited partner was authorized to compete in cellular telephone areas adjacent to the cellular telephone area in which the partnership was operated. Id. at 499. However, the general partner was not granted the same latitude, and instead was required to contribute to the partnership any cellular services which it might be authorized to render in areas adjacent to the limited partnership's operating area. Id. The limited partner sued the general partner, who was also a limited partner of the partnership, based upon the contention that as general partner it had not contributed to the partnership cellular services being rendered in an adjacent area.

In connection with the limited partner's breach of fiduciary duty claim, the Delaware Supreme Court, reviewing the Court of Chancery's dismissal of the claim, noted that the Court of Chancery's dismissal was premised on the failure of the limited partner to plead that the general partner had acted in bad faith. Id. at 504. Since, under § 17-1101(d), a general partner acting in good faith reliance on the provisions of the partnership agreement is shielded from liability for a claim of breach of fiduciary duty, the limited partner's failure to plead lack of good faith in its complaint justified the Court of Chancery's dismissal of the breach of fiduciary claim. Id. The Court did, however, cite to Court of Chancery Rule 15 and note the limited partner may have a right to amend its complaint to make the proper allegations. Id.

In another case, Cincinnati Bell Cellular Systems Co. v. Ameritech Mobile Phone Service of Cincinnati, Inc.,C.A. No. 13389, Chandler, V.C., 1996 WL 506906 (Del. Ch. Sept. 3, 1996), the plaintiff-limited partner sought judicial dissolution and sale of a limited partnership, on the ground that it was no longer reasonably practicable to carry on the partnership's business, and alleged that the defendant-general partner's failure to sell the limited partnership, which purportedly was worth more to the limited partner sold than as a going concern, constituted a breach of the general partner's fiduciary duties to the limited partner. The Court first noted that the partnership was governed by an agreement which gave no power to the general partner to sell the business. Id. at *10. Absent such a provision in the partnership agreement, Delaware partnership law required unanimity of the partners in order to effectuate such a sale. Id. at *11. The limited partner argued that this requirement should be ignored because it would otherwise conflict with fiduciary duties owed by the general partner, who, via the partnership, was commencing direct competition with the limited partner. Id. Broadening its examination, the Court looked to corporate law for an analogy. Id. The Court stated that "corporation law is the source of most Delaware jurisprudence relating to the fiduciary duty of managers." Id. at *12. It noted that similarities exist in the fiduciary principles of corporate and partnership managers. Due to this, the Court felt that it was appropriate to apply general corporate fiduciary principles to the limited partnership at issue. Id. The Court noted that a majority stockholder in a Delaware corporation owes no duty to sell its holdings in the corporation or approve a sale of the corporation's assets just because the sale would profit the minority. Id. Analogizing the general partner of a limited partnership to such a majority stockholder, the Court declared that the general partner in Cincinnati Bell, as majority owner of the partnership, could exercise its property right and veto a sale of the business because to do so would not constitute a breach of its fiduciary duties to the limited partners. Id. at 13.

Delaware courts have also drawn analogies to corporate law authorities with regard to the fiduciary duty of loyalty. See U.S. West, Inc. v. Time Warner Inc., C.A. No. 14555, Allen, C., 1996 WL 307445 (Del. Ch. June 6, 1996). In this decision, Chancellor Allen relied upon an interpretation of a limited partnership agreement to determine that U.S. West, the general partner, had no contractual right to prevent an acquisition by Time Warner. Id. at *20. After a brief, general discussion of the duty of loyalty, without distinguishing between the duties of a fiduciary of a corporation and a fiduciary of a limited partnership, the Court looked to the law of corporate opportunities and remarked that the phrase "corporate opportunity" was a misnomer in the limited partnership context, but stated that the principles as they apply to corporations apply by way of analogy to a limited partnership. Id. at *20-21. Significantly, the Court noted that, for several reasons, differences in duty of loyalty principles of corporations as opposed to other business entities may be few and small. Id. at *22. The Court cited the reasons as being the flexibility of the modern corporation and the lack of incentive for investors to participate in entities without loyalty guarantees. See also Davenport Group MG, L.P. v. Strategic Investment Partners, Inc., 685 A.2d 715 (Del. Ch. 1996) (holding that a general partner, absent contractual modification, has a duty of loyalty to the partnership that parallels that of a corporation's director).

With regard to the fiduciary duties that limited partners, members, or beneficial owners may owe, the Court of Chancery addressed the issue of a limited partner's fiduciary duties in Wilmington Leasing, Inc. v. Parrish Leasing Co., L.P., C.A. No. 15202, 1996 WL 752364 (Del. Ch. Dec. 23, 1996). In Wilmington Leasing, the general partner contested the limited partners' removal of it, claiming that their right to remove the general partner was subject to a fiduciary duty, which they had breached. Id. at *14. The Court analogized the limited partners' removal of the general partner to "shareholders voting to remove a board of directors--action to which fiduciary duties would not normally attach." Id. at *15, n. 19. Furthermore, the Court held that the limited partners had removed the general partner in compliance with the partnership agreement. Thus, "any fiduciary duty that might be owed by the Limited Partners [was] satisfied by compliance with the applicable provisions of the partnership agreement." Id. at *14.

DEMAND/DEMAND EXCUSED

Another area of often litigated issues relates to questions concerning demand requirements. In the corporate context, in Delaware, it is well accepted that before a derivative action may be instituted, demand must be made on a board of directors, unless making such demand would be fruitless. The foregoing is reflected in Chancery Court Rule 23.1, which provides that when a demand is not made, the reasons for not having made a demand must be set forth in a complaint "with particularity." See, e.g., Rothenberg v. Santa Fe Pacific Corp., C.A. No. 11749, Jacobs, V.C., 1995 WL 523599 (Del. Ch. Sept. 5, 1995). The referenced Court of Chancery procedural rule was affirmed as substantive law in Aronson v. Lewis, 473 A.2d 805 (Del. 1984). Under Aronson, demand upon a corporation's board of directors is futile and excused if reasonable doubt exists as to whether the directors are independent and disinterested and as to whether the challenged act was the product of the directors' validly-exercised business judgment. Id. at 812-14.

In the LP Act, there are similar demand requirements, as well as similar rules dictating that a plaintiff should set forth with particularity in its complaint its attempt "to secure initiation of the action by a general partner or the reasons for not making the effort." 6 Del. C. §§ 17-1001, 17-1003. The LLC Act's relevant language is substantially identical to the LP Act provisions. See 6 Del. C. §§ 18- 1001, 18-1003. The Business Trust Act provides that a beneficial owner of a business trust may bring a derivative action if "trustees with authority to do so have refused to bring the action or if an effort to cause those trustees to bring the action is not likely to succeed." 12 Del. C. § 3816(a). Subsection (c) of § 3816 of the Business Trust Act, like the provisions of the LP Act and the LLC Act, requires that the a beneficial owner bringing a derivative action allege with particularity the efforts made in making the demand. These similarities suggest that Court of Chancery Rule 23.1 would be applied in alternative entity cases. If so, it then stands to reason that, in at least some circumstances, the corporate case law will be applicable to alternative entity cases.

This conclusion has been born out in the case law. In Litman v. Prudential-Bache Properties, Inc., 611 A.2d 12 (Del. Ch. 1992), limited partners in a limited partnership brought a direct action against the general partners, alleging various breaches by the general partners of their fiduciary duties to the limited partnership and the limited partners. The general partners moved for dismissal of the action on the ground that the limited partners' claims were derivative in nature. In granting the general partners' motion, the Court found that "the determination of whether a fiduciary duty lawsuit is derivative or direct in nature is substantially the same for corporate cases as it is for limited partnership cases," and, therefore, it was appropriate to rely on corporate as well as partnership case law for a determination of whether the lawsuit was direct or derivative in nature. Id. at 4.

In a later opinion in Litman, C.A. No. 12137, Chandler, V.C., 1993 WL 5922 (Jan. 4, 1993), the Court of Chancery, examining the demand excused concept in the context of a limited partnership, and again used corporate analogies in determining when a demand on the general partner, brought under §§ 17-1001 and 17-1003 of the LP Act, is excused.

Similarly, in Seaford Funding L.P. v. M&M Assocs. II, L.P., 672 A.2d 66 (Del. Ch. 1995), the Court discussed whether corporate demand refused requirements should be used in a limited partnership context. Id. at 70. The Court noted that it had previously decided that the corporate standards applied in demand excused questions. It went on to state that "demand refused issues appear similar in the limited partnership and corporate contexts." Id. Thus, the Court examined the corporate precedents in this area, beginning with Aronson, cited supra. Citing Aronson, the Court determined that it must examine the general partner's refusal of demand with regard to the business judgment rule. Id. Noting that the general partner in the case was on both sides of the transaction, the court stated that some corporate demand rules fail to further judicial efficiency, at least in cases where there is only one general partner. Id. at 71. Looking at the "corporate concessions rule" and its applicability to limited partnerships, the Court felt that "a court of equity ought not blindly apply a corporate rule which is premised upon a reasoned vote of a majority of individuals constituting a board of directors, to a one person general partner enveloped in a self-spun web on conflicting interests." Id. Therefore, the Court decided that the fact that plaintiffs had made demand on the general partner, before commencing the suit, would not constitute a concession that he was disinterested and independent. Id.

SPECIAL COMMITTEES

Another set of issues surrounding derivative actions are those having to do with special litigation committees. In a corporate setting, once demand has been made, the board of directors may appoint such a committee made up of independent directors. The committee is responsible for investigating the demand and recommending a course of action to the board. This recommendation will be protected by the business judgment rule if it is made informedly, in good faith, and freely of self-interest. 2 R. Franklin Balotti and Jesse A. Finkelstein, The Delaware Law of Corporations and Business Organizations 13-49 (3d. ed. 1998).

In the alternative entity context, as in the corporate area, such a committee is not a statutory requirement. The LP Act simply states that demand, if made, should be made upon the general partners with authority to bring suit on behalf of the limited partnership. See 6 Del. C. § 17-1001. Each of the LLC Act and the Business Trust Act contain nearly identical language. See 6 Del. C. § 18-1001; 12 Del. C. § 3816(a). Since alternative entities are creatures of contract, a special committee could be provided for in the agreement governing the entity. Because of the flexibility of the alternative entity statutes in general, and their deference to parties' agreements, the purposes for which a committee could be used can be quite flexible. This area appears, however, to be another in which reference to corporate law may be of use.

The need for such reference was made evident in Katell v. Morgan Stanley Group, Inc., C.A. No. 12343, Chandler, V.C., 1993 WL 205033 (Del. Ch. June 8, 1993). In Katell, the two general partners of a limited partnership entered into a side agreement which purported to form a special committee to investigate a pending derivative suit. Id. at *1. The general partners argued that such an agreement was permitted under the entity's limited partnership agreement. The limited partners challenged the agreement on the grounds that a special committee was not authorized under the limited partnership agreement. Id. The Court of Chancery, in ruling on the general partners' motion to stay the derivative suit pending the decision of the special committee, provided a detailed analysis of the applicability of corporate law in the context of limited partnerships. The Court stated first that "[a]s a general rule, in the absence of Delaware authorities addressing an issue in the limited partnership context, analogues to corporate law may be applied." Id. at *2. Noting that the concept of the special committee has its origins in corporate law "not mirrored in our partnership law," id., the Court found that in order to extend the corporate special committee doctrine to limited partnerships, "one must determine on a case-by-case basis whether the general partners created a valid special litigation committee in accordance with the terms of their particular partnership agreement." Id. at *3. Turning to the language of the limited partnership agreement, the Court found that the side agreement between the general partners was a modification of the limited partnership agreement, one which was not approved in the manner required under the limited partnership agreement (approval by a majority of the limited partners). As such, the Court found the general partners' side agreement to be invalid and, as a result, denied their motion to stay the derivative suit pending the report of the special committee. Id. at *4.

In a later opinion in Katell, C.A. No. 12343, Chandler, V.C., 1995 WL 376952 (Del. Ch. June 15, 1995), the Court of Chancery, referring to its prior opinion in the case, emphasized the standard that the Delaware Supreme Court had established in Zapata v. Maldonado, 430 A.2d 779 (Del. 1981), to examine special committee reviews of demands in the corporate area. The Court noted that in its prior Katell decision it had ruled that one must first look to the terms of the limited partnership agreement itself to determine whether it is appropriate to apply the special litigation committee procedure from Zapata to a derivative suit which has been brought for the benefit of a limited partnership. Katell, 1995 WL 376952 at *6.

In its holding in both Katell opinions, as in its holding in Seaford Funding, cited supra, the Court recognized both the importance of giving force to the parties' contract, that is, the limited partnership agreement, and the fact that corporate authorities and doctrines should not be automatically applied without analysis concerning the appropriateness of their application to partnerships. In Katell, the Court found the use of corporate analogues to be appropriate, whereas in Delphi, cited supra, the Court, at least implicitly, found that indemnification under the GCL was strikingly different than under the LP Act, and, therefore, application of corporate indemnification precedent was not appropriate.

CONCLUSION

As the foregoing discussion demonstrates, Delaware courts are recognizing the contractual basis of the existence and operation of alternative entities, and the importance of enforcing an alternative entity's governing instrument. At the same time, Delaware courts, when finding that reference to a governing instrument or to the appropriate alternative entity statute does not entirely answer a question, have considered whether the courts have addressed a similar issue in a corporate context and, if so, whether it is appropriate to apply by analogy a corporate precedent to a case involving an alternative entity.

In many important respects, each of the LP Act, LLC Act and Business Trust Act bear significant similarities to each other. As a result, it appears probable that Delaware court decisions in limited partnership cases which draw upon corporate law precedent provide a good indication of how a court would decide a limited liability company or a business trust case dealing with a similar issue, assuming, of course, that the relevant alternative entity statutory provisions and policies are similar.

The cases discussed above disclose the development of a pattern in the judicial process of an approach to judicial decision making. Delaware courts are looking first and foremost to the parties' contract, that is, the instrument governing the entity, and then to the statute applicable to the alternative entity which is governed by the agreement which is before the court. If those sources do not provide an answer, the court will examine other alternative entity statutes and the developing body of alternative entity case law, before ultimately turning to corporate law authorities. Corporate law authorities are not automatically applied to issues involving alternative entities. Rather, a court will consider the appropriateness of applying by analogy such authorities to the issue before it and, in that context, will determine whether existing corporate authorities are relevant. In using this approach, Delaware courts are combining the best of both worlds, giving maximum effect to the freedom and flexibility which the alternative entity statutes offer while drawing upon Delaware's body of corporate law as an aid when appropriate.