Auriga Capital Corp. v. Gatz Props., Ltd. Liab. Co. - 40 A.3d 839 (Del. Ch. 2012)

Rule:

In regard to Limited Liability Companies, the purpose of the duty of loyalty is in large measure to prevent the exploitation by a fiduciary of his self-interest to the disadvantage of the minority. The fair price requirement of that duty makes sure that if the conflicted fiduciary engages in self-dealing, he pays a price that is as much as an arms-length purchaser would pay. 

Facts:

 In 1997, defendant William Gatz, through Gatz Properties, and Carr, through Auriga, formed Peconic Bay for the purpose of holding a long-term leasehold in a property owned by the Gatz family (the "Property"). The idea was to develop a golf course on the Property, which was farmland in Long Island that had been in the Gatz family since the 1950s. He thus set out to raise cash for the construction of a golf course on the Property, and approached a local bank to gauge its interest in financing the project. The bank then referred Gatz to Carr, who had worked with the bank on a previous occasion to secure the financing for another golf course in Long Island. On this advice, Gatz reached out to Carr, and Carr agreed to commit Auriga to help finance and develop the course. Auriga agreed to assume responsibility for securing debt financing and raising additional equity, as well as overseeing the construction of the course, which would be named Long Island National Golf Course (the "Course"). Financing was located and contracts were drafted to create the structures that would reflect the parties' business dealings, including an entity — i.e., Peconic Bay — in which the equity investors could hold capital. Peconic Bay took out a note worth approximately $6 million to finance the Course's construction (the "Note"), which was collateralized by the Property. The Gatz family formed Gatz Properties to hold title to the Property, which was then leased to Peconic Bay under a "Ground Lease," dated January 1, 1998. The Ground Lease set an initial term of 40 years, with a renewal option for two 10-year extensions, which were exercisable by Peconic Bay. The terms of the Ground Lease also restricted the Property's use to a high-end daily fee public golf course. Thus, absent an agreement between Peconic Bay and the Gatz family, the Property was to be locked up for use by Peconic Bay as a golf course until 2038. Peconic Bay in turn was governed by an Amended and Restated Limited Liability Company Agreement (the "LLC Agreement"). The LLC Agreement created Class A and Class B membership interests. The Class A interests comprised 86.75% of Peconic Bay's membership, and the Class B, 13.25%. From the inception, Gatz Properties controlled the Class A vote, as it held 85.07% of the Class A interests. The rest of the Class A interests were held by Auriga and Paul Rooney. From the time the Class B shares were first issued in 1998 until 2001, the Class B interests were more diversely held. The Gatz family and their affiliates (together with Gatz Properties, the "Gatz Members") held 39.6% of the Class B interests. The Minority Members, including non-party Hartnett, held 60.3%. But, in 2001, the Gatz Members acquired control of the Class B interests through questionable purchases of certain minority investors' Class B shares. Obtaining control of the Class B interests was important. Under the LLC Agreement, the Manager was forbidden from making a "major decision affecting the Company" without "Majority Approval," which was defined as the vote of 66 2/3% of the  [**15] Class A interests and 51% of the Class B interests. The LLC Agreement designated Gatz Properties as Manager. Gatz, as manager of Gatz Properties, was given the "power, on behalf of [Peconic Bay], to do all things necessary or convenient to carry out the day-to-day operation of the Company." But, the role of the Manager was intended to be a limited, albeit important, one, and Gatz received no management fee in connection with his services as a reflection of this understanding. The Gatzes were instead to be compensated in two other ways: (1) through their interests as members of Peconic Bay; and (2) through rent for the Property. The Manager's limited operational role was attributable to Peconic Bay's initial business model. Under the LLC Agreement, Peconic Bay was initially structured as a passive "black box" entity that would be a conduit for cash flows rather than actually operate the course itself. The Course was instead to be run and managed by a third-party operator. The Manager would then collect rent from that operator, make Peconic Bay's required debt payments on the Note, and then distribute the remaining cash surplus to the investors according to a distribution scheme set forth in the LLC Agreement, which called for payment of 95% of all cash distributions to go to the Class B members until they received a full return of their investment. After that point, the distributions were to be made pro rata. Carr brought in American Golf Corporation ("American Golf"), which was at the time one of the largest golf course operators in the country. On March 31, 1998, Peconic Bay entered into a sublease with American Golf (the "Sublease"). The Sublease was for a term of 35 years, but it gave American Golf an early termination right after the tenth full year of operation. American Golf agreed to pay "Minimum Rent" according to a fixed schedule, starting at $700,000, and rising annually by $100,000 until leveling out at $1 million per year, beginning in 2003. In addition to Minimum Rent, American Golf had to pay "Ground Lease Rent" equal to 5% of its revenue from operations. Although this rent would be payable to Peconic Bay, it would pass directly through to Gatz Properties as rent under the Ground Lease between Peconic Bay and Gatz Properties. However, American Golf never operated the Course at a profit, and later let the Course fall into disrepair. Gatz knew in 2004 or latest 2005 that American Golf would exercise its early termination option in 2010, yet he did nothing to plan for American Golf's exit. Rather, Gatz made a series of decisions that placed Peconic Bay in an economically vulnerable position. Once Peconic Bay was in this vulnerable state, and in the midst of a down economy, Gatz decided to put Peconic Bay on the auction block without engaging a broker to market Peconic Bay to golf course managers or owners (the "Auction"). Gatz, on behalf of Gatz Properties, was the only bidder to show up. Knowing this fact before formulating his bid, Gatz purchased Peconic Bay for a nominal value over the debt, and merged Peconic Bay into Gatz Properties (the "Merger"). Gatz now operates the Course himself through a newly created entity wholly owned by Gatz Properties and seems to be paying the debt from the cash flow of the golf course operations. The plaintiff minority investors sued for damages, arguing that Gatz breached his contractual and fiduciary duties through his course of conduct.

Issue:

Did Gatz breach his contractual and fiduciary duties to the minority members?

Answer:

Yes.

Conclusion:

Gatz pursued a bad faith course of conduct to enrich himself and his family without any regard for the interests of Peconic Bay or its Minority Members. His breaches may be summarized as follows: (1) failing to take any steps for five years to address in good faith the expected loss of American Golf as an operator; (2) turning away a responsible bidder which could have paid a price beneficial to the LLC and its investors in that capacity; (3) using the leverage obtained by his own loyalty breaches to play "hardball" with the Minority Members by making unfair offers on the basis of misleading disclosures; and (4) buying the LLC at an auction conducted on terms that were well-designed to deter any third-party buyer, and to deliver the LLC to Gatz at a distress sale price.

First, he failed to act loyally to protect the LLC when it became clear that American Gold will terminate its sublease. He knew there was trouble with the American Gold sublease with its dwindling income and increasing shortfall. He admitted at trial that he knew by 2004 or 2005 that there was a "high likelihood" that American Golf would exercise its early termination right under the Sublease and walk away from the Course in 2010. By the terms of the LLC Agreement, Gatz was charged with the obligation to manage the operations (i.e., the business) of Peconic Bay, and thus had the fiduciary duty to manage that business loyally for the benefit of the Company's members. This includes the duty to address in good faith known, material risks that threaten the viability of the business. Gatz knew, by at latest 2005, that American Golf was very likely to terminate the Sublease in 2010. With American Golf gone, so too would go its annual $1 million rental payments that constituted Peconic Bay's primary source of revenue. Gatz therefore had a full five years to develop an action plan to address Peconic Bay's viability as a going concern after American Golf's departure. The record is devoid of any credible evidence suggesting that Gatz engaged in a serious or thoughtful effort to look for a replacement operator. There is no evidence that Gatz, in 2005, considered putting Peconic Bay on the market, which would have entailed hiring an appraiser to assess Peconic Bay's value, putting together offering materials, or engaging  a broker to start a search for strategic buyers who might be interested in acquiring the entity. Nor is there evidence that Gatz engaged in a serious analysis at the time to assess whether Peconic Bay could feasibly run the Course itself. Rather, Gatz did two things in anticipation of American Golf's termination of the Sublease. First, he sat back and waited for the time on the Sublease to run. Second, he husbanded Peconic Bay's cash surplus under a provision in § 11 of the LLC Agreement that allowed him to withhold from distribution to Peconic Bay's members those funds that he "reasonably determine[d] [were] necessary to meet the Company's present or future obligations," in this case, Peconic Bay's future debt payments following American Golf's termination of the Sublease. Gatz's actions were inconsistent with those of someone whose duty it was to seek out ways to preserve value for Peconic Bay's investors. Rather, they were consistent with those of someone who was hoping that that Peconic Bay would simply revert back to his family's ownership once Peconic Bay's primary source of revenue ran dry, without regard for the interests of the Minority Members.

Second, Gatz rebuffed a credible buyer for Peconic Bay’s Leasehold. In August 2007, Matthew Galvin, on behalf of RDC Golf Group, Inc. ("RDC") approached Gatz with an interest in acquiring Peconic Bay's long-term lease. RDC is an experienced owner and operator of public and private golf courses. Even though Galvin was aware that American Golf had been losing money on the Course on a post-rent basis, he believed that RDC could profitably operate the Course business by investing resources in it. So, Galvin contacted Gatz to express his willingness to engage in negotiations, and asked for basic due diligence to help him come up with an offer. Specifically, Galvin asked to review the Ground Lease, the Sublease, and American Golf's historical financials. Despite Galvin's willingness to enter into a confidentiality agreement, Gatz refused to provide Galvin even with this basic information, and instead demanded to see Galvin's projections for the Course. Galvin told Gatz that, on a preliminary basis, he thought RDC could achieve annual gross revenues of $4 million on the Course. Gatz testified at trial that if RDC could achieve $4 million in gross revenues, then the Course would be worth $6 million to $8 million. Rather than use RDC's optimistic projections as a basis to bid Galvin up, Gatz criticized the projections and told Galvin that they were too high. Upon Gatz's insistence that he prove he was not on a "fishing expedition," Galvin submitted a non-binding letter of intent, offering to buy Peconic Bay's leasehold assets (the Ground Lease and the Sublease), exclusive of any other assets or liabilities, for $3.75 million. At no point did Gatz inform Galvin that Peconic Bay had debt in excess of $5.4 million, and that his bid was underwater even taking into account the Company's approximately $1.6 million in cash. Instead, Gatz put Galvin's offer up to a membership vote, knowing that the offer would be rejected by the Peconic Bay Members because such a purchase price would render Peconic Bay insolvent. Even sillier, Gatz knew that the vote would fail for another reason: his family intended to vote all their units against it, dooming it to failure. In short, there was no legitimate need for a phony vote. Gatz then waited nearly one month before telling Galvin that his offer had been rejected. Gatz made no counteroffer, continued to refuse Galvin basic due diligence materials, and showed a clear disdain for continuing negotiations when Galvin requested a target asking price. Galvin nonetheless submitted a second letter of intent, upping his offer to $4.15 million. Strangely, Gatz once more put this underwater bid up for a vote when the Gatz family opposed it, and, not surprisingly, it was unanimously rejected by all Members. Galvin tried to reach out multiple times, but Gatz would choose not to respond. At no point in his dealings with Galvin did Gatz act like a motivated seller. A motivated seller does not refuse to provide basic due diligence to a credible buyer.

Third, Gatz used Galvin’s interest in Peconic Bay to play “hardball” with the minority members and attempt to buy them out. Gatz said that he wanted to show the Minority Members "what a third-party person would value the company at." In this way, Gatz could employ Galvin's underwater offers to justify his own low offer to the Minority Members. In other words, by stringing Galvin along, Gatz could turn RDC's interest in Peconic Bay into a sword to use against the Minority Members. Gatz testified that his family would "probably not" approve a deal with RDC at $6 million. But, when Carr asked Gatz to see whether Galvin would be willing to buy Peconic Bay at $6 million, Gatz used the opportunity to determine whether the rest of the Minority Members would sell at $6 million. To that end, Gatz sought authorization from the membership to make a counteroffer of $6 million to RDC knowing beforehand that it would not pass. The Minority Members voted in favor of the proposal, but the Gatz Members voted it down. But, Gatz was now armed with the information that the Minority Members were willing to sell at $6 million. Gatz was not a willing seller at $6 million, but he was a willing buyer. Gatz offered to purchase the Minority Members' interests for a "cash price equal to the amount which would be distributed for those interests as if [Peconic Bay's] asset sold for a cash price of $5.6 million as of today," and he explained that "the results would be as if the sale were for more than $6 million," because in a third-party sale, the purchaser would have to pay closing costs and prepayment penalties on the Note of approximately $475,000. Accordingly, by subtracting Peconic Bay's debt, adding Peconic Bay's cash, and distributing the remainder according to the distribution waterfall set forth in the LLC Agreement, Gatz arrived at his offer to the Minority Members of $734,131. This would have yielded a return of each Minority Member's initial capital investment. Gatz, however, conditioned this offer on the acceptance of all the Minority Members and indicated that his offer would be open for only fifteen days because, supposedly, "time [was] of the essence." However, Gatz's offer to the Minority Members contained incomplete and misleading information about the RDC negotiations. When Gatz's initial buyout offer failed, he hired an appraiser for the purpose of justifying a lower buyout price. On behalf of Peconic Bay, Gatz hired Laurence Hirsh of Golf Property Analysts to "estimate the value of the leasehold...position fo[r] possible future disposition...." Hirsh appraised Peconic Bay's leasehold for $1.35 million less than what a third-party buyer was willing to pay only months prior. Gatz wrote to the Minority Members once more with a new buyout offer, this time trumpeting Hirsh's appraisal to prove that "[Peconic Bay] has no value even after application of its [cash] reserves to its debt." For that reason, Gatz lowered his offer price to 25% of each Minority Member's capital account balance, even though he had offered to return their investment in full only eight months earlier. Gatz told the Minority Members that he was willing to make the Hirsh report available to any of them for the "refundable" fee of $250, plus shipping. According to Gatz, this second buyout offer was a "more than fair and equitable" way to "resolve" the Minority Member problem. Notably absent from the August 7 buyout letter was any mention of Galvin's Forward Lease Proposal and Gatz's rejection of it, which occurred after Gatz made his first buyout offer. But, the Minority Members were not willing to sell for 25 cents on the dollar. When the Minority Members did not respond favorably, Gatz and his family retained counsel at Blank Rome LLP to threaten the Minority Members with litigation if they continued to refuse his offers for their membership interests.

Finally, Gatz conducted a sham auction. On December 8, 2008, Gatz wrote to the Peconic Bay membership that he was proposing to put Peconic Bay up for auction. In this letter, Gatz stated that Gatz Properties intended to bid at the Auction, and that he believed that "the use of an independent, third party auctioneer would satisfy the 'arms-length requirement' set forth in Section 15 of the LLC Agreement." Despite having enough cash to pursue other strategic options for the Course, Gatz sought to look for an auction firm. In February 2009, Gatz sought approval from the membership to hire an auctioneer at the third auction firm — Richard Maltz ("Maltz") of Maltz Auctions, Inc. Maltz Auctions specialized in "debt related" sales, and conducted the majority of its work for bankruptcy courts. Richard Maltz was the son of the business's founder and not a seasoned professional with experience marketing expensive, complex assets. And, to the best of Maltz's knowledge, neither he nor anyone else at the firm had ever auctioned an interest in a golf course before. Regardless, Gatz entered into an auction agreement with Maltz in late May 2009. Hirsh stated in his 2008 appraisal that Gatz would need six to nine months to properly market Peconic Bay. But, Gatz and Maltz decided on a marketing timeframe of approximately 90 days. The advertisements were also not properly done, nor was the due diligence package made available until at least a month before the auction and date and for a fee of $350. The auction terms (the "Terms of Sale") were made available in mid-July 2009 as well, and were based on a prior term sheet used by Maltz for a Chapter 7 liquidation sale. The Terms stated that Peconic Bay would be sold "as-is," "where-is," and "with all faults," without any representations or warranties. This meant that potential buyers had only one month before the Auction in which to conduct the necessary due diligence before deciding whether to bid on this "as-is" entity. On the day of the Auction, Maltz told Gatz that their marketing campaign had not elicited any third-party interest, and that Gatz would be the only bidder. Upon hearing this news, Gatz did not suggest cancelling the Auction to rethink their marketing efforts, as a well-motivated fiduciary would have done. Nor did Maltz. Rather, Gatz finalized his bid in the absence of any competitive pressure, and purchased Peconic Bay for $50,000 in new cash and the assumption of Peconic Bay's debt. This resulted in a $20,985 distribution to the Minority Members, which was funded by Peconic Bay's own approximately $1.6 million in cash.

From the foregoing, it is clear that Gatz breached his fiduciary duty of loyalty and his fiduciary duty of care towards the LLC. The results of this conduct left the Gatz family with fee simple ownership of the Property again, a Property that had been improved by millions of dollars of investments and now contained a clubhouse and first-class golf course.