Chancery Court Finds That Hedge Fund Manager Breached Fiduciary Duties. After a trial in the case Paige Capital Management, LLC v. Lerner Master Fund, LLC (C.A. No. 5502-CS, Del. Ch. Aug. 8, 2011), the Chancery Court found that a hedge fund manager had violated the Partnership Agreement with the fund’s seed investor, and more importantly, her fiduciary duties to the fund and the investor. The dispute arose out of Paige Capital Management's Partnership and Seeder Agreements with Lerner Master Fund, under which Lerner invested $40 million in Paige. Under the agreements, Lerner was generally precluded from withdrawing its capital for the first three years, after which the capital could be withdrawn without penalty. However, the Partnership Agreement also contained a "Gate Provision" that enabled the manager to restrict a withdrawal of capital if it would result in over 20% of the fund's assets being withdrawn in any 6-month period. During the first three years of the fund's existence, the manager deployed very little of the fund's capital and signed up no new investors. Lerner expressed its concerns about Paige's investment strategies and its ability to attract additional capital and ultimately notified Paige of its intention to withdraw at the end of the three-year period. In response, Paige invoked the Gate Provision and filed suit in the Chancery Court seeking a declaratory judgment that the Gate Provision allowed the fund to prevent the withdrawal of all of Lerner's capital. Lerner counterclaimed for breach of contract, breach of fiduciary duties, and dissolution of the fund. Applying New York law to the contract claim, the Court found that the Seeder Agreement and Partnership Agreement, when read together, supplanted the Gates Provisions with the Seeder Agreement’s provisions allowing withdrawal without penalty after the 3-year period expired.

The Court then turned to Lerner's claim that refusing to waive the Gates Provision was a breach of the manager's fiduciary duty to the fund. As a threshold matter, the Board noted that the manager was subject to fiduciary duties in her capacity as managing member of the fund's General Partner, since a director, member or officer of a corporate entity serving as the general partner of a limited partnership who exercises control over the partnership's property owes fiduciary duties directly to the partnership and the limited partners. The Court rejected the manager's "novel" argument that because the manager also owed fiduciary duties to the General Partner, it would be impossible both to waive the Gates Provision and satisfy those duties. Instead of "absolv[ing] a governing fiduciary of responsibility for acting in its own self-interest," the Court explained, the presence of a conflict of interest occasions "more searching judicial review." The Court also rejected the argument that the provision in the Partnership Agreement granting the General Partner "sole discretion" in its decision-making precluded application of fiduciary duties, holding that sole and absolute discretion is circumscribed by the duty of loyalty and exercise of good faith and that any contractual displacement of fiduciary duties of loyalty and care must be made with clarity. Because the decision to use the Gates Provision was made for the purpose of enabling the manager to continue to collect fees rather than to protect the General Partners' 0.01% investment in the fund, the refusal to waive the Gates Provision was self-interested and was therefore a violation of the duty of loyalty. Noting that the manager had consistently represented the Gates Provision as a means of protecting the management fee stream and at trial had been unable to articulate a non-self-interested reason for its use, the Court concluded that the manager's reading of the Partnership Agreement was not in good faith. Refusing to "exculpate fiduciaries for self-serving interpretations of governing instruments" the Court found that the manager could not take refuge in the "good faith" exculpation provisions of 6 Del. Code 17-1101(e), and that the manager and her husband, who served as General Counsel to the fund, were not entitled to indemnification for their legal expenses. The Court also held that the manager was not entitled to indemnification of expenses related to the expanded litigation resulting from Lerner's counterclaims, since the counterclaims were compulsory; in addition, reimbursement of legal expenses related to defamation claims filed against Lerner was not available since these claims were not in connection with the performance of the manager’s duties to the fund.  Link to Chancery Court Opinion: http://courts.delaware.gov/opinions/download.aspx?ID=158540