Why Drafters Should Proceed With Caution When Navigating the Muddy Waters of LLC Fiduciary Duty Law

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1 SEPTEMBER 2012 EXECUTIVE SUMMARY BUSINESS LAW AND GOVERNANCE PRACTICE GROUP Why Drafters Should Proceed With Caution When Navigating the Muddy Waters of LLC Fiduciary Duty Law Tara Ellis, Esquire Balch & Bingham LLP Jackson, MS Fiduciary duty principles are somewhat difficult to apply in the context of the limited liability company (LLC), due to the relative newness of this type of business entity and its principal goal of limiting individual liabilities. Few jurisdictions LLC laws explicitly impose and proscribe fiduciary duties upon LLC members and managers. However, recent court decisions have applied fiduciary duties as the default rule where state statutes explicitly allow fiduciary duties owed to the company or to other members to be limited or waived. 1 Other courts have held that fiduciary duties extend to LLC members or managers by virtue of being formed contractually or due to the status of the parties. Then, even if a jurisdiction is one where fiduciary duties exist, it is often unclear exactly what those duties are and if a court will take into account the "business judgment rule." When there are ambiguities, some courts look to corporation laws and use such as gap-fillers. Therefore, because of the general uncertainty about fiduciary duties, LLC members should take great care in drafting operating agreements to define specifically intended duties and waivers of duties. When Will Fiduciary Duties Apply? Generally, courts have found fiduciary duties apply to LLC members or managers in two ways.the first way is when a state LLC statute expressly states that certain defined fiduciary duties will be imposed on managers or controlling members.second, due to a state LLC act s silence on fiduciary duties, courts will determine whether fiduciary duties apply as a default rule, are formed 1

2 contractually, are imposed due to the status of the parties, or are engrafted by the court from the state's corporation law. Therefore, a brief discussion of each general jurisdictional possibility offers insight for predicting what a given state will decide regarding application of fiduciary duties to LLC members and managers. In those states in which fiduciary duty is a statutory imposition, as one would expect, the analysis is relatively simple. Generally, the court will consider the alleged breach and apply the statutory definition to determine if a breach has, in fact, occurred. 2 Those states that have chosen to create statutory fiduciary duties generally follow the Uniform Limited Liability Company Act (ULLCA) and the Revised Uniform Limited Liability Company Act (RULLCA) in determining whether parties may waive the fiduciary duties owed to companies or their members. ULLCA allows limited waiver of fiduciary duties, but not complete elimination. RULLCA allows LLC agreements to eliminate each specific aspect of the duty of loyalty 3 and allows parties to alter the duty of care. 4 However, it is unclear how far the drafters intended these eliminations and alterations to go. 5 Therefore, it is imperative that operating agreement drafters in states with express statutory fiduciary duties understand their courts position on allowable waiver. Similarly, drafters in states without statutory fiduciary duties should take great care to determine if their states apply a contractual or status-based approach to finding fiduciary duties. Delaware has become the standard for the contractual approach, after it shifted to a policy centered on freedom to create LLC contracts in whatever way LLC members believe best fits the needs of their organization. 6 In 2004, Delaware adopted an amendment to its fiduciary duty law that allows LLC members to contractually abrogate fiduciary duties. 7 Therefore, Delaware courts have interpreted the legislature s intent, holding that the fiduciary duties of loyalty and care exist as default, but may be eliminated by contract. 8 2

3 In status-based jurisdictions, such as Texas, there is no statutory imposition of fiduciary duties, but the courts have determined they may apply depending on the particularities of the relationship of the parties to the agreement. 9 Interestingly, the Texas LLC statute contains the same language as the Delaware statute regarding a party s ability to limit duties; however, Texas courts have not yet held that a fiduciary duty exists as a matter of law among members in a limited liability company. 10 Instead, Texas courts consider whether there is a pre-existing relationship thatwould create a formal fiduciary duty (such as those between an attorney and client or between directors of a corporation and its stockholders) or an informal fiduciary duty (created when one person trusts in and relies on another whether the relationship is moral, domestic, or purely personal). 11 Thus, there are major differences in courts approaches even when states have identical language in their LLC acts. In light of so many possibilities, it is imperative that drafters spend sufficient time learning about their state s approach to fiduciary duties. Even states with identical statutory language have split on how to apply the language such as demonstrated by the varying approaches taken by Delaware and Texas. Other state statutes make no mention of fiduciary duties whatsoever and choose to apply corporate law or consider parties relationships. Therefore, careful drafting coupled with diligent research is the only way to be confident in the representation offered to the LLC client. If Fiduciary Duties Apply, What Effects Will They Have? Actual practical application of fiduciary principles in LLC disputes varies across jurisdictions almost as widely as the divide between jurisdictions in finding fiduciary duties. The one similarity that seems to have broad acceptance in the vast majority of jurisdictions is the determination that generally only managers and controlling members owe fiduciary duties to other LLC members. 12 States also generally agree that the duty of due care and loyalty are the two main fiduciary duties, but they differ on whether to also include the business judgment 3

4 rule or the gross negligence standard. Therefore, a brief discussion of example states is helpful to understand how a state may choose to apply fiduciary duties. As stated above, some states choose to expressly delineate the fiduciary duties in their LLC statutes. These statutes are generally highly descriptive and include definitions of the duty of loyalty and care. 13 These definitions are very similar from state to state, as, when included, they are usually based on the ULLCA. 14 For example, the Montana Code states: (2) [The] duty of loyalty... is limited to the following: (a) to account to the company and to hold as trustee for it any property profit, or benefit derived by the member in the conduct or winding up of the company s business or derived from a use by the member of the company s property, including the appropriation of a company s opportunity; (b) to refrain from dealing with the company in the conduct or winding up of the company s business on behalf of a party or as a person having an interest adverse to the company; and (c) to refrain from competing with the company in the conduct of the company s business before the dissolution of the company. (3) A member s duty of care... in the conduct of and winding up of the company s business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law. Furthermore, a major distinction between these uniform states arises under the difference between ULLCA and RULLCA s fiduciary duty language. 15 ULLCA 4

5 provides the duties of loyalty and care are the only fiduciary duties owed, whereas RULLCA remains open-ended by jettisoning the term only from the text and listing the duty of care and loyalty as if there may be other fiduciary duties. 16 Furthermore, RULLCA adopts the addition of the business judgment rule which allows a rebuttal to claims of breach of the duty of care. 17 Therefore, under RULLCA, or any state adopting the business judgment rule, a challenged manager need only prove that he maintained a reasonable belief that he was acting as a person in a like position and in the best interests of the company. 18 Similarly, states adopting corporation law will apply the business judgment rule as it is an accepted principle in corporate governance. 19 Alternatively, states applying definitions of the duty of care based on ULLCA or traditional definitions of the duty of care outside of corporation law apply a gross negligence standard. 20 The gross negligence standard is a lower standard of care allowing lesser liability on behalf of LLC managers. 21 Though the gross negligence standard seems much more compatible with the ultimate goal of limited individual liability, criticism of its protection of managers and the addition of the business judgment rule to RULLCA indicate pressure to increase judicial or legislative oversight of managers actions. 22 The potential trend demonstrates the importance of clear drafting, specifically in jurisdictions where LLCs are allowed to define their own duties, as individual judges may differ on interpretation. Finally, some states choose to apply gap-fillers from corporation law when a fiduciary duty inquiry arises in the LLC context. 23 The New York LLC Act, for instance, has a duties section that directly tracks the Model Business Corporations Act duties section, so courts look to corporate law to make determinations regarding the application of fiduciary duties. 24 States following corporation rules relative to fiduciary duties typically do not allow full contractual elimination of fiduciary duties, and therefore find fiduciary duties of loyalty and care as the default. 25 Similar to the RULLCA rules, LLCs are allowed to specify particular acts that do not breach fiduciary duties. 26 Therefore, drafters in states 5

6 such as New York and Virginia whose courts utilize the corporation approach would need to be familiar with their state s analogous corporation law duties and courts' interpretations thereof. These widely varied standards and definitions further demonstrate the importance of careful research and drafting. Drafters should specifically focus on the statutory fiduciary duties and their definitions. In states that only have default duties, though there may be a presumption that traditional definitions will apply, careful drafting may be the only way to ensure judges will reach the parties intended interpretations. Conclusion This Executive Summary describes only the most common approaches taken by courts relative to fiduciary duties in the LLC setting. The broad distinctions represented by the few states discussed here indicate the unsettled status of the law. States may follow a contractual, statutory, or corporate approach, but variation is evident even within states with generally established case law on the subject. States allowing contractually created or eliminated duties may still interpret similar contracts differently in light of current pressure to increase oversight on LLC managers. Other states, applying the gross negligence or business judgment rule standards, offer wide discretion for judges to define those standards on a case-by-case basis. Therefore, as the future of LLC fiduciary duty law remains relatively cloudy, practitioners, regardless of jurisdiction, should be cognizant of the various rules regarding fiduciary duties and should draft LLC agreements to precisely articulate the intentions of the parties with respect to such duties. 1 See Auriga Capital Corp. v. Gatz Props., LLC, 40 A.3d 839 (Del. Ch. 2012) (finding fiduciary duties to apply to LLC managers unless expressed waived in LLC agreement, due to provision in Delaware's LLC statute allowing contractual waiver of fiduciary duties in LLC statute). 6

7 2 See, e.g., Lynes v. Helm, 339 Mont. 120, 126 (2007) (applying statutory fiduciary principles to determine whether breach of loyalty occurred). 3 RULLCA is conflicting with respect to elimination of this duty. Section 110(c)(4) of the RULLCA prohibits an operating agreement from eliminating the duty of loyalty, but Section 110(d)(1) provides that the parties may eliminate a specific aspect of the duty of loyalty. 4 RULLCA 110(d)(1), (3). 5 Larry E. Ribstein Analysis of the Revised Uniform Limited Liability Company Act, 3 Va.L. Bus. Rev. 35, (2008) See Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 Del. J. Corp. L. 1, 23 (2007). 7 DEL. CODE ANN. tit. 6, (2010). [T]he member s or manager s or other person s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement Auriga at Gadin v. Societe Captrude, 2009 WL , (S.D. Tex. 2009). 10 Id. (citing Pinnacle Data Servs., Inc. v. Gillen, 104 S.W.3d 188, 198 (Tx. App. 2003)). 11 Gadin at *2. 12 See, e.g., In re S. Canaan Cellular Invs., LLC (S. Canaan Cellular Invs., LLC v. Lackawaxen Telecom, Inc.), 427 B.R. 85 (Bankr. E.D. Penn. 2010) (following and applying Del. law). 13 MONT. CODE ANN (2011). 14 Ribstein at Id. 16 Id. 17 Id. at RULLCA 409(c). 19 See Nathanson v. Nathanson, 20 A.D.3d 403, 404 (N.Y. App. Div. 2005). 20 See Auriga at See Ribstein at See Sandra K. Miller, Fiduciary Duties In The LLC: Mandatory Core Duties To Protect The Interests of Others Beyond The Contracting Parties, 46 Am. Bus. L.J. 243 (2009) (suggesting a need for mandatory duties and greater LLC managerial regulation). 23 See Michael S. Spencer, Uncertainty for Practitioners and the Judiciary As Well As the Need for a Minimum Standard Demonstrate That Fiduciary Duties Should Be Incorporated Into Maryland s LLC Act, 40 U. Balt. L. Rev. 285, Id. 25 Id. (citing Nathanson v. Nathanson, 20 A.D.3d 403, 404 (N.Y. App. Div. 2005) (holding an LLC manager had statutory duty to perform his duties in good faith and with that degree of care that an ordinary prudent person in a like position would use under similar circumstances ). 26 Spencer at

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