Saturday, November 16, 2013

Part III: Fiduciary Duties of LLC Managers in Delaware, New York and Other States

You have probably heard about fiduciary duties. These are the duties owed by a corporation’s directors and officers to the corporation and its shareholders. The duties include a duty of care and a duty of loyalty. Several courts also include the duty of good faith and fair dealing, while others treat it as a subset of the duty of loyalty. The duty of loyalty requires directors to act in good faith and in the best interests of the corporation, and put the corporation’s interests above their personal interests. This also means that directors must abstain from any conduct that would harm the corporation. The subset of duty of loyalty is the duty of good faith and fair dealing that requires that directors “act at all times with an honesty of purpose and in the best interest and welfare of the corporation.” Duty of care requires directors to make informed decisions and consider carefully all of the available information before arriving at a decision. I previously wrote about the duty of loyalty and duty of care here and here.

Today, I want to focus on the question of whether managers in an LLC owe any fiduciary duties to the LLC and its members. After all, we know that internal governance of a corporation is regulated to a large extent by applicable statute that expressly includes the fiduciary duties (in Delaware, only the fiduciary duty of care can be eliminated, but not the duty of loyalty according to Section 102(b)(7) of the DGCL), whereas an LLC is largely a creature of contract and its internal governance is subject mostly to the contractual language of the operating agreement.

In Delaware

Until recently, the Delaware courts have gone back and forth on this question. Finally, effective August 1, 2013, the Delaware General Assembly amended Section 18-1104 of the Delaware Limited Liability Company Act to provide that, unless the limited liability company agreement says otherwise, the managers and controlling members of a limited liability company owe fiduciary duties of care and loyalty to the limited liability company and its members.

This means that if the operating agreement is silent on the issue, the presumption is that managers owe those fiduciary duties. However, according to Sections 18-1101(c) and Section 18-1101(e) of the Delaware LLC Act, members remain free to expand, restrict or eliminate fiduciary duties in their limited liability company agreement, except for one duty that they cannot make go away: the implied contractual covenant of good faith and fair dealing.

In New York

In New York, Section 417 of the New York LLC Law allows managers and members to eliminate or limit fiduciary duties and liability of the LLC members, but sets limits. Exceptions include the liability of any manager for acts or omissions that were made in bad faith or involved intentional misconduct or a knowing violation of law or that caused the manager to personally gain a financial profit or other advantage to which he was not legally entitled, and other instances.

Recently, in late 2012, the New York’s highest court enforced a contractual waiver of fiduciary duties among LLC members in Pappas v. Tzolis (2012). In that case, three individuals formed a New York limited liability company to acquire and manage a long-term lease for a building in Manhattan. Shortly after they formed the LLC, significant business disputes arose among the members, and one of the LLC members, Tzolis, offered to buy out the other two for 20 times what they had contributed to the LLC only a year earlier. The other members accepted the offer. Several months later, Tzolis assigned the LLC’s long-term lease to a developer for $17.5 million, or more than 200 times the initial members’ investment. The former LLC members sued, alleging that Tzolis had been negotiating with the developer even before the buy-out and had violated his fiduciary obligations to them by not disclosing these negotiations. The New York Court of Appeals disagreed and dismissed their complaint. The Court looked at the buy-out documents, in which the departing members certified that they: (a) had performed their own due diligence; (b) had engaged legal counsel to advise them; and (c) were not relying on any representation other than those set forth in the documents. They also certified that Tzolis owed no fiduciary duty to them in connection with the buy-out. Based on these facts, the Court of Appeals held that Tzolis owed no duty to the departing members to disclose his alleged negotiations with the developer. The Court further explained that members could not reasonably rely on Tzolis’ fiduciary obligations to them, if any, given that there was no longer a relationship of trust among them. The Court said “where a principal and fiduciary are sophisticated entities and their relationship is not one of trust, the principal cannot reasonably rely on the fiduciary without making additional inquiry."  What can I say, other than that Tzolis had great lawyers advising him.

Therefore, In New York, it now appears that fiduciary duties of LLC members may be waived by contract (to the extent allowed by Section 417 of the NY LLC Law), at least in the situations where the parties are sophisticated, represented by counsel and demonstrate an understanding of the relinquished rights. It is unclear whether New York courts will extend this contractual waiver of fiduciary duties in other contexts.

In Other States

According to the other blogs, statutes vary all over in terms of fiduciary duties of members and managers. For example, in Washington state, the default standard is that members do not owe any duties to other members unless an act or omission constitutes gross negligence, intentional misconduct or a knowing violation of the law. California statutes allow members to limit fiduciary duties, but California courts have not yet ruled on whether a party can disclaim all fiduciary duties. The Pennsylvania LLC Law is silent about the parties’ ability to alter fiduciary duties. Since the Pennsylvania courts have yet to rule on this issue, it is unclear whether parties can eliminate, restrict or expand fiduciary duties in an operating agreement. In Texas, members can expand or restrict fiduciary duties, but it is not clear which exactly duties may be restricted. Illinois, on the other hand, has gone in the opposite direction and imposed, by statute, the fiduciary duties of loyalty and care upon members of member-managed LLCs without providing any explicit basis for waiving such duties.

In Practice

Modifying fiduciary duties must be done expressly and unambiguously. Actually, instead of simply disclaiming any and all fiduciary duties, it is advisable to have several provisions addressing this and other related issues. First, set the standard of care (it may, for example, provide that covered persons (members, managers) are only liable for acts of fraud, gross negligence or willful misconduct). Second, add a provision on limitation of liability that expressly states that each of the covered persons waives fiduciary duties that absent such waiver, may be implied by applicable law (of course modifications have to be made to ensure that fiduciary duties are waived only to the extent allowed by applicable law). Together, these two provisions will act to limit covered person’s fiduciary duties. Finally, remember to insert exculpation and indemnification provisions in the LLC operating agreement.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Tuesday, November 12, 2013

What Should Be Included in LLC Operating Agreements? Part II of III

As I said in my recent post about LLCs, the internal governance of LLCs is largely determined by contract among the LLC members. This contract, called an operating agreement, is the centerpiece of each LLC. I strongly recommend every multi-member LLC to have a written operating agreement.

The core elements of an LLC operating agreement include provisions relating to equity structure (contributions, capital accounts, allocations of profits, losses and distributions), management, voting, limitation on liability and indemnification, books and records, anti-dilution protections, if any, restrictions on transfer, buyouts, dissolution and liquidation, confidentiality and restrictive covenants, and general provisions such as governing law and dispute resolution. Let's quickly review them.

Equity Structure

(a) Membership Interest. A member’s membership interest is often expressed as a percentage interest. It can vary as new members are added. It is also important to remember that membership interest is comprised of two components: (i) an economic interest and (ii) a management interest. Often, membership interest is expressed in units to give LLC’s equity more of the look and feel of stock. Some LLCs even refer to their units as “shares” and have an authorized and issued number of shares, just like in a corporation.

(b) Classes of Membership Interests. Given the flexible capital structure of LLCs, it is possible to create the equivalents of equity structures of partnerships or corporations. An LLC can have non-voting interests, common interests, preferred interests, convertible interests, profits interests, etc.

(c) Contributions and Capital Accounts. Each member has a capital account. Initial percentage interests are determined based upon value given to initial capital contributions. A member's capital contribution to the LLC may take the form of cash, property, services rendered, a promissory note, or some other obligation to contribute cash or property or to render services, or any combination of the foregoing. If a member contributes property or something other than cash, the value of such contribution often gets negotiated. Also, members need to address in the operating agreement whether there will only be initial capital contributions, or whether members will be asked to make ongoing contributions or there will be potential future capital calls.

(d) Allocation of Profits, Losses, and Distributions. The operating agreement may alter the default rule of proportionate allocation of profits, losses, and distributions among members. The operating agreement may provide each class of units with unique economic rights and may even alter the allocation rules between members of the same class. It is possible, for example, for a member that holds 50% of percentage interest in an LLC to be allocated 100% of the LLC’s profits or losses in a given year or to receive preferred returns.


An LLC may be managed by members or managers. If LLC is manager-managed, this section of the operating agreement would describe the appointment of managers (which members may appoint), the nature and frequency of manager meetings and voting procedures, duties and responsibilities of managers, term, and procedures for manager removal and replacement.


The operating agreement may alter the standard rule that members vote in proportion to their percentage interests.  It can even withhold entirely the voting right of a member or class of members to vote upon any matter. Voting rights can also be determined on the basis of capital contributions, capital commitments or capital accounts. Also, certain members or managers can have veto rights or supermajority votes. For example, a class may not have general voting or managerial rights, but have veto right on certain actions to be taken by the managers.

Limitation on Liability, Indemnification

This section deals with fiduciary duties of the managers. There have been interesting legal developments in this area, and I would like to discuss it in a separate blog post.

Books and Records

This section is self-explanatory. It addresses record keeping and the rights of members to inspect corporate and accounting records of the company.

Anti-dilution Protections

The anti-dilution provisions allow a member to maintain its membership interest percentage in the case when the LLC issues membership interests to new members. Such protections may include: a veto right on new issuance of membership interests and admission of new members; limitation on capital calls (for example, no additional capital calls without consent of all members); and pre-emptive rights that allow a member to purchase any class of membership interest being offered in order to maintain their percentage interest.

Restrictions on Transfer

(a) Assignability of Interests.  Frequently, a membership interest can be assigned, but such assignment does not include management rights. To transfer both the economic and management rights of a membership interest, a member needs to comply with restrictions on transfer and (if the operating agreement so provides) obtain the managers’ consent.

(i) Veto / approval rights. Transfer of a membership interest can require the consent of all members or all managers or a certain percentage thereof.

(ii) Right of first refusal. The company and/or other members receive the right within a set period of time to match the offer of a third party for another member’s membership interest.

(iii) Permitted transfers. Members can agree to carve out certain transactions from the restrictions on transfer, such as transfers to affiliates and / or for estate planning purposes.

(b) Buyout. Certain events (such as death, disability, bankruptcy, termination of employment) can give an option to the company or other members to buy out such member (or a right to the member to be bought out by the company or other members). If the operating agreement has buyout provisions, it is important to describe the procedure of how such buyout will take place, the buyout price and the payout terms (can be over time or perhaps from the proceeds of a key man life insurance).

It may be difficult to determine the buyout price, especially for smaller, pre-revenue LLCs.  There is a lot of room for creativity here.  Sometimes, members agree on a certain fixed price ahead of time. Other times, the price will equal to the fair market value, to be determined by one or more appraisers.

(c) Tag Along and Drag Along Rights.  The tag along rights protect minority members from being left behind upon the sale of a majority member’s interest, whereas the drag along rights assist majority member(s) in packaging all membership interests to facilitate full equity sale of the company.

Confidentiality and restrictive covenants include provisions such as non-compete and non-solicit.

Liquidation and dissolution

This section specifies who determines when to dissolve an LLC or what events can trigger dissolution. There are also winding up procedures and a waterfall of distributions of LLC’s assets upon dissolution.

General provisions

Last but not least, the general provisions can include a provision requiring members to settle disputes first through non-binding mediation, followed by binding arbitration. There should also be a provision regarding required vote to amend the operating agreement (perhaps, a vote by managers and a certain percentage of members). There may also be a “adverse affect” proviso, requiring consent of each member who is adversely affected by such amendment if such amendment relates to the limited liability of such member, or it adversely alters its interest in profits, losses or distributions (other than as a result of admission of additional members).

As you can see, an LLC operating agreement is a complex document that often reaches 30+ pages. It is also a “living” document that should be amended as the needs of the LLC change. A meaningful operating agreement that provides the means to address various situations is a key to success in operating a limited liability company.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Sunday, November 10, 2013

General Solicitation and Hedge Funds

This week I gave a talk about the new and proposed amendments to Form D to the students at NYU Professional Studies program class on Hedge Funds Operations and Due Diligence.  Here are the detailed slides from my presentation.

First, I gave an overview of private placements in general, and how Regulation D and Rule 506 fit within them.  I then talked about the new amendments to Rule 506 (meaning the introduction of Rule 506(c) that allows general solicitation and advertising if all purchasers are accredited investors and what are the reasonable steps that funds will need to take to verify the investor status) and the new bad actor disqualification provisions.

Finally, I discussed the proposed rules that propose to add new Form D filing and disclosure requirements as well as the additional disqualifying events, required legends and proposed rule 510T.

My whole presentation was accompanied by lively Q&A.  It was interesting to get a perspective on these new legal developments from the people who work in the fund industry.  Two things to note here.  First, the group did not seem to be enthusiastic about using general solicitation and advertising to raise capital for hedge funds.  The consensus was that it was strictly a relationship-based business.  Second, people felt uneasy about the proposed additional legends and disclosures when using performance data in solicitation materials.   Everyone agreed that some warnings were needed.  However, the group felt that there was no single standard or criteria used by the funds to calculate and present performance data, so standardized performance reporting could lead to more confusion.

I guess, we are all impatiently waiting for the final rules.

 This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.