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.

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