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Fiduciary Duties for Managers of Delaware Limited Liability Companies

Client Advisory

June 28, 2013

This advisory addresses certain key fiduciary duty concepts applicable to managers of limited liability companies (“LLCs”), with a particular focus on Delaware LLCs. The areas of discussion are: (1) a brief overview of fiduciary duties; (2) contracting for fiduciary duties; (3) default fiduciary duties in an otherwise silent LLC operating agreement; and (4) crafting fiduciary duty provisions for LLC operating agreements. Understanding these areas when forming or managing an LLC should minimize the likelihood that unexpected fiduciary duty issues will arise.

I.          Overview of Fiduciary Duties

Generally, a fiduciary duty exists in “a situation where one person reposes special trust in and reliance on the judgment of another or where a special duty exists on the part of one person to protect the interests of another.”[1] LLC managers may be fiduciaries because they are “vested with discretionary power to manage the business of the LLC” and members have an expectation that managers will act in their interest.[2] 

The primary fiduciary duties of LLC managers, where they are found to exist, are the duty of loyalty and the duty of care.[3] The duty of loyalty requires managers to serve the best interests of the company and avoid conflicts of interest.[4] The duty of care requires managers to act as a prudent person would in similar circumstances.[5]  Managers who comply with their duty of care are afforded the protection of the business judgment rule.[6] This rule protects managers who are reasonably informed and act in good faith from claims of breach of the duty of care.[7] Because an LLC is a unique type of business entity that offers substantial flexibility to members in establishing their own rules of governance,[8] it is imperative that managers understand the potential scope of fiduciary duties to which they may be subject.  

II.        Contracting for Fiduciary Duties

a.         Delaware LLC Act and the Freedom to Contract

While the Delaware Limited Liability Company Act[9] (“LLC Act”) does not impose fiduciary duties of loyalty and care on a manager, it does allow parties to contract for these fiduciary duties in an LLC operating agreement. One of the LLC Act’s main policy objectives is to “give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” [10] Accordingly, Delaware courts will turn first to the contracted-for provisions in the governing LLC operating agreement in determining the parameters of a manager’s duties.[11] Additionally, Section 18-1101(c) of the LLC Act specifically provides that an LLC manager’s duties (including fiduciary duties) “may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.”[12] This statute grants parties wide latitude when crafting the scope of fiduciary duties for managers under LLC operating agreements.

b.         Interpreting Fiduciary Duty Provisions

Delaware courts take a relatively broad interpretive approach in determining the existence of expressly contracted-for fiduciary duties. For example, in Auriga Capital Corp. v. Gatz Properties, LLC,[13] the Chancery Court addressed express arrangements for fiduciary duties. In that case, a manager–majority owner of a Delaware LLC sold the company, at all times controlling the process of sale, and repurchased it at a discounted price in what the court called a “bad faith sham” auction in which he was the sole bidder. The court ruled in favor of the minority members, who claimed that the manager’s actions constituted both a breach of contract and a breach of fiduciary duties.

Auriga’s significance is not so much that the minority members won, but more so how the Chancery Court came to the conclusion that the manager owed a fiduciary duty. The following provision in the parties’ LLC operating agreement determined the case’s outcome:

Neither the Manager nor any other Member shall be entitled to cause the Company to enter . . . into any additional agreements with affiliates on terms and conditions which are less favorable to the Company than the terms and conditions of similar agreements which could be entered into with arms-length third parties, without the consent of a majority of the non-affiliated Members (such majority to be deemed to be the holders of 66-2/3% of all Interests which are not held by affiliates of the person or entity that would be a party to the proposed agreement).[14]

Nowhere in the provision did the words “fiduciary duty,”  “loyalty,” or “care” appear. The Delaware Supreme Court, affirming the Chancery Court, stated, that “there is no requirement that an LLC agreement use ‘magic words such as . . . ‘fiduciary duties.”’[15] Rather, the Delaware courts will look to the real-world effect of the operative language instead of limiting their analysis to the strict wording. Thus, in addition to constituting a contractual obligation that was breached, the wording in that case constituted an express arrangement for fiduciary duties of loyalty and care.[16]

III.       Default Fiduciary Duties in Silent LLC Operating Agreements

a.         LLC Statutes in Delaware and Other States

Although fiduciary duties can be expressly contracted for in LLC operating agreements, the LLC Act does not specify whether default fiduciary duties exist where the agreement is otherwise silent.[17] The relevant section of the LLC Act reads, “[t]o the extent that” a manager owes fiduciary duties to an LLC and its members, those duties can be contractually expanded, restricted, or eliminated.[18] The provision fails to otherwise address the existence of fiduciary duties. As such, it is unclear whether (1) a manager’s fiduciary duty is inherent to the position of manager, which duty the parties can then agree to eliminate, expand, or modify; or (2) a manager’s fiduciary duty only exists if the parties provide for the duty’s existence in the LLC operating agreement.

By contrast, some other states’ LLC statutes use more definitive language. For example, in 2013, New Jersey revised its limited liability company law[19] and adopted the Revised Uniform Limited Liability Company Act (“RULLCA”),[20] which applies to New Jersey LLCs formed after March 2013, and will apply retroactively to the state’s previously formed LLCs starting March 2014. The New Jersey Revised Uniform Limited Liability Company Act, in accordance with the RULLCA, explicitly states that managers do in fact owe fiduciary duties of loyalty and care.[21]   This approach is becoming increasingly popular as the RULLCA provision providing for fiduciary duties has been adopted in six other jurisdictions (Iowa, Idaho, Wyoming, Nebraska, California, and the District of Columbia).

In states with vague LLC acts, courts have nonetheless construed fiduciary duties into their statutes. For example, while New York’s LLC statute[22] does not explicitly use the words “duty of loyalty” or “care,” New York courts have interpreted the statutory language as the functional equivalent of those duties.[23]   Similarly, Connecticut’s LLC statute[24] does not plainly state that LLC managers owe the duties of loyalty and care, but Connecticut courts have acknowledged the presence of the fiduciary duty of loyalty when applying the statute.[25]

b.         Recent Delaware Case Law

The Delaware judiciary has recently responded to the LLC Act’s failure to address the existence of default fiduciary duties by attempting to determine whether or not such duties exist in an otherwise silent operating agreement. While the Delaware Supreme Court has yet to definitively rule on the issue, the Chancery Court has found that the LLC Act does impose default fiduciary duties of loyalty and care absent express contractual arrangements to the contrary.

In Auriga, the Chancery Court found that, even if there was no express language providing for fiduciary duties in the LLC operating agreement, the LLC manager would still owe default fiduciary duties to the LLC and its members. In reaching its conclusion, the court analogized the LLC Act to the Delaware General Corporations Law (“DGCL”) and, given that the DGCL fails to plainly state the existence of such default duties but courts have nevertheless applied them, reasoned for a similar interpretation of the LLC Act.[26] Additionally, the court stated that “because the LLC Act provides for principles of equity to apply, because LLC managers are clearly fiduciaries, and because fiduciaries owe the fiduciary duties of loyalty and care, the LLC Act starts with the default that managers of LLCs owe enforceable fiduciary duties.” [27]

While the Delaware Supreme Court affirmed the lower court’s finding in Auriga that the LLC operating agreement’s language created fiduciary duties, it explained that the Chancery’s discussion of default fiduciary duties was “improvident and unnecessary.”[28] The court stated that reasonable minds could differ over whether the LLC Act imposes default fiduciary duties and that this issue of statutory ambiguity should be considered by the legislature instead. 

In a subsequent decision, Feeley v. NHAOCG, LLC,[29] the Chancery Court was faced with a similar issue regarding default fiduciary duties. The court was persuaded by the reasoning in Auriga and found that, until the Delaware Supreme Court confirms the answer one way or another, default fiduciary duties will be applied to an LLC manager at the Chancery Court level.[30]

c.         Proposed Amendment to the LLC Act

The question of the existence of LLC default fiduciary duties may be definitively answered soon. In March 2013, the Delaware State Bar Association’s Corporation Law Section drafted legislation to amend Section 18-1104 of the LLC Act. The amendment, in relevant part, would state that LLC managers owe default fiduciary duties of loyalty and care, absent an express agreement to the contrary. The amendment was introduced to the floor of the Delaware General Assembly on May 9, 2013.[31] 

If enacted by the Delaware General Assembly and approved by the state’s Governor, the legislation may take effect as early as August 1, 2013. The revisions would resolve the uncertainty as to whether default fiduciary duties apply in the absence of a provision in the LLC operating agreement stating otherwise. The proposed amendment will not alter the ability to eliminate, restrict, or expand fiduciary duties under Section 18-1101(c) of the LLC Act.[32] Importantly, the amendment will apply to all LLC operating agreements and not just those formed after its effective date.

IV.       Crafting Fiduciary Duty Provisions in LLC Operating Agreements

Given that the Delaware Chancery Court has ruled that default fiduciary duties do exist, it is worth considering how parties to an LLC operating agreement can modify them. As discussed above, the LLC Act allows for the terms of an LLC operating agreement to modify default fiduciary duties by restricting, eliminating, or expanding managers’ fiduciary duties.[33] In Zimmerman v. Crothall, the Chancery Court found that language in the operating agreement effectively restricted the managers’ fiduciary duty of loyalty.[34] The court held that, while one of the provisions in the LLC operating agreement set forth full fiduciary duties for managers, another provision restricted the duty of loyalty by allowing managers to participate in transactions with the company if certain requirements were met.[35]

Clearly, the best way to address a manager’s fiduciary duties is to be explicit and unambiguous in the LLC agreement about the existence and scope of such fiduciary duties. If fiduciary duties are to apply to the manager, the parties should describe such duties in the LLC operating agreement and, if something less than full fiduciary duties are intended, the parties should include the appropriate qualifying language. If the parties intend to eliminate a manager’s fiduciary duties, the LLC operating agreement should include an express disclaimer of fiduciary duties (which will not affect the unwaivable covenant of good faith and fair dealing). 

V.        Conclusion

Delaware courts take a broad approach to finding expressly contracted-for fiduciary duties, and while Delaware’s LLC Act fails to address the existence of default fiduciary duties in an otherwise silent LLC operating agreement, the Chancery Court nevertheless has held that such duties do exist.  Whether you are thinking about forming an LLC, drafting an LLC operating agreement, or are reviewing an existing LLC operating agreement, the above-mentioned concepts should be kept in mind. These concepts provide guidance as to the existence, modification, or elimination of an LLC manager’s fiduciary duties and will help ensure that all parties to an LLC operating agreement arrange for the desired scope of fiduciary duties to apply.


Questions regarding this client advisory may be addressed to authors John J. Hanley (212-238-8722, hanley@clm.com) or Austin Keyes (212-238-8641, keyes@clm.com), or your regular CL&M attorney. Summer associates Alex Silagi and Anup Khatri contributed to the preparation of this client advisory.
 

Endnotes


[1] Metro Ambulance, Inc. v. E. Med. Billing, Inc., 1995 WL 409015, at *2 (Del. Ch. July 5, 1995) (quoting Cheese Shop Int’l, Inc. v. Steele, 303 A.2d 689, 690 (Del. Ch. 1973), rev’d on other grounds 311 A.2d 870 (Del. 1973)).

[2] See, e.g., Auriga Capital Corp. v. Gatz Props., LLC, 40 A.3d 839, 850–51 (Del. Ch. 2012) aff'd, 59 A.3d 1206 (Del. 2012).

[3] See Id. at 849–51.

[4] William Penn P’ship v. Saliba, 13 A.3d 749, 756 (Del. 2011) (finding LLC managers breached duty of loyalty by entering into self-interested and unfair sale of company); see In re Ticketplanet.com, 313 B.R. 46, 62 (Bankr. S.D.N.Y. 2004) (applying Delaware law).

[5] Ribstein and Keating on Limited Liability Companies § 9:2 (2013); see also Revised Uniform Limited Liability Company Act § 409(c) (1996).

[6] See Minnesota Invco of RSA No. 7, Inc. v. Midwest Wireless Holdings LLC, 903 A.2d 786, 797 (Del. Ch. 2006). Under the business judgment rule, managers are presumed to have exercised rational business judgment, and, as such, courts are limited in questioning their business decisions.

[7] Id. (applying the traditional corporate definition of the business judgment rule to a breach of duty of care claim against LLC managers).   The business judgment rule presumes that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”  Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985) (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)).

[8] See Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. 4113, 2010 WL 3448227 (Del. Ch. Sept. 2, 2010) (citing 6 Del. C. § 18–1101(b)).

[9] 6 Del. C. § 18-1101 et seq (2010).

[10] 6 Del. C. § 18-1101(b).

[11] Zimmerman v. Crothall, 62 A.3d 676, 702 (Del. Ch. 2013).

[12] This advisory focuses solely on fiduciary duties as applied to LLC managers (who may, but need not be, members). While the LLC Act provides that LLC members can contractually owe fiduciary duties, Delaware case law has refined that proposition by holding that, absent an express fiduciary duty provision in the LLC operating agreement to the contrary, minority members do not have fiduciary duties. See Kelly v. Blum, No. 4516-VCP, 2010 WL 629850, at *10 (Del. Ch. Feb. 24, 2010).

[13]40 A.3d 839 (Del. Ch. 2012) aff'd, 59 A.3d 1206 (Del. 2012).

[14]Id. at 857.

[15]Gatz Properties, LLC v. Auriga Capital Corp., 59 A.3d 1206, 1213 (Del. 2012).

[16]Auriga Capital Corp., 40 A.3d at 859, 874.

[17]See 6 Del. C. § 18-1101 et seq.

[18]6 Del. C. § 18-1101(c) (emphasis added). As previously mentioned, § 18-1101(c) prohibits parties to an LLC operating agreement from contracting out of the implied covenant of good faith and fair dealing. Although the covenant of good faith and fair dealing operates like the fiduciary duties of loyalty and care, it is distinct from such duties. Wood v. Baum, 953 A.2d 136, 143 (Del. 2008).  

[19]N.J. Stat. § 42:2C-1 (2013).

[20]Uniform Law Commission, Acts: Limited Liability Company (Revised), The National Conference of Commissioners n Uniform State Laws (2013), http://uniformlaws.org/Act.aspx?title=Limited Liability Company (Revised).

[21]N.J. Stat. § 42:2C-39; see also Revised Uniform Limited Liability Company Act § 409 (2006).

[22]N.Y. Ltd. Liab. Co. Law § 409 (2013).

[23] See Nathanson v. Nathanson, 20 A.D.3d 403, 404, 799 N.Y.S.2d 83, 85-86 (2005); see also N.Y. Ltd. Liab. Co. Law § 409(a) (“A manager shall perform his or her duties as a manager . . . in good faith and with that degree of care that an ordinary prudent person in a like position would use under similar circumstances.”).

[24]Conn. Gen. Stat. § 34-141(e) (2013).

[25]See Coady v. Martin, 65 Conn. App. 758 (2001).

[26]Auriga Capital Corp., 40 A.3d at 849.

[27]Id.at 851.

[28]Gatz Properties, LLC, 59 A.3d at 1218.

[29]Feeley v. NHAOCG, LLC, 62 A.3d 649 (Del. Ch. 2012).

[30]Id. at 659–63.

[31]2013 Bill Text DE H.B. 126. The amended Section 18-1104 would state: “In any case not provided for in this chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties . . . , shall govern.” Id. (emphasis added).

[32]6 Del. C. § 18-1101(c).

[33]Id.

[34]Zimmerman v. Crothall, 62 A.3d 676 (Del. Ch. 2013).

[35]Id. at 701–04.



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2017 Carter Ledyard & Milburn LLP.
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