The current fashion in drafting limited liability company agreements is to have that contract spell out all of the rights and obligations of the members, managers or other agents involved in the limited liability company. That is in sharp contrast to the Delaware corporate law, for example. Corporations generally are governed by broad enabling provisions in their certificate of incorporation and some to specific statutory requirements, but leave the rest of the relationships of managers and owners to be resolved by the judge-made law of fiduciary duty.
This heavy reliance on the LLC agreement’s language to set the rules has led many to question if the managers of LLCs have any fiduciary duties that limit their actions. The short answer is maybe, whether they realize it or not. Indeed, as this short article will suggest, leaving space for traditional fiduciary duties to operate in an LLC may be a good idea.
Section 1101(e) of the Delaware Limited Liability Act (DLLA) provides:
"A limited liability company agreement may provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a member, manager or other person to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement; provided, that a limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing."
This ability to eliminate fiduciary duties was put into the DLLA after a Delaware Supreme Court decision suggested that it would uphold such a provision if adopted by the Delaware Legislature.
That decision in the Gotham Partners case illustrates the main point made here. Gotham Partners involved a Delaware limited partnership with a partnership agreement more than 50 pages long. The managing general partner bought some limited partnership interests, after being advised by a major law firm and an expert in partnership law that the purchase was proper. The Court of Chancery disagreed, however, and in the suit by a limited partner challenging the transaction, entered a large verdict against the general partner. The court held the general partner had not complied with some of the very detailed requirements for its purchase set out in the complicated partnership agreement. This after all the expert advice the general partner had received.
The point of this story is that even the most detailed partnership or limited liability agreement may not cover every possible future event and, even if it does, mistakes are very possible when trying to comply with very complicated and sometimes contradictory provisions. Moreover, this sort of difficulty is not really cured by the DLLA’s provisions permitting elimination of fiduciary duties.
The Statute Is Not Clear
Recall that the statute requires management not to act or fail to act in a way that “constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.” What does that really mean? There are lots of unanswered questions about this statutory command. For example, does a manager have the burden of proving he acted in good faith and fairly in a self-dealing transaction? Does this mean that management must both use a fair process and reach a fair result in such a transaction? For a corporate fiduciary, the answer to both those questions is clearly “yes” under Delaware law. But, are those fiduciary-duty based commands applicable when fiduciary duties are eliminated by an LLC agreement?
The Case Law Is Complicated
A few recent decisions of the Delaware Court of Chancery illustrate this problem of determining what are management’s duties under a detailed LLC agreement. In Related Westpac LLC v. JER Snowmass LLC, the plaintiff claimed that the defendants had both a fiduciary duty and the implied duty to act in good faith and fairly, to make a capital contribution to the LLC. The court dismissed those claims. It did so because the LLC agreement clearly permitted the defendants to refuse to honor any capital call in their discretion. Thus, when the LLC agreement directly addresses how an issue is to be resolved, there is no room for fiduciary duty or implied covenant arguments for a different result. The parties are stuck with their contract. That seems both clear and sound. But, as other decisions show, the facts are not always so easy to make the legal analysis simple.
In re Atlas Energy Resources LLC Unitholders Litigation , is just such a different case. Atlas involved yet another extensive LLC agreement. The agreement purported to eliminate fiduciary duties and to provide a method to resolve conflict-of-interest situations. Relying on those provisions, the defendants moved to dismiss the complaint. They were only partially successful.
The court did dismiss the breach of fiduciary duty claims against the individual defendant directors. As to those defendants, the court relied on the provisions of the LLC agreement that eliminated their general fiduciary duties and replaced those duties with the duty to act in a way they subjectively believed was in the company’s best interests. Because the plaintiff had not alleged facts sufficient to show a violation of that duty, those claims were dismissed.
However, the court did not dismiss the claims against the controlling owner of Atlas. Those claims alleged that the controlling owner had improperly caused the minority, public owners to be eliminated as owners by an unfair merger. Under Delaware law, a controlling owner has a fiduciary duty to the minority owners not to treat them unfairly in a merger. The LLC agreement did not eliminate that majority-to-minority duty, however, because it only spoke to the duty of the majority owner to the LLC itself. The court held that did not cover the duty to the minority owners of the LLC.
The lesson of Atlas is that even the most detailed limited liability company agreements may fail to eliminate all fiduciary duties, in all future circumstances. Indeed, it can be argued that even when fiduciary duties are eliminated as was the case for the Atlas directors, the LLC agreement should have some sort of substitute provision to measure managers’ conduct. For absent that contractual standard, the court may impose its own view of what is fair.
In considering whether to eliminate fiduciary duties by the LLC agreement and substituting alternative procedures and standards, you should consider the risk that those novel substitutes may not be followed if only because of innocent error. If that occurs, then the courts will fall back on applying the well developed fiduciary duties that apply when the alternatives are not followed. In such a case, it is likely that the parties will also not have acted properly under fiduciary duty law because they thought they were complying with different standards of conduct. They well might have been better off just following the fiduciary duty law they had rejected.
Under a properly drawn limited liability company agreement, managers may not have any of the traditional fiduciary duties to owners of the LLC. However, it is difficulty to draft an agreement that covers all future events and if there is something not covered, then fiduciary duties may still apply in that circumstance. Moreover, it is probably not enough to eliminate all fiduciary duties to avoid possible liability. Instead, a better course is to provide clear guidance on the procedures to be applied and some reasonable standard of conduct to be followed, particularly in conflict of interest situations. The courts simply are not going to let managers act badly without some recourse for the owners.