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Business Law Today

Reforming LLC fiduciary law
A brief for the unrepresented
By John M. Cunningham
For an LLC to succeed, its managers must be aware from the start that in performing their management responsibilities, they will be subject to clear and reasonably stringent fiduciary duties of care and loyalty. In addition, while LLC members obviously must be fair to their managers, they also must be able to remedy manager breaches of these duties promptly and decisively and to receive full compensation from them for injuries caused by these breaches.

However, although many millions of multimember LLCs are formed by members who cannot afford the assistance of lawyers with LLC fiduciary expertise, the fiduciary provisions of many LLC acts have been drafted principally to protect the interests of LLC promoters and managers who can afford these lawyers. Simple fairness requires that state legislatures amend the fiduciary provisions in their LLC acts to the full extent necessary to protect unrepresented members, and LLC lawyers in these states should vigorously support them in doing so. In addition, lawyers drafting operating agreements for LLC formation clients should seriously consider including in each of these agreements provisions reflecting the proposals for LLC fiduciary reform set forth below.

Obviously, it is impossible in this brief article to review all 51 U.S. LLC acts on the issue whether they meet the fiduciary needs of unrepresented members. However, the most influential and widely used LLC act is the Delaware Limited Liability Company Act (the "Delaware Act"). There are presently more than 550,000 Delaware LLCs in good standing—almost one-tenth of all U.S. LLCs. As shown below, many of the more important fiduciary rules of the Delaware Act and in the relevant Delaware cases are designed primarily to address the fiduciary needs of LLC members represented by sophisticated LLC counsel, and the Delaware Act, like many other LLC acts, fails to meet many basic fiduciary needs of unrepresented members. To remedy this imbalance, there are eight principal changes that should be made in the fiduciary provisions of the Delaware Act and other LLC acts with similar provisions.

The Provisions of the Delaware Act
The Delaware Act contains no provisions specifically imposing fiduciary duties of care or loyalty on LLC members or managers. However, it does contain 13 provisions that address fiduciary issues and closely related issues (such as issues concerning penalties for manager misconduct and procedures for challenging this misconduct). The relevant provisions are these (in the order in which they appear in the Delaware Act):

  • Section 18-108 (providing members with a broad right to indemnify managers and others for fiduciary and other claims);

  • Section 18-305 (providing members with a right to obtain six specified types of LLC documents and information for a "proper purpose" and upon written demand);

  • Section 18-402 (permitting LLC members to provide in their LLC agreement for manager removals);

  • Section 18-405 (providing LLC members with broad flexibility in imposing penalties and other consequences on managers for breaches of their fiduciary and other duties);

  • Section 18-406 (providing that managers shall be "fully protected" if, in their management conduct, they rely on, among other things, LLC reports and competent experts);

  • Sections 18-1001 through 1004 (providing for derivative actions to challenge manager misconduct);

  • Section 18-1101(b) (providing that the policy of the Delaware Act is to give maximum effect to the principle of freedom of contract and to the enforceability of LLC agreements);

  • Section 18-1101(c) (permitting members in LLC agreements to "expand, restrict or eliminate" manager fiduciary and other duties except for duties arising under the implied contractual covenant of good faith and fair dealing (the "Implied Covenant"));

  • Section 18-1101(d) (protecting managers from personal liability for conduct arising from good faith reliance on the LLC agreement); and

  • Section 18-1101(e) (permitting members in their LLC agreements to exculpate managers from personal liability for breaches of their fiduciary duties except for duties under the Implied Covenant).

All of the above 13 provisions (except, as discussed below, those concerning manager removals and derivative actions) merit consideration by state legislatures for inclusion in LLC acts that do not already contain similar provisions. Nevertheless, the Delaware Act and other LLC acts with similar provisions need major reforms to meet the fiduciary needs of unrepresented members.

Eight Proposals to Reform LLC Acts
1. Amending LLC acts to maximize clarity and simplicity. The Delaware Supreme Court in Elf Atochem North America, Inc. v. Jaffari, 727 A.2d 286, 291 (Del. 1999), has criticized the Delaware Act as "awkward" and "prolix." There are numerous examples of these flaws in the fiduciary provisions of the Delaware Act and in other LLC acts. In order to meet the needs of unrepresented LLC members, all of these provisions should be set forth in clear and simple statutory language that LLC members and lawyers who do not specialize in LLC law can readily understand. In addition, these provisions must be codified together in a separate statutory division, and, to the extent that the meaning of any of their terms is not self-evident, these terms must be specifically defined.

2. Amending duty-of-care provisions in LLC acts. As noted, the Delaware Act contains no provision imposing a fiduciary duty of care on LLC managers. Rather, the Delaware legislature (called the "General Assembly") has left it to the courts to impose this duty and to define a standard of care.

This General Assembly policy ensures maximum flexibility under the Delaware Act in addressing evolving fiduciary issues. However, it also creates major difficulties for unrepresented LLC members and for lawyers who do not specialize in LLC law. This is because when these lawyers and their clients search the Delaware Act for provisions concerning the duty of care and find none, they may reasonably conclude that no such duty exists. Furthermore, if lawyers not specializing in LLC law search for these provisions in Delaware case law, they may find it virtually impossible to uncover them, since, on many key issues relating to the duty of care, the governing Delaware cases are corporate or limited partnership cases, not LLC cases.

Finally, if, despite the above hurdles, lawyers not specializing in LLC law are able to locate the relevant Delaware cases, they will learn that under them, although Delaware LLC managers and Delaware LLC members who participate in LLC management do have a duty of care, the standard of care is that of avoiding gross negligence. Moreover,
The Truth Is in the (Fiduciary) System
The nineteenth-century German philosopher G. W. F. Hegel famously declared that "the Truth is in the System"—i.e., that no proposition can be evaluated except in light of all related propositions.

Hegel was certainly right about evaluating fiduciary provisions in LLC acts and operating agreements. To illustrate: In the operating agreement of XYZ, LLC imposes on XYZ's manager a duty of care of ordinary prudence and all seven of the subsidiary duties of loyalty discussed in the text of this article. However, these duties will afford no meaningful protection to XYZ's members if their operating agreement also includes

  • a broad exculpation provision exonerating XYZ's manager from money damages except for grave misconduct; or
  • a sweeping manager indemnification provision; or even
  • a requirement that all claims against XYZ's manager be brought as derivative claims.
In short, you can't evaluate the impact of a duty-of-care standard or any other fiduciary provision in a state LLC act or in an operating agreement you're drafting for your LLC formation clients unless you evaluate the provision in light of each other fiduciary provision in the act or agreement.
they will find that the Delaware cases define gross negligence as, in effect, an entire neglectof the duty of care.

The gross negligence standard of care is intended to protect individuals who are candidates for positions as directors of large Delaware corporations from the risk of personal liability for breaches of the duty of care and thus to encourage them to accept these positions. However, the gross negligence standard also makes it extremely difficult for Delaware LLC members to prove that their managers have breached their duty of care. Thus, for unrepresented LLC members who want to protect their LLCs from negligent managers, it is a highly inappropriate standard. The Delaware General Assembly and other state legislatures should reject the gross negligence standard and should, instead, adopt in their LLC acts a default ordinary prudence standard. This is the standard of care in the American Bar Association's Revised Model Business Corporation Act (RMBCA) and in the business corporation acts of the 20 states whose corporate statutes are based on the RMBCA.

3. Amending duty-of-loyalty provisions in LLC acts. In its broadest sense, the duty of loyalty of LLC managers means their duty, in all matters relating to the business and internal affairs of their LLC, to act in the best interest of the LLC and not merely in their own self-interest.

As noted, the Delaware Act imposes no fiduciary duties on managers, including the duty of loyalty. However, Delaware case law imposes on managers not only the above general duty of loyalty but also seven subsidiary duties. These subsidiary duties provide in essence (with certain narrow exceptions) that without the consent of a majority of disinterested members,

  • managers may not compete against the LLC;

  • they may not usurp LLC business opportunities;

  • they may not engage in business transactions with the LLC except on fair terms;

  • they may not use their position as members or managers to obtain improper personal benefits (such as excessive salaries);

  • they may not make unauthorized use of LLC property;

  • they must make certain disclosures to the members of key LLC information; and

  • they must act in good faith.

Delaware corporate case law defines good faith for fiduciary purposes as "an honest belief that [the conduct in question] is in the best interest of the [LLC]." It defines fiduciary bad faith as, in essence, conscious engagement in conduct likely to harm the LLC. In re Walt Disney Co. Derivative Litigation, 906 A.2d 27 (Del. 2006).

In general, Delaware common law rules governing the duty of loyalty are relatively stringent toward persons managing Delaware business entities. However, for the reasons stated above with regard to the duty of care, the Delaware General Assembly and other state legislatures should not relegate duty-of-loyalty issues to case law. Rather, to the extent these acts do not already do so, they should amend their LLC acts to expressly impose both a general duty of loyalty and the above seven subsidiary duties. In doing so, however,

  • they should impose a far broader default duty of disclosure on managers than the duty imposed by Delaware case law and

  • they should define the concept of fiduciary bad faith far less leniently than it is defined in Delaware case law.

4. Amending LLC acts to facilitate manager removals. As noted, Delaware Act § 18-402 permits LLC members to provide for manager removals. However, § 18-402 is radically ambiguous; it can even be reasonably read to imply that unless an LLC agreement expressly provides for their removal, managers may not be removed.

The Delaware General Assembly should amend § 18-402 to be clear and prescriptive: It should provide that unless their LLC agreement provides otherwise, LLC members may remove their managers for any material breach of their duties of care or loyalty. Other state LLC acts should contain similar provisions.

5. Amending LLC acts to include anti-oppression provisions. There is a rich body of state close corporation common law concerning the oppression of minority shareholders by majority shareholders, and many corporate statutes contain anti-oppression provisions. The Delaware Act contains no such provision, and Delaware case law makes clear that the majority members of Delaware LLCs have no duty of loyalty toward minority members.

However, § 701(a)(5)(B) of the Revised Uniform Limited Liability Company Act provides that minority LLC members who are able to prove oppression may force the dissolution of their LLC and receive liquidating distributions of their LLC's cash and other assets. The Delaware General Assembly and other state legislatures should amend their LLC acts to include default provisions similar to § 701(a)(5)(B).

6. Amending LLC acts to address the implied contractual covenant of good faith and fair dealing. Under the implied covenant, referred to above, a party to a contract is subject to a duty not to defeat the reasonable expectations of the other parties to the contract with respect to matters not expressly addressed in the contract. The implied covenant, which is imposed under the common law of Delaware and of most other states, provides a valuable backup to member and manager fiduciary duties, and under Delaware Act § 18-1101(c), it is nonwaivable in LLC agreements. If their state LLC acts do not expressly impose a mandatory implied covenant on parties to LLC operating agreements, state legislatures seeking to meet the fiduciary needs of unrepresented LLC members should amend their acts to do so.

7. Amending LLC acts to encourage ADR and to eliminate derivative action barriers to member fiduciary claims. Because mediation, arbitration, and other means of alternative dispute resolution (ADR) are normally faster, cheaper, more flexible, and more private than litigation, ADR is, for unrepresented LLC members, very often a better method of resolving LLC fiduciary claims than litigation. Delaware statutory law strongly favors ADR for resolving civil disputes, and numerous Delaware cases do likewise.

However, no provision of the Delaware Act reflects this Delaware pro-ADR policy, and the implicit default procedure under the Delaware Act for resolving fiduciary claims and other LLC internal disputes is litigation. Furthermore, Delaware Act §§ 18-1001 through 18-1004 provide in effect that if LLC members want to bring claims against managers that are "in the right of the [LLC]" (i.e., claims of manager misconduct primarily affecting the LLC as an entity rather than any individual member), they must do so through derivative actions. Derivative actions, whether in litigation or arbitration, involve burdensome procedural complexities, delays, and expenses that direct actions by members—i.e., actions in the members' own right—do not involve.

Thus, the Delaware General Assembly and other state legislatures should amend their LLC acts to expressly support the use of ADR to resolve LLC internal disputes. In addition, they should provide in these acts a default
The 51 U.S. LLC Acts—A Fiduciary Headcount
The fiduciary provisions of many LLC acts tend to be scattered haphazardly throughout these acts, and they are often written in less than lucid terms. However, the author's research indicates that

  • at least 18 of these acts must be read to provide for a "gross negligence" standard of care. This standard makes it very difficult for LLC members to prove manager negligence;
  • at least 20 acts are silent as to whether managers have a duty of loyalty;
  • almost all 51 acts are silent as to most or all of the seven subsidiary duties of loyalty discussed in the text of this article. Thus, these acts fail to give unrepresented members clear guidance as to the practical meaning of the duty of loyalty;
  • six contain derivative provisions that create serious barriers to member fiduciary claims against managers;

  • only 13 expressly impose on managers an implied contractual covenant of good faith and fair dealing;
  • only one expressly imposes on managers the burden of disproving adequately pleaded allegations that they have breached their duty of loyalty.
In other words, the failure to address the fiduciary needs of unrepresented LLC members is not just a Delaware problem; it's pervasive.
rule that members may bring any claim against managers in the members' own right and will not be bound by derivative action rules.

8. Amending LLC acts to address burden-of-proof issues. Delaware case law provides in general that if owners of Delaware business entities adequately plead claims that their managers have breached their duty of loyalty (including breaches of any of the seven subsidiary duties under the general duty of loyalty), the burden of disproving those claims will shift from the plaintiffs to the defendants.

In addition, the relevant Delaware case law provides that managers must bear the burden of proof with respect to owner claims that in making business judgments, the managers have breached their duty of care if the owners adequately plead that in making these judgments, managers have acted disloyally or on the basis of inadequate information. In general, Delaware case law holds that the above pleadings will be "adequate" if they are nonconclusory and credible. However, these holdings are not reflected in the Delaware Act itself.

The Delaware General Assembly and other state legislatures should amend their LLC acts to provide for default burden-of-proof rules that mirror the above Delaware common law rules.

Conclusion
The fiduciary provisions of the Delaware Act and many other LLC acts have been drafted primarily to meet the fiduciary needs of LLC members represented by sophisticated LLC counsel, and many of these acts fail to meet the fiduciary needs of unrepresented members. However, well-represented members, through their lawyers, can fend for themselves in addressing their fiduciary needs through tailored operating agreements. Unrepresented LLC members cannot. The Delaware General Assembly and other state legislatures should amend their LLC acts to the full extent necessary to meet the fiduciary needs of unrepresented LLC members. In particular, they should amend them to the extent necessary to implement the eight LLC fiduciary reforms outlined above.

Finally, lawyers representing clients in LLC formations should seriously consider including fiduciary provisions similar to the reform provisions proposed in this article in operating agreements they draft for their clients.

Cunningham is the principal of the Law Offices of John M. Cunningham, P.L.L.C., and is of counsel to the New Hampshire law firm of McLane, Graf, Raulerson & Middleton, Professional Association. He is the author of Drafting Limited Liability Company Operating Agreements (Aspen), and, with Vernon R. Proctor, co-author of Drafting Delaware LLC Agreements (Aspen). He was a principal drafter of the New Hampshire Limited Liability Company Act as enacted in 1993 and of the major amendments to that act in 1997.

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