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Fiduciary Duties in Limited Liability Companies

Added by Hawley Troxell in Articles & Publications, Business Law on September 11, 2009

On March 18, 2008, Idaho became the first state to adopt the Revised Uniform Limited Liability Company Act (the “RULLCA”), drafted by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”).[1] The Idaho Uniform Liability Company Act (the “New Act”) became effective on July 1, 2008, and applies to all Idaho limited liability companies formed after that date. The prior act continues to apply to pre‑existing limited liability companies until July 1, 2010, unless the company elects to “opt‑in” to the New Act. As of July 1, 2010, all limited liability companies will automatically become subject to the New Act, regardless of whether the pre‑existing limited liability companies have “opted‑in.”[2]

Since its inception in the 1990s, the limited liability company (“LLC”) has become the preferred business entity choice for many business relationships because of its flexible nature and the ability to mold the entity to fit virtually any

desired business structure. The LLC is a hybrid entity merging contract principles and statutory principles, as well as concepts from both corporate

law and partnership law. To this end, the RULLCA essentially consists of “default rules,” which apply in the absence of the parties’ contractual agreement to contrary or different terms.[3] For the most part, the parties may draft around these default rules. While it remains true under either Idaho’s prior limited liability company act[4] (the “Prior Act”) or the New Act that parties should take care when forming an LLC to draft around default rules that do not fit the parties’ desired relationship, it is noteworthy that the New Act takes an innovative approach with regard to certain default rules, including its fiduciary duty provisions, which essentially codify many of the fiduciary duties formerly imposed on corporations and partnerships by statute or common law. Because of these new innovations and a recent Idaho Supreme Court decision which establishes that at least some pre‑existing LLCs are also subject to fiduciary duty rules, parties may wish to “opt‑in” to the New Act and draft around certain provisions to ensure that members and managers are not subject to unexpected liability for breach of fiduciary duties.

The Operating Agreement

The operating agreement is the key governance document for LLCs. The New

Since the New Act expressly imposes fiduciary duties on both members and managers, it may be prudent for pre-existing LLCs to take advantage of its clear rules, and re-draft their operating agreements…

Act defines an operating agreement as “the agreement, whether or not referred to as an operating agreement, and whether oral, in a record, implied or in any combination thereof, of all members of a limited liability company, including a sole member.”[5] This new definition of “operating agreement” is expansive – based on this definition, an operating agreement could be written or oral, express or implied, and could even be formed unintentionally. An LLC is bound by its operating agreement; and a person who becomes a member of the LLC is deemed to assent to the operating agreement, whether or not she or he manifestly assented.[6] As a result, once an LLC comes into existence and has at least one member, the LLC necessarily has an operating agreement.[7] In other words, under the New Act, an operating agreement is inevitable.

Since the New Act provides default rules that govern any matters not otherwise addressed in the operating agreement, it is important to note that, if the LLC does not have a written operating agreement, or if its operating agreement does not contain provisions governing certain matters, the default rules will govern the parties’ relationship. Accordingly, members and managers forming an LLC should take great care to draft around any default rules that do not fit their desired business relationships. In particular, the parties’ should properly define the scope and parameters of the parties’ fiduciary duties to the extent the New Act allows them to draft around its fiduciary duty provisions – especially if the intended duties are not consistent with the default rules set forth in the New Act. In so doing, it is important to remember that an operating agreement is a fluid document, and may theoretically be amended by oral or written conduct. Although the parties cannot completely circumvent all of the default rules, the New Act provides substantial flexibility to draft the document to meet the parties’ reasonable expectations.

Fiduciary Duties and the Rullca

Until recently, the existence, scope and extent of fiduciary duties owed by members and managers in an Idaho LLC remained an open question. However, in Bushi v. Sage Health Care, PLLC, the Idaho Supreme Court addressed the question of fiduciary duties under the Prior Act.[8] In Bushi, a case dealing with a member‑managed LLC, the court held that, under the Prior Act, members of an LLC do indeed owe one another fiduciary duties.[9] In reaching this decision, the Court specifically noted the New Act’s fiduciary duty provisions, and that the majority of state courts considering the issue have concluded that members owe one another the fiduciary duties of trust and loyalty. Although the Court did not elucidate the precise parameters of these duties, it is clear that, under both the Prior Act and the New Act, members of a member‑managed LLC owe fiduciary duties to one another.[10] Since the New Act expressly imposes fiduciary duties on both members and managers, it may be prudent for pre‑existing LLCs to take advantage of its clear rules, and re‑draft their operating agreements to the extent their current business relationship could be deemed to violate the fiduciary duty provisions of the New Act, or fiduciary duties that might be applicable under Bushi.

As the drafters wrote in the Comments to RULLCA, “[o]ne of the most complex questions in the law of unincorporated business organizations is the extent to which an agreement among the organization’s owners can affect the law of fiduciary duty.” Since a limited liability company is both a creature of contract and a creature of statute, the drafters sought a balance between “cabining in” the fiduciary duties, by establishing the duties in full, unwavering statutory prescriptions, and leaving them “uncabined,” subject only to the terms of the parties’ contractual obligations to one another. In addition, the drafters did not intend the fiduciary duties set forth in the New Act to be exclusive, but rather sought to “[permit] contractual innovation within the framework of a mandatory core of minimum statutory fiduciary duties.”[11] To accomplish this balance, the drafters ultimately set forth certain fiduciary duties in the statute as “default rules,” but allowed the parties, through the operating agreement, to alter and even eliminate some of these duties, subject to the limitation that such alterations and restrictions must not be “manifestly unreasonable.”

Accordingly, the New Act expressly provides that a member of a member‑managed LLC owes to the company and the other members the fiduciary duties of loyalty and care and the contractual duty of good faith and fair dealing.[12] In a manager‑managed LLC, these fiduciary duties apply to the managers but not the members.[13] The duty of loyalty includes:

  • The duty to account to the company and hold as trustee for it any property, profit or benefit derived by the member or manager in the conduct or winding up of the company’s activities, from a use by the member or manager of the company’s property, or from the appropriation of an LLC’s opportunity;
  • The duty to refrain from dealing with the company in the conduct or winding up of the company’s activities as or on behalf of a person having an interest adverse to the company; and
  • The duty to refrain from competing with the company in the conduct of the company’s activities before the dissolution of the company.[14]

Subject to the business judgment rule,[15] the duty of care of a member of a member‑managed LLC (or a manager of a manager‑managed LLC), in the conduct and winding up of the company’s activities, is to act with the care that a person in a like position would reasonably exercise under similar circumstances and in a manner the member or manager reasonably believes to be in the best interests of the company. In discharging this duty, a member may rely in good faith upon opinions, reports, statements or other information provided by another person that the member or manager reasonably believes is a competent and reliable source of information.

Notwithstanding its pronouncement of certain fiduciary duties, the New Act expressly allows an operating agreement to restrict or eliminate certain aspects of fiduciary duties of members and/or managers of the company, so long as such restrictions are not “manifestly unreasonable.” For example, the operating agreement may restrict or eliminate the duty to account to the company and to hold as trustee any property, profit or benefit derived by the member in the conduct of winding up the company’s business, from a use by the member or manager of the company’s property, or from the appropriation of a limited liability company opportunity. In addition, the operating agreement may restrict or eliminate the duty to refrain from dealing with the company in the conduct or winding up of the company’s business as or on behalf of a party having an interest adverse to the company. Finally, the operating agreement may restrict or eliminate the duty to refrain from competing with the company in the conduct of the company’s business before the dissolution of the company.[16] For example, in a real estate transaction, where the members form an LLC for one purpose, but the parties intend that each member may continue to engage in additional, unrelated projects, it would be important to draft around these duties to provide that the members may enter into additional, separate real estate transactions without violating the duty of loyalty. Similarly, health care entities often lease property owned by one of the members. In this instance, the operating agreement should provide that the member may lease the building to the entity without violating the duty to account to the company for the profits derived from the lease

In addition, an operating agreement may, so long as it is not “manifestly unreasonable,” identify specific types or categories of conduct that do not violate the duty of loyalty; alter the duty of care except to authorize intentional misconduct or knowing violation of law; alter any other fiduciary duty including the elimination of particular aspects of that duty; and prescribe standards by which to measure the performance of the contractual obligation of good faith and fair dealing.[17] Along similar lines, the operating agreement may specify the method by which a specific transaction or act that would otherwise violate the duty of loyalty would be authorized or ratified by one or more disinterested and independent persons after full disclosure of all material facts.[18]

In sum, the New Act provides four separate methods through which those with management power in a limited liability company can proceed with conduct that would otherwise violate the duty of loyalty:

i.the operating agreement might eliminate the duty or otherwise permit the conduct, without need for further authorization or ratification;

ii.the conduct must be authorized or ratified by all members after full disclosure;

iii.the operating agreement might establish a mechanism other than the informed consent for authorizing or ratifying the conduct; or

iv.in the case of self‑dealing the conduct might be successfully defended as being or having been fair to the limited liability company.[19]

For example, with the real estate entity, the operating agreement could expressly permit the members to enter into certain ventures which might otherwise be deemed to violate the duty not to compete with the LLC, or it could eliminate the duty not to compete entirely. In the health care LLC, the operating agreement might expressly provide that a member may lease the member’s individual property to the entity, without accounting to the entity for the profits derived from the lease. Alternatively, the New Act provides defenses if the conduct is challenged. The additional members could ratify the conduct in accordance with the New Act’s ratification provisions, or the LLC could assert and attempt to prove that the conduct was otherwise fair to the company.

Although the parties’ may draft around the New Act’s fiduciary duty rules, provisions seeking to limit or eliminate such duties will be subject to a claim that they are “manifestly unreasonable.” Under the New Act, state courts are tasked with a determination of whether such a provision is “manifestly unreasonable.”[20] However, the New Act does provide some guidelines for courts in making such a determination. According to the New Act, “the court shall make its determination as of the time the challenged term became part of the agreement, considering the circumstances existing at the time, and may invalidate the term only if, in light of the purposes and activities of the limited liability company, it is readily apparent that the objective term is unreasonable or the term is an unreasonable means to achieve the provision’s objective.”[21] Idaho courts have not yet been faced with this question. In any case, parties should take care in their drafting to follow the guidelines set forth by the New Act, and ensure the provisions are not manifestly unreasonable under the circumstances existing at the time.

Conclusion

The provisions of the New Act highlight the importance of written, well‑drafted operating agreements which fit the parties’ expectations as to how their business relationship is structured. In addition, the Bushi ruling makes clear that members of pre‑existing LLCs owe fiduciary duties to other members and to the company. With the adoption of the New Act, however, the good news is that LLCs have the opportunity to “opt‑in” to the New Act and invoke its provisions to draft around the default rules, and mold the LLC to fit the parties’ business expectations.

About the Author

Nicole C. Trammel is an associate at the law firm of Hawley Troxell Ennis & Hawley LLP in the business and finance department. Prior to joining Hawley Troxell, Nicole served as law clerk to the Honorable Justice Jim Jones of the Idaho Supreme Court.

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[1] Idaho Session Laws 2008, ch. 176, p. 480 (approved on March 18, 2008).

[2] Idaho Code § 30‑6‑1104.

[3] While the Prior Act also utilized the concept of default rules, RULLCA revised and altered and expanded many of these defaults.

[4] Chapter 6, title 56, Idaho Code (2008).

[5] Idaho Code § 30‑6‑102(15).

[6] Idaho Code § 30‑6‑111(1), (2).

[7] NCCUSL Comment to RULLCA § 110.

[8] Bushi v. Sage Health Care, PLLC, 146 Idaho 764, 203 P.3d 694 (2009).

[9] Id., 203 P.3d at 699.

[10] In Bushi, a member of a member‑managed LLC asserted breach of fiduciary duty claims against the other members. Thus, this case only establishes that members in a member‑managed LLC owe one another fiduciary duties. The scope of a manager’s fiduciary duties in a manager‑managed LLC remains unclear under the Prior Act.

[11] See Sandra K. Miller, What Fiduciary Duties Should Apply to the LLC Manager After More Than a Decade of Experimentation?, 32 J. Corp. L. 565, at 614.

[12] Idaho Code § 30‑6‑409.

[13] Idaho Code § 30‑6‑407.

[14] Idaho Code § 30‑6‑409(1), (2).

[15] The business judgment rule is the principle, taken from corporate law, that a court will not second‑guess the business judgment of a corporation’s officers and directors, absent conflicting interest transactions, self‑dealing, or other indicia that such decision may be suspect.

[16] Idaho Code § 30‑6‑110(4)(a).

[17] Idaho Code § 30‑6‑110(b)-(e).

[18] Idaho Code § 30‑6‑110(5).

[19] NCCUSL Comments to RULLCA § 409(e); Idaho Code §§ 30‑6‑110(d)(1), (2), 409(f), 110(e), 409(e).

[20] Idaho Code § 30‑6‑110(8).

[21] Idaho Code § 30‑6‑110(8).

As published in the September 2009 edition of The Advocate, the official publication of the Idaho State Bar. Reprinted with permission.