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Fiduciary Duties For Control Persons of Limited Liability Companies

Article

Corporate & Finance Alert

November 11, 2008

In a recent issue of Gibbons “Business Advisor,” we provided an overview of corporate fiduciary duties and how those rules are modified when a corporation confronts severe financial difficulties. It is well-established that directors of a financially troubled corporation owe a duty of care and duty of loyalty to all corporate stakeholders and, absent a conflict of interest transaction, the directors are entitled to the protection of the business judgment rule.

Many businesses or investments, however, are in the form of alternative business entities, very frequently limited liability companies (“LLCs”). The duties of LLC control persons toward owners, and the rights of the company, minority owners and, in the case of an insolvent LLC, creditors, against control persons, are not necessarily the same as in the corporate context. Stakeholders in financially troubled LLCs should not assume that the company control persons owe corporate-like fiduciary duties absent a careful examination of such control persons’ rights and responsibilities. This Alert will explain why.

The New Jersey Limited Liability Company Act, N.J.S.A. 42:2B-1, et seq., is virtually silent on the standard of care expected from LLC control persons. The Act states that, unless otherwise provided in an operating agreement, the members or managers of an LLC shall not be personally liable for any reason except in the case of gross negligence or willful misconduct. The New Jersey Act also provides that an operating agreement may eliminate or limit the personal liability of members or managers. N.J.S.A. 42:2B-26 and -30.

The New York Limited Liability Company Law states that a manager shall perform his or her duties in good faith and with the degree of care that an ordinarily prudent person in a like position would use. §409. The New York Law also provides that the parties may establish the responsibilities of managers in an operating agreement. §417.

Delaware is often the jurisdiction of choice for the organization of business entities. The Delaware Limited Liability Company Act (6 Del. C. §§ 18-101, et seq.), at §18-1101(c), provides in pertinent part as follows:

(c) to the extent that, at law or in equity, a member of manager or other person has duties (including fiduciary duties) 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, the member’s or manager’s or other person’s 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. Under the Delaware Act it is assumed that control persons have fiduciary duties. However, the scope of such duties may be set, or such duties may be eliminated entirely, by contract. The sole exception is the implied covenant of good faith and fair dealing, which has been described as requiring the refrain from arbitrary or unreasonable conduct having the effect of preventing the other party to a contract from receiving the fruits of the bargain. The New York Law also places restrictions on the limitation of managers’ duties by contract.

Thus, if an operating agreement is silent on the matter of the duties of the control persons, in the case of a New Jersey LLC, arguably the conduct of such persons would not be measured by the same principles as would apply to corporate directors and officers. While in the case of a Delaware LLC or New York LLC, corporate-like principles would apply. However, in the case of all three jurisdictions, the persons crafting the governance of the company through the drafting of an operating agreement, may establish the applicable standards of conduct by contract. Minority owners and creditors, in the case of an insolvent LLC, who believe that they have been victimized by the LLC managers on the grounds of mismanagement or on the basis of not meeting an anticipated standard of care may learn, upon careful review of an LLC operating agreement, that the duties of the control persons have been limited to the maximum extent permitted by law.

This could provide a very rude awakening to investors in operating businesses organized as LLCs or investors in certain hedge funds.

In sum because contract prevails over developed statutory and case law principles in the case of LLCs versus corporations, persons managing, investing in or doing business with LLCs need to be mindful that the standard of care for the control persons of LLCs may differ greatly from one company compared to another. As a means of guarding against uncertainty of the applicable standard of care in case a dispute develops, the founders of LLCs should address the issue of control persons’ duties in the drafting process on formation of the company. Similarly, investors in LLCs should be careful to review the standard of care that will be applicable to the persons who will be managing their investment. If the standard is not satisfactory, the investors should refrain from investing or, depending on their degree of leverage, negotiate to modify the contract standard. It is not unusual for an LLC operating agreement to provide that control persons of LLCs will be held to the same standard of care and have the same fiduciary duties as those owed by directors and officers of a corporation.