Fiduciary Duties in LLC Operating Agreements
- Many state LLC acts impose fiduciary duties on LLC members and managers.
- While state LLC acts allow the LLC operating agreement to alter or eliminate fiduciary duties, other state LLC acts limit the operating agreement’s ability to do so.
- Failure to understand state rules regarding fiduciary duties can open the LLC members and managers up to liability.
- State law may also restrict the LLC’s ability to indemnify a member or manager for breach of fiduciary duty.
Fiduciary duties are an often-overlooked aspect of LLC law. When forming a new LLC, most founders focus on how profits will be shared and who will control the LLC. If they are well-advised, they will also consider LLC planning strategies, such as how to organize the LLC to maximize liability protection and provide tax efficiency. But rarely do founders consider fiduciary duties in the LLC formation process.
Failure to consider fiduciary duties can create liability for LLC members and—if the LLC is manager-managed—LLC managers. In some business contexts, such as real estate development, LLC members and managers often own other competitive businesses. Although this is part of standard business practice, it can raise issues when it is unclear whether a member or manager is acting in the best interest of the LLC as opposed to some other business interest. Depending on state law, the member or manager could breach the fiduciary duty of loyalty by engaging in these activities.
Many state LLC acts do not allow the operating agreement to eliminate or freely modify fiduciary duties. The inability to customize fiduciary duties can create limitations if members and managers will be involved in competing ventures.
Founders and LLC attorneys should consider fiduciary duties early in the LLC formation process. If state law does not allow customization or elimination of fiduciary duties, members and managers should consider forming the LLC in a state—like Texas, Delaware, or Nevada—that recognizes freedom of contract and allows the operating agreement to eliminate or define the scope of fiduciary duties.
What is a Fiduciary Duty?
A fiduciary duty is a responsibility to act on behalf of another person and, where necessary, to put the other person’s interest ahead of one’s own. The term “fiduciary duties” (plural) is a catch-all term that generally includes two components: a duty of care and a duty of loyalty.
As applied to LLC members and managers, a fiduciary duty creates a standard that a member and manager must meet when acting on behalf of the LLC. If the member or manager fails to meet that standard, he or she can be personally liable for breach of the fiduciary duty.
The duties of care and loyalty that apply to LLC members and managers vary by state. In states that impose fiduciary duties, the state LLC act will define the duty. The modern trend—embodied in the Revised Uniform Limited Liability Company Act (RULLCA)—is to provide a non-exclusive statutory definition for each duty, then leave it up to the parties and the court system to clarify, supplement, and interpret the scope of each duty.
Section 409 of RULLCA imposes a fiduciary duty of loyalty and a fiduciary duty of care, each discussed below.
Fiduciary Duty of Loyalty
There are three ways that a member or manager may breach the fiduciary duty of care under RULLCA: by failing to account for (and hold in trust) a prohibited benefit; by engaging in a conflict-of-interest transaction with the LLC; and by competing with the LLC.
Improper Use of LLC Property, Profit, or Other Benefits
There are three ways that a member may benefit improperly from an LLC:
- The member may receive a benefit from conducting the LLC’s activities and affairs in a way that benefits the member personally (not just in a way that benefits the LLC and the other members);
- The member may use the LLC’s property for personal use; or
- The member may appropriate an opportunity (for example, by personally taking advantage of an opportunity that was presented to the LLC).
If the member receives a prohibited benefit, the duty of loyalty requires that member to hold that benefit—whether property, profit, or other benefit—as a trustee for the LLC. The member must also account to the LLC for any property, profit, or benefit received.
The fiduciary duty of loyalty requires a member to refrain from dealing with the LLC in the conduct or winding up of the LLC’s activities or affairs as a person having an adverse interest to the LLC. If the interests of the member do not line up with the LLC’s interest, the member cannot deal with the LLC as it relates to the conflict-of-interest transaction.
The fiduciary duty of loyalty requires a member to avoid competing with the LLC in the conduct of the LLC’s activities and affairs before the LLC’s dissolution.
Fiduciary Duty of Care
A member’s duty of care in the conduct or winding up of the LLC’s activities and affairs is to refrain from engaging in grossly negligent or reckless conduct, willful or intentional misconduct, or knowing violation of law.
State Approaches to Fiduciary Duties
RULLCA reflects the modern approach, but it is only a model act. It is up to each state to decide whether to adopt a model act and, if so, whether to alter its provisions. Although more than 20 states have now adopted RULLCA, other states use the prior model act, their own independent act, or a combination of both.
The differences between state LLC acts are often less relevant than they first appear. Unlike corporations, LLCs are creatures of contract. State LLC acts allow the LLC operating agreement to define the relationship between the parties. When there is a conflict between the state LLC act and the operating agreement, the operating agreement generally controls.
In states that recognize broad freedom of contract, operating agreements may completely eliminate fiduciary duties. In states that restrict the operating agreement’s ability to define or waive fiduciary duties, the LLC attorney must be aware of state-specific limitations and draft the operating agreement accordingly.
Some state LLC acts impose fiduciary duties, but allow the operating agreement to make limited modifications to the standards that apply. For example, Section 105 of RULLCA allows the operating agreement to modify fiduciary duties in two ways:
- Ratification after disclosure. RULLCA allows the operating agreement to define a procedure for ratifying a specific act or transaction that would otherwise violate the duty of loyalty. The person with the conflict of interest must disclose all material facts, and one or more disinterested persons must then authorize or ratify the act or transaction.
- “Not manifestly unreasonable” modifications. RULLCA allows the operating agreement to make certain modifications, as long as they are not “manifestly unreasonable.” As long as it meets the “manifestly reasonable” standard, the operating agreement may:
- Alter or eliminate aspects of the duty of loyalty;
- Identify specific types or categories of activities that do not violate the duty of loyalty, alter the duty of care (but not to authorize conduct involving bad faith, willful or intentional misconduct, or knowing violation of law); and
- Alter or eliminate any other fiduciary duty.
Fiduciary Duties and Indemnification
Given that a primary purpose of LLC formation is liability protection, most LLC operating agreements indemnify LLC members or managers for acts taken in good faith on behalf of the LLC. In many state LLC acts, this indemnification does not extend to any actions that breach a fiduciary duty. If a breach of fiduciary duty opens a member or manager up to liability, the LLC may not indemnify the member or manager for that breach.
Duty of Good Faith and Fair Dealing
In addition to the fiduciary duties of loyalty and care, state LLC acts impose a contractual duty of good faith and fair dealing. Although not a fiduciary duty, this duty is important and, as a general rule, may not be waived. Most states do not allow the LLC operating agreement to waive the duty of good faith and fair dealing.