When drafting operating agreements, amendments or
joinders to operating agreements for limited liability companies formed in the
State of California, practitioners should take note of changes to California
limited liability company (LLC) law affecting the fiduciary duties of the
managers and members.
BACKGROUND
On January 1, 2014, the
California Revised Uniform Limited Liability Company Act (“RULLCA”) became
effective. Signed into law on September 21, 2012 by Governor Jerry Brown,
RULLCA replaces the Beverly-Killea Limited Liability Company Act
(“Beverly-Killea”). RULLCA was intended to modernize California LLC law based
on more than two decades of legal developments across the United States. Note
that Beverly-Killea remains in effect to some extent for LLCs formed before
January 1, 2014 for acts or transactions occurring before that date or an
operating agreement or other contracts entered into prior to that date.
In defining the
fiduciary duties of the managers and members of LLCs, Beverly Killea merely cross-referenced
California general partnership law without being more specific. And, although
the rules regarding fiduciary duties under RULLCA are opaque at best, RULLCA
sets forth certain specific fiduciary duties of managers owed to members and
members to each other, and how such fiduciary duties may be modified.
FIDUCIARY DUTIES UNDER RULLCA
Under RULLCA, fiduciary
duties are no longer incorporated by reference from partnership law, but are
specifically contained in the act. Note that RULLCA does not state that these
are exclusive fiduciary duties, and a court could modify the enumerated
fiduciary duties (further, other statutory schemes governing such duties could
be relevant) but that discussion is beyond the scope of this article. Further,
RULLCA sets forth which duties may be modified by agreement.
The Duties
For a member-managed
LLC, the fiduciary duties owed between members are the duty of loyalty and the
duty of care. In a manager-managed LLC, the manager owes the duty of loyalty
and the duty of care to the members. In general, the members do not owe these
duties to each other in a manager-managed LLC solely by virtue of being a
member (however, there could be some duties owed by a “controlling member” in a
manager-managed LLC that are not discussed in this article). However, both
the manager and the members in a manager-managed and a membermanaged LLC owe
the duty of good faith and fair dealing to the members.
1. Duty of Loyalty. There are three subsets within the
duty of loyalty: (1) the duty to account (and hold as a trustee any property,
profit or benefit for the members (including a company opportunity)), (2) the
duty to refrain from selfdealing (or acting on behalf of a person having an
interest adverse to the company) and (3) the duty not to compete.
2. Duty of Care. The
manager (or member in a member-managed LLC) must refrain from engaging in
grossly negligent or reckless conduct, intentional misconduct or a knowing
violation of the law.
3. Obligation of Good Faith & Fair Dealing.
Managers and members of LLCs must discharge their duties to the LLC and the
members under RULLCA or the LLC’s operating agreement and exercise any rights
consistent with the obligation of good faith and fair dealing.
Modifying Fiduciary Duties
While RULLCA allows
modifications, RULLCA prohibits operating agreements from eliminating all
together the duty of loyalty, the duty of care or any other fiduciary duty, and
the obligation of good faith and fair dealing.
1. Duty of Loyalty. An
operating agreement may identify specific types or categories of activities
that do not violate the duty of loyalty if not manifestly unreasonable and
specify the number or percentage of members that may authorize or ratify, after
full disclosure to all members of all material facts, a specific act or
transaction that would otherwise violate the duty of loyalty.
2. Duty of Care. The
duty of care may not be unreasonably reduced, but may be modified to the
statutory minimum by limiting the duty of care to refraining from grossly
negligent or reckless conduct, intentional conduct or a knowing violation of
the law.
3. Obligation of Good
Faith and Fair Dealing. An operating agreement may specify the standards by
which performance of the obligation of good faith and fair dealing is to
measured, so long as the standards are not “manifestly unreasonable” at the
time the standards are prescribed. For example, standards may be implemented
such as “if the manager makes a decision based on the manager’s honest belief”
or “if a disinterested party knowledgeable in the matter states that such
action would be agreed to by persons at arm’s length and in comparable
circumstances."
MANAGER/MEMBER INDEMNITIES AND FIDUCIARY
DUTIES
Under Beverly-Killea
indemnification of members and managers by the LLC was optional. Under RULLCA,
indemnification of managers and members is the default rule, but an operating
agreement may modify a manager’s (or a member’s in member-managed LLC) right to
indemnification; provided, however, that RULLCA requires each LLC to reimburse
for any payment made and indemnify for any debt, obligation or other liability
incurred by a member of a member-managed LLC or the manager of a
manager-managed LLC in the course of the member’s or manager’s activities on
behalf of the LLC, if, in making the payment or incurring the debt, obligation
or other liability, the member or manager complied with his or her fiduciary
duties. Further, although beyond the scope of this article, there are other
ways to limit liability of managers and members, including by insurance.
TAKEAWAYS
In practice, it appears
that many practitioners continue to rely on the code and do not modify
managers’ or members’ fiduciary duties in operating agreements. One reason may
be that RULLCA is fairly new and the courts have not yet had the opportunity to
flesh out these concepts. Further, RULLCA provides that the fiduciary duties of
a manager may be modified only with full disclosure and the “informed consent”
of the members, which is a murky concept at best. RULLCA does provide,
however, that informed consent of a member in a new LLC differs from a member
who is deemed to consent to the operating agreement when such party becomes a
member of an existing LLC.
Accordingly, practitioners should take great care
when drafting operating agreements for new LLCs or joinders admitting new
members to existing LLCs that the informed consent of the members to modify
fiduciary duties is well documented. Additionally, the modifications should be
targeted and the operating agreement should specifically authorize certain actions
that might otherwise be viewed as conflicting with the duty of loyalty (e.g.,
engaging in a competing business venture) or the duty of care (e.g., permitting
the delegation of certain manager duties to officers or agents).
While the exact meaning
of informed consent remains unclear, drawing from other areas of law may give
some guidance. Specifically informed consent, at a bare minimum, likely means
that practitioners should obtain the written consent of the parties after full
written disclosure of the material risks of such modifications. And, if
modification of fiduciary duties is intended, each member must be made fully
aware of such modifications prospectively. From the practitioner’s point of
view, this means that in new LLCs, each member must be fully aware of such
modifications prior to the effectiveness of an operating agreement, and in
existing LLCs with an existing operating agreement, each member must be fully
aware of such modifications prior to the effectiveness of any amendment to an
operating agreement modifying such terms. Further, each new member in an
existing LLC must be made fully aware of such modifications prior to the
effectiveness of a joinder admitting it to the LLC.
CONCLUSION
Prudence dictates that
managers and members of California LLCs pay attention to recent changes in the
laws affecting California LLCs. The courts have not yet addressed many of the
open issues posed by these new laws and such interpretations could lead to
varying results and unintended consequences. To avoid pitfalls and potential
liability, it is imperative that practitioners use the principles provided in
this article to clearly draft governing documents in a manner that will not
require a court to make broad leaps of faith to give effect to the intent of the
parties.
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