Modification of Fiduciary Duties - a Multistate Comparison

(Note: the following is adapted from materials prepared for Litigating the Business Divorce (BNA, forthcoming 2016), co-edited and co-authored by Brian Gottesman, and materials prepared by Michelle Quinn and Brian Gottesman for their CLE webinar "Fiduciary Duties in LLCs and LPs: Considerations for Modifying or Waiving Duties of Alternative Entity Managers.")

The question of what fiduciary duties apply to various forms of business entities and what form such duties take has been addressed with essentially two opposite approaches: (1) to assume that managers[1] of alternative entities such as LLCs have, by default, all of the traditional fiduciary duties of corporate directors, or (2) to apply no default duties other than those assigned in the entity’s governing documents.  Moreover, different jurisdictions take different positions on the extent to which fiduciary duties of managers (if any) can be modified or eliminated by contract.
Given that Delaware is the jurisdiction to which many other states look in interpreting issues of fiduciary duties, it is instructive to note that the question of default duties was hotly debated, and largely unanswered, until fairly recently.  The Delaware LLC Act states in relevant part:

To the extent that, at law or inequity, a member or 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 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.[2]

In the face of this language, no less an authority than Myron T. Steele, then Chief Justice of the Delaware Supreme Court, argued that default fiduciary duties were inappropriate for contract-based entities:

I suggest that although current judicial analysis seems to imply that fiduciary duties engrained in the corporate law readily transfer to limited partnerships and limited liability companies as efficiently and effectively as they do to corporate governance issues, that conclusion is flawed. I conclude that parties to contractual entities such as limited liability partnerships and limited liability companies should be free—given a full, clear disclosure paradigm—to adopt or reject any fiduciary duty obligation by contract. Courts should recognize the parties' freedom of choice exercised by contract and should not superimpose an overlay of common law fiduciary duties, or the judicial scrutiny associated with them, where the parties have not contracted for those governance mechanisms in the documents forming their business entity.[3]

Other voices, however, including several on the Delaware Court of Chancery, argued against Chief Justice Steele’s position.  In 2012, the Court of Chancery held for the first time that default corporate fiduciary duties, unless modified by contract, applied to the managers of alternative contract-based entities:

[T]he Delaware Limited Liability Company Act (the “LLC Act”) contemplates that equitable fiduciary duties will apply by default to a manager or managing member of a Delaware LLC. Section 18–1104 states that “[i]n any case not provided for in this chapter, the rules of law and equity …shall govern.” 6 Del. C. § 18–1104. Like the Delaware General Corporation Law, the LLC Act does not explicitly provide for fiduciary duties of loyalty or care; consequently, the traditional rules of law and equity govern. See Auriga, 40 A.3d at 849–56. “A fiduciary relationship is a situation where one person reposes special trust in and reliance on the judgment of another or where a special duty exists on the part of one person to protect the interests of another.” The managing member of an LLC “is vested with discretionary power to manage the business of the LLC” and “easily fits the definition of a fiduciary.”

A plain reading of Section 18–1101(c) of the LLC Act is consistent with Section 18–1104 and confirms that default fiduciary duties apply.

The introductory phrase “[t]o the extent that” in Section 18–1101(c) does not imply that the General Assembly was agnostic about the ontological question of whether fiduciary duties exist in limited liability companies. The same phrase appears in the parallel provision in the Delaware Limited Partnership Act (the “LP Act”), 6 Del. C. § 17–1101(d), and there has never been any serious doubt that the general partner of a Delaware limited partnership owes fiduciary duties. As the Chancellor explained in Auriga, the introductory phrase “makes clear that the statute does not itself impose some broader scope of fiduciary coverage than traditional principles of equity.” Put differently, the phrase “[t]o the extent that” embodies efficiency in drafting by the organs of the bar responsible for overseeing the alternative entity statutes and recommending changes to the General Assembly.[4]

A number of states follow similar approaches to the question of default duties.  The Massachusetts Limited Liability Company Act assumes that managers have default fiduciary duties.[5]  Such duties, however, may be amended and even eliminated by contract via the certificate of organization or written operating agreement.[6]
Rather than assume or imply the existence of default fiduciary duties, a number of states have established such duties expressly by statute.  In California and New York, for example, the LLC laws clearly set forth that a manager is subject to the same fiduciary duties as a corporate director; namely, the duties of care and loyalty.[7]  The California act is particularly specific:

(a) The fiduciary duties that a member owes to a member-managed limited liability company and the other members of the limited liability company are the duties of loyalty and care under subdivisions (b) and (c).

(b) A member's duty of loyalty to a limited liability company and the other members is limited to the following:

(1) To account to a limited liability company and hold as trustee for it any property, profit, or benefit derived by the member in the conduct and winding up of the activities of a limited liability company or derived from a use by the member of a limited liability company property, including the appropriation of a limited liability company opportunity.
(2) To refrain from dealing with a limited liability company in the conduct or winding up of the activities of a limited liability company as or on behalf of a party having an interest adverse to a limited liability company.
(3) To refrain from competing with a limited liability company in the conduct or winding up of the activities of the limited liability company.

(c) A member's duty of care to a limited liability company and the other members in the conduct and winding up of the activities of the limited liability company is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.

(d) A member shall discharge the duties to a limited liability company and the other members under this title or under the operating agreement and exercise any rights consistent with the obligation of good faith and fair dealing.

(e) A member does not violate a duty or obligation under this article or under the operating agreement merely because the member's conduct furthers the member's own interest.

(f) In a manager-managed limited liability company, all of the following rules apply:

(1) Subdivisions (a), (b), (c), and (e) apply to the manager or managers and not the members.
(2) Subdivision (d) applies to the members and managers.
(3) Except as otherwise provided, a member does not have any fiduciary duty to the limited liability company or to any other member solely by reason of being a member.[8]

Both California and New York recognize that the default fiduciary duties of managers can be amended by contract.[9]  The New York Appellate division has held that:

While it is true [] that partners are accountable as fiduciaries and owe a duty of good faith and fairness to their partners, the parties to a partnership may include in the partnership articles any agreement they wish, including contemplated and authorized self-dealing, and the agreement as so written controls.”[10]

Other states opt for a more restrictive approach, in keeping with the Revised Uniform Limited Liability Company Act (“RULLCA”) drafted by the National Conference of Commissioners on Uniform State Laws in 2006.[11]  In Florida, which substantially adopted the RULLCA, the duties of care and loyalty for managers may not be modified or eliminated if the modification would be “manifestly unreasonable.”[12]  The question of whether a modification of a fiduciary duty is manifestly unreasonable is one of law for the court to determine:

(5) The court shall decide as a matter of law whether a term of an operating agreement is manifestly unreasonable under paragraph (3)(f) or paragraph (4)(c).  The court:

(a) Shall make its determination as of the time the challenged term became part of the operating agreement and shall consider only circumstances existing at that time; and
(b) May invalidate the term only if, in light of the purposes, activities, and affairs of the limited liability company, it is readily apparent that:

1. The objective of the term is unreasonable; or
2. The term is an unreasonable means to achieve the provision's objective.[13]

Other states adopting portions or all of the RULLCA, including New Jersey and Illinois, follow a similar standard, either allowing modification of fiduciary duties where not “manifestly unreasonable” or restricting modification but allowing the establishment of contractual categories of activities not deemed to be violations of a duty (again, under a “manifestly unreasonable standard of review).[14]  Unfortunately, the somewhat nebulous wording has yet to be interpreted in any major jurisdiction.  The invitation for courts to become arbiters of what is “unreasonable” may be troubling for a practitioner attempting to determine the enforceability of contractual limitations to fiduciary duties.[15] Nevertheless, an article published by the New Jersey State Bar Association strikes a somewhat reassuring chord:

In deciding whether a term is manifestly unreasonable, a court must “make its determination as of the time the challenged term became part of the operating agreement and by considering only circumstances existing at that time.” A court may only invalidate a provision as manifestly unreasonable “if, in light of the purposes and activities of the limited liability company, it is readily apparent that: (a) the objective of the term is unreasonable; or (b) the term is an unreasonable means to achieve the provision's objective.” Given this restrictive standard of review, manifestly unreasonable challenges will likely be a narrow avenue of relief for litigants whose operating agreements bar fiduciary-duty claims.[16]

A minority of states adopt an even more constrained approach to the contractual modification of fiduciary duties by prohibiting any relaxation of the duties, even if agreed to contractually.  Pennsylvania, for example, subjects managers to the full range of corporate fiduciary duties.[17]  The Pennsylvania LLC statute expressly provides that “[a] written provision of the operating agreement may increase, but not relax, the duties of representatives of the company to its members under those [corporate] sections [of the statute].”[18]
At the opposite end of the spectrum, Texas courts have never held that fiduciary duties exist by default for managers of an LLC.  Rather, whether fiduciary duties exist is a question of fact determined by interpretation of the agreement or agreements governing the company.[19] 

[1]           Unless otherwise specified, in this chapter the term “managers” includes the holders of analogous in entities other than LLCs, such as general partners in a limited partnership, as well as a member or other equity owner exercising managerial power.
[2]           6 Del. C. § 18-1101(c) (emphasis added).  See also 6 Del. C. § 17-1101(c), which contains analogous language with respect to limited partnerships; Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 163-164 (Del. 2002) (implying that fiduciary duties of a general partner are established by contract rather than by default and that “a limited partnership agreement may provide for contractually created fiduciary duties substantially mirroring traditional fiduciary duties that apply in the corporation law”).
[3]           Myron T. Steele, “Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies,” 32 Del. J. Corp. L. 1 (2007); see also, e.g., Myron T. Steele, “Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies,” American Business Law Journal, 46: 221–242 (2009); Lewis H. Lazarus and Justin C. Jowers, “Fiduciary Duties of Managers of LLCs: The Status of the Debate in Delaware,” Business Law Today (February 2012).
[4]           Feeley v. NHAOCG, LLC, 62 A.3d 649, 661-62 (Del. Ch. 2012) (citing 6 Del. C. § 18–1104; Auriga Capital Corp. v. Gatz Properties, LLC, 40 A.3d 839 (Del. Ch. 2012),  Gatz Properties, LLC v. Auriga Capital Corp., 59 A.3d 1206 (Del. 2012); Metro Ambulance, Inc. v. E. Med. Billing, Inc., 1995 WL 409015, at *2 (Del. Ch. July 5, 1995)); accord, Ross Holding and Management Co., et al. v. Advance Realty Group, LLC, et al., 2014 WL 4374261, at **12-15 (Del. Ch. Sept. 4, 2014).  It is further worth noting that Vice Chancellor Laster based much of the relevant portions of the Feeley opinion on dicta contained in then-Chancellor Leo Strine’s decision in Auriga.  Chancellor Strine succeeded Steele as Chief Justice of the Delaware Supreme Court on January 29, 2014.
[5]           Mass. Gen. Laws 156C § 8.
[6]           Knapp v. Neptune Tower Associates, et al., 892 N.E.2d 820, 824 (Mass. App. 2008).
[7]           E.g., N.Y. Limit. Liab. Co. § 409(a).
[8]           Cal. Corp. Code § 17704.09.
[9]           Cal. Corp. Code § 17701.10(e); In re Die Fliedermaus LLC, 323 B.R. 101, 110 (Bankr. S.D.N.Y. 2005). 
[10]          Carella v. Scholet, 5 A.D.3d (N.Y.A.D. 2004) (dismissing claims for breach of fiduciary duty predicated on self-dealing conduct expressly authorized in a limited partnership agreement, and citing Pace v. Perk, 81 A.D.2d 444 (N.Y.A.D. 1981); Riviera Congress Assoc. v. Yassky, 223 N.E.2d 876 (N.Y.A.D. 1966); Lanier v. Bowdoin, 24 N.E.2d 732 (N.Y.A.D. 1939)).
[11]          Rev. Unif. Lim. Liab. Co. Act § 110 (2006).
[12]          Fla. Stat. § 605.0105(4)(c).  The statute is silent regarding what “other fiduciary duty” may exist.
[13]          Fla. Stat. § 605.0105(5); see also Fla. Stat. § 620.1110 (2) (stating that a limited partnership agreement may not eliminate or “unreasonably” modify the duty of loyalty or care).
[14]          E.g., N.J. Stat. § 42:2C-11(h); 805 Ill. Comp. Stat. § 180/15-5. 
[15]          Indeed, this language seems to fly in the face of the well-settled legal principal, articulated by courts throughout the Anglosphere, that the judiciary will not rescue a party from the adverse effects of an inadvisable, but otherwise unenforceable contractual provision, or seek to substitute the court’s notion of reasonableness for the parties’ express agreement.  See, e.g., Eurofins Panlabs, Inc. v. Ricerca Biosciences, LLC, 2014 WL 2457515, at *1 (Del. Ch. May 30, 2014); Kostyszyn v. Martuscelli, 2015 WL 721291, at **4-5 (Del. Super. Feb. 18, 2015).
[16]          Andrea J. Sullivan and Steven B. Gladis, “New Remedies for LLC Members Oppression and Fiduciary Duties Under the Revised Uniform Limited Liability Company Act,” 287 N.J. Law. 72, 74 (April 2014) (emphasis added and internal citations omitted).
[17]          15 Pa. Stat. § 8943(b)(1) (subjecting managers of an LLC to Sections 1711 through 1717 of the corporate statute); see also, e.g., Jarl Investments, L.P. v. Fleck, 937 A.2d 1113, 1122-1123 (Pa. Super. 2007) (imposing default fiduciary duties on general partners of an LP).
[18]          15 Pa. Stat. § 8943(b)(1) (emphasis added).
[19]          Entertainment Merchandising Technology, L.L.C. v. Houchin, 720 F. Supp. 2d 792, 797 (N.D. Tex. 2010) (citing Gadin v. Societe Captrade, 2009 WL 1704049 (S.D. Tex. June 17, 2009); Suntech Processing Sys., L.L.C. v. Sun Comm., Inc., 2000 WL 1780236 (Tex. App. 2000); Kaspar v. Thorne, 755 S.W.2d 151,155 (Tex. App. 1988)).  Note, however, that Texas appears to take a different approach, similar to the RULLCA standard, with respect to partnerships (including limited partnerships).  Tex. Bus. Orgs. Code § 152.002.