LLC Managers Owe Fiduciary Duties
You may have heard about fiduciary duties, something about loyalty and care, but truth be known, you have no idea what that all means. This blog is to demystify some of the legalese.
Let’s set the scene. Your startup company is up and running. You have consulted with your startup lawyer about forming the company as a limited liability company. You have friends and family who have cheerfully invested in your budding enterprise. Can’t miss, you have told them.
Let’s say that you are the sole manager. Now you ask, what duties do you owe to your friends and family. They are after all part owners and have invested their hard-earned money into your company.
You talk with your startup lawyer and he or she explains that you owe the owners a fiduciary duty—fiduciary what, you ask? If you violate these fiduciary duties, you may be personally liable. Well, that should get your attention. This article discusses what a fiduciary duty is and who it is applied to.
Fiduciary duties on managers
Fiduciary duties come in to play when you are thinking about the limits imposed on the managers of a company.
In general, fiduciary duty serves as a safeguard from mismanagement because every person who manages the operations of the entity owns fiduciary duty to the entity’s owners. Fiduciary duties exist regardless of the entity form and is regulated by state business law and contract law.
In the context of a corporation, officers and directors of the corporation owe a fiduciary duty to the corporation and to its shareholders. When it comes to partnerships, general partners owe a fiduciary duty to each other, but in the partnership context the extent of duties and who is subject to them depends mostly on the partnership agreement.
Fiduciary duties in member managed LLCs will be different compared to manager managed LLC, because only those who manage the affairs of the company are subject to fiduciary duties. To try to prevent some confusion, when we refer to a manager in this article, we are referring to the manager of the LLC regardless of whether the manager is a manager in a manager-managed LLC or a member in a member-managed LLC.
Fiduciary duties on company managers
There are a lot of things to consider when choosing the form for your future business venture, for example: business purpose, taxes, accounting, extent to which the owner is willing to subject him or herself to personal liability and other considerations.
Related article: Negotiating LLC Operating Agreements
We are going to concentrate on the fiduciary duties imposed on managers in limited liability companies.
Related article: Manager-Managed and Member-Managed LLCs: What’s the Difference?
In manager managed LLC, members appoint a manager or managers to take care of the day to day operations of the LLC. The LLC manager can be both an outsider (not a member or owner) or a member.
Managers have a duty to the members and other managers to act in good faith and promote the interests of the LLC. Fiduciary duties include the duty of loyalty and the duty of care.
In member managed LLC, members take part in the day to day operations of the LLC, so they will owe a duty to each other and to the LLC to act in good faith and promote the interest of the LLC. In the following discussion, we refer to managers, which may mean the manager in a manager managed LLC, or means the members in a member managed LLC.
Note that LLC laws that regulate fiduciary duties are state specific, which means that some states have stricter requirement for fiduciary duties and some states allow the parties to narrow those fiduciary duties to which the manager is subjected. Indeed, you may find that a startup lawyer may recommend Delaware as the state of organization for a LLC because Delaware allows greater flexibility to the parties to negotiate the extent to which the manager or member of a LLC is subject to the fiduciary duties.
Duty of care: manage the affairs and activities of the company with care
There are two major fiduciary duties. The first is the duty of care, which is an obligation to act in the best interest of an entity and with the same level of care that a prudent person in a similar situation and under similar circumstances would exercise. A manager will not be liable if the manager acted in good faith and with a certain level of care, even if his or her decision eventually adversely impacted the LLC.
Examples of breaches of duty of care:
– While going through the dissolution the LLC has to limit expenses, instead the manager, on his own accord, decides to significantly increase his own compensation which in turn increased companies general and administrative expenses;
– Manager gets an offer from a big company to acquire the LLC, without assessing the terms of the sale and bringing the offer to the attention of the members he dismisses it on behalf of the LLC.
Duty of loyalty: be loyal to the company
The duty of loyalty is a more extensive obligation, or set of obligations, imposed on the manager. Most of the litigation revolves around the duty of loyalty. The manager owes a duty of loyalty to the LLC and to the members. Depending on the jurisdiction, the members may reduce or even eliminate the duty of loyalty. In Delaware, for example, the members can completely eliminate the duty of loyalty. But if the duty is not narrowed, it can be a major constraint on the manager.
Under the duty of loyalty, the manager has a duty not to compete with the LLC. If you think that the purpose clause in the LLC agreement is not important, think again. If the purpose of the LLC is to do anything that is allowed under the law and the manager has other business interests, he or she can easily violate the duty of loyalty. If the manager simply steers a business opportunity to one of the manager’s other companies, that in of itself could be a violation of this fiduciary duty.
Similarly, if there is a business opportunity that the manager discovers, the manager cannot take it for his or her own purposes. The manager has the duty to maintain the information of the LLC as confidential. The duty of loyalty may also include an affirmative obligation to disclose important information to the members.
Examples of breaches of duty of loyalty:
– While being a manager of company A the manager is also involved in the operations of company B, which is in the same area of business as company A. Manager decides to redirect some orders received by company A to company B, stripping company A of potential profit;
– While being a manager of company A the manager is also involved in the operations of company B, which is in the same area of business as company A. Company A has some licenses and tools that company B does not. The manager uses his or her position to allow company B to access tools and licenses of company A without demanding any compensation for the use from company B.
Remedies for breach of fiduciary duties
One remedy for breach of the manager’s duties to the owners is dissolution of the company. That’s right, a court can enter an order dissolving a company. For example, under District of Columbia law on limited liability companies,
On application by a member, the entry by Superior Court of an order dissolving the company on the grounds that the managers or those members in control of the company: (A) Have acted, are acting, or will act in a manner that is illegal or fraudulent; or (B) Have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant.
If a manager is found to violate a fiduciary duty, he or she can be personally liable for damages. The manager may also be removed from the management of the LLC through expulsion or by a judicial order. The person petitioning to the court for an expulsion also has to show actual harm from such violation in order to prevail.
Related article: Business Divorce and Small Businesses
Keep in mind that because LLC laws are state specific, the outcome of the judiciary decision as to the remedy can vary state by state. In general, courts prefer to dissolve the LLC. The reason why dissolution is preferred is that courts interpreted expulsion to be a discretionary remedy and under the principles of equity it is unfair to remove the member/manager from management but still have him be a “member” of the LLC in other ways (liability, contribution remains tied in to the LLC until its dissolution etc.) so they do not exercise this discretion very often.
There are not many situations in which expulsion of the member/manager (removal) was granted, even though LLC statutes have provisions listing the causes for which judicial expulsion is warranted.
Operating agreements may help in defining the managers’ duties
The operating agreement is an agreement among the members of a limited liability company. Some states allow the members to contract away or limit fiduciary duties in the operating agreement.
The members may also want to expand the fiduciary duties. In general, members do not have fiduciary duties to one another in a manager-managed LLC. But let’s say that in a closely-held business, the members want to impose the duty of loyalty on all the members. They can do so in the operating agreement.
Even if you don’t want to limit or expand the fiduciary duties, addressing the fiduciary duties is a good idea as it allows the members and managers to know what is expected of the managers. In other words, it can be an educational tool. And if there is a breach, the court or arbitrator will first look to the operating agreement to understand the breadth of the fiduciary duties and the remedies for their breach.
To make sure that your interests are protected, you should consult with a small business attorney before organizing an LLC or amending an existing operating agreement.