Operating Agreements That Modify Fiduciary Duties


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Statutory Fiduciary Duties May Be Limited or Eliminated – Sometimes

 

A Series on New Jersey’s Adoption of the Revised Uniform Limited Liability Company Act

 

The revised limited liability company law that takes effect in March 2013 creates a new statutory structure of fiduciary duties for LLC members and managers.  The statutory standards are floor, not a ceiling, and courts are still able to find a duty based on the circumstances at issue.  Limited liability companies may alter or amend those duties by statute – or ratify a breach after it has occurred – but not without limits.

The new law is a significant improvement over the existing law, which is largely silent on the precise duties owed by members and managers to an LLC.  The current law seems to presume that the members will define these duties for themselves; an assumption that in practice is often not true.  It also opens the door to business practices that may be oppressive and assumes that all have an equal say in the terms under which an agreement is organized.  The new law adopts a “manifestly unreasonable” standard that limits the ability of LLC members to create businesses under contracts that include oppressive provisions.

The drafters of the Revised Uniform Limited Liability Company Act (RULLC) noted that the model statute

rejects the ultra-contractarian notion that fiduciary within a business organization is merely a set of default rules and seeks instead to balance the virtues of “freedom of contract” against the dangers that inescapably exist when some have power over the interest of others.

 

No Limits Under Current LLC Law to Eliminate Member Duties

The current law does not seem to impose any limits on the ability to eliminate or modify fiduciary duties (N.J.S.A. 42:2B-66).  We often see special-purpose LLCs in which the relationship of the members is an arms-length contract; they are free to compete and owe no duties of care or loyalty.  These agreements will be problematic under the new law because the waiver may be ineffective.

Another word of warning that current operators of LLCs should consider is that the definition of operating agreement is much broader under the new law than under current law which provides that an operating agreement, if it exists, must be written.  Members can expect that the courts will look at the actual practices of the LLC, not just what has been included in the operating agreement (N.J.S.A 42:2C-2).  Under the RULLC, there is no such thing as an LLC without an operating agreement because just about anything can be an operating agreement.  It is any agreement – written, oral or implied – that governs any aspect of the LLC’s business.

The RULLC defines the fiduciary duties created by default under the statute, and prescribes a duty of good faith and fair dealing. Those duties may be eliminated or restricted when to do so is not “manifestly unreasonable.”

Fiduciary Duties May Be Restricted or Eliminated

The statute provides that the operating agreement may restrict or eliminate the duties

  • to hold any property of benefit derived from the LLC,
  • to refrain from dealing with the LLC on behalf of someone with an adverse interest,
  • to refrain from competing with the LLC, or
  • to exercise due care, except to permit intentional misconduct or knowing violation of the law.

Because the statute foresees other fiduciary duties that may arise out of particular circumstances, it also permits the LLC to “identify specific types or categories of activities that do no violate the duty of loyalty” and to “alter any other duty, including eliminating the particular aspects of that duty.”  The RULLC also permits the operating agreement to provide explicit standards by which to “measure the contractual obligation of good faith and fair dealing.”

There are some areas of law that are off limits.  The operating agreement may not alter the law applied to the internal affairs of the limited liability company, restrict the court’s power to judicially dissolve the LLC, unreasonably restrict the right of the members to bring an action under the LLC act or to void the veto power of any member over a business combination that would result in that member having personal liability.

The Manifestly Unreasonable Standard

The new statute in N.J.S.A. 42:2C-11 contains specific guidelines for applying the “manifestly unreasonable standard” that in the event of a dispute appears to make the application of the standard a threshold question for a judge:

h. The court shall decide any claim … that a term of an operating agreement is manifestly unreasonable. The court:

(1) shall 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; and

(2) may invalidate the term only 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.

There is one perhaps significant distinction between the model act drafted by the National Conference of Commission Uniform State Laws and the act adopted in New Jersey, which is the tip of the hat given to freedom on contract in a rule of construction not found in the model statute.

“This act is to be liberally construed to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.”

It seems unlikely that a rule of construction is likely to have much affect on the individual application of the manifestly unreasonable standard, but one can see the scales tipped ever so slightly in favor of freedom of contract in a close case.

The changes to the law, which will take effect for existing LLCs in 2014, are such that many operating agreements should be reviewed and revised.  The new statute is a clear improvement over existing law, but likely will be problematic for LLCs with operating agreements drafted under the existing statute.

§ N.J.S.A 42:2C-2 provides that

“Operating agreement” means the agreement, whether or not referred to as an operating agreement and whether oral, in a record, implied, or in any combination thereof, of all the members of a limited liability company, including a sole member, concerning the matters described in subsection a. of section 11 of this act.  The term includes the agreement as amended or restated.

As always, we welcome your questions or comments.

 

§ 42:2C-11. Operating agreement; scope, function, and limitations [Effective March 18, 2013]

a. Except as provided in subsections b. and c. of this section, the operating agreement governs:

(1) relations among the members as members and between the members and the limited liability company;

(2) the rights and duties under this act of a person in the capacity of manager;

(3) the activities of the company and the conduct of those activities; and

(4) the means and conditions for amending the operating agreement.

b. To the extent the operating agreement does not otherwise provide for a matter described in subsection a of this section, this act governs the matter.

c. An operating agreement may not:

(1) vary a limited liability company’s capacity under section 5 of this act to sue and be sued in its own name;

(2) vary the law applicable under section 6 of this act;

(3) vary the power of the court under section 21 of this act;

(4) subject to subsections d. through g. of this section, eliminate the duty of loyalty, the duty of care, or any other fiduciary duty;

(5) subject to subsections d. through g. of this section, eliminate the contractual obligation of good faith and fair dealing under subsection d. of section 39 of this act;

(6) unreasonably restrict the duties and rights stated in section 40 of this act;

(7) vary the power of a court to decree dissolution in the circumstances specified in paragraphs (4) and (5) of subsection a. of section 48 of this act;

(8) vary the requirement to wind up a limited liability company’s business as specified in subsection a. and paragraph (1) of subsection b. of section 49 of this act;

(9) unreasonably restrict the right of a member to maintain an action under Article 9 (sections 67 through 72 of this act);

(10) restrict the right to approve a merger, conversion, or domestication under section 86 of this act to a member that will have personal liability with respect to a surviving, converted, or domesticated organization; or

(11) except as otherwise provided in subsection b. of section 13 of this act, restrict the rights under this act of a person other than a member or manager.

d. If not manifestly unreasonable, the operating agreement may:

(1) restrict or eliminate the duty:

(a) as required in paragraph (1) of subsection b. and subsection g. of section 39 of this act, to account to the limited liability company and to hold as trustee for it any property, profit, or benefit derived by the member in the conduct or winding up of the company’s business, from a use by the member of the company’s property, or from the appropriation of a limited liability company opportunity;

(b) as required in paragraph (2) of subsection b. and subsection g. of section 39 of this act, to refrain from dealing with the company in the conduct or winding up of the company’s business as or on behalf of a party having an interest adverse to the company; and

(c) as required by paragraph (3) of subsection b. and subsection g. of section 39 of this act, to refrain from competing with the company in the conduct of the company’s business before the dissolution of the company;

(2) identify specific types or categories of activities that do not violate the duty of loyalty;

(3) alter the duty of care, except to authorize intentional misconduct or knowing violation of law;

(4) alter any other fiduciary duty, including eliminating particular aspects of that duty; and

(5) prescribe the standards by which to measure the performance of the contractual obligation of good faith and fair dealing under subsection d. and subsection g. of section 39 of this act.

e. The operating agreement may specify the method by which a specific act or transaction that would otherwise violate the duty of loyalty may be authorized or ratified by one or more disinterested and independent persons after full disclosure of all material facts.

f. To the extent the operating agreement of a member-managed limited liability company expressly relieves a member of a responsibility that the member would otherwise have under this act and imposes the responsibility on one or more other members, the operating agreement may, to the benefit of the member that the operating agreement relieves of the responsibility, also eliminate or limit any fiduciary duty that would have pertained to the responsibility.

g. The operating agreement may alter or eliminate the indemnification for a member or manager provided by section 38 of this act and may eliminate or limit a member or manager’s liability to the limited liability company and members for money damages, except for:

(1) breach of the duty of loyalty;

(2) a financial benefit received by the member or manager to which the member or manager is not entitled;

(3) a breach of a duty under section 36 of this act;

(4) intentional infliction of harm on the company or a member; or

(5) an intentional violation of criminal law.

h. The court shall decide any claim under paragraph (1) of subsection d. of this section that a term of an operating agreement is manifestly unreasonable. The court:

(1) shall 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; and

(2) may invalidate the term only 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.

i. This act is to be liberally construed to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.

 

§ 42:2B-66. Liberal construction [Repealed effective March 1, 2014]

a. This act is to be liberally construed to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.

b. To the extent that, at law or in equity, a member or manager has duties (including fiduciary duties) and liabilities relating to a limited liability company or to another member or manager: (1) any member or manager acting under an operating agreement shall not be liable to the limited liability company or to any other member or manager of the limited liability company for the member’s or manager’s good faith reliance on the provisions of the operating agreement; and (2) the member’s or manager’s duties and liabilities may be expanded or restricted by provisions in an operating agreement.