Limited liability companies are the most popular entity structure for new businesses. As a result , the law applicable to limited liability companies has become more certain in many ways.
One area where certainty has not happened is the question of the fiduciary duty of limited liability company managers. Unlike corporate law where the fiduciary duties of shareholders, directors and officers is fairly clear; in the limited liability context, clarity has not happened.
Delaware, the lead state for entity formation, is an example of the lack of clarity. Through a series of cases it was thought that a rule was beginning to emerge – that the Delaware limited liability act imposed a fiduciary responsibility on limited liability company managers. When the Delaware Supreme Court got its hands on the case, however, that rule disappeared. The Delaware Supreme Court specifically held that because of the circumstances of the case, it was leaving to another – undetermined – day the question of whether Delaware law imposed any fiduciary duty on limited liability company managers.
Another aspect of limited liability company structure that creates fiduciary duties issues is the operating agreement. As most know, the provisions of state limited liability company acts only loosely govern the terms of operating agreements. Unlike corporate bylaws and articles of organization which are highly structured and regulated, limited liability company operating agreements are mostly the product of ad hoc language. As a result, the members and managers of any particular limited liability company can create just about any set of rules they would like for their entity structure.
One of the questions arising as limited liability companies get older is whether and what fiduciary responsibility the managers and members of limited liability companies have to each other. Because of their structure, there are two sources of possible law on this question. The state statute itself and the operating agreement.
Many state laws, like Delaware state law, do not say anything specifically about fiduciary obligations of limited liability company managers and members. The statute in Massachusetts, for instance, does not impose any specific fiduciary duties on limited liability company members or managers. All it says is that the statute does not affect any fiduciary duties that might arise by operation of law. It does contain a provision that says that applicable fiduciary duties can be expanded or limited by the operating agreement and that the operating agreement may eliminate or limit liability of a member or manager for violation of fiduciary duties. The provisions of Massachusetts law that allow for the operating agreement to amend fiduciary duties and liabilities for violations of fiduciary duties has not been tested in court even though the statute has been around for at least 20 years.
Although the Delaware statute and the Massachusetts statute are similar in that they do not specifically impose a fiduciary responsibilities are limited liability company members and managers, the courts have gone in radically different directions.
Delaware courts have ruled that there is no inherent fiduciary obligation by limited liability company members and only limited inherent fiduciary obligations by limited liability company managers. Effectively, Delaware courts have ruled that the fiduciary obligations of limited liability company participants are a matter of contract.
Massachusetts courts have ruled that the members and managers of limited liability companies have effectively the same fiduciary obligations as the shareholders closely held corporations; a fiduciary obligation which is effectively the same as partners in a general partnership.
Both Massachusetts and Delaware have basically stopped there for the time being. The net result is that we know that in Delaware the fiduciary obligations of limited liability company participants is a matter of the operating agreement. We know that in Massachusetts it is a matter of inherent obligation. We know that because it is a matter of contract in Delaware, the parties presumably have the ability to change or eliminate those duties. We also know that since the Massachusetts law specifically allows for changes in fiduciary obligations in operating agreements, some level of control is in the hands of the parties.
What we do not know is the extent of that control. Is it full control? In other words, can the parties decide that they do not want to have any fiduciary obligation to each other and put that in the agreement? Are they going to be limited so that they can only reduce but not eliminate fiduciary obligations? Are different standards going to apply to different parts of the obligations?
We know from around the country that courts have taken three basic approaches to this question. Some have ruled that limited liability company participants can actually eliminate all fiduciary obligations among members and managers in the operating agreement. Other states have said that the operating agreement can limit the remedies available for breaches of fiduciary obligation but not terminate all fiduciary obligations. In other states courts have ruled that the fiduciary obligations are inherent and cannot be changed by the operating agreements. The third class is a small minority.
The bottom line is that the law is still evolving. It is not likely to settle down soon. In the meantime the prudent course would be to make a decision about what level of obligations you want in your relationship and put it in the operating agreement. You should consider adding an arbitration provision to the operating agreement so that the issue is not decided in court. That action, together with being relatively careful about your business dealings should give you about as much control as you can get over this circumstance under current law.