The role of the court in balancing contractual freedom with the need for mandatory constraints on opportunistic and abusive conduct in the LLC.

• Author: Miller, Sandra K.
• Position: Limited liability company

Courts are establishing a mandatory core of acceptable business conduct within the relatively new context of the limited liability company (LLC). Outside of Delaware, courts have tailored traditional notions of corporate and/or partnership fiduciary duties to the LLC, while within Delaware, courts are developing minimum standards of conduct through restricted interpretations of contractual waivers, rigorous application of the entire fairness standard, and recourse to contractually based concepts of good faith. This Article suggests that a broad and traditional approach to fiduciary duties is preferable to a narrower analysis of entire fairness or contractually oriented good faith because a broader formulation better reflects society's norms of ethical conduct, more adequately serves all sectors of the private business community, may be more effective in combating subtle freeze-out schemes, and does not presume that the parties' relationship is governed by a highly negotiated contract. Furthermore, this Article emphasizes that courts are central to all LLC modeling, including Delaware's contractarian paradigm, and are leading the way toward the development of a mandatory frame of reference for balancing the interest in contractual freedom with the need for minimum standards to curb opportunistic and abusive conduct.

INTRODUCTION

The limited liability company (LLC) has been hailed as the entity of choice in the privately owned business arena. Freed from mandatory tax classification rules, the LLC, in addition to limiting liability, can now possess the corporate characteristic of "continuity of life" and need not dissolve when a member withdraws, dies, or becomes bankrupt. (1) Private entrepreneurs have an unparalleled range of choices for structuring LLC relationships, and LLC participants have access to the twin benefits of corporate limited liability and flow-through partnership tax status.

Two major forces contributed to the development of the LLC. First, practitioners sought the flexibility to structure their clients' internal relationships while continuing to receive favorable flow-through tax treatment. (2) Second, in an atmosphere of escalating jury awards, (3) practitioners advocated control over the legal liability of their clients with respect to both coinvestors and third parties. (4) They wanted a framework that would reduce judicial encroachment into the business deals that they negotiated and formalized. (5)

Each state, as well as the District of Columbia, now has its own LLC statute, (6) and these statutes allow a great deal of freedom in forming an LLC. (7) The statutes typically assume that the individual owners will develop their own LLC operating agreements that define their respective rights, responsibilities, and remedies. Often described as enabling legislation, the LLC statutes largely provide a series of default rules that apply in the absence of contractual provisions to the contrary. (8) While some LLC statutes contain express mandatory fiduciary duties, (9) others, particularly the Delaware LLC statute, do not. (10) Delaware's contractarian vision of business entities is evidenced in its policy to give the maximum effect to the principles of freedom of con tract and strict enforcement of LLC agreements. (11)

Now that over a decade has elapsed since the first LLCs were formed, it is an opportune time to evaluate the LLC experiment. How successful has enabling legislation been in reducing disputes among business associates? Has there been a reduction in the need for judicial intervention? Is Delaware's contractarian model leading to fewer lawsuits and increased freedom from judicial monitoring? The short answer to these questions is "no." (12)

This Article compares the developing case law on fiduciary duties both outside and inside Delaware and finds that across the board, there is a continuing need for the imposition of judicial remedies for abusive and opportunistic conduct. Regardless of whether the LLC statutes contain express fiduciary duties or, conversely, embrace a broad mandate for contractual freedom, courts are compelled to address the enduring issue of fiduciary breaches. The LLC statutes are relatively new, but abusive conduct is not. LLC cases have arisen repeatedly in which majority-owners have removed or reduced the ownership percentages of their minority partners. (13) Allegations of abusive LLC conduct have included claims that business opportunities have been stolen, (14) that LLC members have been improperly excluded, (15) and that LLC assets have been improperly transferred to another entity. (16) These classic "squeeze-out techniques," which have a long history in the close corporation setting of the past fifty years, are now surfacing in the context of the LLC. (17)

In response to these abuses, courts are formulating a mandatory core of fiduciary duties as they mediate disputes among LLC business associates. How then can this development in the LLC case law be reconciled with the contractarian model of the business entity? (18) At first glance, this external monitoring does not appear to fit within the contractarian equation that emphasizes the supremacy of the private contract and the importance of reducing transaction costs through lack of external interference. It is suggested, though, that the contractarian model can be reconciled with the mandatory core of duties emerging in LLC case law by recognizing that at the heart of the private contract is the notion that there is a legally enforceable bargain subject to the many mandatory constraints of the legal environment. (19)

The primary message of this Article is that the courts are central to all LLC models, including Delaware's contractarian paradigm, and are leading the way toward balancing the interest in contractual freedom with the need to constrain opportunistic and deceptive conduct through the development of a minimum mandatory core of acceptable business conduct. This developing LLC case law illustrates that even under Delaware's contractarian approach, the LLC is not the proper vehicle for eliminating or diminishing judicial intervention; rather, the LLC is a business entity that permits private contracting within the context of mandatory restraints. The private business entity contract can be seen as operating within a framework of mandatory fiduciary duties that may be modified, but not wholly eliminated, and that are enforced through active judicial intervention.

Part I of this Article discusses the contractarian model, its manifestations in corporate, partnership, and LLC law, and its theoretical basis. Part II examines the statutory underpinnings of fiduciary duties applicable to LLC members and managers and the policy questions that are raised. Parts Ill and IV explore the judicial monitoring of fiduciary dudes that has occurred in LLC cases both outside and inside Delaware.

In particular, Part III observes that in spite of the broad, permissive language that exalts the primacy of the contract, a mandatory core of minimum fiduciary duties appears to be thriving in Delaware through express statements by the Delaware courts and in cases requiring a showing of fundamental fairness where the presumption of the business judgment rule has been rebutted. Also, this network of minimum standards of acceptable business conduct is supported in Delaware through the courts' resourcefulness in using contractually based principles of good faith.

Next, Part IV addresses the common ground shared by courts outside and inside Delaware and argues that across all jurisdictions, the courts are defending plaintiffs against the usual litany of evils--clandestine, fundamental changes in the business, (20) unilateral transfers of assets, (21) sudden meetings that dramatically reduce the plaintiffs control of the company, (22) and the diversion of business opportunities to a competing entity. (23) Regardless of whether the judicial safeguards are described as a partnership-style duty to account for benefits of the business, a corporate-style duty to act in good faith in the best interests of the company, or a required showing of fundamental fairness based on a conflict of interest and lack of good faith, the courts appear to be fashioning a mandatory core of acceptable business conduct in the context of the LLC.

Finally, Part V of the Article emphasizes that all LLC models, including the contractarian paradigm, should acknowledge the influence of courts in an environment of private ordering, the valuable role played by equitable principles generally, and the role fiduciary duties play in reflecting ethical norms in the business community." (24)

1. THE CONTRACTARIAN THEORY OF THE BUSINESS ENTITY

   LLC statutes may be characterized as enabling legislation. While LLC statutes typically contain some mandatory rules, many simply provide default rules that apply only in the absence of contrary provisions in the parties' operating agreements. (25) Implicit in the structure of LLC legislation is the notion that parties will contractually fine-tune the parameters of their legal relationship in the governing documents of the business entity.

   A similar situation developed earlier in the corporate context regarding directors' liability for monetary damages arising out of violations of the standard of care. Here, the concept of contractually limiting director liability manifested itself in the enactment of enabling statutes that allow shareholders to insulate directors from liability by adopting certain provisions in their articles of incorporation. (26) Prompted by the decision in Smith v. Van Gorkom (27)--holding outside directors liable for gross negligence in approving a cash-out merger without properly informing themselves about the value of the company--the Delaware legislature led what soon became a national stampede toward allowing articles of incorporation to eliminate personal director liability for monetary...