The best of both worlds: default fiduciary duties and contractual freedom in alternative business entities.

• Author: Miller, Sandra K.
• Position: I. Introduction through IV. Economic and Empirical Factors B. The Empirical Data 3. Unequal Bargaining Power in Some Contexts, p. 295-320 - Author abstract

1. INTRODUCTION II. FIDUCIARY DUTIES IN LLCS: RESPONSIBILITY AND AGENCY PRINCIPLES A. Fiduciary Duties: The Risk-Responsibility Connection and Default Fiduciary Duties B. Diverse Statutory Approaches to LLC Fiduciary Duties Outside of Delaware C. Need for Flexible Contractually Modifiable Terms D. Developing LLC Case Law Outside Of Delaware Recognizes Both Fiduciary Duties and the Important Role Of Contract 1. Broad-based recognition of the existence of fiduciary duties in the LLC outside of Delaware 2. Complexity Is Inevitable And Courts Can Handle It III. THE FIDUCIARY DUTY DEBATE IN DELAWARE A. The Delaware Supreme Court Acknowledges Default Fiduciary Duties in Delaware LPs and LLCs B. Rekindling of The Delaware Fiduciary Duty Debate IV. ECONOMIC AND EMPIRICAL FACTORS A. The Economic Perspective: Standard Terms, Actual Usage Of LLCS, and the Kaldor-Hicks Notion of Efficiency B. The Empirical Data 1. Fiduciary Duty Waivers in Publicly Traded Corporations: Suggestions of little bargaining 2. Fiduciary Duty Waivers in Publicly Traded LLCS and LLPS: Prevalence of Waivers with Mixed Picture On Negotiation 3. Unequal Bargaining Power in Some Contexts 4. Mixed Picture on Active Negotiation 5. Vulnerability of Going Private 6. Studies on Practitioner Experience Raise Questions About Disparities in Negotiating Power C. Investor Optimism: Does It Reduce The Likelihood that People Will Contractually Self-Protect? V. IMPLICATIONS & RECOMMENDATIONS: CONTRACTUAL FREEDOM TEMPERED BY CONSTRAINTS A. The Default Fiduciary Duty Question and Small Business B. Empirical Data Reveals a Distinctly Pro-Management Orientation C. The Implied Covenant of Good Faith and Fair Dealing Is Not a Substitute for Fiduciary Duties D. Offering the Best of Both Worlds: Contractual Freedom Subject to Constraints Via the UPA or the RULLCA E. Developing a Research Agenda VI. CONCLUSION APPENDIX A: LLC STATUTES NATIONWIDE APPENDIX B: HIGHLIGHTS OF RULES PERMITTING SOME FORM OF CONTRACTUAL ELIMINATION OF THE DUTY OF CARE AND LOYALTY APPENDIX C: PERCENTAGE OF TAX RETURNS REPORTING RECEIPTS UNDER $1,000,000 AND RECEIPTS UNDER $100,000 I. INTRODUCTION

   Imagine that Thomas and Easton each owned 50% of T & E Boating, LLC, a limited liability company (LLC) that sold small boats on the shoreline of Connecticut. Although Thomas and Easton had intended to sign an LLC operating agreement, they never got around to it. The business was run quite informally, with Thomas as the manager and Easton involved in management matters only occasionally. over the next 20 years, the company acquired a small marina. Then, unbeknownst to Thomas, Easton was contacted by Christal & Krafters, Inc., which offered to buy the business for $8,000,000. Almost immediately thereafter, knowing that Thomas was planning to re-locate, Easton offered to buy out Thomas' LLC interest for $500,000. Two weeks after buying out Thomas, Easton sold the LLC to Christal and Krafters, Inc. for $8,000,000.

   This tale is all too familiar. (1) What duty of disclosure, if any, should LLC members and investors owe, absent an LLC operating agreement? Should Thomas be able to sue Easton to effectively obtain 50% of the sales price received for the business? Should the parties have been allowed to enter into an operating agreement that eliminated all fiduciary duties? Presumably, in this context, such duties would include a duty to promote the best interests of the LLC, to be candid in disclosing material information such as an offer of purchase, an obligation not to compete, and an obligation to refrain from grossly negligent conduct or, put another way, a duty to exercise reasonable care subject to one's business judgment. (2)

   In the recent case of Gatz Properties, LLC v. Auriga Capital Corp., (3) the Delaware Supreme Court stunned the legal community by calling into question what everyone, including the Delaware Chancery Court, had always assumed--that absent express contractual language eliminating fiduciary duties, such duties apply to limited liability partnership (LLP) and LLC managers and directors. (4) An in-depth discussion of this controversy is extremely timely now that many states are updating their LLC statutes. (5) This Article discusses the most recent census data and other studies on publicly traded company, LLP, and LLC operating agreements, which reveal the extensive use of waivers without a substantial increase in other investor protections. (6) it argues that, at least until further research is done, the fiduciary duty provisions of the Revised Uniform Limited Liability Company Act (2013) (RULLCA), as modified by California, offer a compelling alternative to the Delaware paradigm: default fiduciary duties coupled with contractual freedom subject to reasonable management constraints, the best of both worlds. (7)

   Following this Introduction in Part I, Part II provides a brief discussion of fiduciary duties generally, discusses the strong connection between agency law and fiduciary duties, and addresses competing approaches to fiduciary duties applicable to LLCs. Part III focuses on the fiduciary duty debate in Delaware, and Part IV analyzes economic and empirical data on publicly traded LLCs and on practitioner experience with LLC operating agreements. Part V concludes the discussion with an agenda for interdisciplinary research.

2. FIDUCIARY DUTIES IN LLCS: RESPONSIBILITY AND AGENCY PRINCIPLES

   Corporate law has traditionally imposed an affirmative duty on management to actively assume duties. (8) Corporate directors have long owed fiduciary duties to the shareholders consisting of a duty of loyalty and a duty of care. (9) Typically, the duty of loyalty requires conduct to further the best interests of the corporation. (10) The duty of care is variously phrased, sometimes defined as a duty to act carefully or reasonably, (11) subject to the business judgment rule; or put another way, to refrain from grossly negligent decision-making. (12)

   In the corporate arena, the stringency of the above duties has been substantially reduced by judicial interpretations of statutory indemnification rules and through expansive application of the business judgment rule. (13) Delaware's Section 102(b)(7) indemnification rules permit the corporation to eliminate or limit the personal liability of a director, except for a breach of the duty of loyalty; for acts or omissions not in good faith or that involve intentional misconduct or a knowing violation of law; and for liability for other misconduct (i.e., unlawful dividends and improper personal benefits). (14) Under this approach, the corporation may indemnify the director for violations of the duty of care but not for violations of "good faith."15 However, lack of good faith has proved to be a formidable obstacle to imposing liability for extreme incompetence. (16) Only inexcusable inattentiveness or a complete abdication of duties to oversee the business has resulted in legal liability. (17)

   In LLCs, the standards of conduct for members and managers typically consist of the duty of loyalty and the duty of care. (18) The fiduciary duty of loyalty is typically a duty to act in furtherance of the best interests of the business, to avoid self-interested conduct, to have candor, and to refrain from competing with the business. (19) The duty of care consists of a duty to refrain from engaging in grossly negligent or reckless conduct, willful or intentional misconduct, or knowing violation of law. (20) While these duties appear to be formidable, their impact has been substantially softened, if not completely eliminated, because of statutory provisions that permit the contractual elimination of duties. (21) As discussed below, the view that fiduciary duties are available only if expressly adopted in an LLC operating agreement would present a dramatic break with fundamental agency law concepts, as would an approach to LLC governance permitting contractual elimination of duties without significant restrictions. (22)

   1. Fiduciary Duties: The Risk-Responsibility Connection and Default Fiduciary Duties

      The substantial elimination of fiduciary duties in LLCs and LLPs, whether through interpretations that eschew default fiduciary duties or through statutory provisions allowing the LLC to indemnify managers for "all claims, whatsoever," undermines what Professor Daniel Kleinberger has called the "fundamental risk-responsibility" premise of civil law. (23) This risk-responsibility connection is one of the central tenets of agency and property law. (24) Noting the decline in personal responsibility of managers under Delaware law, (25) Professor Kleinberger observes that the trend away from personal director accountability under Delaware corporate law actually runs counter to the law's fundamental premise that the risk of civil liability fosters careful behavior. (26) Professor Kleinberger cites the design and manufacture of products, the conduct of doctors, the ownership of intellectual property, the handling of employer liability for sexual harassment, and the handling of environmentally sensitive items as examples of how the law encourages careful behavior through the imposition of civil liability. (27)

      Agency law has long recognized the importance of regulating self-interested conduct when handling another's property interests. In recognition of a principal's vulnerability when an agent handles the principal's property, the law of agency has long imposed a duty to account. (28) Agency law prohibits dealings on behalf of an adverse party (29) and competition with the principal. (30) Further, agency law places restrictions on the use of confidential information. (31) The essential prohibitions requiring the duty to account, to refrain from competing, and to refrain from exploiting confidential information are deeply embedded in corporate and partnership law. In addition, agency principles impose the duty to "act with care, competence, and diligence normally...