The Duty of Care in the Llc: Maintaining Accountability While Minimizing Judicial Interference

• Publication year: 2021

87 Nebraska L. Rev. 125. The Duty of Care in the LLC: Maintaining Accountability While Minimizing Judicial Interference

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Sandra K. Miller(fn*)

The Duty of Care in the LLC: Maintaining Accountability While Minimizing Judicial Interference

TABLE OF CONTENTS

I. Introduction ....................................................... 126

II. Policy Goals ...................................................... 130 A. The Public Interest and the Economic Role of the LLC ............................................................ 132 B. Investor Confidence ............................................ 134 C. The Descriptive Role ........................................... 135 D. The Socializing, Expressive, and Deterrent Roles ............... 136 E. The Remedial Role .............................................. 137 F. Encouraging Service and Appropriate Judicial Intervention ................................................... 137

III. Partnership and Corporate Models ................................. 138 A. The Shortcomings of the Revised Uniform Partnership Act ............................................... 141 B. The Advantages and Shortcomings of the Corporate Model ......................................................... 145

IV. Statutes, Indemnification, and LLC Case Law ......................... 153 A. A Range of Standards ........................................... 154 B. Contractual Definition ......................................... 154 C. Indemnification Restrictions ................................... 157 D. LLC Duty of Care Case Law and Standards of Conduct ........................................................ 159 1. The Infrastructure Cases .................................... 160

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2. The Duty to Actively Assume Management Duties ...................................................... 162 3. Guidance on Gradations of Care .............................. 164 4. Circumventing Corporate Duties Through the LLC ......................................................... 167

V. Recommendations for Duties in the LLC .............................. 169 A. The Duty to Act Reasonably is Rooted in Agency Law ............................................................. 171 B. Fine-Tuning to the Facts and Circumstances and Suitable to a Unified Business Entity Statute ................... 172 C. A Socializing Influence for the Private Market .................. 174 D. Fulfilling the Remedial Role .................................... 178 E. Consistency with Overall Goals of Tort and Other Business Laws ................................................... 180 F. A Balanced Approach is Recommended .............................. 180

VI. Conclusion ........................................................ 183

Appendix A. LLC Statutes .............................................. 184

Appendix B. Good Faith/Prudent Person ................................. 186

Appendix C. Gross Negligence/Willful Misconduct ....................... 187

Appendix D. Indemnification: Best Interests ........................... 188

Appendix E. Indemnification: Other Restrictions ....................... 189

Appendix F. Indemnification Without Restrictions ...................... 190

Appendix G. Sample Statutory Language ................................. 191

Appendix H. Sample Statutory Language ................................. 193

Appendix I. Ratio of LLC Filings to Corporate Filings, 2006 ...................................................... 195

I. INTRODUCTION

Limited Liability Companies (LLCs) are now publicly as well as privately owned. They may provide critical nursing home care, engage in environmental remediation involving toxic chemicals, or provide electrical power in Iraq or elsewhere. At what point should investors be able to remove an errant LLC manager and/or obtain damages where the manager is neglecting patients or not diligently handling chemicals? The National Conference of Commissioners on Uniform State Laws (NCCUSL) has grappled with this question in the revision of its Uniform Limited Liability Company Act, and the American Bar Association has just begun overhauling its model LLC statute.(fn1) The Revised Uniform Limited Liability Company Act now

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defines the duty of care as being, subject to the business judgment rule, a duty to act with "the care that a person in a like position would reasonably exercise under similar circumstances and in a manner the member reasonably believes to be in the best interests of the company."(fn2) This reflects a change from the original Uniform Limited Liability Company Act, which imposed a duty to refrain from grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.(fn3) State LLC statutes are almost evenly divided between those that state that the duty of care is a duty to exercise standard care or prudence(fn4) and those that require managers to refrain from grossly negligent or intentional misconduct.(fn5) Also, conflicting positions are being taken with regard to the degree to which the duty of care may be modified by contract. Delaware permits fiduciary duties in limited partnerships and LLCs to be expanded, restricted or eliminated by contract, except for the implied contractual covenant of good faith and fair dealing--the parameters of which are expected to emerge in Delaware case law.(fn6)

Prior literature has analyzed the merits of contractual freedom in the LLC, but relatively few recent articles specifically address the duty of care and the unique attributes of the contemporary LLC manager.(fn7) The cases reviewed in this Article involve LLCs that provide

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extremely important services ranging from psychiatric care to electrical power. The analysis showcases the inappropriateness of the gross negligence standard of care which has been interpreted as involving a "devil-may-care attitude or indifference to duty amounting to recklessness"--a standard that seems particularly low for LLCs that provide important services affecting the public health and welfare.(fn8) Also, this Article offers a fresh and contemporary perspective on the duty of care and takes into account a number of developments that had not yet occurred when LLC statutes were first enacted. Treasury Regulations now permit LLCs to restrict the LLC member's withdrawal rights-- increasing the prospects of a "lock-in" effect that may leave LLC investors at the mercy of entrenched incompetent management--a possibility all too likely if the investor has executed a simple form LLC agreement without seriously studying and negotiating contractual terms, exit rights, or management termination provisions.(fn9) Also, numerous accounting scandals and duty of loyalty controversies have

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surfaced that arguably create a need to increase rather than decrease the accountability of management.(fn10)

This Article raises two major questions. First, should the duty of care be articulated as a duty to refrain from grossly negligent conduct, or is there a need for a more demanding standard such as one based upon negligence and/or reasonable care with perhaps a separate statutory articulation of the business judgment rule? Second, should extensive contractual freedom be granted permitting the LLC operating agreement to indemnify the LLC managers for all types of violations, or should the LLC statute prohibit the LLC operating agreement from indemnifying managers for certain specific types of misconduct (i.e. prohibiting indemnification for intentional wrongful acts or criminal violations, the sustained failure to perform one's duties, or the taking of improper distributions)? Following this introduction in Part I, Part II addresses the policy goals served by the duty of care. Part III explores the advantages and drawbacks of partnership and corporate models of the duty of care and critiques the duty to refrain from grossly negligent conduct--the standard contained in the Revised Uniform Partnership Act.(fn11) Part IV examines existing LLC duty of care provisions and case law and explores the disconnect between the standard of care one would expect of one discharging highly important services and the gross negligence standard.

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Part V of this Article recommends that the duty of care be statutorily defined as a duty to act reasonably, subject to the business judgment rule--the language that the author vigorously supported as a member of the NCCUSL Drafting Committee and the formulation that was ultimately adopted in the Revised Uniform Limited Liability Company Act. This position is endorsed largely because it is particularly appropriate to the LLC manager who may assume operational, officer-like duties as well as policy decision-making responsibilities associated with a corporate board of directors.(fn12) It is a standard that fulfills the socializing role of the duty of care by conveying the important social cue that responsible managerial conduct is expected of management--a message made all the more important because of the significant role LLCs now play in providing goods and services as well as quasi-governmental functions.(fn13) Also, it holds the promise of providing appropriate equitable remedies on a timely basis, thus enabling investors to intervene to remove entrenched management before the misconduct has deteriorated to the point of becoming reckless or intentionally harmful.(fn14)

II. POLICY GOALS

Many views have been expressed as to how to best formulate the duty of care applicable to LLC managers and corporate directors.(fn15) To be sound, the recommended standard must rest upon an accurate understanding of the role played by LLCs in the economy, a grasp of ex

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isting practices used by the LLC, and a clear conception of the overarching goals to be served by the legal duty of care. Specific policy...