As limited liability companies (LLCs) continue to become more prevalent, courts have begun to consider the extent to which members may waive fiduciary obligations. Recent decisions by the Delaware Court of Chancery and the New York Court of Appeals exhibit a trend that favors contractual waiver, but courts in many other states have yet to make their own contours clear.
The Delaware LLC Act expressly allows members of an LLC to insert in their Operating Agreement a provision that they do not owe each other any fiduciary duties. Notably, the Delaware Supreme Court had ruled that fiduciary duties could not be waived, but in 2004, the legislature amended the LLC Act to allow for such waivers.
What if the Operating Agreement is silent on this issue? In Feeley v. NHAOGC, LLC, the Delaware Court of Chancery ruled that if the Operating Agreement does not expressly disclaim fiduciary duties, then the managing member will owe such duties. The Delaware Supreme Court has not yet addressed this issue, and until it does, it is safer to assume that managers and managing members owe fiduciary duties in Delaware in the absence of an explicit limitation in an LLC Operating Agreement.
New York’s highest court recently enforced a contractual waiver of fiduciary duties among LLC members. In Pappas v. Tzolis, three individuals formed a New York limited liability company to acquire and manage a long-term lease for a building in downtown Manhattan. Shortly after they formed the LLC, significant business disputes arose among the members, and one of the LLC members, Tzolis, offered to buy out the other two for $1.5 million, or 20 times what they had contributed to the LLC only a year earlier. The other members accepted the offer. Seven months later, Tzolis assigned the LLC’s long-term lease to a developer for $17.5 million—or more than 200 times the departing members’ initial investment.
Not surprisingly, the former LLC members sued. The members alleged that, even before the buy-out, Tzolis had been negotiating with the developer and had failed to disclose these negotiations to the other members, in violation of his fiduciary obligation to them. Tzolis moved to dismiss.
The New York Court of Appeals affirmed the dismissal of their complaint. In the buy-out documents, the departing members certified that they:
a) Had performed their own due diligence
b) Had engaged legal counsel to advise them
c) Were not relying on any representation other than those set forth in the documents
Further, they certified that Tzolis had no fiduciary duty to them in connection with the buy-out. Based on these facts, the Court of Appeals held Tzolis owed no duty to the departing members to disclose his alleged negotiations with the developer.
In New York, therefore, it appears fiduciary duties may be waived by contract, at least where the parties are sophisticated, represented by counsel and demonstrate an understanding of the relinquished rights. Whether New York courts will extend contractual waiver of fiduciary duties in other contexts remains to be seen, but certainly the Pappas case puts counsel on notice that a contractual waiver provision must be considered when making an investment or selling an interest in an LLC.
In other states, statutes provide for a range of obligations, and courts have yet to provide guidance on their interpretation. In the state of Washington, for example, the default standard is that members do not owe any duties to other members unless an act or omission constitutes gross negligence, intentional misconduct or a knowing violation of the law. California statutes, on the other hand, appear to permit members to limit fiduciary duties, but California courts have not yet ruled on whether a party can disclaim all fiduciary duties. The Texas Limited Liability Act allows duties to be expanded or restricted, but the Texas Supreme Court has not yet ruled on the extent to which duties may be restricted. Finally, Illinois has gone in the opposite direction and imposed, by statute, the fiduciary duties of loyalty and care upon members of member-managed LLCs without providing any explicit basis for waiving such duties.
Lessons to be learned
In-house attorneys should be particularly careful to consider variations in state law when deciding where to form an LLC. Moreover, if acquiring or selling an LLC, in-house counsel should not only confirm whether the LLC Operating Agreement disclaims or limits fiduciary duties, but also confirm whether courts in the relevant jurisdiction will enforce such limitations, or will enforce limitations in an agreement outside the organizational documents.