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LLC Operating Agreements Crafting Provisions on Fiduciary Duties, Indemnification and Exculpation to Minimize Business Disputes
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TUESDAY, MARCH 27, 2012
Presenting a live 90-minute webinar with interactive Q&A
Benyamin S. Ross, Gibson Dunn & Crutcher, Los Angeles
Tammy L. Mercer, Young Conaway Stargatt & Taylor, Wilmington, Del.
Melissa K. Stubenberg, Director, Richards Layton & Finger, Wilmington, Del.
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Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved.
LLC Operating Agreements: Fiduciary Duties In Context of LLCs
Tammy L. Mercer
Young Conaway Stargatt & Taylor, LLP (302) 571-6556
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 6
7%10%
5%
5%
4%
4%
65%
Delaware
Florida
California
Texas
New Jersey
New York
Other
Source: Rodney D. Chrisman, LLCS are the New King of the Hill: An Empirical Study of the Number of New LLCs, Corporations, and LPs Formed in the United States Between 2004-2007 and How LLCs were Taxed for Tax Years 2002-2006, 15 Fordham J. Corp. & Fin. L. 459, 468-76 (2010).
• Principal place of business.
• Large firms prefer Delaware.
• Delaware Limited Liability Company Act disproportionately guides statutes of other states.
Percentage of LLC’s Formed by State, 2004-2007
Limited Liability Company Dispersion
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 7
A fiduciary relationship exists where “one person
reposes special trust in and reliance on the judgment of
another or where a special duty exists on the part of one
person to protect the interests of another.” Auriga
Capital Corp v. Gatz Props, LLC, 2012 Del. Ch. LEXIS
19, at *26-27 (Jan. 27, 2012).
Fiduciary Relationships
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 8
• Duty of Care
– Duty to act on an informed basis
• Duty of Loyalty
– Duty to protect the interests of the corporation (or
of the entity or person whose interests are being
managed).
Duties of A Fiduciary
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 9
Fiduciary Relationships In LLCs
• Managers of LLCs
– Court of Chancery has held that a manager of an
LLC qualifies as a fiduciary of the LLC and its
members.
• Non-Managing Members?
• Controlling Members?
– Kelly, 2010 Del. Ch. LEXIS 31, at *44 (Parsons,
V.C.) (Feb. 24, 2010)
Who Owes Fiduciary Duties In LLC?
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 10
Fiduciary Relationships In LLCs
• Individual Controllers of Entity Managers of LLCs
– USA Cafes and its progeny suggests there is a limited context in
which fiduciary duties extend to such individuals.
– See Bay Ctr Apartments, 2009 Del. Ch. LEXIS 54, at *37 (Apr.
20, 2009) (Strine, V.C.) (holding that a complaint stated a breach
of fiduciary duty claim against the owner of an entity that
managed the LLC where the complaint alleged that the owner
had used his control to stave off personal liability under a
guarantee).
– But see Feeley v. NHAOCG, LLC, C.A. No. 7304-VCL (Mar.
20, 2012) (questioning whether USA Cafes extends to individual
controllers of LLCs two steps removed from the LLC at issue in
the litigation).
Who Owes Fiduciary Duties In LLC?
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 11
Default Fiduciary Duties?
• Auriga Capital, 2012 Del. Ch. LEXIS 19, at *29
(Strine, C.) (Jan. 27, 2012) (“the LLC Act starts with
the default that managers of LLC’s owe enforceable
fiduciary duties”).
• Phillips, 2011 Del. Ch. LEXIS 137, at *64-65
(Laster, V.C.) (Sept. 22, 2011) (“Unless limited or
eliminated in the entity’s operating agreement, the
member-managers of a Delaware limited liability
company owe traditional fiduciary duties to the LLC
and its members”).
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 12
• Kelly, 2010 Del. Ch. LEXIS 31, at *44 (Parsons,
V.C.) (Feb. 24, 2010) (“in the absence of a contrary
provision in the LLC agreement, LLC managers and
members owe traditional fiduciary duties of loyalty
and care”).
• Atlas, 2010 Del. Ch. LEXIS 216, at *19 (Noble,
V.C.) (Oct. 28, 2010) (“in the absence of explicit
provisions in a limited liability company agreement to
the contrary, the traditional fiduciary duties owed by
corporate directors and controlling stockholders
apply”)
Default Fiduciary Duties?
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 13
• Auriga Capital
– Answers the question of whether default fiduciary
duties exist under the LLC Act in following
manner:
6 Del. C.
18-1104
LLC
Managers
Fit
Definition of
Fiduciary
Managers of
LLCs owe
default
fiduciary duties
Default Fiduciary Duties?
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 14
• Auriga Capital (cont’d)
– The existence of default fiduciary duties is
confirmed by the history of the LLC Act because
the legislature chose to insert language that permits
parties to eliminate fiduciary duties or exculpate
parties for liability as a result of breaches of
fiduciary duties See 18-1101(c) and 1101(e).
– If there are no fiduciary duties to eliminate or
exculpate, why include these provisions?
Default Fiduciary Duties?
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 15
• Chief Justice Steele has publicly expressed his view
that default fiduciary duties do not exist in LLCs.
– His view is that LLCs are creatures of statute and
in order to maximize the freedom of contract, in
the absence of the parties imposing fiduciary
duties in the contract, such duties do not exist.
– In his view, to create default fiduciary duties
would be to create a conflict between those duties
and the implied covenant of good faith and fair
dealing.
Default Fiduciary Duties?
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 16
This presentation contains general information. It is being provided for general
informational purposes and the user should not rely on information in this presentation
as legal advice. The information provided herein is not intended to establish an
attorney-client relationship. Young Conaway Stargatt & Taylor, LLP provides legal
advice only to individuals or entities with which it has established an attorney-client
relationship and such advice is based on the particular facts and circumstances of each
matter.
Defining or Eliminating Fiduciary Duties in
Limited Liability Companies
Statutory treatment of fiduciary duties (comparative analysis)
Statutory approaches to waiving or modifying fiduciary duties (comparative analysis)
Practical considerations in drafting waivers of fiduciary duties
Presented by:
Ben Ross
Associate
Los Angeles Office
333 South Grand Avenue
Los Angeles, California 90071
Tel: 213 229 7048
18
29%
31%
13%
10%
7%
10%
Delaware - No Provision
Florida - Members Owe Duties Even If Manager-Managed
New York - May Transact Business with LLC
RULLCA - No Member Duties if Manager-Managed
ULLCA - Combination of New York & RULLCA
Other
Who Owes Fiduciary Duties?
Sources: Chrisman, LLCS are the New King of the Hill, 468-76.
Ribstein and Keatinge on LLCs, 583-585.
Non-Managing Members Statutory Fiduciary Duties
(weighted by LLC formations 2004-2007)
19
Duty of Care
• Delaware – silent; reliance on reports.
• ULLCA – liable only for gross negligence, bad faith, recklessness or equivalent conduct.
• RULLCA – prudent person in similar circumstances.
• California (other) – partner style duties.
• Applicable?
26%
39%
28%
7%
Delaware - Generally Silent
ULLCA - Liable for Bad Faith, etc
RULLCA - Prudent Person
Other
Statutory Duty of Care
(weighted by LLC formations 2004-2007)
Sources: Chrisman, LLCS are the New King of the Hill, 468-76.
Ribstein and Keatinge on LLCs, 574-576.
20
Waiver of Fiduciary Duties
Sources: Chrisman, LLCS are the New King of the Hill, 468-76.
Ribstein and Keatinge on LLCs, 580-582.
Statutory Limitations on Waiver of Fiduciary Duties
(weighted by LLC formations 2004-2007) Freedom of Contract
• Most states permit the (near)
complete waiver and elimination of
fiduciary duties.
8%
18%
19%
14%
41%
Delaware - No Limitation on Waiver
Silent
New York - Some Limitations
RULLCA - Manifestly Reasonable and Approved
Other
21
Addressing Conflicts of Interest
• Know your limitations.
• Between whom?
– Kahn v. Portnoy
– In re Atlas Energy Resources, LLC,
2010 WL 1979050 (Del. Ch., 2010)
• Waive duties.
– Solar Cells
• Define approval standard.
– Brinckherhoff v. Texas Eastern
Products, 986 A.2d 370 (Del. Ch.,
2008)
35%
9%30%
11%
8%
7%
Delaware - No Provision
UPA - Consent
New York - Disinterested Approval or Fairness
Prototype - Disinterested Approval
RULLCA - Manifestly Reasonable and Approved
Other
Required Authorizations for
Conflicts of Interest
(weighted by LLC formations 2004-2007)
Sources: Chrisman, LLCS are the New King of the Hill, 468-76.
Ribstein and Keatinge on LLCs, 577-579.
22
Waiver of Fiduciary Duties
• Definition: Eliminating (or otherwise restricting) the duties of a member or manager in the LLC agreement.
• Distinguished: Not a limitation of liability (exculpation) or a right of payment or reimbursement (advancement and indemnification).
– Solar Cells, Inc. v. True North Partners, LLC,
2002 WL 749163 (Del. Ch., 2002)
23
Delaware’s Limitations on Waivers of Fiduciary Duties
• DELAWARE STATUTE 18-1101.
• Bad faith exception:
“provided that a limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.” Del Code Ann tit 6, § 18-1101.
• Clear and unambiguous.
Delaware’s Limitations on Waivers of Fiduciary Duties
• 18-1101(c)
– To the extent that, at law or in equity, a member or manager
or other person has duties (including fiduciary duties) to a
limited liability company or to another member or manager
or to another person that is a party to or is otherwise bound
by a limited liability company agreement, the member’s or
manager’s or other person’s duties may be expanded or
restricted or eliminated by provisions in the limited liability
company agreement; provided, that the limited liability
company agreement may not eliminate the implied
contractual covenant of good faith and fair dealing.
24
Delaware’s Limitations on Waivers of Fiduciary Duties
• 18-1101(e)
– A limited liability company agreement may provide for the
limitation or elimination of any and all liabilities for breach
of contract and breach of duties (including fiduciary duties)
of a member, manager or other person to a limited liability
company or to another member or manager or to another
person that is a party to or is otherwise bound by a limited
liability company agreement; provided, that a limited
liability company agreement may not limit or eliminate
liability for any act or omission that constitutes a bad faith
violation of the implied contractual covenant of good faith
and fair dealing.
25
Delaware’s Limitations on Waivers of Fiduciary Duties
• 18-1101(c) and (e) permit the elimination or
exculpation to extend to any member, manager or
other person to a limited liability company.
• Important because under USA Cafes line of cases,
individual directors/owners of an entity manager may
be liable for breach of fiduciary duty if they control
the LLC’s property to benefit themselves at the
expense of the LLC.
26
27
Practical Considerations in Drafting Waivers of
Fiduciary Duties
Proven Approaches
• Build “Express Standards” – Waive all fiduciary duties, “except as explicitly provided in the Agreement.” – Fisk Ventures, LLC v. Segal, 2008 WL 1961156 (Del. Ch., May 7, 2008)
• Addressing Conflicts of Interest – May help further avoid the implied covenant.
– Lonergan v. EPE Holdings LLC, 2010 WL 3987173 (Del. Ch., Oct. 11, 2010)
– Consider addressing corporate opportunities and affiliate transactions.
28
Practical Considerations in Drafting Waivers of
Fiduciary Duties
Use Caution When
• Trimming Duties – Adopt fiduciary duties, “except as explicitly provided in the Agreement.”
– Kahn v. Portnoy, 2008 WL 5197164 (Del. Ch., December 11, 2008)
• Selectively Waiving – Members, Managers and Officers.
– In re Atlas Energy Resources, LLC, 2010 WL 1979050 (Del. Ch., 2010)
• Overbuilding – Multiple clauses can create ambiguities.
– Bay Center Apartments Owner, LLC v. Emery Bay PKl, LLC, 2009 WL
1124451 (Del. Ch., April 20, 2009)
29
Practical Considerations in Drafting Waivers of
Fiduciary Duties
Additional Considerations
• Members and Permitted Transfers
• Withdrawal
• Intellectual Property
29
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 30
• 18-1101(c) permits the elimination of all duties
except the implied contractual covenant of
good faith and fair dealing.
• 18-1101(e) permits exculpation of liability for
breach of contract and breach of fiduciary
duties except the implied contractual covenant
of good faith and fair dealing.
Implied Covenant of Good Faith & Fair Dealing
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 31
• Only applies to developments that could not be
anticipated, and not to developments that the parties
simply failed to consider.
– Nemec v. Schrader, 991 A.2d 1120, 1126 (Del. 2010)
• A “limited and extraordinary legal remedy” designed
to protect parties from “arbitrary conduct.”
– Atlas, at *42 (citing Nemec)
Implied Covenant of Good Faith & Fair Dealing
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 32
• Contractual and not a substitute for fiduciary duties.
– Auriga, at *37 (“A generalized ‘fairness’ inquiry under the guise
of an implied covenant review is an invitation to, at best,
reinvent what already exists in another les candid guise”).
– Atlas, at *42 (“where the parties have contractually agreed to
eliminate fiduciary duties, they may not invoke the implied
covenant as a back door through which such duties may be
reimposed after the fact.
– Lonergan, 5 A.3d 1008, 1019 (Del Ch. 2010) (“To use the
implied covenant to replicate fiduciary review would vitiate the
limited reach of the concept of the implied duty of good faith
and fair dealing”) (citing to Nemec).
Implied Covenant of Good Faith & Fair Dealing
Copyright © 2012 Young Conaway Stargatt & Taylor, LLP All rights reserved. 33
• Only Extends to Parties to the Contract
- Gerber, 2012 Del. Ch. LEXIS 5, at *41-44 (Jan. 6, 2012)
(observing that because the implied covenant is contractual
only parties to the contract may breach it and that where a
contract eliminates common law duties, non-parties may be
“fully absolved” of any duties they owe, but still not be
subject to the implied covenant). Gerber is currently on
appeal to the Delaware Supreme Court.
Implied Covenant of Good Faith & Fair Dealing
www.rlf.com
LLC Operating Agreements:
Indemnification and Exculpation provisions
Melissa K. Stubenberg
Richards, Layton & Finger, P.A.
Wilmington, DE
302-651-7515
Tuesday March 27, 2012
http://www.rlf.com/
Indemnification
The Delaware Limited Liability Company Act (the
“LLC Act”) does not have any “default”
indemnification provisions
– Section 18-108 of the LLC Act permits an LLC, subject
to such standards and restrictions set forth in its LLC
Agreement, to have the power to indemnify and hold
harmless any member, manager or other person for
an against any and all claims and demands
whatsoever
– Sections 18-1101(b) of the LLC Act states that it is the
policy of the LLC Act to give maximum effect to the
principle of freedom of contract and to the
enforceability of LLC Agreements.
35
Indemnification cont’d
Consider including mandatory and/or permissive indemnification provisions in the LLC Agreement. – Potential conflict situation for management in determining to give
indemnification to themselves in discretionary provisions
– Provide standard of conduct
without a standard, a court will create one, and it likely will not indemnify for negligence
– In order to indemnify for negligence or gross negligence, must be express
» Downey v. Sanders, Del. Super., C.A. No. 93C-02-005, Graves, J. (Mar. 22, 1996) ("[The language must be] crystal clear or sufficiently unequivocal to show that the contracting party intended to indemnify the indemnitee for the indemnitee's own negligence.")
Question is how low can you go with your standard?
– James v. Getty Oil Co., 472 A.2d 33, 36 (Del. Super. 1983)(“A contract to relieve a party from its intentional or willful acts is invariably held to be unenforceable as being against clear public policy.”)
36
Sample Indemnification
Provision To the fullest extent permitted by applicable law, a
Covered Person shall be entitled to indemnification from
the Company for any loss, damage or claim incurred by
such Covered Person by reason of any act or omission
performed or omitted by such Covered Person in good
faith on behalf of the Company and in a manner
reasonably believed to be within the scope of the
authority conferred on such Covered Person by this
Agreement, except that no Covered Person shall be
entitled to be indemnified in respect of any loss, damage
or claim incurred by such Covered Person by reason of
such Covered Person's [gross negligence or willful
misconduct with respect to such acts or omissions ].
37
Indemnification cont’d
– Address Priority of Indemnification sources, if
applicable
Levy v. HLI Operating Co., Inc., 2007 WL 1500032 (Del. Ch.,
May 16, 2007)
– Corporate case but probably applicable in an LLC/LP
context as the provisions at issue were contractual in
nature
– Allow LLC to enter into separate indemnity
agreements
Choice of law considerations
Allowing different standards
– Specifically contemplate insurance
38
Sample Levy type provision
The indemnification obligation of the Company to an Indemnitee with respect to any Damages shall be reduced by any indemnification payments actually received by such Indemnitee from a Portfolio Company with respect to the same Damages. Solely for purposes of clarification, and without expanding the scope of indemnification pursuant to this Section __, the Members intend that, to the maximum extent permitted by law, as between the Portfolio Companies and the Company, this Section __ shall be interpreted to reflect an ordering of liability for potentially overlapping or duplicative indemnification payments, with any applicable Portfolio Company having primary liability, and the Company having only secondary liability. The possibility that an Indemnitee may receive indemnification payments from a Portfolio Company shall not restrict the Company from making payments under this Section __ to an Indemnitee that is otherwise eligible for such payments, but such payments by the Company are not intended to relieve any Portfolio Company from any liability that it would otherwise have to make indemnification payments to such Indemnitee and, if an Indemnitee that has received indemnification payments from the Company actually receives duplicative indemnification payments from a Portfolio Company for the same Damages, such Indemnitee shall repay the Company to the extent of such duplicative payments. If, notwithstanding the intention of this Section __, a Portfolio Company’s obligation to make indemnification payments to an Indemnitee is relieved or reduced under applicable law as a result of payments made by the Company pursuant to this Section __, the Company shall have, to the maximum extent permitted by law, a right of subrogation against (or contribution from) such Portfolio Company for amounts paid by the Company to an Indemnitee that relieved or reduced the obligation of such Portfolio Company to such Indemnitee.
39
Indemnification cont’d
Additional considerations
– Addressing former Indemnitee/Covered Person
Is term defined to cover former officers, managers etc.?
– Can provisions be amended without consent by
person benefiting from such provision?
No statutory protection in the LLC Act unlike with respect to a
corporation under the DGCL.
– Advancement of expenses
Mandatory v. Permissive provisions
– Consider limiting obligation to advance expenses to
indemnitees when claim against them is by the
Company?
40
Exculpation
Limited statutory provisions – Section 18-1101(d) of the Delaware LLC Act has a limited
statutory exculpation for liability for breach of fiduciary duty for such persons good faith reliance on the provisions of the LLC Agreement.
May be overridden by the LLC Agreement
– Section 18-406 of the Delaware LLC Act gives protection in the limited context of good faith reliance on experts with respect to valuation of assets or other facts pertinent to the existence and amount of assets from with distributions to members or creditors might properly be paid
– Section 18-1101(e) provides for exculpation provisions to be included in the LLC Agreement provided that an LLC Agreement “may not limit or eliminate liability for an act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair deal
Unclear what is a “bad faith” violation of the implied contractual covenant of good faith and fair dealing
41
Exculpation cont’d
Can we contractually define Good Faith?
Gerber v Enterprise Products Holdings, LLC,
2012 WL 34442 (Del. Ch. Jan. 6, 2012), Noble,
V.C. (appeal pending) and Brinckerhoff v.
Enbridge Energy Company, 2011 WL 4599654,
Noble, V.C. (Del. Ch. Sept. 30, 2011) (appeal
pending)
– Agreements in each case included clear fiduciary duty
waiver, with provisions permitting conflict transactions
if approved by an independent conflicts committee
– Agreements in each case also provided conclusive
presumption of good faith if the conflicts committee
relied upon an expert opinion (e.g., a fairness opinion)
42
Exculpation cont’d
Brinckerhoff offers a red flag of caution from a
drafting perspective. Section 6.10 of the LPA
created a presumption of “good faith” when the
general partner relies upon experts as to matters
that the general partner reasonably believed to
be within such person’s professional or expert
competence.
– Such presumption did not clearly extend to the board
of the general partner
– Court did not decide the issue but it was noted
43
Exculpation cont’d
Auriga Capital Corp. v. Gatz Properties, LLC,
2012 WL 361677, Strine, C (Del. Ch. January 27,
2012
– LLC Agreement contained a similar exculpation
provision as on the next slide.
– Court engaged in a detail analysis of the facts to find
that Gatz failed to act in good faith
44
Sample Exculpation:
No Covered Person shall be liable to the
Company, any Member or any other person or
entity who is bound by this Agreement for any
loss, damage or claim incurred by reason of any
act or omission performed or omitted by such
Covered Person in good faith on behalf of the
Company and in a manner reasonably believed
to be within the scope of the authority conferred
on such Covered Person by this Agreement[,
except a Covered Person shall be liable for any
such loss, damage or claim incurred by reason of
such Covered Person's [gross negligence or
willful misconduct]]. 45
www.rlf.com
This presentation and the material contained herein are provided as general information and should not be construed as legal advice on any specific matter or as creating an attorney-client relationship. Before relying on general legal information or deciding on legal action, request a consultation or information from a Richards, Layton & Finger, P.A. attorney on specific legal needs.
http://www.rlf.com/