Closely held companies are like marriages but without the sex or kids to hold things together. And just like some marriages, closely held companies can fall apart. Sometimes these “business divorces” and the painful litigation they generate are inevitable. Business partners have different personalities, expectations regarding finances and strategies for interacting with the world and one another. Some business divorce litigation involving limited liability companies might be resolved more easily or avoided altogether with the operating agreement’s inclusion of thoughtfully drafted provisions that address the owners’ fiduciary and other duties.
Many transactional practitioners devote significant time to drafting and refining complex capitalization structures and distribution waterfalls in their operating agreements. In our experience, nearly all business divorce litigation arises from alleged breaches of fiduciary duties. In such cases, the operating agreements typically are either silent as to what fiduciary or other duties govern the relationships between the parties or give the topic short shrift. These shortcomings may be the result of the mistaken belief among many practitioners that fiduciary duties are neatly defined by statute or caselaw and need not be spelled out in the agreements themselves.
Fiduciary duties generally, and within the context of limited liability companies more specifically, are subject to slippery rules and definitions. For years, Delaware courts have struggled with the concept. Pennsylvania’s jurisprudence, which is not nearly as well developed, has adopted a certain “I know it when I see it” method for identifying such duties. Given the limitless ways a manager can run a business without the requisite care or checks on self-dealing, defining the scope of fiduciary duties is perhaps an inherently fact-intensive exercise that necessitates this ad hoc approach.
Further complicating the landscape is that the duty of good faith and fair dealing is implied in most contracts. This duty is independent of other fiduciary duties. Although it is not clear under the pre-2016 version of the Pennsylvania LLC law whether an operating agreement is subject to the implied duty of good faith and fair dealing, the Pennsylvania Uniform Limited Liability Company Act of 2016 (the act) expressly imposes one (Section 8849.1(d)). The duty is often discussed as a “gap filler” that addresses conduct violating the spirit of a contract. We think of it, less formally, as a “don’t be a jerk” rule.
The transactional practitioner that defers to these foggy standards by not addressing them in the operating agreement is likely to invite litigation between the parties to the operating agreement. Fiduciary standards imposed by court decisions or statutes may conflict with the expectations of business owners. This disconnect between what an owner thinks they can do under the ill-defined terms of the operating agreement and what the court- or statutorily defined fiduciary duties permit is fodder for potential litigation should the parties’ business relationship go awry.
Given that limited liability companies are creatures of contract, there is no reason not to address fiduciary duties in a company’s operating agreement. Pennsylvania, like many states including Delaware, allows operating agreements to modify the traditional corporate fiduciary duties—i.e., the duty of care and duty of loyalty—and the duty of good faith and fair dealing. Modifying these provisions requires thoughtful and precise drafting. For example, while the act permits the alteration of the duty of care, the act ostensibly prohibits the elimination of this duty. In this regard, a generalized disclaimer that “all fiduciary duties are eliminated” or “the parties hereby disclaim the covenant of good faith and fair dealing” is unlikely to be effective. Moreover, modifications can be made only when they are not “manifestly unreasonable.” Thus, the only way to modify, or attempt to eliminate, these duties is to affirmatively and precisely state what they are and define their scope. Should a court ever inquire as to whether a modification is “manifestly unreasonable,” it may also be helpful to provide detailed recitals on the background of the owners’ relationship, the purpose of the company and the reasons for modifying any duties.
Well-drafted duty-of-care provisions should, at a minimum, address the applicable standard of care and the scope of the business judgment rule, exculpation from monetary damages for breach of the duty and the advancement litigation expenses. In crafting these provisions, practitioners should consider the following questions, among others: Is the standard for the duty of care negligence, gross negligence or something else? To what extent can a manger or controlling person rely on information provided by others? Should the managers or controlling members be liable to the company for the monetary damages that result from a breach of the duty of care? Should they receive indemnity or advancement of fees for litigation expenses in the event of an alleged beach?
The duty of loyalty is particularly important in the context of closely held businesses. If controlling owners are going to compete with the company, charge it a fee, cause it to deal with an affiliate or be employed by the business, those issues should all be addressed in the operating agreement. The act encourages this type of specificity by allowing an operating agreement to “identify specific types or categories of activities that do not violate the duty of loyalty.” The agreement should also identify a procedure by which the noncontrolling members can review activities that might otherwise violate a duty of loyalty.
The act allows the parties to prescribe the standards, if not manifestly unreasonable, by which performance of the contractual obligation of good faith and fair dealing is measured. As a practical manner, the obligation is so amorphous that it is difficult to articulate how it should be modified. The obligation, however, cannot contradict the express terms of an agreement. Therefore, careful drafting of the fiduciary duty sections helps to minimize the unexpected invocation of the duty of good faith and fair dealing. Practitioners should nevertheless codify this principal by making clear that whatever duty it creates, such duty cannot supplant the express terms or duties articulated elsewhere in the operating agreement.
Much like including certain provisions in a prenuptial agreement may give rise to awkward conversations between partners before getting married, including these provisions in an operating agreement may provoke uncomfortable discussions between owners at the outset of a new venture. Transactional practitioners should nevertheless encourage those discussions and address owners’ concerns head-on. Resolving these issues up-front will likely avoid punting them to litigators and courts in the back-end and prevent unnecessary or unnecessarily contentious litigation.
Reprinted with permission from the September 20, 2018 issue of The Legal Intelligencer.
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