Category: Contractarianism

LLC FIDUCIARY PROVISIONS—THE CONTRACTARIANS VS. THE TRADITIONALISTS

By , March 5, 2010 9:31 am

Myron T. Steele is the chief justice of the Delaware Supreme Court.  He is an eminent jurist who has made important contributions to business organization law both in his opinions and in law journal articles.  He is also a contractarian; he believes that the parties to LLC agreements (the Delaware term for operating agreements) should have virtually unlimited contractual freedom to tailor their agreements to meet their needs and interests.

Last summer, Chief Justice Steele published an article in 46 AM. BUS. L. J. 221 entitled “Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies.”  The article makes clear his low estimation of traditional fiduciary provisions in LLC agreements and his view that, at least in the case of LLCs with sophisticated members, the courts should not apply default common law rules on fiduciary issues on which operating agreements are silent.  His article is likely to have a powerful impact not only on the Delaware courts but also on the many courts in other states that look to Delaware courts for leadership in business organization law.

I believe that the legal philosophy of contractarianism has much merit.  But I also believe that it must be balanced carefully against traditional law, above all on fiduciary matters.

Thus, I deeply disagree with many propositions in Chief Justice Steele’s article.  I think that, in the absence of strong considerations to the contrary, prospective members and managers of multi-member LLCs in Delaware and every other jurisdiction, whether or not they are sophisticated, should negotiate fiduciary issues comprehensively and should reflect the results of these negotiations in full detail in the fiduciary provisions of their operating agreements.  In my view, these provisions can have a major impact in ensuring careful, loyal LLC management and in uncovering and sanctioning manager misconduct.  I will elaborate on this view again and again in this blog.

Copyright considerations prevent me from providing a hyperlink to Chief Justice Steele’s article.  However, if you are interested in LLC fiduciary issues, I urge you to access his article on Lexis, WestLaw or elsewhere and to read it with care.  If you do so, I must warn you that it is only in the second sentence of footnote 71 of the article, the article’s next-to-last footnote, that Chief Justice Steele makes clear that his seemingly sweeping skepticism in his article about the value of common law LLC fiduciary rules is limited, at least for purposes of the article, to the application of these rules to LLCs with sophisticated members who are able to participate in the negotiation of the LLC deal in question.  It is quite beyond me why he chose to bury this critical point in footnote 71.

Finally, if, after reading Chief Justice Steele’s article, you’d like to consider an opposing view, the February 24, 2010 issue of the CCH LLC Advisor has published my rejoinder to it.  Click here to read my rejoinder.

DRAFTING STANDARD-OF-CARE PROVISIONS IN OPERATING AGREEMENTS FOR MULTI-MEMBER LLCs

By , February 10, 2010 2:37 pm

DRAFTING STANDARD-OF-CARE PROVISIONS IN <BR>OPERATING AGREEMENTS FOR MULTI-MEMBER LLCs

Lawyers of the contractarian school believe that the negotiation and drafting of fiduciary provisions in LLC operating agreements, including provisions covering the two classic duties of care and loyalty, are a waste of time and money—in fact, a bit quaint.

I disagree. I think that well-drafted operating agreement fiduciary provisions can do a lot to encourage sound LLC management and to prevent and remedy mismanagement.

The key issue in drafting duty-of-care provisions is to choose the right standard of care. If you’re representing managers and, as is often the case, these managers want to minimize the risk that members will sue them for negligence, you can eliminate the duty of care altogether under § 18-1101(c) of the Delaware Limited Liability Company Act and under similar provisions of a few other LLC acts. Or if that won’t fly, you can provide that the sole duty of care of the managers will be to avoid gross negligence. Under the relevant case law of Delaware and other states, this generally means that only intentional negligence can trigger manager liability.

However, if you’re representing the members and want good management, you’ll probably want the operating agreement to contain some variant of the “ordinary prudence” standard.

Classically, this means providing that in managing the LLC, “managers shall perform their duties with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances.” This, for example, is the formulation of the ordinary prudence standard in Section 409 of the New York Limited Liability Company Law (under which, as I read it, the standard is mandatory and can’t be reduced or eliminated).

I’m no opponent of the New York formulation. However, I think its focus on prudence as such doesn’t quite take into account the fact that in most LLCs, managers, unlike corporate directors, have not only a prudential role but also a very hands-on one.

Thus, the duty and standard of care in Section 17 of Form 6.2 in my Wolters Kluwer general LLC practice manual and formbook are as follows:

Section 17 MANAGERS’ DUTY OF CARE

17.1 Manager’s Fiduciary Duty of Care; Standard of Care

The managers shall owe a duty of care to the LLC and to the other members. The standard of care shall be competence (as defined in Section 17.2).

17.2 Competence— Definition

The managers shall be deemed to perform their duties under this Agreement competently if they perform them with the knowledge, judgment, skill, diligence, initiative and timeliness that an ordinarily competent person in a like position would use under similar circumstances.

Form 6.2 is the template form in the above book. If you want to view it in its entirety, click here. The above “competence” standard is based on the standard of lawyer competence in the American Bar Association’s Rules of Professional Conduct.

However, there is yet another option in defining the duty of care of LLC managers in an LLC operating agreement that may, in some cases, be the best of all. This is to spell out in the agreement not only the applicable standard of care but also the specific types of management skill and experience managers must possess—e.g., skill and experience in marketing specified types of products and services; in sales; in financial projections; in specified foreign languages or specified software applications.

Finally, if you really want to put the managers’ feet to the fire, you can make them expressly represent in the operating agreement that they possess these skills and this experience.