When drafting operating agreements, amendments or joinders to operating agreements for limited liability companies formed in the State of California, practitioners should take note of changes to California limited liability company (LLC) law affecting the fiduciary duties of the managers and members.
On January 1, 2014, the California Revised Uniform Limited Liability Company Act (“RULLCA”) became effective. Signed into law on September 21, 2012 by Governor Jerry Brown, RULLCA replaces the Beverly-Killea Limited Liability Company Act (“Beverly-Killea”). RULLCA was intended to modernize California LLC law based on more than two decades of legal developments across the United States. Note that Beverly-Killea remains in effect to some extent for LLCs formed before January 1, 2014 for acts or transactions occurring before that date or an operating agreement or other contracts entered into prior to that date.
In defining the fiduciary duties of the managers and members of LLCs, Beverly Killea merely cross-referenced California general partnership law without being more specific. And, although the rules regarding fiduciary duties under RULLCA are opaque at best, RULLCA sets forth certain specific fiduciary duties of managers owed to members and members to each other, and how such fiduciary duties may be modified.
FIDUCIARY DUTIES UNDER RULLCA
Under RULLCA, fiduciary duties are no longer incorporated by reference from partnership law, but are specifically contained in the act. Note that RULLCA does not state that these are exclusive fiduciary duties, and a court could modify the enumerated fiduciary duties (further, other statutory schemes governing such duties could be relevant) but that discussion is beyond the scope of this article. Further, RULLCA sets forth which duties may be modified by agreement.
For a member-managed LLC, the fiduciary duties owed between members are the duty of loyalty and the duty of care. In a manager-managed LLC, the manager owes the duty of loyalty and the duty of care to the members. In general, the members do not owe these duties to each other in a manager-managed LLC solely by virtue of being a member (however, there could be some duties owed by a “controlling member” in a manager-managed LLC that are not discussed in this article). However, both the manager and the members in a manager-managed and a membermanaged LLC owe the duty of good faith and fair dealing to the members.
1. Duty of Loyalty. There are three subsets within the duty of loyalty: (1) the duty to account (and hold as a trustee any property, profit or benefit for the members (including a company opportunity)), (2) the duty to refrain from selfdealing (or acting on behalf of a person having an interest adverse to the company) and (3) the duty not to compete.
2. Duty of Care. The manager (or member in a member-managed LLC) must refrain from engaging in grossly negligent or reckless conduct, intentional misconduct or a knowing violation of the law.
3. Obligation of Good Faith & Fair Dealing. Managers and members of LLCs must discharge their duties to the LLC and the members under RULLCA or the LLC’s operating agreement and exercise any rights consistent with the obligation of good faith and fair dealing.
Modifying Fiduciary Duties
While RULLCA allows modifications, RULLCA prohibits operating agreements from eliminating all together the duty of loyalty, the duty of care or any other fiduciary duty, and the obligation of good faith and fair dealing.
1. Duty of Loyalty. An operating agreement may identify specific types or categories of activities that do not violate the duty of loyalty if not manifestly unreasonable and specify the number or percentage of members that may authorize or ratify, after full disclosure to all members of all material facts, a specific act or transaction that would otherwise violate the duty of loyalty.
2. Duty of Care. The duty of care may not be unreasonably reduced, but may be modified to the statutory minimum by limiting the duty of care to refraining from grossly negligent or reckless conduct, intentional conduct or a knowing violation of the law.
3. Obligation of Good Faith and Fair Dealing. An operating agreement may specify the standards by which performance of the obligation of good faith and fair dealing is to measured, so long as the standards are not “manifestly unreasonable” at the time the standards are prescribed. For example, standards may be implemented such as “if the manager makes a decision based on the manager’s honest belief” or “if a disinterested party knowledgeable in the matter states that such action would be agreed to by persons at arm’s length and in comparable circumstances."
MANAGER/MEMBER INDEMNITIES AND FIDUCIARY DUTIES
Under Beverly-Killea indemnification of members and managers by the LLC was optional. Under RULLCA, indemnification of managers and members is the default rule, but an operating agreement may modify a manager’s (or a member’s in member-managed LLC) right to indemnification; provided, however, that RULLCA requires each LLC to reimburse for any payment made and indemnify for any debt, obligation or other liability incurred by a member of a member-managed LLC or the manager of a manager-managed LLC in the course of the member’s or manager’s activities on behalf of the LLC, if, in making the payment or incurring the debt, obligation or other liability, the member or manager complied with his or her fiduciary duties. Further, although beyond the scope of this article, there are other ways to limit liability of managers and members, including by insurance.
In practice, it appears that many practitioners continue to rely on the code and do not modify managers’ or members’ fiduciary duties in operating agreements. One reason may be that RULLCA is fairly new and the courts have not yet had the opportunity to flesh out these concepts. Further, RULLCA provides that the fiduciary duties of a manager may be modified only with full disclosure and the “informed consent” of the members, which is a murky concept at best. RULLCA does provide, however, that informed consent of a member in a new LLC differs from a member who is deemed to consent to the operating agreement when such party becomes a member of an existing LLC. Accordingly, practitioners should take great care when drafting operating agreements for new LLCs or joinders admitting new members to existing LLCs that the informed consent of the members to modify fiduciary duties is well documented. Additionally, the modifications should be targeted and the operating agreement should specifically authorize certain actions that might otherwise be viewed as conflicting with the duty of loyalty (e.g., engaging in a competing business venture) or the duty of care (e.g., permitting the delegation of certain manager duties to officers or agents).
While the exact meaning of informed consent remains unclear, drawing from other areas of law may give some guidance. Specifically informed consent, at a bare minimum, likely means that practitioners should obtain the written consent of the parties after full written disclosure of the material risks of such modifications. And, if modification of fiduciary duties is intended, each member must be made fully aware of such modifications prospectively. From the practitioner’s point of view, this means that in new LLCs, each member must be fully aware of such modifications prior to the effectiveness of an operating agreement, and in existing LLCs with an existing operating agreement, each member must be fully aware of such modifications prior to the effectiveness of any amendment to an operating agreement modifying such terms. Further, each new member in an existing LLC must be made fully aware of such modifications prior to the effectiveness of a joinder admitting it to the LLC.
Prudence dictates that managers and members of California LLCs pay attention to recent changes in the laws affecting California LLCs. The courts have not yet addressed many of the open issues posed by these new laws and such interpretations could lead to varying results and unintended consequences. To avoid pitfalls and potential liability, it is imperative that practitioners use the principles provided in this article to clearly draft governing documents in a manner that will not require a court to make broad leaps of faith to give effect to the intent of the parties.