LLC Operating Agreementsmedia.straffordpub.com/products/llc-operating...Mar 27, 2012 · 18 29% 31% 13% 10% 7% 10% Delaware - No Provision Florida

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

[email protected]

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


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


• 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


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?


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?


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”).


• 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”)



• 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



• 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?



• 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.



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

[email protected]

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




20

Waiver of Fiduciary Duties



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




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.


• 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


• 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


• 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


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


Fiduciary Duties

Additional Considerations

• Members and Permitted Transfers

• Withdrawal

• Intellectual Property

29


• 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


• 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)



• 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).



• 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.


www.rlf.com

LLC Operating Agreements:

Indemnification and Exculpation provisions

Melissa K. Stubenberg

Richards, Layton & Finger, P.A.

Wilmington, DE

[email protected]

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


– 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


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


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


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

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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.
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Documents

LLC Operating Agreementsmedia.straffordpub.com/products/llc-operating...Mar 27, 2012 · 18 29% 31% 13% 10% 7% 10% Delaware - No Provision Florida