Idaho's First Case on LLC Fiduciary Duties
The law of fiduciary duties in LLCs is not well settled. For example, less than half of the states have reported opinions on fiduciary duties in LLCs. Cases of first impression on basic fiduciary duty issues in LLCs will be arising for a long time to come.
State courts, when first faced with a claim of breach of fiduciary duty by an LLC manager or member, normally look initially to the state’s LLC Act. Many state LLC Acts have provisions setting fiduciary standards. For example, Ohio’s LLC Act requires managers to act in good faith, in (or not opposed to) the best interests of the company, and with the care of an ordinarily prudent person.
Sometimes there is no help in the Act – some states have no provisions addressing whether members or managers of an LLC owe fiduciary duties to the company or the members. For example, the LLC Acts of Delaware, Washington and Indiana are silent on the issue.
The Idaho Supreme Court recently addressed member fiduciary duties for the first time, in Bushi v. Sage Health Care, PLLC (March 4, 2009). Applying Idaho’s pre-RULLCA LLC Act, the court found no prescribed fiduciary duties in the Act. (In 2008 Idaho enacted RULLCA into law, which does contain express fiduciary duty language, but it does not become effective until July 1, 2010.)
Looking further afield, the justices found that the majority of courts considering the issue have concluded that LLC members owe one another the fiduciary duties of trust and loyalty. In the cases referred to in the Idaho opinion, the courts analogized LLCs to partnerships. The court concluded that under Idaho’s LLC Act, managing members of an LLC owe each other fiduciary duties.
This is not a surprising result. In fact, it’s hard to imagine a state court finding that LLC members with managing authority, or nonmember managers, do not have fiduciary duties of good faith, loyalty, and care akin to those of partners in a partnership or directors in a corporation. But the Idaho case is a good example of a court looking first to its statute, and upon not finding an answer, looking to persuasive precedent and the reasoning used by other courts.
We can anticipate later, more difficult questions involving matters such as the scope of a member’s or manager’s fiduciary duties, the extent to which the members can agree by contract to limit or exclude each other’s fiduciary duties, and whether claims for breach of fiduciary duties can be brought by a member or only derivatively in the name of the LLC. But those are discussions for a later date.
Courts Continue to Find an Accounting Remedy
A recent decision of the New York Appellate Division, Gottlieb v. Northriver Trading Co. LLC (Jan. 27, 2009), garnered some controversy when it recognized that members of an LLC may seek an equitable accounting under common law. The New York LLC Law does not explicitly authorize an accounting remedy, and the court’s decision has been characterized by Professor Larry Ribstein as an example of the unpredictability of New York’s LLC law and as a contribution to the “impenetrable murk” of New York’s LLC Law.
The Gottlieb opinion relied on the reasoning of New York’s highest court in Tzolis v. Wolff. The court in Tzolis had to decide whether members of an LLC may bring a derivative suit on the LLC’s behalf, even though there were no provisions authorizing or governing derivative suites in New York’s LLC Law. The Tzolis court reasoned by analogy to both corporations and limited partnerships. The New York courts had in the past found an equitable right to a derivative suit for shareholders of a corporation and for limited partners in a limited partnership. In neither of those prior cases, at the times of their holdings, was there a statutory authorization of derivative suits for shareholders or limited partners.
Two recent cases from other states have dealt with this issue, both handed down just a month after publication of the New York court’s opinion in Gottlieb. One state had statutory language explicitly authorizing an accounting, one did not. Both upheld the availability of an accounting.
In February the Indiana Court of Appeals concluded in Perkins v. Brown that the trial court erred when it failed to order an accounting of an LLC’s finances in connection with the dissolution of the two-member LLC. Without discussing or analyzing whether Indiana’s LLC Act authorizes an accounting, the court simply concluded that an accounting was necessary to determine the LLC’s creditors and expenses and whether any improper distributions had been made. Indiana’s LLC Act does not expressly authorize an accounting, but it does provide that “[a] court may enforce an operating agreement by injunction or by granting other relief that the court in its discretion determines to be fair and appropriate in the circumstances.” Section 23-18-4-7(a). That section was also not discussed by the court.
In another February decision, the South Carolina Supreme Court recognized that its courts have “broad judicial discretion in fashioning remedies in actions by a member of an LLC against the LLC and/or other members,” including the remedy of an accounting. Historic Charleston Holdings, LLC v. Mallon. The court proceeded to reverse the trial court’s order for an accounting, but only because “a full financial accounting would unnecessarily prolong this otherwise simple matter.” The court’s conclusion about the authority for an accounting was based on South Carolina’s LLC Act. South Carolina has enacted the ULLCA, and Section 33-44-410(a)of South Carolina’s Act states that “[a] member or manager may maintain an action against a limited liability company or another member or manager for legal or equitable relief, with or without an accounting as to the company’s business . . . .”
In contrast to the explicit ULLCA language, the Revised Uniform Limited Liability Company Act (RULLCA), currently recommended by the National Conference of Commissioners on Uniform State Laws, states that “[u]nless displaced by particular provisions of this Act, the principles of law and equity supplement this Act.” Section 107. Many courts would likely see that as an implicit statutory approval of the accounting remedy for LLCs. RULLCA has been adopted by Idaho and Iowa.
The right to seek an accounting has long been recognized by U.S. courts as an equitable remedy with origins in England’s Chancery Courts. 1 Dan B. Dobbs, Law of Remedies 609-14 (2d ed. 1993). An accounting is generally available when there is a claim of breach of fiduciary duty or other wrongdoing, and is often used in partnership dissolution cases.
Washington, the state where I practice, danced around the issue of an LLC accounting in 2007, but concluded that it need not reach that issue on the facts of the case. Noble v. A&R Envtl. Services, LLC, 140 Wn. App. 29, 164 P.3d 519 (2007). One party appealed the trial Court’s refusal to order an accounting. The Court of Appeals decided that the trial court had not made sufficient findings of fact, remanded the case for adequate findings, and concluded that it need not reach the accounting argument.
The three opinions handed down this year (in New York, Indiana and South Carolina) all recognized that on request of a member of an LLC, an accounting may be ordered in appropriate situations. In none of the three was an accounting to be automatically granted – the analysis is fact-specific and will likely depend on whether there was fraud, breach of fiduciary duty or other wrongdoing, and whether the facts are complex enough to warrant the accounting process. The courts find the authority either in their LLC statute (explicitly or implicitly), by analogy to partnership and corporate law, or under general principles of equity.
These three opinions seem to reflect an unspoken reluctance to rule out the accounting remedy unless the applicable LLC Act expressly bars it, and I’m not aware of any LLC Act that does so. It seems likely that in the absence of such a statutory prohibition, most courts, when first presented with the issue and on request of a member of an LLC, will order an accounting in appropriate situations.
Deadlocks and Puts in Delaware
LLCs sometimes reach a point where the owners or managers disagree on business issues and find themselves unable to reach agreement on any course of action. This can happen because the members or managers have equally balanced voting power or because their LLC agreement requires a supermajority vote that neither side can reach. A long-running deadlock can be a huge problem for a business, since it will keep the company from responding to business changes. What’s the owners’ remedy then?
Sometimes the LLC agreement will have a solution. For example, the agreement may have a “cut and choose” provision, so that either side can initiate a buyout process that will leave one or the other with full ownership of the company. That may or may not be practicable, and in many cases the agreement simply has no answer for a deadlock.
If the agreement has no solution for deadlock, the parties are forced back to their state’s LLC statute. In Fisk Ventures, LLC v. Segal (Jan. 13, 2009), one member of a Delaware LLC asked the Court of Chancery to order dissolution, citing Section 18-802 of Delaware’s LLC Act. This section is short and sweet:
On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.
NCCUSL’s Revised Uniform LLC Act and many state statutes have similar provisions. Note that the operative word is “may” – the court has discretion. And the test is not one of oppression or wrong-doing, but simply a question of carrying on the business in conformity with the agreement.
In Fisk, the LLC agreement provided for a five-member Board to manage the LLC. One faction had three Board members; the other faction had two. (One side was dominated by the founder, the other by subsequent investors.) The agreement required a vote of 75% of the Board for most actions, including dissolution, and neither side could muster four Board members. The agreement provided no mechanism for resolving a stalemate. For five years the two factions had been in disagreement about financing and other issues. The result: five years of deadlock.
The court found that as a result of the deadlock and the Company’s inability to raise capital, the company had “no office, no employees, no operating revenue, and no prospects of equity or debt infusion,” and that there was effectively no business to operate.
Dr. Segal, however, argued that the LLC agreement did provide a means of navigating around the deadlock, because the agreement granted Fisk Ventures, the plaintiff seeking dissolution, a “put” right. The put meant that Fisk could require the company to buy Fisk’s interest in the company for its fair value. The agreement provided for the price to be determined by an independent valuation, and to be paid either in cash at closing or in time payments over two years, based on the amount. Exercise of the put was at Fisk’s discretion.
The court found that the existence of Fisk’s optional put right did not resolve the deadlock, and refused to force Fisk to exercise its put. The court analyzed the put as an independent, economic right that was not a remedy for the deadlock. In the court’s words, “it would be inequitable for this Court to force a party to exercise its option when that party deems it in its best interests not to do so.” The court emphasized the primacy of freedom of contract under Delaware’s LLC Act: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Section 18-1101(b).
Once the court had concluded that Fisk’s put was not relevant to whether it was “reasonably practicable to carry on the business” in conformity with the LLC agreement, and given the dismal five-year history of the company, the court easily found that the company should be dissolved. Under the LLC Act, of course, once dissolved the company would have to be wound up in accordance with Section 18-801.
The 75% supermajority requirement may have been intended to prevent a bare majority from dominating or oppressing the minority, but here it led to a different type of bad result. The agreement did not provide for a way to resolve a deadlock, and the put apparently turned out to be an unsatisfactory mechanism for its holder.
The obvious moral for founders and investors (and their counsel) is to think hard about the contingencies when the LLC is being formed and when new investors come in. Concentrate not only on the upside of the proposed business deal but also on the alternative scenarios, and address the potential for deadlock. This is basic risk analysis – not easy, as evidenced by our recent history, even for highly experienced investors and business people. There’s no substitute for probing the parties’ assumptions and asking the hard questions.
