Post on 14-Jul-2018
MODIFYING FIDUCIARY DUTIES IN LLCS
First Run Broadcast: March 22, 2016
Live Replay: August 4, 2016
1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00a.m. P.T. (60 minutes)
Statutory and common law impose certain fiduciary duties – care, diligence, good faith and fair
dealing – on directors and managers of corporate entities, managers of LLCs, and in certain
instances on members of LLCs. There is also the important corporate/LLC opportunity doctrine
that prevents misappropriation of certain corporate or LLC opportunities. In certain instances,
the owners of the entity may want to expand, limit, or even entirely eliminate these duties.
Depending on the entity involved and the specific duty, the law permits modification by
agreement. But great care in drafting these modifications, including full understanding of what
law allows, is essential to avoiding subsequent litigation on the basis of fraud, bad faith and self-
dealing, or misappropriation of entity opportunities. This program will provide you with a
practical guide to modification of fiduciary and other duties in corporations, LLCs and other
entities.
Modifying fiduciary duties in LLCs, corporations and entities
Duties of care, diligence, good faith and fair dealing
What duties may be modified and which may not – and to what extend?
Circumstances in which modification might make sense – competing businesses, finance,
risk of litigation, and more
Defining and limiting application of the corporate/LLC opportunity doctrines
Understanding self-dealing and conflicts of interest, and practical risks
Effective drafting to modify fiduciary duties in new and existing LLCs
Counseling clients about the substantial risks of reducing the fiduciary duties of managers
Speakers:
Frank Ciatto is a partner in the Washington, D.C. office of Venable, LLP, where he has 20
years’ experience advising clients on mergers and acquisitions, limited liability companies, tax
and accounting issues, and corporate finance transactions. He is a leader of his firm’s private
equity and hedge fund groups and a member of the Mergers & Acquisitions Subcommittee of the
ABA Business Law Section. He is a Certified Public Accountant and earlier in his career
worked at what is now PricewaterhouseCoopers in New York. Mr. Ciatto earned his B.A., cum
laude, at Georgetown University and his J.D. from Georgetown University Law Center.
Laura B. Springer is an attorney in the Washington, D.C. office of Venable, LLP, where she
has experience drafting and structuring corporate transaction documents, including purchase
agreements, operating agreements, stockholder agreements, non-disclosure agreements, licensing
agreements, data supply arrangements, professional services arrangements and other sourcing
agreements. Ms. Springer received her B.A. from the University of Virginia and her J.D., cum
laude, from Boston College of Law.
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Fiduciary Duties in LLCs Teleseminar
August 4, 2016 1:00PM – 2:00PM
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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: August 4, 2016 Seminar Title: Fiduciary Duties in LLCs Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.
1 © 2012 Venable LLP
Fiduciary Duties in Closely-Held Corporations and Limited Liability Companies
Frank A. Ciatto, Venable, LLP (202) 344-8510 / faciatto@Venable.com
Laura B. Springer, Venable, LLP
(202) 344-4211 / lbspringer@Venable.com
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Overview
Traditional Corporate Fiduciary Duties
Fiduciary duties
Standards of review in the corporate context
Conflicts and self dealing
Fiduciary Duties in Limited Liability Companies
Contractual fiduciary duties
Default fiduciary duties
Developments in Delaware law
Waiver of Fiduciary Duties and Drafting Limited Liability
Company Agreements
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Duty of Care
Directors and officers are required to exercise the care that a
reasonably prudent person in a like position would exercise
under similar circumstances (Delaware General Corporation
Law)
May rely on experts and advisors – reliance must be
reasonable and made in good faith (Delaware General
Corporation Law Section 141(e))
Must act with care in the discharge of their duties
In a manner in which they would act if conducting their own
affairs
The materials provided to the directors, the length of the
deliberations and the documentation of the process in the
minutes will be critical to the analysis
Gross negligence – reckless indifference or deliberate disregard
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Duty of Loyalty
Directors and officers must put the interest of the
company/shareholders ahead of personal interests
Two pronged analysis
Is the director interested – stands to receive a material
benefit in the transaction different from the stockholders
Is the director independent – analysis is whether the director
is influenced by or beholden to a party with an interest in the
transaction
Good faith – subset of the duty of loyalty
Subjective bad faith – an actual intention to do harm
Intentional/conscious disregard of duties
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties
Functions of Board of Directors: Directors have two principal
functions:
Decision-making – approving or rejecting corporate actions
Oversight – supervising the business and affairs of the
corporation
When are Challenges Most Likely to Arise?
Change of Control transaction
Failure to Act/Oversee
Self Dealing/Conflict of Interest/Corporate Opportunity
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Standards of Conduct
Change of control transactions – implicates duties of care and
liability
Under Delaware law, there are generally three standards against
which the courts will measure director conduct in a change in
control transaction:
business judgment rule -- for a decision to remain
independent or to approve a transaction not involving a sale
of control;
o policy that courts will not second guess the valid business
judgment made by informed boards
enhanced scrutiny -- for a decision to adopt or employ
defensive measures or to approve a transaction involving a
sale of control; and
entire fairness -- for a decision to approve a transaction
involving management or a principal shareholder or for any
transaction in which a plaintiff successfully rebuts the
presumptions of the business judgment rule.
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Standards of Conduct
Rejecting an Offer - the business judgment rule applies
The Board must determine in the exercise of its business
judgment whether the offer is in the best interests of the
corporation and its stockholders.
Directors must have a reason for rejecting the offer – even in
a closely-held corporation.
Defensive Measures – enhanced scrutiny will be applied if the
Board employs defensive measures in response to a takeover
bid
Directors must satisfy two tests before the business judgment
rule applies: (1) did the directors have reasonable grounds
for believing that a danger to corporate policy or
effectiveness existed, and (2) was the action reasonable in
relation to the threat posed.
May not be likely in the case of a closely-held corporation
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Standards of Conduct
Sale of Control – Revlon Duties
In Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., the
Delaware Supreme Court imposed an affirmative duty on the
board of directors to seek the highest value reasonably
obtainable to the stockholders when a sale of the company
becomes inevitable.
The duty established in Revlon was restated in Paramount
Communications Inc. v. QVC Network Inc., in which the
Delaware Supreme Court further explained the extent of
enhanced scrutiny:
o The consequences of a sale of control impose special obligations
on the directors of a corporation. In particular, they have the
obligation of acting reasonably to seek the transaction offering
the best value reasonably available to the stockholders. The
courts will apply enhanced scrutiny to ensure that the directors
have acted reasonably.
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Standards of Conduct
Sale of Control – Revlon Duties (cont.)
If a change of control transaction is challenged, the care with
which the directors acted will be subjected to close review.
For this review there will be no “bright line” tests, and it may
be assumed that the board may be called upon to show care
commensurate with the importance of the decisions made,
whatever they may have been in the circumstances.
A recent Delaware case noted that no “court can tell directors
exactly how to accomplish [the goal of getting the best price
for the company] because they will be facing a unique
combination of circumstances.”
In the absence of bright lines and blueprints that fit all cases,
the process to be followed by the directors will be paramount.
© 2016 Venable LLP
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Fiduciary Duties: Standards of Conduct
Limitation of Liability
State law may permit the corporation to eliminate or limit the
personal liability of directors
o Section 102(b)(7) of Delaware General Corporation Law – for
duty of care
o Section 2.02(b)(4) of Model Business Corporation Act
Duty of Loyalty in Change of Control Context
Did the directors fail to act in good faith – assuming no
conflict of interest
May be the dispositive issue if no personal liability for
breaches of duty of care
In Lyondell Chemical Company, et al. v. Ryan, 970 A.2d 235
(Del. 2009), the Delaware Supreme Court applied the Disney
bad-faith standard in the transactional context
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Standards of Conduct
In Lyondell, the Supreme Court discussed its analysis of good faith in the
Disney case, in which it had identified three types of bad faith conduct by
a director:
intentionally acts with a purpose other than that of advancing the best interests
of the corporation;
acts with the intent to violate applicable positive law; or
intentionally fails to act in the face of a known duty to act, demonstrating a
conscious disregard for his duties.
The Supreme Court found that:
“Directors’ decisions must be reasonable, not perfect. ‘In the transactional
context, [an] extreme set of facts [is] required to sustain a disloyalty claim
premised on the notion that disinterested directors were intentionally
disregarding their duties.’ The trial court denied summary judgment because
the Lyondell directors’ ‘unexplained inaction’ prevented the court from
determining that they had acted in good faith. But, if the directors failed to do all
that they should have under the circumstances, they breached their duty of
care. Only if they knowingly and completely failed to undertake their
responsibilities would they breach their duty of loyalty. The trial court
approached the record from the wrong perspective. Instead of questioning
whether disinterested, independent directors did everything that they (arguably)
should have done to obtain the best sale price, the inquiry should have been
whether those directors utterly failed to attempt to obtain the best sale
price.” © 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Standards of Conduct
Oversight Liability – Claims for failure of oversight generally
require showing that directors breached duty of loyalty by failing
to attend to their duties in good faith.
In re Caremark Int'l Inc. Derv. Litig., 698 A.2d 959 (Del. Ch.
1996) was the first case in which a Delaware court articulated
the fiduciary duties of directors in an oversight context. That
case involved breach of fiduciary duty claims against defendant
directors based upon their alleged failure to monitor actions in
violation of the federal Anti-Referral Payments Law.
“[g]enerally where a claim of directorial liability for corporate
loss is predicated upon ignorance of liability creating
activities within the corporation . . . only a sustained or
systematic failure of the board to exercise oversight—such
as an utter failure to attempt to assure a reasonable
information and reporting system exists—will establish the
lack of good faith that is a necessary condition to liability.”
© 2016 Venable LLP
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Traditional Corporate Fiduciary Duties: Standards of Conduct
Stone v. Ritter, 911 A.2d 362 (Del. 2006):
“the Caremark standard for so-called ‘oversight’ liability draws
heavily upon the concept of director failure to act in good faith. That
is consistent with the definition(s) of bad faith recently approved by
this Court in its recent Disney decision, where we held that a failure
to act in good faith requires conduct that is qualitatively different
from, and more culpable than, the conduct giving rise to a violation of
the fiduciary duty of care (i.e., gross negligence).”
Caremark claims fall within the third type of bad faith described by
the Court in Disney—director intentionally fails to act in the face of a
known duty to act, demonstrating a conscious disregard for his
duties.
In re Citigroup Shareholder Derivative Litigation, 964 A.2d 106
(Del Ch. 2009):
Delaware Chancery Court found that Caremark-type duties were not
designed to impose oversight liability for business risk in case that
involved potential liability of directors under Delaware law for losses
suffered by the corporation as a result of exposure to sub-prime debt
© 2016 Venable LLP
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Conflicts of Interest and Self Dealing
Duty of Loyalty and Conflicts of Interest
No self dealing – Directors must refrain from self dealing and
must act in good faith and deal fairly with stockholders when
they have an interest in the transaction
o Director has a personal interest in the transaction
o Director is not independent – even if a director does not have a
personal interest in the transaction, may still be treated as
interested if “beholden” to an interested party such that he or
she cannot exercise independent judgment
A conflict does not constitute a breach – must analyze how
the directors address the conflict
© 2016 Venable LLP
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Conflicts of Interest and Self Dealing
Dealing with Conflicts of Interest
Statutory “Safe Harbors”
Disclosure of material information to and approval by
disinterested directors
Disclosure of material information to and approval by
stockholders
Transaction fair to corporation
Entire Fairness – burden on directors to prove entire fairness
Fair dealing – analyze the process – timing, structure,
negotiation, disclosure, approvals of directors and
stockholders
Fair Price – is the price one the corporation would receive in
an arms-length transaction – analysis typically involves
factors generally accepted in the financial community
(economic considerations, enterprise value, etc.)
© 2016 Venable LLP
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Conflicts of Interest and Self Dealing
Dealing with Conflicts of Interest (cont.)
Issues when controlling stockholder is on both sides of the
transaction
o Approval by disinterested directors/special committee
– controlling stockholder cannot dictate the terms of the transaction
– special committee must have real bargaining power that it can
exercise on arms-length basis – authority to consider alternatives
and hire independent advisors
– disinterested directors must be fully-informed and have access to
all material information relating to the company and the
transaction
o Approval by disinterested stockholders
– approval must be a non-waivable condition to the deal
– approved by majority of all disinterested shares – not just those
voted
– stockholders must receive complete and accurate disclosure of
all material information relating to the company and the
transaction
o Approval by disinterested directors or stockholders shifts to the
plaintiff the burden of proving the transaction is unfair © 2016 Venable LLP
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Conflicts of Interest and Self Dealing
Issues for privately-held corporations
Conflict or independence issues may arise more frequently
because of ownership, oversight and management structures
Lack of disinterested or independent directors
Reluctance of controlling stockholder to condition transaction
on vote of the minority stockholders
Disclosure Issues – requires disclosure of information that
management may not be accustomed to or comfortable
providing
May be more difficult for privately-held corporation to avoid
the entire fairness standard of review
o More likely to settle with minority stockholders
© 2016 Venable LLP
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Corporate Opportunity Doctrine
Corporate Opportunity Doctrine
Subset of the duty of loyalty
General rule is that a director, officer or controlling
stockholder may not appropriate an opportunity rightfully
belonging to the corporation without full disclosure to the
Board and a decision by the disinterested directors to reject
or decline to pursue the opportunity
Fact specific determination
Standard of Review – A corporate fiduciary may not pursue an
opportunity if:
The corporation is financially able to exploit the opportunity;
The opportunity is within the corporation’s line of business;
The corporation has an interest or expectancy in the
opportunity; and
By taking the opportunity, the fiduciary will be in a position
adverse to his duties to the corporation.
© 2016 Venable LLP
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Corporate Opportunity Doctrine
Exceptions – A corporate fiduciary may pursue an opportunity if:
The opportunity is presented to the director in an individual
and not corporate capacity;
The opportunity is not essential to the corporation;
The corporation holds no interest or expectancy in the
opportunity; and
The fiduciary has not wrongfully used the resources of the
corporation in pursuing or exploiting the opportunity.
May also be pursued if full disclosure is made to the Board and it
is approved by disinterested directors – this may present
challenges in the case of a closely-held corporation
Depending on jurisdiction, there may be statutory safe harbors
for pursuing certain corporate opportunities (Section 122(17) of
Delaware General Corporation Law; Section 870 of Model
Business Corporation Act)
© 2016 Venable LLP
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Fiduciary Duties and Limited Liability Companies
Application of fiduciary duties - While states vary on the nature
of the obligations, there is general agreement that members and
managers of an LLC owe fiduciary obligations to the entity, as
well as their co-participants.
Care, loyalty, good faith
Competing business opportunities
Some states have limited liability company statutes that explicitly
apply the duties of care and loyalty to managers (for example,
District of Columbia, California)
Other states have vague limited liability statutes that fail to
specify whether fiduciary duties apply to managers of limited
liability companies (for example, New York)
Threshold Issue: How is an LLC fundamentally different from a
corporation?
It is a creature of contract and the operating agreement is
generally dispositive on the issue of fiduciary duties.
© 2016 Venable LLP
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Implied Fiduciary Duties and Limited Liability Companies
In some states (e.g., Delaware, Virginia), the operating
agreement of an LLC can expand, restrict or eliminate the
fiduciary obligations of the members and managers.
Based on principles of freedom to contract
Not permitted in all jurisdictions
Will a court “read-in” fiduciary duties where the statute and
operating agreement are silent – depends on the jurisdiction
Delaware – yes
Virginia – no
Implied covenant of good faith and fair dealing
Based on contractual principals
Courts may “read-in” implied terms to the contract if the
contract is silent
Not applied when the express terms of the operating
agreement are clear
© 2016 Venable LLP
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Statutory Development in Delaware
In the Delaware Supreme Court case of Gatz Properties, LLC v.
Auriga Capital Corp., the Court created a question as to whether
default fiduciary duties applied to managers of limited liability
companies where the LLC agreement was silent. In this case,
the Court held that the LLC agreement in question expressly
stated the fiduciary duties that applied, and therefore the lower
court holding stating that default duties did imply were dicta (and
did not need to be addressed) without any precedential value.
In a subsequent case, Feeley v. NGAOCG, LLC, the Delaware
Court of Chancery recognized that the dicta in the lower court’s
decision in Auriga was persuasive and held that when an LLC
agreement does not limit or eliminate a managing member’s
fiduciary duties, default fiduciary duties of care and loyalty are
imposed under the DLLCA
© 2016 Venable LLP
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Statutory Development in Delaware
Due to the subsequent confusion, in response, the Delaware
legislature amended the DLLCA Section 18-1104 to make clear
that in accordance with the common law rules of law and equity
relating to fiduciary duties, managers, managing members,
officers and possibility majority or controlling members owe
fiduciary duties to LLC equity owners that are not explicitly
provided for in LLC agreements. (See DLLCA Section 18-1104).
Following the amendment, cases applied the amended law, as
was done in Grove v. Brown, C.A. No. 6793-VCG (Del. Ch. Aug.
8, 2013)
The court held that an LLC agreement must expressly modify
fiduciary duties owed by the managing members – as permitted
by the DLLCA – to avoid the application of default corporate-like
fiduciary duties.
Parties to the limited liability company agreement are left to
determine whether to impose fiduciary duties and/or how to
contract the default duties away
© 2016 Venable LLP
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Drafting Fiduciary Duty Provisions
Precise drafting is critical
Use clear and unambiguous language as to intent
Considerations:
Scope of fiduciary duties
o Fully inclusive
o Complete disclaimer
o Modified duties
Parties to which duties are owed
Indemnification
Pursuing competing business opportunities is often the key
issue
Examples
Multimember limited liability companies
Private equity funds
© 2016 Venable LLP
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Multimember Limited Liability Companies
LLCs are a common entity form for joint ventures, start-up
companies and closely-held businesses of all sizes
Modification of fiduciary duties:
Defines parameters of relationship between members
Avoids uncertainty of whether default fiduciary duties apply
Establishes clear guidelines and expectations for
management
Avoids conflict of interest issues that arise if parties are
competitors or engage in other business ventures
Economic efficiency - Establishes the use of financial
resources of members in the business
Avoids application of corporate opportunity doctrine –
o Drafters should clearly describe and define the purpose of the
business and describe any opportunities members and
managers of the LLC may pursue without having to present them
to the LLC
© 2016 Venable LLP
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Multimember Limited Liability Companies
Modification of fiduciary duties (continued):
Eliminates uncertainty for managers and members in making
management decisions
Benefits members and managers of board-managed LLCs
o If applicable under the state law, default fiduciary duties would
apply
o Permits the board members to act for the benefit of the
appointing member without breaching fiduciary duties to the
other members
© 2016 Venable LLP
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Private Equity Funds
Private equity funds are frequently formed as Delaware limited
liability companies
Critical that fiduciary duties be addressed in the LLC agreement
to avoid problems
Structure
Manager manages the fund and investors invest as non-managing
members
Manager owes fiduciary duty to the company and the investor
members
Inherent conflict of interest if manager is managing related funds
Mitigating Problems
Explicitly eliminate all fiduciary duties of the manager and its affiliates
to the fund in the LLC agreement
Include “sole discretion” provision that modifies fiduciary duties in
specified instances when the manager acts in its “sole discretion”
Specifically authorize certain transactions or relationships in the LLC
agreement “notwithstanding duties otherwise existing at law or in
equity (including fiduciary duties)”
© 2016 Venable LLP
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Contact Information
Frank A. Ciatto, Partner
faciatto@venable.com
t 202.344.8510
f 202.344.8300
Laura B. Springer, Associate
lbspringer@venable.com
t 202.344.4211
f 202.344.8300
Venable D.C. Office
575 7th Street, NW
Washington, DC 20004
© 2016 Venable LLP