A limited liability company has historically been considered an attractive structure for an entity based upon its flexibility in organizational structure (like a corporation or partnership), its taxation as a pass-through entity (like a partnership) and the owners’ limited liability for actions and debts of the company (like a corporation). Based on two recent Delaware court decisions, there is now another reason to favor LLCs: the parties can contractually agree upon and limit management’s liability.
The Delaware Limited Liability Company Act (the “LLC Act”) gives the parties to a limited liability company operating agreement almost unfettered freedom to structure its liability provisions in whatever manner the parties may agree. Unlike corporate law, which binds directors and officers to a liability framework developed in common law judicial decisions, the LLC offers an opportunity to its members to draft a governing agreement that embodies the parties’ understanding with respect to liability. While limited liability companies have been prevalent in nearly all states since 1996, during the last twelve years there has been limited case law ruling on the liability of managers (including directors and officers) of a limited liability company. In 2004, the Delaware General Assembly amended Section 18-1101(e) of the LLC Act to allow a limited liability company to “provide for the limitation or elimination of any and all liabilities . . . for breach of duties (including fiduciary duties) of a [director],” except that the LLC “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” (emphasis added).
In Fisk Ventures, LLC v. Segal (Del. Ch. May 7, 2008) and Wood v. Baum (Del. Supr., July 1, 2008), Delaware courts have recently begun to clarify the differences between the duties owed by directors and officers of a limited liability company and a corporation. In both Fisk and Wood, the limited liability company operating agreements at issue included an exculpatory provision limiting the directors and officers liability to the fullest extent permitted under Section 18-1101(e) of the LLC Act. Noting that the operating agreement contained such an exculpatory provision, the Delaware Supreme Court in Wood explained that the directors’ exposure to liability was limited to claims for fraud, illegal conduct, or bad faith violations of the implied contractual covenant of good faith and fair dealing.[1] Both courts rejected the plaintiffs’ attempts to impose the corporate law fiduciary duties of loyalty, care and good faith, and upheld the principle that LLCs are contracts. The court in Fisk noted that “in the context of limited liability companies, which are creatures not of the state but of contract,” the duties and obligations alleged to have been breached “must be found in the LLC agreement or some other contract.” The Fisk court quotes Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 DEL. J. CORP. L. 1, 4 (2007):
“I conclude that parties to contractual entities such as limited liability partnerships and limited liability companies should be free – given a full, clear disclosure paradigm – to adopt or reject any fiduciary duty obligation by contract. Courts should recognize the parties’ freedom of choice exercised by contract and should not superimpose an overlay of common law fiduciary duties . . . .”
The Delaware courts’ recent rulings in Fisk and Wood point out the stark differences between director and officer liability for a corporation and for an LLC. It appears Delaware courts will not imply duties or obligations, either at law or equity, when the LLC Act provides otherwise or where the operating agreement is clear on its face. These cases emphasize the importance of using clear, express and unambiguous language in the operating agreement to reflect the contractual bargain reached by the parties.
[1] The court in Fisk specifically distinguished between the common law fiduciary duty of good faith and the relatively clear case law surrounding the implied contractual covenant of good faith and fair dealing (the standard required under Section 18-1101(e) of the LLC Act).
