California limited liability company disputes | Courtroom war stories and lessons learned

LLC Managers: No Immunity for Bad Faith Conduct

Under the “default” rules of most limited liability company laws, including California’s Revised Uniform Limited Liability Company Act, LLC managers owe fiduciary duties to the LLC and its members.  Those default fiduciary duties include the duties of care, loyalty, and good faith and fair dealing.

While those duties can be modified and limited by agreement, liability for bad faith conduct cannot be completely eliminated.  That is true even in Delaware, a jurisdiction known as “manager-friendly.”

LLC operating agreements often contain provisions attempting to limit fiduciary duties as much as possible.  Noteworthy examples include specifying that the manager has “sole discretion” as to decision-making or can engage in competing business activities.  (See prior LLC Jungle post: Does an LLC Manager’s “Sole Discretion” Eliminate the Implied Covenant of Good Faith and Fair Dealing?)

Do these types of provisions insulate a manager from liability for “bad faith” conduct?

No.

Two recent opinions from Delaware’s Court of Chancery illustrate that bad faith conduct is never excused, even if the operating agreement is as “manager-friendly” as possible.  While these opinions are unpublished and from Delaware, they provide useful guideposts as to how a California court would rule under similar facts.

MKE Holdings Ltd v. Schwartz — “sole discretion” does not mean “bad faith is OK”

In the MKE Holdings case, the LLC was formed to sell agricultural products, such as fertilizers and pesticides, the rights to which it planned to obtain through a series of acquisitions of established companies with “proprietary specialty plant health technologies.”  The plaintiff LLC members alleged that the managers solicited additional member equity investments for a bogus acquisition.

The LLC’s operating agreement gave the managers “full and exclusive discretion” as to all decision-making, waived fiduciary duties “to the fullest extent permitted,” waived conflicts of interest, and allowed the managers to act in their own self-interest.

The plaintiff LLC members alleged that the managers breached their duties by soliciting member contributions used to fund a $313.5 million acquisition of another company.  The acquired company had declining financial metrics grossly out of line with the purchase price, and that ugly financial data was not disclosed to the members before the acquisition.  The members alleged that the managers solicited their equity investments so the managers could earn large transaction fees and management service fees.

The managers attempted to dismiss all of the claims based on the “sole discretion” and other duty-limiting provisions of the operating agreement.  The court rejected the motion as to several key claims, stating that “good faith” was “the standard by which these Defendants’ actions must be measured.”  The court held that the members’ complaint stated valid claims against the managers and could proceed beyond the pleading stage.

Skye Mineral Investors, LLC v. SCS Capital Ltd. — allowing pursuit of “other opportunities” does not excuse bad faith

In the Skye Mineral case, one group of LLC members alleged that the managers and other members orchestrated a scheme to wrongfully divest the LLC of its lone asset (a wholly-owned subsidiary with valuable mineral deposit rights) by driving the subsidiary into bankruptcy and then separately buying its assets at a steep discount at a bankruptcy auction sale.  The plaintiff members alleged that the scheme worked, and their substantial investments in the LLC were effectively looted.

The LLC operating agreement stated that each manager could “engage in whatever activities such Manager or its Affiliates may choose, without having or incurring any obligation to offer any such interest in such activities to the Company or to the Members.”

According to the complaint filed by the plaintiff LLC members, one of the LLC’s managers learned — but failed to disclose to the members — that the mineral deposits owned by the LLC’s subsidiary asset were “world class” and worth at least $600 million.  Armed with that knowledge, the manager implemented a scheme with some of the members to saddle the LLC with unsustainable debt, and then (according to an email written by the manager) “sit back and hold our position and when this collapses we have the first lien and can buy it out of bankruptcy very cheap.”

The court denied the manager’s motion to dismiss the claims, holding that the plaintiffs stated a valid claim for breach of fiduciary duty.

Lesson

While LLC operating agreements can restrict the fiduciary duties owed by LLC managers, conduct wreaking of bad faith usually finds a pathway to liability.

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