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

LLC Managers or Members With “Sole Discretion” Must Still Act in Good Faith

LLC managers (or members vested with decision-making authority) are sometimes lulled into a false sense of security by “sole discretion” provisions in their LLC’s operating agreement.  That can be a costly mistake.

The LLC Jungle has covered this issue on prior occasions.  See prior posts Does an LLC Manager’s “Sole Discretion” Eliminate the Implied Covenant of Good Faith and Fair Dealing? and LLC Managers: No Immunity for Bad Faith Conduct.

A recent opinion issued by the Appellate Division of New York’s Supreme Court — Shatz v. Chertok — piled on.  While not precedential in California, the opinion illustrates the prevailing legal theme that “sole discretion” clauses do not grant an LLC’s managers or members license to act in bad faith.

Facts and lower court ruling

According to the allegations of the complaint filed by the plaintiff LLC member, the defendants breached fiduciary duties by failing to pursue a previously-agreed investment opportunity, diverting that opportunity to another entity related to one of the defendants, and failing to disclose aspects of the investment opportunity.

The defendants filed a motion to dismiss the complaint, arguing that the claims were barred because the LLC’s operating agreement gave them the “sole and absolute discretion” over investment decisions.

The lower court rejected the defendants’ attempt to have the breach of fiduciary duty claim dismissed.

Appeal opinion

The appellate division affirmed the lower court’s ruling, holding the plaintiff stated a valid claim for breach of fiduciary duty.

Quoting from an earlier opinion, the court held: “even where one has an apparently unlimited right under a contract, that right may not be exercised solely for personal gain in such a way as to deprive the other party of the fruits of the contract.  Thus, even an explicitly discretionary contract right may not be exercised in bad faith so as to frustrate the other party’s right to the benefit under the agreement.”

Turning to the allegations at hand, the court held:

Here, although defendants possessed sole discretion over investment decisions, the complaint sufficiently alleges that they exercised that discretion in bad faith and to self-deal.  Thus, the fiduciary duty claim was properly sustained, despite the existence of the sole discretion clause.

Lesson

This is just the latest of several opinions confirming the general principal, in the court’s words, that an “explicitly discretionary contract right cannot be exercised in bad faith so as to deprive the other party of the benefit of the bargain.”

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