Operating Agreement Doesn’t Excuse Breach of Fiduciary Duty
Many posts on The LLC Jungle blog have focused on the fiduciary duties owed by LLC managers to both the LLC’s members and the LLC itself.
Other posts have focused on the pitfalls of LLC Operating Agreements that fail to properly document the parties’ intentions with sufficient detail or clarity.
If the parties prepare a detailed Operating Agreement allowing certain conduct by the LLC’s manager, is the manager immune from liability for “breach of fiduciary duty” by engaging in that very conduct? A recent opinion filed by California’s Fourth Appellate District — Wardak v. WLOW Partners, LLC — answers this question with a resounding “No.” While the Wardak opinion is unpublished and therefore not binding precedent, it is still useful to see how courts react to certain fact patterns.
Facts: manager and allied member “squeeze out” another member; manager asserts defense based on language of operating agreement
The Wardak case has a very twisted set of facts.
Long-time friends and neighbors, Dwaine Dirks and Weiss Omar, formed WLOW Partners, LLC (“WLOW”) with Bastel Wardak. Based on a Memorandum of Understanding, which was later mostly converted into an Operating Agreement, the parties formed WLOW for the purpose of redeveloping an apartment building in Placentia. Dirks contributed $465,000 of equity in the property to WLOW in exchange for a 50% interest in WLOW, and became WLOW’s manager. Omar and Wardak each received a 25% interest and each paid Dirks an initial amount of $50,000 and monthly payments of $6,000.
Disputes arose, and the parties amended the Operating Agreement. The Second Amended Operating Agreement required Omar and Wardak “collectively and together on a 50/50 basis” to provide the balance of construction financing in the amount of $1,735,872 plus interest into a separate escrow account approved by Dirks within seven days of the amendment’s execution. The amended agreement further provided that if Omar and Wardak fulfilled their obligations to fund the construction money, they would retain their ownership interests in WLOL. However, if they failed to timely provide the construction money, then Dirks “may elect to dissolve the company … and obtain 100 percent Ownership of the Membership Interests of the company.” In that event, any funds previously advanced by Omar and Wardak would be treated as debt, to be repaid from the proceeds of the property’s eventual sale. By this time, Omar and Wardak had advanced $605,538 to WLOW. They made these advances from a solar energy business that they jointly owned together on the side, not from their individual funds.
Before signing, Wardak expressed discomfort over the provisions of the amended operating agreement allowing Dirks to dissolve WLOW and take the property. Dirks agreed to remove those provisions, but never did, claiming that it would have been too much trouble to have the attorney make the change. Dirks also said those provisions were moot because Omar had a cashier’s payment to pay his share of the construction funds. Based on these representations, Wardak signed the amended operating agreement. Dirks’ statements turned out to be false — Omar never had the money.
Then Dirks’ real shenanigans began. Wardak promptly gave Dirks a cashier’s check from his personal account in the amount of $867,936 — his half of the $1.7 million in required construction funds. Omar provided no payment. Dirks rejected Wardak’s cashier’s check because it was made out to “WLOW, LLC” instead of “WLOW Partners, LLC.” Wardak offered to wire funds to escrow, and Dirks agreed but later said he could not open an escrow and refused to provide escrow instructions to Wardak. Wardak eventually succeeded in depositing his half of the construction funds into WLOW’s bank account, and indicated willingness to pay Omar’s half too. However, Dirks rejected the payment, claiming that because the money was not received within seven days of the execution of the amended operating agreement, it was late, and he was exercising his rights under the agreement to dissolve the company and take 100 percent ownership of the property for himself.
As for the funds previously advanced by Omar and Wardak through their separate solar energy business (which now amounted to more than $623,000), instead of paying that debt out of the property’s sale Dirks elected to pay it immediately through an escrow. Omar and Wardak each submitted payoff demands; Wardak claimed he was entitled to half of the jointly contributed funds. Omar, however, claimed that he had advanced $440,337.77 of the funds, and had already been repaid by WLOW outside of escrow. Escrow issued a check to Wardak for only $193,837.47 as “payment in full” for all of his advances.
In fact, Omar did not personally advance the $440,337.77. Instead, that money had been paid by the solar energy business owned by Omar and Wardak. Additionally, instead of WLOW paying Omar the $440,337.77 outside of escrow, at Dirks’ request Omar advanced the $440,337.77 to a new entity — LJS Placentia Partners, LLC (“LJS”). In return, Omar became a 49 percent owners of LJS, with Dirks owning the other 51 percent. Dirks transferred the property from himself to LJS, which developed the property and sold it for more than $5 million.
As recited in the Court of Appeal’s opinion: “Thus, when all was said and done, Dirks and Omar had managed, by virtue of Omar’s ‘failure’ to pay his agreed-upon amount under the Second Operating Agreement, to take the Property for themselves, strip Wardak of his ownership interest in WLOW, strip WLOW of the Property, and pay Wardak only a portion of the reimbursement of the advances to which he was entitled.”
Trial court: jury finds in favor of Wardak; court takes away parts of jury’s award
After a trial, the jury found in favor of Wardak and against Dirks and Omar. Specifically, the jury found that Dirks was not entitled to take 100 percent ownership of WLOW and its property, Dirks breached his fiduciary duty to WLOW, and Dirks acted with malice, oppression, or fraud, justifying punitive damages. The jury also found against Omar, and that Omar acted with malice, oppression, or fraud.
However, the court granted Dirks’ and Omar’s post-trial motions for JNOV setting aside the jury’s key findings.
As stated in the Court of Appeal’s opinion, “The basis for the trial court’s JNOV … is, quite simply, its conclusion that the Second Operating Agreement permitted Dirks to do what he did. … The trial court apparently concluded (1) because Omar did not personally pay 50 percent of the $1.7 million, the contract/agreement permitted Dirks to dissolve WLOW and take the Property for himself, and (2) because Dirks had the right to do those things, Dirks could not possibly have done so in a manner that violated his fiduciary obligations to WLOW.”
Wardak appealed.
Court of Appeal: trial court’s JNOV reversed; jury findings restored
The Court of Appeal reversed the trial court’s JNOV ruling and restored the jury’s verdict. The court held that despite the operating agreement language facially allowing Dirks’ conduct, the jury could reasonably conclude that Dirks availed himself of the operating agreement’s remedies — “or, perhaps more accurately, placed himself in a position to invoke those remedies — in violation of his fiduciary duties.” The court pointed to substantial evidence supporting the jury’s verdict, including Dirks’ false representations to Wardak and his unreasonable refusals to accept payment from Wardak.
The court concluded:
In short, even though the Second Operating Agreement allowed Dirks to dissolve WLOW and take the Property if he did not receive the entire $1.7 million sum, it certainly did not authorize him to place himself in a position to exercise that remedy by engaging in deceit, trickery, or other machinations vis-a-vis his fellow LLC members.
The court also held that an operating agreement cannot relieve the manager of his fiduciary duties in matters “fundamentally related to the LLC’s business.” Here, the court held, it was undisputed that “Dirks acquired WLOW’s property to the detriment, indeed, the destruction, of WLOW.”
The court remanded the case back to the trial court with the jury’s verdict reinstated, and for a new trial on the amount of punitive damages to be awarded against Dirks and Omar.
Lesson
Under the unpublished Wardak opinion, just because certain conduct is authorized in an LLC operating agreement does not mean that the exercise of that conduct can never violate fiduciary duties.