Thursday, November 19, 2015

Contract Law, Fiduciary Duties, Good Faith, Fair Dealing, and the Legal Status of LLC Operating Agreements (Contract Is King Micro-Symposium)

The title of this post undoubtedly promises too much.  But that won't prevent me from trying to establish a few points that approach the many topics that could be discussed under a title that includes this much great stuff.  I make that attempt here.

I start with contract law.  As I noted in my prior post for this micro-symposium, one of my appearances at last week's ABA LLC Institute included a debate on whether an operating agreement is a common law contract.  This question arose in connection with my teaching of operating agreements (and also has arisen in my teaching of partnership agreements) in Business Associations.  Of course, lawyers understand that not all agreements are contracts.  A significant amount of energy is spent on this matter in the beginning of the standard contracts course in law school.  

Is an LLC operating agreement a contract?  I like the question not just for its face value, but because I believe that the answer does or may matter for purposes of resolving other questions arising in and outside LLC law.  I captured some thoughts about this question in a draft essay soon to be published in revised form in the SMU Law Review.  (I blogged about it here over the summer.)  Among other things, with judicial and legislative attention on freedom of contract in the LLC, the status of the LLC as a matter of contract law may shed light on the extent to which contract law can or should be important or imported to legal issues involving LLC operating agreements.

My interest in the subject emanated from a Tennessee bankruptcy case, In re Denman, 513 B.R. 720 (Bankr. W.D. Tenn. 2014), that has gotten a lot of press on this and other issues.  The Denman court finds that aTennessee LLC operating agreement is not a common law contract (but rather an organic document) and, therefore, that it cannot be an executory contract for bankruptcy law purposes.  No offense meant to bankruptcy folks, but I am less interested in the bankruptcy law/executory contract part of the opinion.  So, I focused in on the common law contract part.

The Denman court references that law as follows:

Contracts are unique instruments under the law with distinct elements: offer, acceptance, adequate consideration, and mutual assent. Contract rights arise upon an offer, acceptance, and transfer of adequate consideration between at least two assenting parties. If these elements do not exist, a contract right does not exist . . . .

Id. at 723 (citations omitted).  The opinion sets forth four attributes of Tennessee's LLC law that support the court's conclusion that an operating agreement adopted under that law is not a contract:

  • the deemed agreement to the operating agreement of those becoming members of the LLC after the operating agreement has been executed;
  • the ability to amend an operating agreement with less than unanimous consent of the LLC's members;
  • the possibility that an LLC may have only one member; and
  • the material breach by  an LLC member of the member's obligations under an operating agreement does not excuse the performance of other members' obligations to contribute to the LLC.

Id. at 723-25.  If the operating agreement is not a contract, what is it?  The court concludes that "the LLC operating agreement here is . . . more appropriately classified as a business formation and governance instrument."  Id. at 726.  

Although I challenge some of the court's analyses of the four attributes listed above in my essay, there are some solid points raised in the court's opinion--points that would benefit from further thought.  With that in mind, let's assume that the Denman court may be correct and that operating agreements are not (or not always) contracts.  What are some possible ramifications?

First, we may not be able to rely on contract law principles to govern the validity, binding nature, and enforceability of operating agreements .  That may be inconsequential as a matter of LLC law to the extent that, independent of the contract status of the operating agreement, LLC law provides for the enforceability, binding nature, and enforceability of the operating agreement in a particular context.  But if the operating agreement (or an agreement comprising the operating agreement) is intended to have functions that extend beyond LLC law, its failure to meet contract norms may render it--or components of it--invalid or unenforceable or may change the extent to which it may be binding on various parties.

An interesting pair of footnotes to this observation relates to what the Revised Uniform Limited Liability Company Act (RULLCA) terms the "contractual obligation of good faith and fair dealing," provided for in RULLCA Section 409(d).   (See generally Dan Kleinberger's posts here, here, and here.)  First, the RULLCA's reference to a "contractual" obligation, in its direct reference to the law of contracts, seems to invite the application of contract law in the interpretation and enforcement of that statutory obligation.  Second, the very inclusion in the RULLCA of that provision seems to indicate a question about the contract law status of an operating agreement.  If an operating agreement is a contract, there would be no need to have an express statutory provision on the obligation of good faith and fair dealing.  The obligation would be read into the operating agreement as an implied covenant under common law.  Admittedly, the RULLCA provision references the application of the covenant to the discharge of the duties and obligations both under the operating agreement and the statute itself.  (And I have not looked to see if there are cases implying good faith and fair dealing in statutory compliance.)  But the fact that the drafters of the RULLCA (and the Revised Uniform Partnership Act, from which this provision comes) determined to expressly include in the RULLCA a statutory obligation of good faith and fair dealing may indicate their doubt that the obligation otherwise would be implied in an operating agreement, perhaps because it may not be a contract.

As to the impact of the contract law status of operating agreements on fiduciary duties in the LLC context . . . well . . . unless one is willing to take literally the assertions in work by, e.g., Frank Easterbrook and Daniel Fischel that fiduciary duties may be "presumptive contractual terms" (see Frank H. Easterbrook & Daniel R. Fischel, Contract and Fiduciary Duty, 36 J.L. & Econ. 425. 429 (1993)), fiduciary duty law is not generally deemed to be read into contractual relationships as a matter of contract law.  Instead, fiduciary duties are said to exist in or arise out of certain types of relationships between parties, some of which may be contractual relationships.  In any event, the degree to which a party in a fiduciary relationship should be able to agree around the duty depends on the theory of fiduciary relations to which one subscribes.  This is what the debate now centers on in LLC law--especially in Delaware, as others in this micro-symposium have described (including notably Mohsen Manesh here and here and Sandra Miller here).  So, the existence or non-existence of fiduciary duties in the LLC is not dependent in a palpable way on the LLC operating agreement being or not being a contract.

Apart from these headline issues, however, there are many other LLC questions that may be impacted by the determination that an LLC operating agreement is or is not a contract.  For example, the application of laws relating to contract enforcement (like statutes of frauds and limitations) may be at issue.  In addition, if contract law is not applicable to controversies involving LLC operating agreements, we might question whether legal capacity is a predicate to enforcement of an operating agreement against a party.  Also, the status of LLC operating agreements as common law contracts may impact whether a court may void an operating agreement term as, e.g., against public policy or apply third-party beneficiary law in construing an operating agreement.  Finally, the judiciary's willingness to bind non-signatories, including managers, to operating agreements (in the absence of statutory provisions requiring non-parties to be bound) also may depend on whether an operating agreement is a contract.

So, while contract may be king in LLC law, we may question whether a contract even exists under LLC law.  Of course, maybe all of the foregoing says less about the contractarian nature of LLC law than it says about the contract law status of operating agreements. Still, as the post indicates, there is some overlap between the two that is worth exploring.

Business Associations, Joan Heminway, LLCs | Permalink


Fascinating post Joan! I will be adding the Denman case to my casebook. Thank you for your thoughtful analysis of the implications. Looking forward to reading your essay.

Posted by: Anne Tucker | Nov 20, 2015 6:57:56 AM

I appreciate the thoughts, Anne. Just for the record, the SMU Law Review essay covers part of the material here and some things not covered here, too. But some of this post is new material about which I may write in the future. I hope I can count on you to help me in thinking through the new piece!

Posted by: joanheminway | Nov 20, 2015 9:00:14 AM

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