Tuesday, February 2, 2016
Embracing Freedom of Contract in the LLC: Linking the Lack of Duty of Loyalty to a Duty of Disclosure
I have been giving a lot of thought to the idea of waiving the duty of loyalty in LLCs in Delaware. The more I think about it, the more I am okay with the concept of allowing members of an LLC to decide to do away with the duty of loyalty when they form the entity. Delaware, of course, retains the implied covenant of good faith and fair dealing in any contract, and I think parties to a contract should be able to decide the terms of their deal.
Still, I am sympathetic to those who are concerned about eliminating the duty of loyalty because it does seem rather awful, and yet, I am also a proponent of freedom of contract. How to reconcile these things? Well, I am now of the mind that perhaps we need to bring a partnership principle to LLCs to help. In partnerships, the default rule is that changes to the partnership agreement or acts outside the ordinary course of business require a unanimous vote. See UPA § 18(h) & RUPA § 401(j). I think changes to the duty of loyalty should have the same requirement, and perhaps that even the rule should be mandatory, not just default.
At formation, then, those creating an LLC would be allowed to do whatever they want to set their fiduciary duties, up to and including eliminating the consequences for breaches of the duty of loyalty. This is part of the bargain, and any member who does not agree to the terms need not become a member. Any member who joins the LLC after formation is then on notice (perhaps even with an affirmative disclosure requirement) that the duty of loyalty has been modified or eliminated. This is not especially concerning to me.
What would concern me more is a change in the duty of loyalty after one becomes a member. That is, if the majority of LLC members could later change the loyalty provision, then that seems problematic to me, as fiduciary duties are not just to protect the majority. As such, it seems to me more proper that changes to the duty of loyalty, when a member does not have any say in that change, is what should be restricted. Like in changing a partnership agreement, if everyone agrees, then there is not a problem. And if you accept the provision when you join, it is not a problem. But you shouldn't have a fiduciary duty removed or modified after the fact without your consent.
Because the duty of loyalty is a fixture that most people expect, I do see value in requiring (at least for some time) that there be clear disclosure of the applicable to duties to potential LLC members. But at least for the moment, I am feeling the freedom of contract option on the duty of loyalty is quite reasonable.
https://lawprofessors.typepad.com/business_law/2016/02/i-have-been-giving-a-lot-of-thought-to-the-idea-of-waiving-the-duty-of-loyalty-in-llcs-in-delaware-the-more-i-think-about-it.html
Comments
Thanks for the comment, and it's a good question, Mohsen. I think it’s fair to say I see this a normative issue in that I see part of the concern regarding fiduciary duty provisions, especially the duty of loyalty, as different than other terms of an agreement because people expect the duty of loyalty to be part of the bargain, and they have for a long time. The duty of loyalty norm is sufficiently ingrained that I think more active notice (and more explicit consent) is necessary, and that eliminating the duty of loyalty is sufficiently unique that it warrants unique treatment if it is to be eliminated. Duty of loyalty provisions were typically considered mandatory provisions, and while I am okay with easing that requirement as mandatory, I am not comfortable with allowing such provisions to be treated as equal to any other part of the agreement. The duty of loyalty is a big enough deal to me that I am fine with active and repeated disclosure. If you want to get rid of it, shout it from the rooftops. I frankly don’t think many investors would worry about it. Clear and full disclosure can also help manage investor expectations and create (hopefully) some efficiencies in the courts by creating some clearer boundaries around the duty of loyalty and the implied covenant of good faith. I think it’s obvious I need to think this through more, and I admit this is a “freedom-ish of contract” argument, but I think the downside to such a requirement is minimal, and there is potential upside in terms of market confidence through disclosure.
Posted by: Joshua Fershee | Feb 3, 2016 6:24:53 AM
Isn’t it pretty clear now in Delaware, after Auriga and Kelly v. Blum that the duty of loyalty exists as the default rule and that the otherwise permissible waiver has to be clearly stated? That is, if you are a promoter seeking to have any fiduciary duties disclaimed, the burden is on you to make it crystal clear, or you run the risk, after the fact, of not having the waiver. That strikes me as the functional equivalent of a disclosure requirement built into the very mechanics of the waiver itself.
Posted by: Jeff Lipshaw | Feb 3, 2016 7:11:20 AM
See Colorado Supreme Court decision in fox v i-10 re amendments. Not sure duty of loyalty is more supreme than capital contributions.
Posted by: Callison | Feb 3, 2016 8:29:10 AM
Jeff Lipshaw, I agree with you, other than the very last part. I think that an overt disclosure requirement as part of the mechanics of the waiver sends an additional measure of information to the market. For me, it’s not just about the need for an overt disclosure, but also about the signaling to investors the duty of loyalty is in play and that it should be actively considered as part of the investment process. I was long of the view that if investors really cared, they’d investigate, but the response to freedom of contract principles on this front runs into the common objection that "investors can’t really know” and that it is somehow unfair. As such, I have evolved to advocate more overt disclosures because I don’t think they will harm the operation of the market, they have minimal costs, and they would serve to protect the current freedom of contract protections available in Delaware, which I fear will be rolled back unnecessarily.
Posted by: Joshua Fershee | Feb 3, 2016 10:37:33 AM
It would have been helpful to me, and perhaps some other readers, if the excellent discussion of the concept of allowing members of the LLC to decide to do away with the duty of loyalty would have also provided readers with a clear explanation of the difference between (X) a duty of loyalty, (Y) a duty of good faith, and (Z) a duty of fair dealing.
For example, some discussion of how, when and under what circumstances an LLC member could be in breach of a duty of good faith and/or fair dealing under circumstances where that member would not have any duty of loyalty.
Posted by: Dom Greco | Feb 3, 2016 10:51:17 AM
Nice job. I comment here: http://www.professorbainbridge.com/professorbainbridgecom/2016/02/regulating-mid-term-llc-operating-agreement-limitations-of-fiduciary-duties.html
Posted by: Steve Bainbridge | Feb 3, 2016 3:03:30 PM
Following up on Bill Callison's comment, why is the modification of the duty or loyalty, or even its waiver, more deserving of a special disclosure obligation than is any other departure from the default model? Why not treat in a similar manner an arbitration clause? Or an obligation to contribute additional capital? Or a provision permitting amendment of the agreement by less than unanimous approval (the factual underpinning of the I-10 case Bill referenced)? Or the ...
In fact any provision, whether it incorporates or departs from the default regimen, is only "important" when it is used by one side as a shield or by another as a sword. Ergo, a priori, every provision (that's an admitted overstatement; it does not apply to the identification of the registered agent) is of equal import.
Posted by: Tom Rutledge | Feb 9, 2016 10:44:28 AM
If an LLC member consents to an LLC agreement that includes a provision allowing for amendment of the agreement by less than unanimous member consent, then wouldn’t the same freedom of contract principles dictate that the amendment provision should be enforced, even if the result is an amendment to the LLC agreement that abates or eliminates the fiduciary duty of loyalty? Perhaps the same limits-of-human-cognition argument that is made against fiduciary waiver provisions could be made against provisions allowing for amendment by less than unanimous member consent—namely that such provisions should not be enforced because an individual simply cannot conceive and anticipate ex ante the numerous ways in which such provisions could play out and so the nature of the individual’s “consent” is suspect. But if you buy that argument for provisions allowing for amendment by less than unanimous member consent, then why not also for fiduciary waiver provisions? How do you distinguish the two?
Posted by: Mohsen Manesh | Feb 2, 2016 8:38:08 PM