modifying fiduciary duties in llcs live … revlon, inc. v. macandrews & forbes holdings, inc.,...

MODIFYING FIDUCIARY DUTIES IN LLCS

First Run Broadcast: March 22, 2016

Live Replay: August 4, 2016

1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00a.m. P.T. (60 minutes)

Statutory and common law impose certain fiduciary duties – care, diligence, good faith and fair

dealing – on directors and managers of corporate entities, managers of LLCs, and in certain

instances on members of LLCs. There is also the important corporate/LLC opportunity doctrine

that prevents misappropriation of certain corporate or LLC opportunities. In certain instances,

the owners of the entity may want to expand, limit, or even entirely eliminate these duties.

Depending on the entity involved and the specific duty, the law permits modification by

agreement. But great care in drafting these modifications, including full understanding of what

law allows, is essential to avoiding subsequent litigation on the basis of fraud, bad faith and self-

dealing, or misappropriation of entity opportunities. This program will provide you with a

practical guide to modification of fiduciary and other duties in corporations, LLCs and other

entities.

Modifying fiduciary duties in LLCs, corporations and entities

Duties of care, diligence, good faith and fair dealing

What duties may be modified and which may not – and to what extend?

Circumstances in which modification might make sense – competing businesses, finance,

risk of litigation, and more

Defining and limiting application of the corporate/LLC opportunity doctrines

Understanding self-dealing and conflicts of interest, and practical risks

Effective drafting to modify fiduciary duties in new and existing LLCs

Counseling clients about the substantial risks of reducing the fiduciary duties of managers

Speakers:

Frank Ciatto is a partner in the Washington, D.C. office of Venable, LLP, where he has 20

years’ experience advising clients on mergers and acquisitions, limited liability companies, tax

and accounting issues, and corporate finance transactions. He is a leader of his firm’s private

equity and hedge fund groups and a member of the Mergers & Acquisitions Subcommittee of the

ABA Business Law Section. He is a Certified Public Accountant and earlier in his career

worked at what is now PricewaterhouseCoopers in New York. Mr. Ciatto earned his B.A., cum

laude, at Georgetown University and his J.D. from Georgetown University Law Center.

Laura B. Springer is an attorney in the Washington, D.C. office of Venable, LLP, where she

has experience drafting and structuring corporate transaction documents, including purchase

agreements, operating agreements, stockholder agreements, non-disclosure agreements, licensing

agreements, data supply arrangements, professional services arrangements and other sourcing

agreements. Ms. Springer received her B.A. from the University of Virginia and her J.D., cum

laude, from Boston College of Law.

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Fiduciary Duties in LLCs Teleseminar

August 4, 2016 1:00PM – 2:00PM

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: August 4, 2016 Seminar Title: Fiduciary Duties in LLCs Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

1 © 2012 Venable LLP

Fiduciary Duties in Closely-Held Corporations and Limited Liability Companies

Frank A. Ciatto, Venable, LLP (202) 344-8510 / [email protected]

Laura B. Springer, Venable, LLP

(202) 344-4211 / [email protected]

2

Overview

Traditional Corporate Fiduciary Duties

Fiduciary duties

Standards of review in the corporate context

Conflicts and self dealing

Fiduciary Duties in Limited Liability Companies

Contractual fiduciary duties

Default fiduciary duties

Developments in Delaware law

Waiver of Fiduciary Duties and Drafting Limited Liability

Company Agreements

© 2016 Venable LLP

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Traditional Corporate Fiduciary Duties: Duty of Care

Directors and officers are required to exercise the care that a

reasonably prudent person in a like position would exercise

under similar circumstances (Delaware General Corporation

Law)

May rely on experts and advisors – reliance must be

reasonable and made in good faith (Delaware General

Corporation Law Section 141(e))

Must act with care in the discharge of their duties

In a manner in which they would act if conducting their own

affairs

The materials provided to the directors, the length of the

deliberations and the documentation of the process in the

minutes will be critical to the analysis

Gross negligence – reckless indifference or deliberate disregard

© 2016 Venable LLP

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Traditional Corporate Fiduciary Duties: Duty of Loyalty

Directors and officers must put the interest of the

company/shareholders ahead of personal interests

Two pronged analysis

Is the director interested – stands to receive a material

benefit in the transaction different from the stockholders

Is the director independent – analysis is whether the director

is influenced by or beholden to a party with an interest in the

transaction

Good faith – subset of the duty of loyalty

Subjective bad faith – an actual intention to do harm

Intentional/conscious disregard of duties

© 2016 Venable LLP

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Traditional Corporate Fiduciary Duties

Functions of Board of Directors: Directors have two principal

functions:

Decision-making – approving or rejecting corporate actions

Oversight – supervising the business and affairs of the

corporation

When are Challenges Most Likely to Arise?

Change of Control transaction

Failure to Act/Oversee

Self Dealing/Conflict of Interest/Corporate Opportunity

© 2016 Venable LLP

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Traditional Corporate Fiduciary Duties: Standards of Conduct

Change of control transactions – implicates duties of care and

liability

Under Delaware law, there are generally three standards against

which the courts will measure director conduct in a change in

control transaction:

business judgment rule -- for a decision to remain

independent or to approve a transaction not involving a sale

of control;

o policy that courts will not second guess the valid business

judgment made by informed boards

enhanced scrutiny -- for a decision to adopt or employ

defensive measures or to approve a transaction involving a

sale of control; and

entire fairness -- for a decision to approve a transaction

involving management or a principal shareholder or for any

transaction in which a plaintiff successfully rebuts the

presumptions of the business judgment rule.

© 2016 Venable LLP

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Rejecting an Offer - the business judgment rule applies

The Board must determine in the exercise of its business

judgment whether the offer is in the best interests of the

corporation and its stockholders.

Directors must have a reason for rejecting the offer – even in

a closely-held corporation.

Defensive Measures – enhanced scrutiny will be applied if the

Board employs defensive measures in response to a takeover

bid

Directors must satisfy two tests before the business judgment

rule applies: (1) did the directors have reasonable grounds

for believing that a danger to corporate policy or

effectiveness existed, and (2) was the action reasonable in

relation to the threat posed.

May not be likely in the case of a closely-held corporation

© 2016 Venable LLP

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Sale of Control – Revlon Duties

In Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., the

Delaware Supreme Court imposed an affirmative duty on the

board of directors to seek the highest value reasonably

obtainable to the stockholders when a sale of the company

becomes inevitable.

The duty established in Revlon was restated in Paramount

Communications Inc. v. QVC Network Inc., in which the

Delaware Supreme Court further explained the extent of

enhanced scrutiny:

o The consequences of a sale of control impose special obligations

on the directors of a corporation. In particular, they have the

obligation of acting reasonably to seek the transaction offering

the best value reasonably available to the stockholders. The

courts will apply enhanced scrutiny to ensure that the directors

have acted reasonably.

© 2016 Venable LLP

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Sale of Control – Revlon Duties (cont.)

If a change of control transaction is challenged, the care with

which the directors acted will be subjected to close review.

For this review there will be no “bright line” tests, and it may

be assumed that the board may be called upon to show care

commensurate with the importance of the decisions made,

whatever they may have been in the circumstances.

A recent Delaware case noted that no “court can tell directors

exactly how to accomplish [the goal of getting the best price

for the company] because they will be facing a unique

combination of circumstances.”

In the absence of bright lines and blueprints that fit all cases,

the process to be followed by the directors will be paramount.

© 2016 Venable LLP

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Fiduciary Duties: Standards of Conduct

Limitation of Liability

State law may permit the corporation to eliminate or limit the

personal liability of directors

o Section 102(b)(7) of Delaware General Corporation Law – for

duty of care

o Section 2.02(b)(4) of Model Business Corporation Act

Duty of Loyalty in Change of Control Context

Did the directors fail to act in good faith – assuming no

conflict of interest

May be the dispositive issue if no personal liability for

breaches of duty of care

In Lyondell Chemical Company, et al. v. Ryan, 970 A.2d 235

(Del. 2009), the Delaware Supreme Court applied the Disney

bad-faith standard in the transactional context

© 2016 Venable LLP

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In Lyondell, the Supreme Court discussed its analysis of good faith in the

Disney case, in which it had identified three types of bad faith conduct by

a director:

intentionally acts with a purpose other than that of advancing the best interests

of the corporation;

acts with the intent to violate applicable positive law; or

intentionally fails to act in the face of a known duty to act, demonstrating a

conscious disregard for his duties.

The Supreme Court found that:

“Directors’ decisions must be reasonable, not perfect. ‘In the transactional

context, [an] extreme set of facts [is] required to sustain a disloyalty claim

premised on the notion that disinterested directors were intentionally

disregarding their duties.’ The trial court denied summary judgment because

the Lyondell directors’ ‘unexplained inaction’ prevented the court from

determining that they had acted in good faith. But, if the directors failed to do all

that they should have under the circumstances, they breached their duty of

care. Only if they knowingly and completely failed to undertake their

responsibilities would they breach their duty of loyalty. The trial court

approached the record from the wrong perspective. Instead of questioning

whether disinterested, independent directors did everything that they (arguably)

should have done to obtain the best sale price, the inquiry should have been

whether those directors utterly failed to attempt to obtain the best sale

price.” © 2016 Venable LLP

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Oversight Liability – Claims for failure of oversight generally

require showing that directors breached duty of loyalty by failing

to attend to their duties in good faith.

In re Caremark Int'l Inc. Derv. Litig., 698 A.2d 959 (Del. Ch.

1996) was the first case in which a Delaware court articulated

the fiduciary duties of directors in an oversight context. That

case involved breach of fiduciary duty claims against defendant

directors based upon their alleged failure to monitor actions in

violation of the federal Anti-Referral Payments Law.

“[g]enerally where a claim of directorial liability for corporate

loss is predicated upon ignorance of liability creating

activities within the corporation . . . only a sustained or

systematic failure of the board to exercise oversight—such

as an utter failure to attempt to assure a reasonable

information and reporting system exists—will establish the

lack of good faith that is a necessary condition to liability.”

© 2016 Venable LLP

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Stone v. Ritter, 911 A.2d 362 (Del. 2006):

“the Caremark standard for so-called ‘oversight’ liability draws

heavily upon the concept of director failure to act in good faith. That

is consistent with the definition(s) of bad faith recently approved by

this Court in its recent Disney decision, where we held that a failure

to act in good faith requires conduct that is qualitatively different

from, and more culpable than, the conduct giving rise to a violation of

the fiduciary duty of care (i.e., gross negligence).”

Caremark claims fall within the third type of bad faith described by

the Court in Disney—director intentionally fails to act in the face of a

known duty to act, demonstrating a conscious disregard for his

duties.

In re Citigroup Shareholder Derivative Litigation, 964 A.2d 106

(Del Ch. 2009):

Delaware Chancery Court found that Caremark-type duties were not

designed to impose oversight liability for business risk in case that

involved potential liability of directors under Delaware law for losses

suffered by the corporation as a result of exposure to sub-prime debt

© 2016 Venable LLP

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Conflicts of Interest and Self Dealing

Duty of Loyalty and Conflicts of Interest

No self dealing – Directors must refrain from self dealing and

must act in good faith and deal fairly with stockholders when

they have an interest in the transaction

o Director has a personal interest in the transaction

o Director is not independent – even if a director does not have a

personal interest in the transaction, may still be treated as

interested if “beholden” to an interested party such that he or

she cannot exercise independent judgment

A conflict does not constitute a breach – must analyze how

the directors address the conflict

© 2016 Venable LLP

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Dealing with Conflicts of Interest

Statutory “Safe Harbors”

Disclosure of material information to and approval by

disinterested directors

Disclosure of material information to and approval by

stockholders

Transaction fair to corporation

Entire Fairness – burden on directors to prove entire fairness

Fair dealing – analyze the process – timing, structure,

negotiation, disclosure, approvals of directors and

stockholders

Fair Price – is the price one the corporation would receive in

an arms-length transaction – analysis typically involves

factors generally accepted in the financial community

(economic considerations, enterprise value, etc.)

© 2016 Venable LLP

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Dealing with Conflicts of Interest (cont.)

Issues when controlling stockholder is on both sides of the

transaction

o Approval by disinterested directors/special committee

– controlling stockholder cannot dictate the terms of the transaction

– special committee must have real bargaining power that it can

exercise on arms-length basis – authority to consider alternatives

and hire independent advisors

– disinterested directors must be fully-informed and have access to

all material information relating to the company and the

transaction

o Approval by disinterested stockholders

– approval must be a non-waivable condition to the deal

– approved by majority of all disinterested shares – not just those

voted

– stockholders must receive complete and accurate disclosure of

all material information relating to the company and the

transaction

o Approval by disinterested directors or stockholders shifts to the

plaintiff the burden of proving the transaction is unfair © 2016 Venable LLP

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Issues for privately-held corporations

Conflict or independence issues may arise more frequently

because of ownership, oversight and management structures

Lack of disinterested or independent directors

Reluctance of controlling stockholder to condition transaction

on vote of the minority stockholders

Disclosure Issues – requires disclosure of information that

management may not be accustomed to or comfortable

providing

May be more difficult for privately-held corporation to avoid

the entire fairness standard of review

o More likely to settle with minority stockholders

© 2016 Venable LLP

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Corporate Opportunity Doctrine


Subset of the duty of loyalty

General rule is that a director, officer or controlling

stockholder may not appropriate an opportunity rightfully

belonging to the corporation without full disclosure to the

Board and a decision by the disinterested directors to reject

or decline to pursue the opportunity

Fact specific determination

Standard of Review – A corporate fiduciary may not pursue an

opportunity if:

The corporation is financially able to exploit the opportunity;

The opportunity is within the corporation’s line of business;

The corporation has an interest or expectancy in the

opportunity; and

By taking the opportunity, the fiduciary will be in a position

adverse to his duties to the corporation.

© 2016 Venable LLP

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Exceptions – A corporate fiduciary may pursue an opportunity if:

The opportunity is presented to the director in an individual

and not corporate capacity;

The opportunity is not essential to the corporation;

The corporation holds no interest or expectancy in the

opportunity; and

The fiduciary has not wrongfully used the resources of the

corporation in pursuing or exploiting the opportunity.

May also be pursued if full disclosure is made to the Board and it

is approved by disinterested directors – this may present

challenges in the case of a closely-held corporation

Depending on jurisdiction, there may be statutory safe harbors

for pursuing certain corporate opportunities (Section 122(17) of

Delaware General Corporation Law; Section 870 of Model

Business Corporation Act)

© 2016 Venable LLP

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Fiduciary Duties and Limited Liability Companies

Application of fiduciary duties - While states vary on the nature

of the obligations, there is general agreement that members and

managers of an LLC owe fiduciary obligations to the entity, as

well as their co-participants.

Care, loyalty, good faith

Competing business opportunities

Some states have limited liability company statutes that explicitly

apply the duties of care and loyalty to managers (for example,

District of Columbia, California)

Other states have vague limited liability statutes that fail to

specify whether fiduciary duties apply to managers of limited

liability companies (for example, New York)

Threshold Issue: How is an LLC fundamentally different from a

corporation?

It is a creature of contract and the operating agreement is

generally dispositive on the issue of fiduciary duties.

© 2016 Venable LLP

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Implied Fiduciary Duties and Limited Liability Companies

In some states (e.g., Delaware, Virginia), the operating

agreement of an LLC can expand, restrict or eliminate the

fiduciary obligations of the members and managers.

Based on principles of freedom to contract

Not permitted in all jurisdictions

Will a court “read-in” fiduciary duties where the statute and

operating agreement are silent – depends on the jurisdiction

Delaware – yes

Virginia – no

Implied covenant of good faith and fair dealing

Based on contractual principals

Courts may “read-in” implied terms to the contract if the

contract is silent

Not applied when the express terms of the operating

agreement are clear

© 2016 Venable LLP

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Statutory Development in Delaware

In the Delaware Supreme Court case of Gatz Properties, LLC v.

Auriga Capital Corp., the Court created a question as to whether

default fiduciary duties applied to managers of limited liability

companies where the LLC agreement was silent. In this case,

the Court held that the LLC agreement in question expressly

stated the fiduciary duties that applied, and therefore the lower

court holding stating that default duties did imply were dicta (and

did not need to be addressed) without any precedential value.

In a subsequent case, Feeley v. NGAOCG, LLC, the Delaware

Court of Chancery recognized that the dicta in the lower court’s

decision in Auriga was persuasive and held that when an LLC

agreement does not limit or eliminate a managing member’s

fiduciary duties, default fiduciary duties of care and loyalty are

imposed under the DLLCA

© 2016 Venable LLP

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Statutory Development in Delaware

Due to the subsequent confusion, in response, the Delaware

legislature amended the DLLCA Section 18-1104 to make clear

that in accordance with the common law rules of law and equity

relating to fiduciary duties, managers, managing members,

officers and possibility majority or controlling members owe

fiduciary duties to LLC equity owners that are not explicitly

provided for in LLC agreements. (See DLLCA Section 18-1104).

Following the amendment, cases applied the amended law, as

was done in Grove v. Brown, C.A. No. 6793-VCG (Del. Ch. Aug.

8, 2013)

The court held that an LLC agreement must expressly modify

fiduciary duties owed by the managing members – as permitted

by the DLLCA – to avoid the application of default corporate-like

fiduciary duties.

Parties to the limited liability company agreement are left to

determine whether to impose fiduciary duties and/or how to

contract the default duties away

© 2016 Venable LLP

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Drafting Fiduciary Duty Provisions

Precise drafting is critical

Use clear and unambiguous language as to intent

Considerations:

Scope of fiduciary duties

o Fully inclusive

o Complete disclaimer

o Modified duties

Parties to which duties are owed

Indemnification

Pursuing competing business opportunities is often the key

issue

Examples

Multimember limited liability companies

Private equity funds

© 2016 Venable LLP

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Multimember Limited Liability Companies

LLCs are a common entity form for joint ventures, start-up

companies and closely-held businesses of all sizes

Modification of fiduciary duties:

Defines parameters of relationship between members

Avoids uncertainty of whether default fiduciary duties apply

Establishes clear guidelines and expectations for

management

Avoids conflict of interest issues that arise if parties are

competitors or engage in other business ventures

Economic efficiency - Establishes the use of financial

resources of members in the business

Avoids application of corporate opportunity doctrine –

o Drafters should clearly describe and define the purpose of the

business and describe any opportunities members and

managers of the LLC may pursue without having to present them

to the LLC

© 2016 Venable LLP

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Multimember Limited Liability Companies

Modification of fiduciary duties (continued):

Eliminates uncertainty for managers and members in making

management decisions

Benefits members and managers of board-managed LLCs

o If applicable under the state law, default fiduciary duties would

apply

o Permits the board members to act for the benefit of the

appointing member without breaching fiduciary duties to the

other members

© 2016 Venable LLP

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Private Equity Funds

Private equity funds are frequently formed as Delaware limited

liability companies

Critical that fiduciary duties be addressed in the LLC agreement

to avoid problems

Structure

Manager manages the fund and investors invest as non-managing

members

Manager owes fiduciary duty to the company and the investor

members

Inherent conflict of interest if manager is managing related funds

Mitigating Problems

Explicitly eliminate all fiduciary duties of the manager and its affiliates

to the fund in the LLC agreement

Include “sole discretion” provision that modifies fiduciary duties in

specified instances when the manager acts in its “sole discretion”

Specifically authorize certain transactions or relationships in the LLC

agreement “notwithstanding duties otherwise existing at law or in

equity (including fiduciary duties)”

© 2016 Venable LLP

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Contact Information

Frank A. Ciatto, Partner

[email protected]

t 202.344.8510

f 202.344.8300

Laura B. Springer, Associate

[email protected]

t 202.344.4211

f 202.344.8300

Venable D.C. Office

575 7th Street, NW

Washington, DC 20004

© 2016 Venable LLP

mailto:[email protected]

mailto:[email protected]

29

the road ahead for ABC CORPORATION Thank You.

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modifying fiduciary duties in llcs live … revlon, inc. v. macandrews & forbes holdings, inc.,...

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