I mean, who writes this stuff? (II)

I mean, who writes this stuff? (II)

As I have otherwise noted, a significant portion of my practice is devoted to both writing operating agreements and as well reading operating agreements written by others. Sometimes, in the latter role, I am just shocked by what I read.

For example, recently I was reviewing an operating agreement, written by an attorney in another law firm here in Louisville (I’m not going to disclose either the attorney or the firm), which contained a provision modifying (well, maybe modifying) the fiduciary duties that applied in the LLC. The Kentucky LLC Act expressly permits the modification of the fiduciary duties provided that such is done in a written operating agreement. See KRS § 275.170. It needs to be understood, however, that modifying fiduciary duties is a very complicated procedure for which a series of questions must be addressed. Fail to address any of those questions, and ambiguity is created.

With that as background, the agreement I was recently reviewing provided in part:

Fiduciary Duties of Members and Managers. Each Member and Manager shall have a fiduciary duty of good faith, loyalty and fair dealing towards the Company and the Members. Nothing in this paragraph [XX] shall be interpreted or applied to alter the explicit terms of this Agreement or the Act, including without limitation, the limitations set forth in this Agreement and the Act (including without limitation, KRS 275.150) on a Member’s obligation to contribute towards the liabilities of the Company or other Members.

Okay, let’s start breaking this down.

Who Owes Fiduciary Duties?

Initially, the LLC governed by this operating agreement has elected to be manager-managed. As such, pursuant to KRS § 275.170(4), while the managers owe fiduciary duties, the members do not. The first sentence of this provision provides, however, that each “member” shall owe a “fiduciary duty” to the company and to the members. As such, this provision imposes duties upon the members to which they would not otherwise be bound.

What are the duties owed?

As recited above, members and managers owe the fiduciary duties of “good faith, loyalty and fair dealing.” However, none of these terms are defined in the operating agreement, and they are not elsewise well-defined in Kentucky law. As such, what is meant by an obligation of “good faith” is indeterminate. The same would apply to a fiduciary obligation of “fair dealing.” While there is the implied contractual covenant of “good faith and fair dealing,” that is a principle of contract, and not a fiduciary, law, so what is meant by that term cannot be applied in determining what are these fiduciary duties. Likewise, while there are a category of obligations that are generally categorized as falling within a fiduciary “duty of loyalty,” there is no freestanding definition of what is the fiduciary duty of loyalty. Ultimately, while the sentence has passed spellcheck, it is functionally ambiguous as to what are the fiduciary duties undertaken.

Back to the Statute?

The above quoted language goes on to provide that “Nothing in this paragraph shall be interpreted or applied to alter the explicit terms of ... the Act.”  Except it does exactly that. First, as noted above, this is a manager-managed LLC. The members, pursuant to the terms of the Act, do not owe fiduciary duties. The lead-in sentence of this provision, however, imposes fiduciary duties upon the members. In so doing, the language of the agreement serves to “alter the explicit terms of … the Act” with respect to who owes the fiduciary duties.

The Kentucky LLC Act contains comprehensive provisions as to what is the duty of care and what is the duty of loyalty imposed in an LLC. None of those formulae include either “good faith” or “fair dealing” as fiduciary obligations. As such, the language employed in this provision would again “alter the explicit terms of … the Act,” thereby potentially rendering the references to “good faith” and “fair dealing” nullities. Conversely, while the LLC Act does recognize a duty of loyalty, it provides specific requirements as to what is required of that obligation. Therefore, in order to avoid any alteration of the explicit terms of the Act, “loyalty” as employed in this operating agreement likely should be interpreted as in effect incorporating by reference the statutory duty of loyalty.

To Whom is the Duty Owed?

Under the language above quoted, the duty of loyalty is owed “the Company and the Members.” A duty of loyalty and may be interpreted as requiring that the balance fiduciary put the interest of the beneficiary of the fiduciary obligation above their own interest. Under the LLC Act, the duty of loyalty is owed only to the company; it does not as well run to the members of the company. Here, the duty would run as well to the other members. But how does that work? If a particular transaction will benefit the company but be to the detriment of one or more of the other members, or be to the advantage of one or more particular members but disadvantageous to the company, how is the duty of loyalty to be satisfied?

But then, as has been otherwise discussed, it is provided that nothing shall be “applied to alter the explicit terms of … the Act.” The Act is quite specific that the duty of loyalty is owed only to the company. For that reason, is the suggestion that the duty of loyalty should as well run to the other members of the essentially a dead letter?

I’m not going to even bother with the last clause of this provision beyond noting that the limited liability rule of KRS § 275.150 has absolutely nothing to do with the liability of a member or manager for their own breach of a fiduciary duty. If, for example, a manager expropriates a company asset, the manager is liable to the LLC for both the value of the asset and all of the gain realized from its use.  The rule of limited liability enjoyed by members and managers does nothing to shield the manager from that liability.

Again repeating myself, I am always amazed at the willingness of general practitioners to draft operating agreements. While nobody will “take a stab” at writing a 401(k) plan, it seems everybody thinks they can write an operating agreement.