Monday, November 25, 2019
Respectfully, I Dissent: Dean Fershee and Elimination of Fiduciary Duties
Respectfully, I Dissent: Dean Fershee and Elimination of Fiduciary Duties
Dean Fershee recently circulated of a short paper titled An Overt Disclosure Requirement for Eliminating the Duty of Loyalty; HERE IS A LINK to the posting he made on the Business Law Prof Blog with respect to this short paper. Therein, at the risk of oversimplifying his argument, he suggests that the various LLC and other unincorporated entity statutes should be amended to provide, inter alia, that a post-formation amendment of the controlling agreement, he being focused in this context on LLC operating agreements, that would either reduce (even to the point of elimination) or expand the duty of loyalty would be permissible if and only if expressly provided for in the operating agreement or, otherwise, with the unanimous consent of the participants. He wrote that “it would be appropriate to me for Delaware to adopt a requirement that, to change or eliminate a fiduciary duty, there must be agreement of all parties or an expressed and clear statement as to what it requires to change that.” He would not allow such a modification to proceed under language providing only “This operating agreement can be modified or changed via majority vote.”
As outlined below, I must respectfully dissent from this view. Generically, absent bespoke private ordering to the contrary, where either the controlling state law (examples being Kentucky and New York) or the operating agreement itself permits modification by less than a unanimous vote of the participants in the venture, they have placed themselves at the mercy of the agreement as amended. With precise drafting, the operating agreement may protect a minority participant protection from what might, ex post, be considered an abusive or oppressive amendment, that protection is, as it should be, the product of negotiated private ordering. Recall that the test is for whether the participants to an agreement understood the agreement they were entering into (i.e., this agreement may be amended by less than all of the participants in the venture.) and not all of the implications of the agreement into which they have entered (i.e., the duty of loyalty owed under this agreement is subject to subsequent modification, waiver or elimination.).
In short, I do not believe there is justification for protecting people from the consequences of the contracts into which they enter.
Second, I do not see the application of a rule such as that espoused by Dean Fershee could practically be applied as there would be myriad questions as to its scope. Admittedly, it would control with respect to a proposed amendment to the operating agreement of “notwithstanding [cite duty of loyalty provision of controlling LLC Act], and to its exclusion, no member/manager in the Company shall be bound by or subject to any duty of loyalty.” Okay, fine, but let us now assume an LLC organized for real estate development purposes that is the current title owner of 234 Chestnut Street. May whatever threshold of the members is defined in the operating agreement as being able to amend it [the “Majority Members”] change the purpose clause of the LLC to provide “the sole and exclusive purpose of the Company is to own, develop, lease and ultimately sell the improved real property located at 234 Chestnut Street. The Company will engage in no other activities.”? With this amendment to the operating agreement the scope of the duty of loyalty that might otherwise apply has been constrained, thereby allowing the members to be engaged in other real estate project without violation of the opportunity doctrine or an obligation to not be involved in activities that are competitive with the LLC. May the Majority Members amend the operating agreement to provide, inter alia, that they are permitted to engage in self-interested transactions with the LLC without the requirement of a disinterested vote, and that in any challenge thereto the minority members will bear the burden of proof as to the impropriety of the transaction? May the Majority Members amend the operating agreement to provide mandatory advancement of expenses in the event of any challenge to any transaction they undertake vis-a-vie the company and as well first dollar indemnification for any ultimate liability that does not involve a knowing violation of law? May the Majority Members amend the operating agreement to provide that, in the event of any direct or derivative action challenging an action undertaken by a member of the majority with the company, it shall be referred to a special litigation committee that need not be appointed on a disinterested basis? Alternatively, may it be provided that any direct or derivative challenge to an action undertaken by a member of the company and the LLC shall be subject to mandatory arbitration? Last, but without meaning to suggest that this listing exhaust the possible options, may the majority members amend the operating agreement to provide that they have the capacity to set their own compensation for services rendered to the Company?
Ultimately, what constitutes a restriction on the duty of loyalty is open to dispute.
There is a separate and distinct mechanism that needs to be considered. Assume that the LLC is organized in a state that allows a merger to be approved by less than all the members or, in the alternative, that the LLC’s operating agreement grants a similar capacity. Assume as well that neither the controlling act nor the operating agreement provide for dissenter rights in the event of a merger. In that circumstance, without triggering a liquidity opportunity for the minority members, the Majority Members have the capacity to merge an LLC that does not restrain the otherwise applicable duty of loyalty into an LLC in which the duty of loyalty is expressly waived. While the argument should ultimately fail, no doubt the minority members, in an LLC organized in a state that is adopted Dean Freshee’s suggestion would argue that the merger is nothing more than an amendment to the operating agreement.
Last, I question whether modifications of the duty of loyalty are really that important in typical business organizations. While we read a great deal from Delaware about fiduciary waivers, typically in the instance of fund cases, it is striking how little litigation we see on the point in other jurisdictions. Maybe this is consequent to the fact that those states that have adopted an incarnation of the Uniform LLC Act do not allow a complete waiver of the duty of loyalty, thereby restricting the number of states in which such of provision may appear in the operating agreement. I would submit that rather than being concerned with waivers of the duty of loyalty, minority members in LLCs should focus their efforts at protecting against the elimination of a liquidity right that they might otherwise enjoy, the imposition of a drag-along right or the elimination of a mandatory tax liability distribution. In most circumstances, it is these sorts of modifications in the operating agreement that are more likely to have a true impact upon the minority member’s enjoyment of the benefits of being a member in a particular venture.
Ultimately, I am of the view that entering into an operating agreement that may be amended without the approval of a particular member constitutes that member placing themselves almost entirely at the mercy of those with the capacity to amend the operating agreement, a point addressed in An Amendment Too Far?: Limits on the Ability of Less Than All Members to Amend the Operating Agreement, 16 Florida State University Business Review 1 (Spring 2017) (with Katharine M. Sagan). Persons entering into those arrangements certainly have the ability to negotiate for any of a number of protections. But when they do not, I do not see it as proper for those members and other participants to be protected from the consequence of the decision they have made.