Policing limited liability companies under contract law

American Business Law Journal

Volumn 46, Issue 2, 2009, Pages 279-310

  Dimatteo, Larry A ^a  

^a UNIVERSITY OF FLORIDA   (United States)

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EID: 67650284967     PISSN: 00027766     EISSN: 17441714     Source Type: Journal    
DOI: 10.1111/j.1744-1714.2009.01079.x     Document Type: Article

References (165)

1. DEL. CODE ANN. tit. 6, §17-110.1(c) & (d) (2007).
2. An operating agreement "may not limit or eliminate liability for any act or omission, that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing." DEL. CODE ANN. tit. 6, §18-110.1(e) (2007).
3. Sandra K. Miller, Fiduciary Duties: 'Theoretical Underpinnings and the Mandatory Core Approach (unpublished manuscript, on file with the author) [hereinafter Mandatory Core];
4. Sandra K Miller, Developing a Conceptual Framework for a Model LLC Statute (unpublished manuscript, on file with the author) [hereinafter Conceptual Framework];
5. Sandra K. Miller, Fiduciary Duties in the LLC: Mandatory Core Duties to Protect the Interests of Others Beyond the Contracting Parties, 46 AM. BUS. I.J. 243 (2009);
6. Sandra K. Miller, What Fiduciary Duties Should Apply to the LLC Manager After More Than a Decade of Experimentation?', 32 J. CORP. L. 565 (2007) [hereinafter Fiduciary Duties].
7. There is a growing body of literature directed at the contractarian-communitarian (traditionalist) debate. See, e.g., Henry N. Butler & Larry E. Ribstein, Opting Out of Fiduciary Duties: A Response to the Anti-Contractarians, 65 WASH. L. REV. 1 (1990);
8. Frances S. Fendler, A License to Lie, Cheat, and Steal? Restriction or Elimination of Fiduciary Duties in Arkansas Limited, Liability Companies, 60 ARK. L. REV. 643 (2007);,
9. Miller, Fiduciary Duties, supra note 3; Larry E. Ribstein, Fiduciary Duty Contracts in Unincorporated Firms, 54 WASH. & LEE L. REV. 537 (1997).
10. ARK. CODE ANN. §4-32-1304(a) (2006).
11. See DEL. CODE ANN. 6-1.101(d) (2007);
12. DEL. CODE ANN. 6-18-1101 (2007).
13. See ARK. CODE ANN. §4-32-404 (2006).
14. See GA. CODE ANN. §14-11-305(1) (2007);
15. MICH. COMP. LAWS ANN. §450.4404(1) (2007);
16. MINN. STAT: ANN. §322B.69 (West 2006).
17. NEV. REV. STAT. ANN. §§86.411 & 86.421. (2007) (permitting indemnification if in the best interests of the company or not opposed to the best interests, or if in a criminal suit, there was no reasonable cause to believe the conduct was unlawful);
18. N.Y. LTD. LIAB. CO. LAW §420 (Consol. 2007) (prohibiting indemnification if bad faith, deliberate dishonesty, or personal gain not entitled to);
19. VA. CODE ANN. §.1.3.1-1025 (2007) (prohibiting indemnification if there was willful misconduct or a knowing violation of law).
20. See ARIZ. REV. STAT. ANN. §29-610 (2006);
21. N.J. STAT: ANN. §42:2B-10 (2006).
22. Fendler, supra note 4.
23. Delaware courts have tapped into this case law pertaining to other types of business organizations as an aid in the interpretation of LLC operating agreements. For example, in NAMA Holdings, LLC v. World Market Center Venture, LLC, 948 A.2d 411, 421 (Del. Ch. 2007), the Delaware Court of Chancery, relying on Delaware corporation law, construed an ambiguous inspection rights clause in an LLC operating agreement to require reasonable access.
24. See Meghan Gruebner, Delaware's Answer to Management Deadlock in the Limited Liability Company: Judicial Dissolution, 32 J. CORP. L. 641, 649-50 (2007).
25. See Rebecca J. Huss, Revamping Veil Piercing for all Limited Liability Entities: Forcing the Common Law Doctrine into the Statutory Age, 70 U. CIN. L. REV. 95 (2001);
26. David L. Cohen, Theories of the Corporation and the Limited, Liability Company: How Should Courts and Legislatures Articulate Rules for Piercing the Veil, Fiduciary Responsibility and Securities Regulation for the Limited Liability Company?, 51 OKLA. L. REV. 427 (1998).
27. [A]ny transaction from which the manager, director, or executive derived an improper personal benefit... except that indemnification ... may be provided if approved by all the members." N.C. GEN. STAT. §57C-3-32(b) (2007)'(emphasis added).
28. Id.
29. Morris v. Hennon & Brown Props., 2008 U.S. Dist. LEXIS 55963 (M.D.N.C. 2008) (quoting RUSSELL M. ROBINSON II, ROBINSON ON NORTH CAROLINA LAW §34.04[3], at 34-23-34-24.1 (7th ed. 2007)).
30. VA. CODE ANN. §§ 13.1-1000 (2008). Sections 13.1-1022-13.1-1028 are silent regarding fiduciary obligations among LLC members. VA. CODE ANN. §§13.1-1022-13.1-1028 (2008).
31. VA. CODE ANN. § 13.1-1024.1 (2008).
32. See, e.g., GA. CODE ANN. §14-11-305(1) (2007);
33. IOWA CODE ANN. §490A.706(1) (2006);
34. OHIO REV. CODE ANN. §1705.29(B) (2007).
35. See, e.g., FLA. STAT. ANN. §608.4225(l)(b) (West 2007);
36. IND. CODE ANN. §23-18-4-2 (West 2007);
37. WASH. REV. CODE ANN. §25.15.155(1) (West 2007).
38. See, e.g., MASS. GEN. LAWS ch. 156C, § 8 (2007);
39. NY LTD. LIAB. CO. LAW §420 (Consol. 2007);
40. VA. CODE. ANN. §13.1-1025 (2007).
41. Myron T Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited, Partnerships and Limited Liability Companies, 32 DEL. J. CORP. L. 1, 5 (2007).
42. See generally Revised Uniform Limited Liability Company Act, cmt., §110 (2006), http:// www.law.upenn.edu/bll/archives/ulc/ullca/2006act- final.htm [hereinafter RULLCA] (adopting the Delaware model, noting "limited liability is as much a creature of contract as of statute").
43. See Haley v. Talcott, 864 A.2d 86, 98 (Del. Ch. 2004) (where the LLC operating agreement did not expressly provide a standard for dissolving the LLC, the court granted dissolution under Section 243 of the Delaware General Corporation Law).
44. See, e.g., 6 DEL. CODE ANN. 17-802 (2008) (authorizing the dissolution of the partnership whenever it is no longer reasonably practicable to carry on the business).
45. See also 6 DEL. CODE ANN. 18-802 (2008) (authorizing the dissolution of the LLC whenever it is no longer reasonably practicable to carry on business).
46. See Gruebner, supra note .13, at 652-53.
47. RESTATEMENT (SECOND) OF CONTRACTS §205 (1981).
48. U-C.C. §.1-304 (2001).
49. RAYMOND YOUNGS, ENGLISH, FRENCH & GERMAN COMPARATIVE LAW 55 (1998). In some cases, courts "have been prepared to prevent contracting parties exercising their right where it would be unfair to do so."
50. Id, at 421-22. Despite its modern iteration, in the U.C.C, the doctrine of good faith is traceable to the Roman law principle of bona fides.
51. See HAROLD J. BERMAN, LAW AND REVOLUTION: THE FORMATION OF THE WESTERN LEGAL TRADITION 34 (1983).
52. Luigi Russi, Can Good Faith Performance be Unfair? An Economic Framework for Understanding the Problem, 29 WHITTIER L. REV. 565 (2008)
53. (quoting Simon Whittaker & Reinhard Zimmermann, Good Faith in European Contract Law: Surveying the Legal Landscape, in GOOD FAITH IN EUROPEAN CONTRACT LAW 34 (Reinhard Zimmermann & Simon Whittaker eds., 2000)).
54. Id.
55. Id.
56. E. ALIAN FARNSWORTH, GOOD FAITH AND FAULT IN CONTRACT LAW .154 (Jack Beatson & Daniel Friedman eds., 1995).
57. RESTATEMENT (SECOND) OF CONTRACTS §205 cmt. d (1981).
58. Robert S. Summers, "Good Faith" in General Contract Law and the Sales Provisions of the Uniform Commercial Code, 5 VA. L. REV. 195 (1968) [hereinafter Good, Faith].
59. See also Robert S. Summers, The General Duty of Good Faith-Its Recognition and Conceptualization, 67 CORNELL L. REV. 810 (1982) [hereinafter General Duty];
60. RESTATEMENT (SECOND) CONTRACTS §205 (1981). Compare Steven J. Burton, Breach of Contract and the Common Law Duty to Perform in Good Faith, 94 HARV. L. REV. 369 (1980) (indicating that the discretion-exercising party exercises good faith when exercising discretion within the reasonable contemplation of the parties but exercises bad faith when using discretion to recapture lost opportunities)
61. with Steven J. Burton, More on Good Faith Performance of a Contract: A Reply to Professor Summers, 69 IOWA L. REV. 497 (1984).
62. Daniel B. Bogart, Good Faith and Fair Dealing in Commercial Leasing: The Right Doctrine in the Wrong Transaction., 41 JOHN MARSHALL L. REV. 275, 289 (2008).
63. The moral basis for the good faith doctrine has much in common with the moral underpinnings of fiduciary duties imputed in governance law: "The traditionalists, by contrast, start from the premise that fiduciary principles are grounded in moral standards that concern society as a whole." See Fendler, supra note 4, at 652.
64. See Robert S. Summers, Good Faith, supra note 35, at 198.
65. For a conceptualization, of the moral-independent obligation approach to the obligation of good faith see Andrew S. Gold, On the Elimination of Fiduciary Duties: A Theory of Good Faith for Unincorporated Firms, 41 WAKE FOREST L. REV. 123, 136 (2006).
66. See Gold, supra note 38, at 136
67. (quoting Summers, General Duty, supra note 34, at 811).
68. See Burton, supra note 35, at 372.
69. See also Emily M. S. Houh, The Doctrine of Good Faith in Contract La,w: A (Nearly) Empty Vessel, 2005 UTAH L. REV. 1, 8 (2005).
70. See Charles W. Murdock, Fairness and Good Faith as a Precept in the Law of Corporations and Other Business Organizations, 36 LOY. U. CHI. L.J. 551, 563 (2005) (describing the LLC as a hybrid form of organization, having both partnership and corporate characteristics and recommending the imposition of partnership fiduciary duties upon LLC members).
71. See Steele, supra note 23, at 16.
72. Professor Miller asserts that the duty of good faith and the fiduciary duty are fundamentally different: "The imposition of an implied covenant of good faith may appear to be interchangeable with the recognition of fiduciary duties in the partnership, corporate, or LLC relations."
73. Miller, Fiduciary Duties, supra note 3, at 8. I agree that good faith and fiduciary duty are different. As stated previously, the place of self-interest as a negative norm is more pronounced in fiduciary duty law than in general contract law. Professor Miller states that good faith, "may appear" the same as a fiduciary duty in a given context. This is consistent with, my point that given the context of existing fiduciary duty law in corporations and partnerships, courts may be tempted to expand the current role of contractual good faith to mimic fiduciary duty law.
74. Miller, Fiduciary Duties, supra note 3, at 8.
75. Farnsworth, supra note 33, at 163.
76. Id.
77. Karl N. Llewellyn, Book Review, 52 HARV. L. REV. 700, 704 (1939)
78. (reviewing O. PRAUSNITZ, THE STANDARDS OF COMMERCIAL CONTRACTS IN ENGLISH AND CONTINENTAL LAW (1937)).
79. See generally Dale Beck Furnish, Custom as a Source of Law, 30 AM. J. COMP. L. 31, 42-43 (1982) (noting how custom and usage serve as the basis for modern law).
80. Id.
81. Many of these rules and doctrines trace their origins to the nineteenth century or earlier. See PATRICK SELIM ATIYAH, ESSAYS ON CONTRACT (1986);
82. JOEL P. BISHOP, COMMENTARIES ON THE LAW OF CONTRACTS (2d ed. 1907); GRANT GILMORE, THE AGES OF AMERICAN LAW (1977).
83. See also Morton J. Horwitz, The Historical Foundations of Modern Contract Law, 87 HARV. L. REV. 917 (1974).
84. W. DAVID SLAWSON, BINDING PROMISES: THE LATE 20TH CENTURY REFORMATION OF CONTRACT LAW (1996) (tracing the equitable adjustment).
85. See also LARRY A. DIMATTEO, EQUITABLE LAW OF CONTRACTS: STANDARDS AND PRINCIPLES (2001);
86. Larry A. DiMatteo, Equity's Modification of Contract: An. Analysis of the Twentieth Century's Equitable Reformation of Contract Law, 33 NEW ENG. L. REV. 265 (1999).
87. -817 A.2d 160(Del. 2002).
88. 'Steele, supra note 23, at 12.
89. No. B .164377, 2004 Cal. App. Unpub. LEXIS 7824, at *26 (Cal. Ct. App. Aug. 25, 2004).
90. Labovitz v. Dolan, 545 N.E.2d 304, 310 (Ill. App. Ct. 1989).
91. See, e.g., OR. REV. STAT. §63.155(10)(a)(A) (2007) ("an operating agreement may identify specific types or categories of activities that do not violate the duty of loyalty, if not unconscionable").
92. See RULLCA, supra note 24.
93. See generally Daniel S. Kleinberger & Carter G. Bishop, The Next Generation, Revised Uniform Limited Liability Company Act, 62 BUS. LAW. 515 (2007).
94. The Comment to Section 409 of the RULLCA provides: "The duty of good faith and fair dealing should be used only to protect agreed-upon arrangements from conduct that is manifestly beyond what a reasonable person could have contemplated when the arrangements were made ." RULLCA, supra note 24, §409(d).
95. See generally Mark J. Loewenstein, Fiduciary Duties and Unincorporated Business Entities: In Defense of the 'Manifestly Unreasonable' Standard, 41 TULSA L. REV. 411, 411 (2006).
96. Miller, Decade of Experimentation, supra note 3, at 585-86.
97. Id. Professor Miller argues that "the empirical research paints a picture of an imperfect and diverse contractual playing field. The LLC serves a broad constituency of businesses varying widely in sophistication, financial stature, and legal representation."
98. Id, Another commentator suggests that "the vast majority of these LLCs appear to be small businesses, and many if not most of them are probably formed by persons relatively unsophisticated about the legal rules which govern the operation of LLCs."
99. Fendler, supra note 4, at 643-44.
100. See Todd D. Rakoff, The Law and Sociology of Boilerplate, in BOILERPLATE: THE FOUNDATION OF MARKET CONTRACTS 200, 203 & 210 (Omri Ben-Shahar ed., 2007).
101. For an analysis of the role of bargaining power in contract law, see Daniel Barnhizer, Inequality of Bargaining Power, 76 U. COLO. L. REV. 139 (2005).
102. Sandra K. Miller et al., An Empirical Glimpse into Limited Liability Companies: Assessing the Need to Protect Minority Investors, 43 AM. BUS. L.J. 609 (2006).
103. The Miller et al. study found that of attorneys representing clients holding minority interests in Delaware, only 69% of these clients agreed that the agreements incorporated a buyout provision, while 83% of the attorney-respondents stated the agreements contained a buyout provision. Id. at 623-24.
104. See generally W. David Slawson, Contractual Discretionary Power: A Law to Prevent Deceptive Contracting by Standard Form, 2006 MICH. ST. L. REV. 853, 875-76 (2006) (asserting that the representation of the form given and the context should be viewed as the contract and the standard form as an exercise of "contractual discretionary power").
105. Dalton v. Educational Testing Serv., 663 N.E.2d (N.Y. 1995).
106. See generally Larry A. DiMatteo, The Norms of Contract: The Fairness Inquiry and the 'Law of Satisfaction' - A Nonunified Theory, 24 HOFSTRA L. REV. 349 (1995).
107. HUGH COLLINS, REGULATING CONTRACTS 254 (1999).
108. See generally Symposium, The Enduring Legacy of Lucy, Lady Duff-Gordon, 28 PACE L. REV. 161 (2008) (reviewing Justice Cardozo's opinion recognizing the implied duty of best efforts in agency contracts).
109. See E. Allan Famsworth, On Trying to Keep One's Promises: The Duty of Best Efforts in Contract Law, 46 U. PITT. L. REV. 1 (1984) (noting that the duty of best efforts is different from the implied duty of good faith with which it is currently associated).
110. Professor Fendler notes the greater potential for abuse of discretion or power in the fiduciary relationship: "The relationship between the parties is therefore one which gives the fiduciary a special opportunity to exercise the power or discretion to the detriment of that other person." Fendler, supra note 4, at 646.
111. COLLINS, supra note 68, at 254.
112. Steele, supra note 23, at 4.
113. Miller, Conceptual framework, supra note 3, at 9.
114. For a theoretical examination, of the duty to disclose, see Geoffrey A. Manne, The Hydraulic Theory of Disclosure Regulation and Outer Costs of Disclosure, 58 ALA. L. REV. 473 (2007).
115. See also J. William Callison & Allan W. Vestal, "They've Created a Lamb with Mandibles of Death": Secrecy, Disclosure, and Fiduciary Duties in Limited Liability Company Firms, 76 IND. L. REV. 271 (2001).
116. Mariana Pargendler, Modes of Gap Filling: Good Faith and fiduciary Duties Reconsidered, 82 TUL. L. REV. 1315, 1323-24(2008).
117. The "efficient market hypothesis" is described in Basic, Inc. v. Levinson, 485 U.S. 224, 248-49 (1988).
118. See also Butler & Ribstein, supra note 4, at 33-35.
119. Fendler, supra note 4.
120. See generally IAN R MACNEIL, THE NEW SOCIAL CONTRACT (1980);
121. Ian. R. Macneil, Contracts: Adjustment of Long-Term, Economic Relations under Classical, Neoclassical, and Relational Contract Law, 72 NW. U. L. REV. 854 (1978).
122. See W David Slawson, The New Meaning of Contract: The Transformation, of Contract Law by Standard Forms, 46 U. PITT. L. REV. 21 (1984) (discussing how the parties' reasonable expectations imbue meaning to contracts).
123. KARL LLEWELLYN, THE COMMON LAW TRADITION 364-70 (1960).
124. See also Michael I. Meyerson, The Efficient Consumer Form Contract: Law and Economies Meets the Real World, 24 GA. L. REV. 583 (1990) (discussing the doctrine of reasonable expectations).
125. Id.
126. See RESTATEMENT (SECOND) OF CONTRACTS §195(1) (1981) (term exempting a contracting party from liability for gross negligence is "unenforceable on grounds of public policy").
127. ARK. CODE ANN. §4-32-402 (2008).
128. Id.
129. Even though acts of gross negligence are not exempted, the statute does allow for indemnification, for such acts. ARK. CODE ANN. §4-32-404 (2008).
130. RESTATEMENT (SECOND) OF CONTRACTS §.195(1) (1981).
131. Pargendler, supra note 75, at 1316 (noting that "the precise relationship between good faith and fiduciary duties remains largely unexplored").
132. See Steele, supra note 23, at 17-18 (the Hon. Myron T. Steele, Chief Justice of the Delaware Supreme Court argues that the good faith standard based in fiduciary duty law is more amorphous than the doctrine of good faith in contract law).
133. See Daniel S. Kleinberger, Seven, Points to Explain Why the Law Ought Not Allow the Elimination of Fiduciary Duty Within, Closely Held Businesses-Cardozo Is Dead: We Have Killed Him (William Mitchell Legal Studies Research Paper No. 61), available at http://ssrn.com/abstract= 948234 (last visited Apr. 13, 2009) ("To rely on the contractual duty of good faith as a substitute for fiduciary duty is akin to replacing heavy cream with skim milk.").
134. Professor Farnsworth describes the evolution of the doctrine of good faith performance as a "tangled case law that has marked the doctrine's somewhat uncertain course." Farnsworth, supra note 33, at 169.
135. Llewellyn, supra note 47, at 704.
136. See generally Richard H. McAdams, The Legal Construction of Norms: A Focal Point Theory of Expressive Law, 86 VA. L. REV. 1649 (2000).
137. Miller, Conceptual Framework, supra note 3, at 22.
138. Seana Shiffrin, The Divergence of Contract and Promise, 120 HARV. L. REV. 709 (2007).
139. Roemmich v. Eagle Eye Dev., LLC, 526 F.Sd 343, 353 (8th Cir. 2008).
140. Professor Miller's "Mandatory Core" approach allows for: (1) the delineation, but not the elimination of the duty of loyalty and (2) prohibition, against the indemnification due to conscious disregard of duties and bad faith acts. See Miller, Conceptual Framework, supra note 3, at 40.
141. See also Sandra K. Miller, The Role of the Court in Balancing Contractual Freedom with the Need for Mandatory Constraints on Opportunistic and Abusive Conduct in the LLC, 152 U. PA. L. REV. 1609 (2004).
142. The Uniform Limited Liability Company Act (ULLCA) strikes a reasonable balance between freedom of contract and the mandatory core approach. See ULLCA, http://www.law.upenn. edu/bll/archives/ulc/fnact99/1990s/ullca96.htm (1996). The ULLCA allows the parties to modify these fiduciary duties by agreement, but only to a standard centered on reasonableness. ULLCA §103(b)(2)-(4): "The operating agreement may specify types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable" and may not "eliminate the obligation of good faith and fair dealing under Section 409(d), but the operating agreement may determine the standards by which the performance of the obligation is to be measured, if the standards are not manifestly unreasonable." However, the RULLCA permits the restriction or elimination of duties if not manifestly unreasonable. See RULLCA, supra note 24.
143. OR. REV. STAT. §63.155(1 )-(4) (2007).
144. Id. §63.155(3).
145. Id. §63.155(4).
146. Id. §63.155(9)(c).
147. See supra Part IV.B.
148. OR. REV. STAT. §63.155(10) (2007).
149. Id. §63.155(11).
150. Id, §63.155(10)(b).
151. See, e.g., Butler & Ribstein, supra note 4;
152. Farnsworth, supra, note 33;
153. Miller, Fiduciary Duties, supra note 3.
154. Sometimes, the same facts will give rise to allegations of both a breach of the implied covenant of good faith and a breach of fiduciary duties. See Blue Chip Capital Fund II Ltd P'ship, v. Tubergen, 906 A.2d 827, 833-34 (Del. Ch. 2006) (denying a motion to dismiss a claim of a breach of the implied covenant of good faith and fair dealing but granting dismissal of a claim for breach of fiduciary duty over allegations of directors' overpayment of sales proceeds to another class of stockholders).
155. Miller, Mandatory Core, supra note 3. Professor Miller states, "The imposition of an implied covenant of good faith may appear to be interchangeable with the recognition of fiduciary duties in the partnership, corporate, or LLC relations."
156. Id. at 8-9.
157. Id. at 10.
158. Id.
159. This is what Hugh Collins refers to as the "social dimensions" of organizational contracts: "The organization has a social dimension, one of membership in the association, which creates expectations that go beyond the formal rules." HUGH COLLINS, REGULATING CONTRACTS 254 (1999).
160. RESTATEMENT (SECOND) OF CONTRACTS §205 (1981).
161. Ian. R. Macneil, Reflections on, Relational Contract Theory After a Neoclassical Seminar, in IMPLICIT DIMENSIONS OF CONTRACT: DISCRETE, RELATIONAL, AND NETWORK CONTRACTS 207, 211 (David Campbell et al. eds., 2003).
162. Frank H. Easterbrook & Daniel R. Fischel, Contract and Fiduciary Duty, 36 J.L. & ECON. 425, 438 (1993).
163. See also Stephen M. Bainbridge et al., The Convergence of Good Faith and Oversight, 55 UCLA L. REV. 559 (2008).
164. KARL LLEWELLYN, THE COMMON LAW TRADITION (1960). In Llewellynian parlance, a situationsense approach to contract law application is the use of the "type-facts in their context and at the same time in their pressure for a satisfying working result." Id. at 60.
165. For an outstanding analysis of situation-sense, see Todd Rakoff, The Implied Terms of Contract: Of 'Default Rules' and 'Situation-Sense, in GOOD FAITH AND FAULT IN CONTRACT LAW 191 (Jack Beatson & Daniel Friedman eds., .1995).