Recent Changes Regarding Member and Manager Duties
[Note: This is part 3 of series of articles regarding changes to Arizona's Limited Liability Company Law]
Arizona’s newly revised limited liability act (RULLA) clarifies many of the duties that managers and members of the LLC owe.
The act expressly allows (a) limited modifications by agreement, and (b) members to elect to apply the rules governing corporate director liability based on fiduciary duty (including the business judgment rule) to LLC managers in lieu of the new act’s default rules on fiduciary duties. A.R.S. § 29-3409.
Default rules governing the right of a manager or member to be indemnified by the company against third-party claims are also provided in the act. A.R.S. §29-3408. (whereas the previous LLC statute in effect (A.R.S. §§ 29-601 to 29-858) (the “Old Act”) did not.
FIDUCIARY AND OTHER DUTIES
Fiduciary duties are among the most important topics found (or often not found) in operating agreements. Often, disputes among LLC members, claims of “breach of fiduciary duty” are alleged. The new act’s default rules are more clear and are designed to increase clarity about fiduciary duties with the goal of avoiding needless litigation.
Under the new LLC act, the duties of a member in a member-managed limited liability company are similar to those of a manager in a manager-managed limited liability company. In addition, the New Act precludes any implied presumption that a member in a manager-managed LLC owes no fiduciary duties, because an operating agreement may confer extensive management rights upon one or more members in such an entity. ARS § 29-3409(A)-(H).
The New Act states that members in member-managed LLCs and managers in manager-managed LLCs owe to the company and its members the duty of loyalty and the duty of care, and must discharge the members’ duties and obligations and exercise any right consistently with the contractual obligation of good faith and fair dealing. A.R.S. § 3409(I)-(P)
1. Duty of Loyalty
The duty of loyalty includes, but is not limited to, four components:
- to account to the company (and hold as trustee) any benefit to which the manager or member is not entitled;
- to refrain from dealing with the company “as or on behalf of a person having an interest adverse to” the LLC;
- to refrain from competing with the company before the company’s dissolution (which does not prevent competition after dissolution while the company’s affairs are being wound up); and
- to disclose to the other members and managers any material conflict of interest with respect to any decision under consideration or any transaction regarding the company or another member’s interest in the company.
If a material conflict of interest exists, the manager or member must disclose all material facts relating to the decision or transaction under consideration, other than facts already known or reasonably available to the other members and managers. A.R.S. § 29- 3409 provides guidance on whether a conflict of interest is “material.”
2. Duty of Care
The duty of care consists of the requirement to refrain from reckless or grossly negligent conduct or willful or intentional misconduct. A.R.S. §§ 29-3409 (C) and (K) This “sets the bar” where the duty of care traditionally has been set in partnership agreements, but the company’s operat ing agreement can raise or lower the bar (except that that the bar cannot be lowered below willful or intentional misconduct). Unlike the Revised Uniform Limited Liability Act (“RULLCA”), upon which the New Act was largely based, the duty of care under the New Act does not require refraining from a “knowing violation of law” because that standard does not distinguish between trivial and serious violations and because of inconsistencies among federal and state laws regarding cannabis and other subjects.
3. Good Faith and Fair Dealing
The contractual obligation of good faith and fair dealing is implied by contract law in every contract. Under A.R.S. §§ 29-3409(D) and (L), each manager and member must perform his or her duties, and exercise his or her rights, under the New Act and under the operating agree- ment consistently with the contractual obligation of good faith and fair dealing. This obligation may not be varied or eliminated by the operating agreement. Note, too, that this obligation applies not only to all provisions of written operating agreements, but also to pro- visions supplied by the “default” rules of the New Act.
PROVISIONS OF A.R.S. §29-3409
All members must join in any authorization (before the fact) or ratification (after the fact) of any act or omission by a manager or member that would otherwise violate the duty of loyalty, and only after the manager or member has disclosed all material facts. A.R.S. §§29-3409(F) and (N). This unanimity rule is a default rule. A.R.S. §§ 29- 3409(G) and (O) establish a “no harm no foul” rule as a defense for a manager or member who has violated the duty to refrain from acting adverse to the company or has failed to disclose a conflict of interest, to prevent inconsequential violations from being used as a sword against a manager or member. A.R.S. §§ 29-3409(H) and ℗ state that a member has the same enforcement rights against the limited liability company as a third party with respect to a transaction or contract that involves a conflict of interest so long as the operating agreement or the other members authorized or ratified the transaction or contract. Lastly, note that other duties may exist under the common law and are not displaced by the New Act.
LIMITS ON WAIVING FIDUCIARY DUTIES AND DISCLAIMERS
The New Act prohibits any modification or elimination of the contractual obligation of good faith and fair dealing in whole or in part, and any lessening of the duty of care below the standard of willful or intentional misconduct. The New Act allows an operating agreement to specify a method by which a specific act that would otherwise violate a duty can be authorized or ratified, or a method by which liability for violating such a duty can be eliminated, limited or indemnified against. A.R.S. §§29-3105(D)(3) - (4).
THE CORPORATE MODEL ALTERNATIVE
The New Act expressly allows an operating agreement to incorporate the fiduciary duties of a corporate director, officer or shareholder in Arizona and, unless the operating agreement provides otherwise, adopts the rules of evidence and evidentiary presumptions that apply to the fiduciary duties of a director or shareholder of a corporation under Arizona law. A.R.S. §29-3409(E).
IF YOU OPERATE AN EXISTING LLC
Members and managers of existing LLCs should take this opportunity to review existing operating agreements, particularly provisions on fiduciary duties, in light of the new law, and make appropriate changes.