You may have heard that the Washington legislature enacted a new limited liability company act this year. The new law becomes effective January 1, 2016. It affects both new companies and LLCs formed prior to that effective date.
Much of the new law restates existing requirements. However, the new statute contains a few important changes to LLC law. One of the important changes is the addition of specific language concerning fiduciary duties an LLC manager owes the LLC and its members. The prior law did not contain a definite description of some of these fiduciary duties, although a few court cases had defined such duties in broad terms similar to those used in the new statute.
“Fiduciary duties” are higher standards of conduct based on trust -- like the relationships between people. The new law describes two such duties that an LLC manager owes to the company and its members: the duty of care and the duty of loyalty. These duties may sound familiar because similar concepts have long existed between directors and officers and corporations, under corporate law, and between general partners under partnership law.
The duty of loyalty is a particular concern. The new statute generally defines the duty of loyalty to include (1) the duty to account to the LLC and hold “as a trustee” any property, profit or benefit derived from LLC activities or the use of LLC property, (2) the duty to refrain from having an interest adverse to the LLC and (3) the duty to refrain from competing with the LLC. At first glance, imposing these obligations on an LLC manager does not seem surprising and some of these duties existed either in the former LLC statute or in case law. However, given the language in the new statute, how far do these duties extend? What is meant by manager interests “adverse” to the company? What “competition” by the manager with the LLC is prohibited? Many limited liability company operating agreements do not address the parties’ expectations in this area, in part because some of the specific terms now in the statute were not part of the prior LLC statutory scheme.
The manager of an LLC and the members should always try to have a specific understanding about which activities of the manager are potentially adverse or competitive with the LLC. Such an understanding prevents potential disputes between the manager and the members. An understanding of the scope of the duty of loyalty is particularly important when the manager operates more than one business or other separate LLCs with different members. The parties’ understanding should be documented in the LLC agreement.
As a result of the new law,existing LLC agreements should be reviewed to determine whether the parties need to enhance the provisions concerning the manager’s duty of loyalty, conflicts of interest and competition with LLC activities. I suggest several initial steps:
- The manager and members should look carefully at the provisions in the LLC agreement and certificate of formation concerning the purpose of the company. Although in the past it may have been useful to describe the purpose broadly to give the company flexibility to engage in future new activities, under the new LLC act the broader the purpose the more opportunity for claims of manager conflicts and competition. Based on the new law, the purpose of the LLC should be reasonably narrow to encompass only the business the members actually intend to conduct. If the original purpose changes, it is easy to amend the LLC agreement to add additional purposes.
- The manager and members should determine whether the LLC agreement specifically authorizes key contracts between the LLC and the manager or other businesses affiliated with the manager. Management agreements, real estate development agreements and construction contracts are examples of common agreements between managers and LLCs that should be specifically authorized in the LLC agreement.
- The manager and members should consider adding specific provisions in the LLC agreement that describe what is and is not “competition” with the LLC. For example, if the purpose of the LLC is to own and manage income-producing real estate, the LLC agreement could say that the manager’s management or ownership of other real estate investments is not competitive with the LLC. Or the LLC agreement could impose geographic limits for competitive activity similar to limits found in noncompetition covenants in employment or other agreements.
Within certain limits, the new LLC act allows the parties to modify or limit the fiduciary obligations of the manager in the LLC agreement. A clear understanding between the manager and the members of the scope of those fiduciary duties, documented by specific provisions in the LLC agreement, has always been important. The new LLC law raises the focus on these issues by LLC managers and members to an even higher level.