California LLCs: Outlining the Fiduciary Duties of Members and Managers

California LLCs: Outlining the Fiduciary Duties of Members and Managers

A limited liability company (“LLC”) is often the preferred choice among the forms of business entities because it combines the advantages of a corporation, such as liability protection for investor-level members, and the advantages of a partnership, such as “pass-through” taxation. In addition, LLCs enjoy more flexibility in their organization and internal governance than many other entities. LLC may be organized and run more informally, and their default rules may be largely modified under the company’s main governing document – the operating agreement. A member of an LLC may be an individual, a corporation, a partnership, a trust, another LLC, or any other legal entity, and a member’s interest is denoted not by shares, as in a corporation, but by “membership interests.”

An LLC will either be structured as manager-managed, or member-managed, and such structure will determine the fiduciary duties of the members. In a manager-managed LLC, the members vote to appoint one or more managers to run the day-to-day operations of the LLC while the members take a more passive role. In a member-managed LLC, all of the members are involved in the running of the company. Whether managers or members, those who are charged with the responsibility of running the LLC are required do so by acting in the best interest of the company. The duties associated with this obligation are known as fiduciary duties. The key fiduciary duties, specifically defined under California law, are the duty of loyalty and the duty of care.

In a manager-managed LLC, a member does not owe any fiduciary duty to the LLC, or to any other member, solely by reason of being a member, unless otherwise provided (such as under the company’s operating agreement). (Corp. Code § 17704.09(f)(3)). In a member-managed LLC, however, a member owes the LLC and the other members the duties of loyalty and care. (Corp. Code § 17704.09(a)).

The duty of loyalty requires the member: (1) to account to the LLC and hold as trustee for it any property, profit, or benefit derived by the member in the conduct and winding up of the activities of the LLC or derived from use of the LLC property, including the appropriation of an LLC opportunity; (2) to refrain from dealing with the LLC as or on behalf of a person having an adverse interest to the company; and (3) to refrain from competing with the LLC. (Corp. Code § 17704.09(b)(1)(2)(3)).

The duty of care requires that the member refrain from engaging in (1) grossly negligent or reckless conduct; (2) intentional misconduct; and (3) any knowing violation of the law, in its activities with the LLC. (Corp. Code § 17704.09(c)).

Additionally, as with a manager-managed LLC, a member in a member-managed LLC is also bound with the contractual obligation of good faith and fair dealing when dealing with the LLC or other members. (Corp. Code §17704.09(d)).

The Revised Uniform Limited Liability Act (known as “RULLCA”) allows the LLC’s members to modify, but not eliminate the duty of loyalty, subject to a “not manifestly unreasonable standard.” For example, the members can, if not manifestly unreasonable: 1) identify specific types or categories of activities that do not violate the duty of loyalty; 2) specify the number or percentage of members that may authorize or ratify, after full disclosure to all members of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty; 3) reasonably reduce the duty of care under §17704.09(c); 4) prescribe the standards by which the obligation of the contractual obligation of good faith and fair dealing, under Corp. Code § 17704.09(d), is to be measured; and 5) modify the fiduciary duties of a manager to a manger-managed LLC and a member to a member-managed LLC by way of a written operating agreement with the informed consent of the members.  (Corp. Code § 17701.10(e).)
RULLCA also requires full disclosure and the informed consent of the members in connection with any modification of the fiduciary duties of members and/or mangers.

Those looking to start or invest in a limited liability company would be prudent to first determine which fiduciary duties may or may not apply, depending on the company’s management structure, and, secondly, review the company’s operating agreement to conclude whether any of those duties have been modified. While the flexible nature of an LLC can be its most redeeming quality, it can also impart confusion when the default rules are adjusted. An experienced business attorney should assist in drafting or reviewing the LLC operating agreement to be sure it is in compliance with California law, and that it best protects you as a member and/or manager of the company.

Contact the attorneys at Khashayar Law Group and LOKK Legal for more information.