You represent a minority shareholder of a closely-held corporation and the company is having an off year. The majority shareholder is the sole member of the board and serves in every officer position. She draws significant compensation. Without a business justification, she unilaterally decides to double her salary and have the company pay the mortgage on her vacation home. Your client is the only other shareholder and likely the only person hurt by the majority shareholder’s self-declared raise. Although the minority shareholder suffers a clear injury, characterizing the injury as direct or derivative can have a significant impact on the outcome of the litigation.

Until recently, minority shareholders in closely-held companies could assert claims for breach of fiduciary duty and corporate waste directly against the majority owner. If the claimant was successful, a court could order the majority shareholder to disgorge the spoils of her behavior and pay them to the minority shareholder. This type of direct recovery is no longer permissible. Since 2014, Pennsylvania courts have made clear that claims arising from breach of the duties owed to a corporation, even a closely-held one, belong to the corporation and must be asserted on a derivative basis. This requirement creates procedural and substantive complexities when compared to direct claims. Bringing such claims requires strategic and creative analysis and careful attention to detail.

Without a shareholder’s agreement, minority shareholders are largely at the mercy of the majority shareholder. Minority shareholders have no formal ability to direct how the company spends money, compensates employees or hires vendors. Some majority owners use their power to disadvantage the minority shareholder by excessively compensating themselves or causing the corporation to contract with vendors affiliated with the majority on unfair terms. Although the minority shareholder is the party ultimately damaged by this behavior, the Pennsylvania Business Corporation Law (“BCL”) makes clear that “[t]he duty of the board of directors … is solely to the business corporation … and may not be enforced directly by a shareholder.”  To obtain redress for the majority shareholder’s misconduct, the minority shareholder is therefore required to assert their claims on a derivative basis on behalf of the corporation.

Notwithstanding the language of the BCL, Pennsylvania courts previously allowed minority shareholders to directly assert claims arising from a majority owner’s breach of the duties owed to the company and without the need for the formality of a derivative action. The impetus for this flexibility was dicta contained in a footnote in a case not involving a closely-held corporation. In Cuker v. Mikalauskas, 692 A.2d 1042, 1049, n. 5 (Pa. 1997), the Supreme Court relied heavily on the American Law Institute’s Principles of Corporate Governance: Analysis and Recommendations (“ALI Principals”) and offered its resounding endorsement of the publication generally. It emphasized the interlocking character of the provisions of the ALI Principals and invited the lower courts to apply them to the extent consistent with Pennsylvania law.

Pennsylvania trial courts accepted the Court’s invitation in the context of closely-held corporations. Section 7.01(d) of the ALI Principals recognizes that the traditional justifications for requiring derivative claims may be less persuasive in the closely-held company setting and gives courts discretion to relax the requirement in certain circumstances:

In the case of a closely held corporation, the court in its discretion may treat an action raising derivative claims as a direct action, exempt it from those restrictions and defenses applicable only to derivative actions, and order an individual recovery, if it finds that to do so will not (i) unfairly expose the corporation or the defendants to a multiplicity of actions, (ii) materially prejudice the interests of creditors of the corporation, or (iii) interfere with a fair distribution of the recovery among all interested persons.

Trial courts, notably the First Judicial District’s Commerce Program, adopted both the substantive and procedural aspects of Section 7.01(d). They allowed individual recovery to plaintiff shareholders, rather than to the corporation. Adoption of Section 7.01(d) also gave the courts discretion to reduce the procedural hurdles attendant to a derivative suit, such as the requirement that the minority shareholder formally demand that the corporation’s board sue the majority shareholder prior to the minority shareholder filing suit.

In 2014, the Superior Court reversed this trend when it expressly rejected application of the substantive aspects 7.01(d) as inconsistent with Pennsylvania law. Hill v. Ofalt, 85 A.3d 540, 556 (Pa. Super. Ct. 2014)Although the Superior Court left open the possibility that the Supreme Court might adopt the procedural aspects of Section 7.01(d), it rejected the notion that trial courts may “simply ignore the corporate form and … treat an action raising derivative claims as a direct action and order an individual recovery.”  Id. (internal quotation and ellipsis omitted).

The post-Hill regime requires attorneys representing minority shareholders to look for opportunities to assert direct claims in lieu of derivative claims. The same facts that support a derivative claim may also be the basis of a direct claim. This is particularly common when the minority shareholder is involved in the operation of the business. For example, claims arising from the wrongful termination of a minority shareholder’s employment may form the basis of a direct claim on behalf of the minority shareholder, as well as a derivative claim against the majority shareholder for the breach of duty of care owed to the company.

Shareholder oppression claims are direct claims and may provide a viable method for a minority shareholder to obtain an individual recovery. Pennsylvania has long recognized that a majority shareholder has a quasi-fiduciary duty not to use their power in such a way as to exclude the minority shareholder from the “benefits accruing from the enterprise.”  Carefully structured, a shareholder oppression claim can often address the same conduct that a court might otherwise classify as giving rise to a derivative claim. A claim that a majority shareholder increased their compensation to a level that leaves no profits available to be distributed to shareholders is likely a direct shareholder oppression claim. It may also be a derivative claim if the compensation is excessive by objective measure.

Fraud claims against majority shareholders may also be asserted directly if they arise from a misrepresentation made to the minority shareholder. The misrepresentation, however, must not be related to malfeasance in relation to the company. For example, misrepresenting the financial status of the business to induce a minority shareholder to invest additional capital that is subsequently lost is likely a direct claim. Falsely representing the terms of the majority shareholder’s excessive compensation is likely derivative because it is so closely related to the breach of the majority’s duty owed to the company itself.

When developing claims, keep in mind that counsel’s labeling of claims in pleadings as direct or derivative is not dispositive. Courts look to the substance of the allegations to determine the nature of the wrong.

The distinction between direct and derivative claims presents a variety of challenges in the context of closely-held business disputes. Recognizing the issue at that outset of the litigation and developing theories for asserting direct claims is critical to the successful representation of the minority shareholder.

This column previously analyzed the Commonwealth Court’s decision in Pittsburgh History and Landmarks Foundation, 161 A.3d 394 (Pa. Commw. Ct. 2017), and its potential impact on the attorney-client privilege in derivative litigation. The Pennsylvania Supreme Court subsequently granted petitions for allowance of appeal in the case, setting the stage for the court’s first decision addressing derivative litigation in more than 20 years. The court’s Jan. 23 decision in Pittsburgh History emphasized the strength of the attorney-client privilege in Pennsylvania but its narrow holding leaves significant questions related the application of the privilege in derivative cases unanswered (see Pittsburgh History & Landmarks Foundation v. Ziegler, No 53 WAP (Pa. Jan. 23, 2019)).

Pittsburgh History arose when a group of former board members of two related nonprofit corporations asserted derivative claims against the president and current board members alleging misconduct. The defendant board members formed a putatively independent investigation committee consisting of themselves to investigate the plaintiffs’ allegations and determine whether the corporations should take action against the defendants. The committee generated an investigative report concluding that the defendants’ actions were proper and that the derivative litigation was not in the best interest of the corporations. Relying on the report, the boards of the two corporations voted to reject the derivative plaintiffs’ demands and filed a motion to dismiss the derivative action. The motion relied on the independent committee’s investigation and report.

While the motion to dismiss was pending, plaintiffs sought to compel production of various communications between the independent committee and its counsel as well as materials generated by the committee. Defendants invoked the attorney-client privilege on behalf of the corporation and refused to produce the requested materials to the derivative plaintiffs.

The court began its analysis by discussing its decision in Cuker v. Mikalauskas, 692 A.2d 1042 (1997), and reaffirming Cuker’s adoption of various sections the “American Law Institute’s, Principles of Corporate Governance: Analysis and Recommendations” (1994) (ALI Principles) related to derivative litigation. The sections of the ALI Principles cited in Cukercontemplate that when faced with a derivative claim against the officers and directors of the corporation, a board may form an independent committee to investigate the allegations and determine whether the corporation should take action against management directly. If the committee determines that the corporation should not take direct action, the board, purporting to act on behalf of the corporation, can file a motion to dismiss the derivative plaintiffs’ claims. Such motions are often supported by opinions of counsel addressing whether the board’s actions complied with its fiduciary obligations to the corporation.

In evaluating the motion to dismiss, a trial court applies the deferential “business judgement rule” to determine whether the board’s decision to terminate the derivative action is in the best interest of the corporation. In an effort to rebut the application of the business judgement rule, derivative plaintiffs will attempt to establish that the board’s decision-making process was infirm, either by showing that directors were conflicted or that the committee failed to consider relevant information in reaching their decision. In making such an argument, access to communications from counsel to the committee members and other ancillary documents can be crucial. For example, a committee action that accepted opinions of its counsel that rejected the merits of a derivative action while rejecting opinions of counsel that supported a derivative action, would be suspect.

Section 7.13 of the ALI Principles describes the procedures to be used by a trial court when reviewing a defendant’s motion to dismiss derivative litigation, including what access a derivative plaintiff has to an investigating committee’s communications with its counsel. Although the court in Cuker adopted Section 7.13 of the ALI Principles in bulk, it did not specifically address how the provisions related to the attorney-client privilege. The Pittsburgh History court addressed this issue directly, considering whether the provisions of Section 7.13(e) of the ALI Principles comported with Pennsylvania’s attorney client privilege jurisprudence.

Section 7.13(e) addresses attorney-client privilege with respect to communications between an independent litigation committee and its counsel. Section 7.13(e) provides a derivative plaintiff with access to certain information that would otherwise be subject to the attorney-client privilege:

“The [derivative] plaintiff’s counsel should be furnished a copy of related legal opinions received by the board or committee if any opinion is tendered to the court. … Subject to that requirement, communications, both oral and written, between the board or committee and its counsel with respect to the subject matter of the action do not forfeit their privileged character, and documents, memoranda, or other material qualifying as attorney’s work product do not become subject to discovery, on the grounds that the action is derivative or that the privilege was waived by the production to the plaintiff or the filing with the court of a report, other written submission, or supporting documents.”

The Pittsburgh History court expressly reaffirmed its adoption of Section 7.13(e). The court reasoned that Section 7.13(e)’s exception to the attorney-client privilege protection is consistent with long standing Pennsylvania attorney-client privilege jurisprudence that prevents a party from relying on an “advice-of-counsel” defense without providing plaintiff with access to that advice. In effect, Section 7.13(e) prevents a litigation committee from submitting a cherry-picked opinion of counsel in support of its motion to dismiss derivative litigation without disclosing unfavorable opinions.

In adopting Section 7.13(e), the court rejected the derivative plaintiffs’ contention that a broader “good cause” exception to the attorney-client privilege should apply. The good cause exception was first articulated by the U.S. Court of Appeals for the Fifth Circuit in Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970), and has been adopted by a number of courts throughout the county, including Delaware. In Garner, the Fifth Circuit balanced the interests of derivative plaintiffs and defendant managers where both groups purport to represent the corporation. Garner confirmed that a corporation may still invoke the attorney-client privilege to prevent disclosure of information to derivative plaintiffs but held that a derivative plaintiff is entitled to pierce the privilege upon a showing of “good cause.” The Garner court identified nine factors for evaluating whether good cause exists.

The Pittsburgh History court rejected the Garner analysis as inconsistent with Pennsylvania’s attorney-client privilege. In reaching its conclusion, the court emphasized the need for predictability in the application of the privilege. The court reasoned that “an uncertain privilege, or one which purports to be certain but results in widely varying application by the courts, is little better than no privilege at all.” It held that the Garner test does not provide the predictability that Pennsylvania law requires and leaves managers and the corporation’s attorneys without a “meaningful way of determining whether their otherwise privileged communications would be later divulged in derivative litigation discovery.”

The court’s decision is important but narrow. The court was careful to limit its discussion to the application of the attorney-client privilege with respect to communications between a special litigation committee and its counsel regarding the committee’s decision to file a motion to dismiss derivative litigation. The broader question of whether a derivative plaintiff can pierce the attorney-client privilege with respect to communications outside of a motion to dismiss derivative litigation remains open. Indeed, Garner arose because its derivative plaintiffs sought putatively privileged communications with counsel that occurred in conjunction with defendants’ alleged wrongdoing, not a decision to end derivative litigation. This broader issue affects a much larger group of potential litigants. In practice, most closely-held businesses do not go to the trouble of attempting to dismiss derivative litigation using the procedures employed in Pittsburgh History. Access to communications between a majority management group and the company’s counsel, however, is highly relevant to a minority owner’s claims in the context of a closely-held business dispute.

Although the court did not address whether a derivative plaintiff may access otherwise privileged information outside of a motion to dismiss context, the court’s rationale for rejecting Garner’s analysis provides some insight on how it might view the issue. In rejecting Garner, the court emphasized that its nine-factor analysis injected unacceptable uncertainly into whether the privilege would apply. Since communications between managers and corporate counsel may be wide-ranging, the preference of the Pittsburgh History court for predictability would seem to apply with equal or greater force.

Notwithstanding the court’s apparent preference for certainty over a derivative plaintiffs’ access to information, a rigid application of the privilege in the name of predictability would ignore the representative nature of derivative litigation. Indeed, derivative litigation involves parties that are both purporting to represent the same corporation. When a defendant asserts the attorney client privilege against derivative plaintiffs, it creates an unusual situation of a client asserting privilege against itself. The court has yet to grapple with the issue.

Reprinted with permission from the March 5, 2019 issue of The Legal Intelligencer. © 2019 ALM Media Properties, LLC. Further duplication without permission is prohibited.  All rights reserved.

There are many ways that an owner of a closely-held business can use their superior financial resources to gain an advantage over their co-owners in a dispute. One common way is the use of a capital call provision to dilute the interest of minority owners or to create off-setting claims against them. “Weaponizing” capital call and dilution provisions can be an effective sharp elbow tactic in business divorce situations but practitioners should be wary of the risks that come with it.

Weaponized capital calls are typical in situations where there are claims of shareholder oppression and where there is a significant disparity in financial resources between owners. Such a strategy usually is in response to a claim by a minority owner that the majority owner has breached their fiduciary duty to the minority owner, the company or both. Faced with the prospect of litigation from the minority owner, the majority owner causes the company to exercise a right provided in the entity’s governing documents to demand that each of the owners contribute additional capital to the company. In initiating the capital call, it is the expectation of the majority member that the minority member will have insufficient financial resources to make the necessary capital contribution within the time specified in the operative documents. Failure to make a timely contribution could result in dilution of the minority’s interest, trigger a mandatory sale of their interest to the majority or, minimally, create a counterclaim against the minority owner that would act as a setoff against any amounts that might be awarded to the minority owner.

Majority holders considering a capital call in the context of a dispute with a minority owner should exercise caution. Even when expressly permitted by the governing documents, using capital call provisions in bad faith can give rise to claims for breach of fiduciary duty and the implied obligation of good faith and fair dealing.

Improper exercise of capital call provisions may breach the fiduciary duty of loyalty. By setting the terms of the capital call that he or she will have to answer, a majority owner is engaged in self-dealing. Absent a provision in the company’s operative documents to the contrary, courts evaluate self-dealing transactions using an “entire fairness” analysis. Under this approach, the majority owner has the burden to show that the transaction was objectively fair to the company. A majority owner that is unable to meet this high bar will have breached their fiduciary duty to the company.

Weaponizing capital call provisions also risks breaching the implied duty of good faith and fair dealing. Operating agreements, partnership agreements and shareholder agreements are contracts and are subject to the duty of good faith and fair dealing. Just as in any other agreement, courts will not permit a party to a contract to exercise its contractual rights in such a way as to deprive the counterparty of the benefit of its bargain. Contractual provisions that provide an unfettered right to make a capital call invite court scrutiny as to whether the capital call was made in good faith. In evaluating whether a majority owner has complied with its obligations to act in good faith, courts perform a fact-intensive inquiry about the circumstances and the motivations surrounding the exercise of the contractual right and the reasonable expectations of the parties as reflected in the agreement.

There are several strategies for reducing the risks associated with making a capital call. Majority owners can address the risk prospectively by taking the time to create robust operating documents. Fiduciary duties can often be modified or eliminated in operative documents, thereby creating predictability for the majority when engaging in corporate transactions.

Even with the existence of supportive documents, proper exercise of a capital call requires a bona fide business need for capital coupled with a reasonable exercise of the right. Whether a bona fide need exists and whether the capital call was reasonable is a fact-intensive inquiry. Courts will evaluate the timing of the capital call, the capital needs it purports to address, the treatment of past capital calls and the motivations of the majority in making it. Notwithstanding the unpredictability associated with such an inquiry, certain practices can help a majority act with confidence in causing a capital call.

Seeking the assessment of independent directors or managers involved with the company may buttress assertions that the capital call is being made in good faith and may avoid application of the “entire fairness” analysis. If there is no way to avoid the entire fairness standard, the majority owner should be prepared to demonstrate and substantiate a bona fide business purpose that justifies a demand for additional capital. This might require the use of business valuation or accounting experts ready to explain cash flow or other financing issues. At a minimum, the majority should be ready with clear documentation of the need for capital and the amount required. Capital calls for excessive amounts smack of bad faith and suggest that the majority is attempting to exploit the minority owner.

The majority should also be ready to explain why it caused the company to raise money with a capital call rather than other financing sources that would not require additional money from the owners. Well-documented and unsuccessful efforts to obtain bank or other third-party financing before resorting to a capital call can provide helpful justification. Majority owners should be especially wary if the new capital is being used to retire loans or pay debts owed to the majority owners or their affiliates. In such cases, a capital call might only compound claims of self-dealing.

Lastly, majority owners should be prepared for the prospect that a minority owner may, through strategic alliances with other investors or lenders, make a timely contribution, potentially maintaining the status quo ante.

Majority owners do well to remember that no matter how favorable the language of the governing agreements, courts exercising equity powers may not look kindly on capital calls whose purpose is strategic rather than operational.

In a perfect world, groups of potential business partners would sit down before they started their new ventures to hash out the details of their relationship. They would work in close consultation with one or more attorneys to produce detailed subscription, operating and loan agreements documenting their arrangements and clearly delineating responsibilities. In the real world, the birth of closely-held businesses is sometimes far messier.

Despite their sophistication, entrepreneurs and businesspeople sometimes build and invest in companies without the legal scaffolding necessary to withstand disagreements among the owners. Individuals provide money without having a clear agreement on whether the payments are a loan or were made in exchange for an equity interest. Particularly in the early stages of a business, individuals often provide valuable services for little or below market compensation based on the oral promise of equity, either immediately or vesting in the future. Such arrangements are frequently evidenced only by the vaguest of email exchanges or sometimes “friends” forego any kind of writing.

When disputes involving such businesses boil over into litigation, there is often fierce disagreement on the threshold question of whether someone is an owner at all. The determination of whether someone is an owner, a lender, an employee or simply a “volunteer” who provided services out of family ties or affection is dispositive for many claims common in closely-held company litigation. A putative owner that cannot establish their ownership lacks standing to assert claims for breach of fiduciary duty, waste, dissolution and access to books and records.

There are a variety of ways to prove or disprove that a person is an equity holder in the absence of membership certificates, stock ledgers or written operating agreements.  A perennial favorite, however, is using an entity’s tax returns, specifically, the Schedule K-1.

Entities taxed as partnerships or S-corporations must prepare a Schedule K-1 for each of its owners. The Schedule K-1s identify the owners of the business and specify their percentage of equity and profits and losses that will be attributed to each for tax purposes. The entity’s representative signing the tax return certifies under penalties of perjury that the return, including the schedules, are accurate to the best of their knowledge. The Schedule K-1 must be distributed to each owner and filed with the entity’s tax return. Owners then utilize the K-1 when preparing their personal returns to substantiate the profits or losses they are claiming.

Although the IRS generally requires filers to report profits or losses from the business in conformity with the Schedule K-1 they receive from the entity, a filer can object to the contents of the Schedule K-1 by filing a “notice of inconsistent treatment or administrative adjustment request” (Form 8082) with their return. Form 8082 is also used to alert the IRS that an entity has failed to issue a Schedule K-1 to an owner as required by law.

Schedule K-1 would appear to provide clear and unequivocal evidence of an ownership interest in a business. Most courts, however, have taken a more cautious view. Pennsylvania state and federal courts presented with Schedule K-1s generally treat them as probative but not dispositive of an entity’s ownership. The Schedule K-1 is meant to describe, rather than establish as a matter of substantive law, ownership of an entity at a given point in time. It may be subject to error, change and even outright manipulation. Consequently, it is unusual to find cases where a court has held that the contents of a Schedule K-1 is enough to estop a party from asserting that an ownership structure deviates from that reported on the K-1.

Although courts do not usually consider the existence of a Schedule K-1 to be dispositive of the existence or percentage of ownership, the weight afforded a Schedule K-1 often depends on which party is proffering it and for what purpose.

Because the company official signing the business’s return certifies the accuracy of the Schedule K-1 under penalties of perjury, a K-1 tends to be strong evidence of the entity’s position as to who owns it. In the event of litigation, the entity or the owner that controls it may be hard pressed to disavow the contents of the Schedule K-1 it filed. Indeed, the entity or controlling owner likely had exclusive control over the records provided to the accountants preparing the return.

Filing an individual return with a Schedule K-1 attached may also establish the position of a noncontrolling owner with respect to their percentage of ownership. Although an individual owner may not have had any involvement or control over the contents of the Schedule K-1, individual returns (Form 1040) require the filer to certify the accuracy of the return and schedules under penalty of perjury. Presumably this requirement also includes the Schedule K-1. Moreover, the failure of an individual to dispute the Schedule K-1 by filing Form 8082 also suggests that an individual agrees with the information contained in the K-1.

The failure of a putative owner to receive a Schedule K-1 can also be used show that no ownership interest exists. Many individuals provide services to companies without pay or defer salary on the promise of equity from a founder. These individuals often claim to have operated for years under the belief that they were owners, even though the entity never issued a Schedule K-1 to them. The failure of such individuals to file Form 8082 to give notice of the failure to issue the Schedule K-1, as well as the failure to include any profits or losses from the entity in their individual returns, can undermine claims that the individuals reasonably believed that they were owners of the business.

The issuance or failure to issue a Schedule K-1 can also impact the application of the statute of limitations. When defendants assert the statute of limitations, plaintiffs often attempt to rely on the discovery rule or the doctrine of fraudulent concealment to toll the statute. Some courts, notably the U.S. Court of Appeals for the Third Circuit, have held that the failure to receive a Schedule K-1 should provide notice sufficient to start the statute of limitations running. Other courts may take a case by case approach in deciding whether a reasonable person would understand that failure to receive a tax form from an entity that has elected a particular form of taxation equates to the entity denying that they are an owner.

No matter what the posture of the court, it is clear that the Schedule K-1 is an important factor to consider in any litigation that involves an ownership dispute. In the event a client intends to advance an ownership structure that is inconsistent with what was reported on the entity’s Schedule K-1, they should be prepared to present evidence explaining the deviation.

Reprinted with permission from the July 2, 2019 issue of The Legal Intelligencer. © 2019 
ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

Closely held companies are like marriages but without the sex or kids to hold things together. And just like some marriages, closely held companies can fall apart. Sometimes these “business divorces” and the painful litigation they generate are inevitable. Business partners have different personalities, expectations regarding finances and strategies for interacting with the world and one another. Some business divorce litigation involving limited liability companies might be resolved more easily or avoided altogether with the operating agreement’s inclusion of thoughtfully drafted provisions that address the owners’ fiduciary and other duties.
Many transactional practitioners devote significant time to drafting and refining complex capitalization structures and distribution waterfalls in their operating agreements. In our experience, nearly all business divorce litigation arises from alleged breaches of fiduciary duties. In such cases, the operating agreements typically are either silent as to what fiduciary or other duties govern the relationships between the parties or give the topic short shrift. These shortcomings may be the result of the mistaken belief among many practitioners that fiduciary duties are neatly defined by statute or caselaw and need not be spelled out in the agreements themselves.
Fiduciary duties generally, and within the context of limited liability companies more specifically, are subject to slippery rules and definitions. For years, Delaware courts have struggled with the concept. Pennsylvania’s jurisprudence, which is not nearly as well developed, has adopted a certain “I know it when I see it” method for identifying such duties. Given the limitless ways a manager can run a business without the requisite care or checks on self-dealing, defining the scope of fiduciary duties is perhaps an inherently fact-intensive exercise that necessitates this ad hoc approach.
Further complicating the landscape is that the duty of good faith and fair dealing is implied in most contracts. This duty is independent of other fiduciary duties. Although it is not clear under the pre-2016 version of the Pennsylvania LLC law whether an operating agreement is subject to the implied duty of good faith and fair dealing, the Pennsylvania Uniform Limited Liability Company Act of 2016 (the act) expressly imposes one (Section 8849.1(d)). The duty is often discussed as a “gap filler” that addresses conduct violating the spirit of a contract. We think of it, less formally, as a “don’t be a jerk” rule.
The transactional practitioner that defers to these foggy standards by not addressing them in the operating agreement is likely to invite litigation between the parties to the operating agreement. Fiduciary standards imposed by court decisions or statutes may conflict with the expectations of business owners. This disconnect between what an owner thinks they can do under the ill-defined terms of the operating agreement and what the court- or statutorily defined fiduciary duties permit is fodder for potential litigation should the parties’ business relationship go awry.
Given that limited liability companies are creatures of contract, there is no reason not to address fiduciary duties in a company’s operating agreement. Pennsylvania, like many states including Delaware, allows operating agreements to modify the traditional corporate fiduciary duties—i.e., the duty of care and duty of loyalty—and the duty of good faith and fair dealing. Modifying these provisions requires thoughtful and precise drafting. For example, while the act permits the alteration of the duty of care, the act ostensibly prohibits the elimination of this duty. In this regard, a generalized disclaimer that “all fiduciary duties are eliminated” or “the parties hereby disclaim the covenant of good faith and fair dealing” is unlikely to be effective. Moreover, modifications can be made only when they are not “manifestly unreasonable.” Thus, the only way to modify, or attempt to eliminate, these duties is to affirmatively and precisely state what they are and define their scope. Should a court ever inquire as to whether a modification is “manifestly unreasonable,” it may also be helpful to provide detailed recitals on the background of the owners’ relationship, the purpose of the company and the reasons for modifying any duties.
Well-drafted duty-of-care provisions should, at a minimum, address the applicable standard of care and the scope of the business judgment rule, exculpation from monetary damages for breach of the duty and the advancement litigation expenses. In crafting these provisions, practitioners should consider the following questions, among others: Is the standard for the duty of care negligence, gross negligence or something else? To what extent can a manger or controlling person rely on information provided by others? Should the managers or controlling members be liable to the company for the monetary damages that result from a breach of the duty of care? Should they receive indemnity or advancement of fees for litigation expenses in the event of an alleged beach?
The duty of loyalty is particularly important in the context of closely held businesses. If controlling owners are going to compete with the company, charge it a fee, cause it to deal with an affiliate or be employed by the business, those issues should all be addressed in the operating agreement. The act encourages this type of specificity by allowing an operating agreement to “identify specific types or categories of activities that do not violate the duty of loyalty.” The agreement should also identify a procedure by which the noncontrolling members can review activities that might otherwise violate a duty of loyalty.
The act allows the parties to prescribe the standards, if not manifestly unreasonable, by which performance of the contractual obligation of good faith and fair dealing is measured. As a practical manner, the obligation is so amorphous that it is difficult to articulate how it should be modified. The obligation, however, cannot contradict the express terms of an agreement. Therefore, careful drafting of the fiduciary duty sections helps to minimize the unexpected invocation of the duty of good faith and fair dealing. Practitioners should nevertheless codify this principal by making clear that whatever duty it creates, such duty cannot supplant the express terms or duties articulated elsewhere in the operating agreement.
Much like including certain provisions in a prenuptial agreement may give rise to awkward conversations between partners before getting married, including these provisions in an operating agreement may provoke uncomfortable discussions between owners at the outset of a new venture. Transactional practitioners should nevertheless encourage those discussions and address owners’ concerns head-on. Resolving these issues up-front will likely avoid punting them to litigators and courts in the back-end and prevent unnecessary or unnecessarily contentious litigation.
Reprinted with permission from the September 20, 2018 issue of The Legal Intelligencer. © 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.