Reprinted with permission from the October 27, 2016 edition of the The Legal Intelligencer.
Suppose two new clients come to your office next week. Both hold interests in small companies, and both are also, unfortunately, hopelessly at loggerheads with their colleagues. In both cases, one or more of the various interest holders are poised to raise a hue and cry — about oppression, fiduciary duties and financial malfeasance. All the usual skullduggery. One way or another, then, a “business divorce” seems inevitable in each matter.
The difference? One of the clients holds shares in a close corporation, and the other is an LLC member. Does it matter? Should it?
Your initial review of Pennsylvania’s statutory framework suggests a distinction. In the corporate context, the statutes expressly allow for judicial relief when “those in control of the corporation have acted illegally, oppressively or fraudulently.” See 15 P.S. §§ 1767, 1981. By contrast, the analogous LLC statute provides for judicial relief only “whenever it is not reasonably practicable to carry on the business in conformity with the operating agreement.” See 15 P.S. § 8972.
There are other statutory differences as well. For example, the corporate statutes unambiguously provide that corporate directors “stand in a fiduciary relation to the corporation.” See 15 P.S. §§ 512, 1712. By contrast, the duty of a member in a member-managed LLC is (like in a partnership) to “account to the company for any benefit and hold as trustee for it any profits.” See 15 P.S. §§ 8943(a), 8334. And in a manager-managed LLC, while the managers have the same fiduciary duties as a corporate director, “[a] member who is not a manager shall have no duties to the company or to the other members solely by reason of acting in his capacity as a member” (but courts have found such duties arising from relationships, undertakings or employment). See 15 P.S. § 8943(b) (emphasis added).
So you turn next to the case law. What you find is that there are plenty of Pennsylvania cases addressing the fiduciary duties of shareholders in the corporate context. The court in Grill v. Aversa, 2014 WL 4672461 (M.D. Pa. Sep. 18, 2014), for example, summarized that law nicely.
But as it turns out, there’s not really very much Pennsylvania case law addressing analogous issues in the LLC context. This may simply be, as the Pennsylvania Superior Court has suggested, “because the LLC is a relatively new legal entity in Pennsylvania [only since 1994], there is a dearth of cases addressing judicial dissolution.” Staiger v. Kevin Holohan, 200 E. Airy St., LLC, 100 A.3d 622, 625 (Pa. Super. Ct., 2014) (analogizing instead to partnership law).
Fortunately, you discover that a jurist in the Philadelphia Court of Common Pleas has thoughtfully considered this very issue. In Harbor v. Gem (Phila. CCP No. 021440, July 18, 2001), the late Judge Albert Sheppard considered, as a matter of first impression, whether one member of a limited liability company may hold the other member liable for breach of fiduciary duty. In finding such a claim viable, Judge Sheppard relied primarily on two legal arguments.
To begin with, the court pointed out that the LLC Act itself provides a basis for such fiduciary duties in Section 8943 – i.e., the above-mentioned provision obligating LLC members to “account to the company for any benefit and hold as trustee any profits. . . .” 15 P.S. § 8943. The court noted, further, that the 1994 Committee Comment to Section 8943 voiced the legislature’s expectation that “courts will fashion rules in appropriate circumstances by analogy to principles of corporate or partnership law to deal with situations such as oppression of minority members, actions taken in bad faith, etc. . . .”
Next, the court pointed out that the statute itself specifically provides for application of the Uniform Partnership Act (“UPA”) to limited liability companies. See 15 P.S. § 8311(b) (UPA “shall apply to . . . limited liability companies . . . except insofar as the statutes relating to those associations are inconsistent with this chapter”). The court then cited some half-dozen Pennsylvania cases standing for the well-established principle that “partners stand in a fiduciary relationship to each other.” Id. at 21. Accordingly, the court concluded that the members of LLCs may bring claims against one another for breach of fiduciary duty.
Judge Sheppard’s approach appears to represent the trend of the law in Pennsylvania relative to LLC member disputes. More recently, a federal district judge sitting in Pennsylvania has likewise held that fiduciary duties apply in the LLC context. See Gladstone Tech., Partners, LLC v. Dahl (E.D. Pa., 2016) (“LLC partners owe fiduciary duties to each other, including the duty of loyalty and the obligation to act for the benefit of other members of the partnership”).
Similarly, the drafters of the proposed Uniform Limited Liability Company Act provided for judicial dissolution of LLCs under circumstances akin to corporate precedents, that is, when “the managers or members in control of the company have acted, are acting, or will act in a manner that is illegal, oppressive, fraudulent, or unfairly prejudicial to the petitioner.” Unif. Ltd. Liab. Co. Act § 801 (1996). But this language has never been adopted in Pennsylvania.
Legal commentators have recognized that the same sorts of disagreements arise within LLCs as in partnerships and corporations, and that parties often lack the prescience to have anticipated them in their operating agreements.
As Douglas K. Moll explained in Minority Oppression & the Limited Liability Company: Learning (or Not) from Close Corporation History, 40 Wake Forest L. Rev. 883, 962, 965–67 (2005), “it is inevitable that some majority owners will abuse their control at the expense of minority investors. Just as in the close corporation, legitimate judicial scrutiny of majority conduct is needed. The oppression doctrine, in other words, has a place in the LLC structure as well.” An experienced practitioner has taken the same view: “[a]s a matter of public policy, there seems little reason to distinguish between LLCs and closely held business corporations when it comes to the grounds for business divorce.” Peter A. Mahler, When Limited Liability Companies Seek Judicial Dissolution, Will the Statute Be Up to the Task? (74 NY St BJ 8, 16 [June 2002]).
On the other hand, at least one appellate court has held otherwise. In In the Matter of 1545 Ocean Ave., LLC v. Crown Royal Ventures, LLC, 2010 NY Slip Op 00688 (N.Y. App. Div. 1/26/2010), the Court found that — since the legislature itself had not chosen to align the partnership, corporate and LLC statutes — “it would be inappropriate for this Court to import dissolution grounds” from the corporate or partnership contexts. Id. at 3. Instead, the court focused on the feasibility of continuing to operate under the terms of the parties’ LLC operating agreement. Id. at 5.
More typically, though, courts around the country have agreed that corporate and partnership legal principles may be applied in the LLC setting, even in the absence of express statutory authorization. See, e.g., Tzolis v. Wolff, 884 N.E.2d 1005 (N.Y., 2008) (derivative action may be brought in LLC setting, despite statutory absence, by analogy to corporate law); Anest v. Audino, 773 N.E.2d 202, 209-11 (Ill. App. Ct. 2002) (LLC member owed a fiduciary duty to another member by analogy to partnership principles); Credentials Plus, L.L.C. v. Calderone, 230 F. Supp. 2d 890, 898-99 (N.D. Ind. 2002) (analogizing fiduciary duties in an LLC to a close corporation and a partnership); VGS, Inc. v. Castiel, No. C.A. 17995, 2000 WL 1277372, at *4 (Del. Ch. Ct. Aug. 31, 2000) (LLC members violated duty of loyalty owed to a third member).
In the final analysis, the policy grounds for drawing on corporate and partnership principles in the LLC context are compelling, at least in the absence of a clear mandate otherwise in a particular operating agreement. And Judge Sheppard has already provided a road map for doing so under Pennsylvania law. It will be interesting to see how litigants grapple with these gaps in Pennsylvania’s LLC statute — as time passes and more LLCs founder — but my bet is that our courts will look to fill gaps in LLC law by reference to more-developed doctrines in the corporate and partnership contexts.
Better yet, of course, is to resolve such ambiguities at the outset, when drafting the LLC’s operating agreement. The ability to craft your own rules is one of the benefits of forming an LLC. And precisely because of that ability, some courts may prove unsympathetic when parties seek judicial relief after having entered into poor agreements. So (if it’s not already too late) take advantage of the LLC’s inherent flexibility by making sure the operating agreement has member-exit provisions that are clear, fair, efficient and readily implemented.
Reprinted with permission from the October 27, 2016 edition of the The Legal Intelligencer. Copyright 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For further information, contact 877-257-3382 – [email protected] or visit www.almreprints.com.