Since the appreciable advent of the limited liability company (LLC) over 30 years ago, it is not unusual for two or more people to go into business together and form an LLC to “house” operations.
One particularly challenging aspect is the relationship between members (passive or active), managers, and other partners. The law of LLCs – across the states – provide legal details of the fiduciary duties owed by each owner and manager.
Some states’ laws allow the owners to limit fiduciary duties to an almost non-existent extent, provided the governance documents so provide. As example is Illinois: the Illinois Limited Liability Act (“LLC Act”) details what managers and members of Illinois LLCs need to know as to what is required of them by the law – especially as to fiduciary duties. This is found in the LLC Act.
The failure of otherwise savvy and knowledgeable LLC managers and members to know the nature and extent of their fiduciary duties to each other and the entity can and frequently does lead to avoidable missteps, misunderstandings, and conflicts. Reducing the likelihood of such problems, as well as misguided allegations that someone has breached their duty, starts with knowing what, exactly, are LLC fiduciary duties.
Fiduciary Duty Defined
In the context of an Illinois LLC, for example, fiduciary duty refers to two distinct obligations:
- Duty of loyalty: This duty requires each manager or member of an LLC to put the interests and success of the LLC above any personal or individual interests. This means acting honestly, avoiding conflicts of interest, and not diverting business opportunities from the LLC to themselves or third parties.
- Duty of care: This duty requires each manager and member to act in good faith and use reasonable care when making decisions acting for or on behalf of the LLC, including during any “winding up” phase of the LLC.
- As such, managers and members must refrain from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law.
- However, as discussed below, not every bad call or unfortunate outcome of the decisions of a member or manager violates the duty of care.
Section 15-3 of the LLC Act further details the nature and scope of these duties.
A Member’s Fiduciary Duties Differ In Member-Managed and Manager-Managed LLCs
From a management standpoint, there are two types of LLCs in Illinois: a member-managed and a manager-managed LLC. A member-managed LLC is generally one in which all members share management responsibilities for the entity. In a manager-managed LLC, the members designate someone to run the business, whether a member of the LLC or otherwise. A member’s fiduciary duties depend on which type of entity they are involved in.
Under the LLC Act, every member in a member-managed LLC owes the duties of care and loyalty to each other and the entity. However, in a manager-managed LLC, a member who is not also a manager owes no duties to the LLC or to the other members solely by reason of being a member. That said, a member who exercises some or all authority of a manager, whether or not they are officially listed or named as a manager, will be subject to fiduciary duties of care and loyalty and could face liability for a breach of those obligations.
The “Business Judgment” Rule: Duty of Care ≠ Duty to Ensure Every Decision Works Out
As noted, every LLC member involved in the business’s operations or decision-making owes a duty to use reasonable care when acting on behalf of the LLC. But the duty of care does not mean a duty to ensure that every act or decision has a good outcome. Plenty of good faith business decisions end disastrously.
However, the “business judgment rule” – common in most jurisdictions – provides that it is not a breach of the duty of care, and a member will not be personally liable, for the unfortunate results of business actions or decisions that they take in the ordinary course of business so long as they used their best judgment, acted on an informed and knowledgeable basis, and acted in good faith. A bad call, without more, is not bad faith.
Members Can Define Their Duties In Their Operating Agreement
The LLC Act provides the “default” rules for LLCs. In 2017, Illinois revised its LLC Act and modified the default fiduciary duty provisions to allow LLCs to define, restrict, or eliminate some of the fiduciary duties of members or managers to the entity, and otherwise as to each other, in a written operating agreement.
For example, under Section 15-5(c) of the LLC Act, an operating agreement can:
- restrict or eliminate a fiduciary duty, other than the duty of care, but only to the extent the restriction or elimination in the operating agreement is clear and unambiguous;
- identify specific types or categories of activities that do not violate any fiduciary duty; and
- alter the duty of care, except to authorize intentional misconduct or a knowing violation of the law.
Of course, how the law applies to specific acts or decisions in particular circumstances is a unique issue. The best course of action when starting a new business, or line or division of an existing business, using an LLC is to consult competent counsel to understand the issues and properly guide the parties.
Should you have questions about this topic, general LLC matters, or fiduciary duties as an LLC member or manager (especially whether a fellow member or manager conduct comports with those duties), please contact me at 312-840-7004 or fmendelsohn@burkelaw.com.
