NC Business Court Clarifies Exception to Rule that LLC Members Do NOT Owe Fiduciary Duties to One Another
One of the hallmarks of limited liability companies ("LLCs") is that members of an LLC ordinarily do not owe fiduciary duties to each other or to the company itself.
Generally speaking, a fiduciary duty is an obligation to act in the best interest of another party, and it serves to protect the party to whom the duty is owed. In recent years, however, the North Carolina Business Court ("Business Court") has recognized a narrow exception (the "Exception") to this general rule: A member who owns a majority interest in the LLC and who exercises control of the LLC has a fiduciary duty not to use this control to harm the minority members unless such duty is expressly disclaimed in the LLC's governing documents. Thus, the member who owes this duty is required to consider the interests of minority members when directing the LLC to take action and is subject to liability if he or she breaches that duty by taking an action on behalf of the LLC that, for example, injures the minority members' financial interests in the LLC or their rights as defined in the LLC's governing documents. Notably, the Exception only applies to a singular majority member who exercises control of the LLC and does not apply where multiple minority members, acting together, constitute a majority in interest of the LLC.
The Business Court has defined the contours of this Exception in a number of recent decisions. The Exception is borrowed from North Carolina law governing corporations, which recognizes that controlling shareholders owe a fiduciary duty to minority shareholders. However, due to fundamental differences between LLCs and corporations, the Business Court has been reluctant to apply the Exception and has made clear that the Exception is narrower than its corporate law counterpart.
One of the distinctions that the Business Court's decisions emphasize is that LLCs are primarily creatures of contract. The LLC's operating agreement generally governs the rights and duties of LLC members. An operating agreement is an LLC's primary governing document, and ordinarily establishes the rights, powers, obligations, duties, and liabilities of the members of an LLC. Minority members of an LLC can negotiate for and include protections in the operating agreement that negate a majority member's ability to control the LLC. For example, LLC members can require supermajority votes for some or all company matters. Thus, the mere fact that a member owns a majority interest does not create a presumption of control.
Additionally, LLC members can fully address the issue of whether members owe fiduciary duties to one another, and the nature of the duties owed, in the operating agreement. Recognizing the role that operating agreements play in LLCs, the Business Court has reasoned that blindly applying this Exception could undermine the contractual nature of an operating agreement and our State's policy to give full effect to the principle of freedom of contract and the enforceability of operating agreements. Therefore, the Business Court has declined to extend this Exception where the relevant operating agreement contained adequate protections for minority members or expressly disclaimed fiduciary duties between members.
Though the Business Court has emphasized that the Exception is narrow, it nonetheless recognizes that it can apply in appropriate circumstances. Those circumstances appear to exist where the majority member has the authority to exercise managerial control over the LLC, and the operating agreement does not provide any restrictions or checks and balances on the majority member's use of such control or expressly disclaim the possibility of a fiduciary duty arising. In determining whether the Exception applies, the Business Court examines the LLC operating agreement to see whether it thoroughly addresses the duties, powers, and potential liability of members. Relevant considerations include whether the provisions of the operating agreement provide minority members equal rights to participate in the management of the LLC and its assets or whether provisions expressly disclaim fiduciary or fiduciary like duties on behalf of the members. If the majority member has no meaningful ability to exercise control over the LLC or if the operating agreement disclaims fiduciary duties, this fiduciary duty will not exist.
As a practical matter, the Business Court's application of the Exception appears to create the following dichotomy with regard to a minority member's avenue for pursuing a claim of wrongdoing against a majority member: (a) if the operating agreement clearly protects the minority members against an abuse of control by the majority member or expressly disclaims a majority member's fiduciary duty, then the Exception does not apply, and the minority member will likely have to rely on a claim for breach of the operating agreement to pursue any damages; or (b) if the operating agreement does not protect minority members from an abuse of control by the majority member and does not expressly disclaim the possibility that a majority member might owe a fiduciary duty then the Exception likely applies and the minority member can pursue recovery of its damages through a breach of fiduciary duty claim.
In conclusion, given the limitations of this Exception, minority LLC members should not count on its potential protection, but should instead ensure that their operating agreement adequately protects them from an abuse of power by a majority member. Minority LLC members can protect themselves by including provisions in their operating agreement that ensure majority members will not be able to exercise total control, or by imposing a contractual fiduciary duty on the majority member. Ultimately, the Business Court's application of the Exception reinforces how important it is for LLC members to carefully review their operating agreements to affirm that they are satisfied with the protections it provides.