Majority LLC Members Take Note: You May Have a Fiduciary Duty to the Other Members

Whitman Legal Solutions, LLC

Whitman Legal Solutions, LLC

Amazon’s Mozart in the Jungle is a binge-worthy combination of comedy, drama, and a little romance based upon the lives of members of the fictional New York Symphony. Like most nonprofits, the New York Symphony faces seemingly unending financial concerns.

Played by Bernadette Peters, orchestra president Gloria Windsor is continuously courting donors. In season 4, it appears the orchestra’s financial woes may be solved when Fukumoto Akihiro expresses interest in supporting the orchestra.

Fukumoto is the multi-millionaire CEO of a Japanese tech company with a passion for classical music. His company has invented WAM (short for Wolfgang Amadeus Mozart), a robot composer/conductor that has completed Mozart’s unfinished Requiem. Fukumoto wants New York Symphony’s conductor, Rodrigo, to conduct the symphony in a performance WAM’s version.

Since a donation from Fukumoto could save the struggling orchestra, Gloria urges Rodrigo to cooperate. After all, money is power in the nonprofit world.

Rodrigo, unimpressed by the power money yields and fueled by a visitation from Mozart himself, refuses to cooperate. Rodrigo views WAM’s composition as soulless and believes it will harm the orchestra’s (and his) reputation. In the end, Rodrigo unceremoniously throws WAM into a pond, and Fukumoto presumably decides to place his charitable dollars elsewhere.

Although Mozart in the Jungle is about a nonprofit, for-profit businesses and real estate investments frequently operate similarly. Money leads to power. That power might be wielded by a single individual, is it was with Fukumoto. But a group of investors can band together to exercise control over the business or real estate investment.

Power and control can provide the means to promote a personal agenda (such as a robot composer) at the expense of the investment or business objectives and the other owners’ interests. This article discusses the duty that majority or controlling members (called majority members in this article) in a limited liability company (LLC) owe to minority members. The focus is on the Maryland Court of Appeals’ (Maryland’s court of last resort) recent decision in Plank v. Cherneski.

The LLC Fiduciary Duty Debate

It’s well-established that majority shareholders owe a fiduciary duty to a corporation’s minority shareholders. But US corporation law, which dates back to the American Revolution, has had much time to develop. The LLC, on the other hand, was unheard of until the end of the 20th century. Yet, because an LLC couples the limited liability of a corporation without the double taxation issue associated with corporations, it quickly has become the preferred entity for real estate investments and many small businesses.

LLCs can have one of two management structures – manager-managed or member-managed. The manager-managed structure vests control over the LLC in a manager (who may or may not be a member). The manager has the control a general partner has in a limited partnership, but without the personal liability, a general partner would have. This structure is popular for real estate and other passive investments where the equity members aren’t interested in controlling day-to-day management.

It’s likely that if a manager has iron-clad control over the LLC decision-making process (as is the case in most real estate investments), the manager will have a fiduciary duty to the members. But the members can agree to change the manager’s duty of care in the LLC operating agreement.

In a member-managed LLC, the members are collectively responsible for day-to-day business operations. Member-managed LLCs are popular with small businesses. A member-managed LLC is similar to a general partnership, but again, without the members having personal liability for the LLC’s obligations.

Frequently, in the LLC’s operating agreement, the members will agree among themselves to allocate responsibilities for business operations. Commonly, members’ voting rights and control will be allocated based upon their contribution to the LLC. But sometimes, a single member will be designated as managing member, having exclusive control over day-to-day operations.

Although all 50 states allow LLCs, LLC law varies from state to state. The National Conference of Commissioners on Uniform State Laws (NCCUSL) adopted the Uniform Limited Liability Company Act in 1996 and the Revised Uniform Limited Liability Company Act (RULLCA) in 2006. But these uniform laws have not been widely adopted. For instance, only 21 states have adopted the RULLCA. Neither Maryland nor Delaware (a popular state for entity formation) has adopted these uniform laws.

State statutes also vary in how they treat the relationship among members in a member-managed LLC. The RULLCA references a “fiduciary duty of loyalty of a member” in a member-managed LLC. That duty is defined in the RULLCA and may not match the common law concept of fiduciary duty.

Maryland’s LLC statute is silent on the standard of care members in a member-managed LLC owe to each other. Members can agree to a standard of care in their operating agreement, but otherwise, any rights must come from Maryland common law.

In George Wasserman & Janice Wasserman Goldsten Family LLC v. Kay (Wasserman), the Maryland Court of Special Appeals (Maryland’s intermediate appellate court) held in 2011 that managing members owe a fiduciary duty to the LLC and the other non-managing members. But the decision in Wasserman didn’t end the fiduciary duty debate in Maryland.

Wasserman involved a managing member, not a member or members with control by virtue of voting power. The Wasserman court also held that breach of fiduciary duty isn’t a separate, stand-alone cause of action. In Plank v. Cherneski, the Maryland Court of Appeals resolves these open questions.

Why It Matters Whether There is a Fiduciary Duty

Subtitle 8 of Maryland’s LLC Act includes the right for members to bring a derivative action to require the LLC to take (or not take) a specific action. Since minority members have a judicial remedy to protect their rights, some may ask why a fiduciary duty matters. The answer is that it’s important that majority members be personally responsible for their actions to disincentivize them from abusing their control over LLC decisions.

If a majority member decides to award an LLC contract to a business owned by their spouse at an above-market price, a derivative action won’t help much. The contract technically will have been duly authorized by majority vote (assuming majority vote is adequate under the LLC’s operating agreement), so there is no legal basis to sue the spouse’s business or to cancel the contract. And the excess price paid to the member’s spouse’s business is no longer in the LLC’s coffers, so the minority members can’t recover it from the LLC itself.

The minority members probably think that the majority member should pay back the extra amount paid to their spouse’s business. But members of an LLC usually have no liability for the LLC’s obligations, including the LLC’s obligations to the other members. That’s a key feature of LLCs, and most LLC operating agreements include strongly-worded statements to that effect.

This is a situation that I call “gastrointestinal law,” where in your gut, you sense the proper legal result, even though there is nothing in the law that supports that result. Absent a right in the state LLC act or the LLC’s operating agreement, the minority members must look to common law for any rights.

At common law, the right to pursue the majority member for the excess paid to their spouse would arise out of a breach of fiduciary duty. Plank v. Cherneski didn’t involve awarding a contract to Cherneski’s spouse, but it did involve alleged mismanagement that affected the minority members’ investments.

Cherneski and Trusox

James Cherneski, a former professional soccer player, invented a no-slip athletic sock and formed Trusox, LLC, with Cherneski and two other members to sell the socks. Two years later, Plank invested in Trusox in exchange for a 20% interest.

At that time, Cherneski, who owned 65% of Trusox, was named President and CEO and given authority over most decisions. I’ll call the members who owned the remaining 35% of Trusox the Minority Members.

In the face of less-than-stellar financial results, the Minority Members disagreed with Cherneski’s decisions. Eventually, they filed a lawsuit claiming, among other things, Cherneski had breached a fiduciary duty owed to the Minority Members.

The trial court held in favor of Cherneski on the Minority Members’ claims for money damages. The Minority Members appealed the breach of fiduciary duty claim to Maryland’s Court of Special Appeals. The Court of Special Appeals then certified questions of law to the Maryland Court of Appeals.

One of those certified questions read:

May minority members of an LLC (a) bring a stand-alone cause of action for breach of fiduciary duty against the managing member of the LLC (b) premised on allegations that the managing member was engaged in unlawful actions that placed at risk the investments of the minority members?

The Court of Appeals Ruling

The Court of Appeals answers this question in a lengthy, but well-reasoned, opinion. The opinion also serves as a comprehensive treatise on Maryland fiduciary law generally. I recommend that anyone interested in the history and concepts behind fiduciary law read the entire 82-page opinion.

For those who want to jump to the last chapter, the Court responded to the certified question as follows:

This Court recognizes an independent cause of action for breach of fiduciary duty. To establish a breach of fiduciary duty, a plaintiff must demonstrate: (1) the existence of a fiduciary relationship; (2) breach of the duty owed by the fiduciary to the beneficiary; and (3) harm to the beneficiary. . . [A] court should consider the nature of the fiduciary relationship and possible remedies afforded for a breach, on a case-by-case basis. If a plaintiff describes a fiduciary relationship, identifies a breach, and requests a remedy recognized by statute, contract, or common law applicable to the specific type of fiduciary relationship and the specific breach alleged, a court should permit the count to proceed. The cause of action may be pleaded without limitation as to whether there is another viable cause of action to address the same conduct. To be clear, this does not mean that every breach will sound in tort, with an attendant right to a jury trial and monetary damages. The remedy will depend upon the specific law applicable to the specific fiduciary relationship at issue.

What Does This Mean for Member-Managed LLCs?

The takeaway from Plank v. Cherneski is simple. Members should agree upon the standard of care they want to owe each other in advance in their LLC operating agreement. State law can change, but those changes are unlikely to impact existing operating agreements.

Most states allow members to establish (or waive) their duties to each other in the LLC operating agreement, even if it is contrary to the default state law. Members may not want to assume a fiduciary duty to each other. They may prefer a duty or loyalty or another, lower standard of care. Or, they may want to have different standards of care, depending on the circumstances.

In Mozart in the Jungle, Gloria agreed that the symphony would perform Fukumoto’s composition without knowing anything about the composer. Had she inquired further, she might not have agreed to his terms or might have been able to prepare the temperamental Rodrigo for WAM. Rodrigo possibly still wouldn’t have cooperated, but it would have gone better if Gloria had known this in advance.

Majority members may not agree to assume a fiduciary duty to other members. If that’s the case, then it’s best that the minority members know this up front. And, if a majority member, like Cherneski, who has a terrific idea but needs cash from investors who will become minority members, it’s best that he be aware of what the investors expect.

Finally, responsibility shapes behavior. Rodrigo threw WAM into the pond because (as is evident throughout the series) there was no standard of conduct to which Rodrigo was held in his contract.

It’s possible that even an explicit standard of care might not have dissuaded the mercurial Rodrigo from destroying WAM. But although he was unpredictable, Rodrigo, as a man of his word, might have struggled with his decision if he knew it would breach a standard he had agreed to uphold. And the orchestra might have chosen a different conductor had it understood in advance that the untethered Rodrigo would be an unpredictable and capricious leader.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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