What happens when the manager of a company acts in their own self-interest, rather than for the benefit of the company or those that own the company? This is where the concept of “fiduciary duties” comes into play. Fiduciary duties obligate the people who make important decisions for an entity act in the best interests of the entity, and its owners. Fiduciary duties can be triggered by law or by virtue of the relationship itself. Fiduciary duties are created when one party must trust and rely on another to exercise their judgment.
While many believe that duties that a fiduciary owes are absolute, in certain circumstances, they may be waived. The ability to waive these duties, depends on the company’s legal entity type and where it was incorporated.
I. The Different Types of Fiduciary Duties
There are several kinds of fiduciary duties, including:
- the duty of care that requires a fiduciary to use his or her informed business judgment in their role of overseeing the Company and making business decisions;
- the duty of candor that requires a fiduciary to disclose material information that may negatively affect the business. This typically involves interactions between board members, shareholders and management of a company; and
- the duty of loyalty that requires a fiduciary to act in the best interests of a party owed such duty. This prohibits a fiduciary from putting their personal financial interests ahead of a party that is owed such duty.
Encompassed within the duty of loyalty is a duty of good faith and fair dealing. This obligates a fiduciary to act honestly when carrying out his/her duties and participating in transactions on behalf of the entity. Intentionally violating a law, while acting as a director, violates the duty of good faith and fair dealing because criminal behavior cannot advance an entity’s interest.
II. Fiduciary Duties in Delaware
The duties of care and loyalty of managers and members of a limited liability company (“LLC”) vary by state. Certain states recognize a broad freedom of contract, meaning members of an LLC have a large amount of discretion to define their relationship through the company’s operating agreement. In these states, LLC operating agreements may completely eliminate fiduciary duties.
Other states prohibit the waiver fiduciary duties completely. Companies, corporations, and their owners (whether shareholders of members), must be aware of such state-specific limitations and draft and negotiate corporate documents to meet their needs.
A. Delaware LLCs
In Delaware operating agreements can waive a manager’s fiduciary duties to other members and the LLC itself. Even when an LLC’s operating agreement disclaims fiduciary duties, however, the covenant of good faith and fair dealing will remain implicit in such agreement, as the covenant is non-waivable.
In Miller v. HCP & Co., 2018 WL 656378 (Del. Ct. Ch. Feb. 1, 2018), the Delaware Court of Chancery ruled that the implied covenant of good faith and fair dealing is inherent in every contract governed by Delaware law, including documents that govern corporate formation. However, the Court cautioned that a party seeking to invoke this doctrine rarely succeeds because the implied covenant only applies when a party proves that the other party acted arbitrarily or unreasonably and thus frustrated the purpose of the contract.
In Miller the plaintiffs alleged that the Board of Directors failed to maximize the sale price of the company and thus the sale did not benefit all the members equally. The proceeds from the sale greatly favored certain classes of unit holders, while other unit owners were paid a pittance. Plaintiffs were in the underpaid class of unit holders. The Court ruled in favor of the Board holding that the company’s operating agreement waived any fiduciary duties of the managers and contemplated the procedure they used for the sale of the Company. Because the Board followed the explicit terms of the operating agreement in selling the company, the implied covenant of good faith and fair dealing did not apply.
While the covenant of good faith and fair dealing will always be implied in contracts governed by Delaware law, courts will still rely on an agreement’s actual terms, including the waiver of certain fiduciary duties, to determine whether such covenant has been breached.
B. Delaware Corporations
By contrast, Delaware common law (court-made law, not legislation) has established that directors owe fiduciary duties of due care and loyalty to a corporation and its stockholders. These duties cannot be disclaimed or modified by agreement in the context of a corporation. Because such duties cannot be disclaimed, Delaware courts have stated that directors should be free of any material financial or other benefit derived from an action or transaction, except in their capacity as stockholders. In other words, directors should not have an economic interest in a specific transaction or arrangement requiring the approval of the Board of Directors. Directors should also be independent and not have a material relationship with another party that could influence the director’s decision-making.
C. Delaware Limited Exception for Corporations
As a limited exception, Delaware corporations can waive certain fiduciary duties with a “corporate opportunity waiver.” A company can accomplish such action by referencing Section 122(17) of the Delaware Corporation Law in its certificate of incorporation. The certificate of incorporation is the document filed and approved by the State during the incorporation process. Typically, directors are prohibited from personally benefitting from an opportunity that is aligned with the corporation’s business and the corporation is financially able to pursue. However, the corporate opportunity waiver allows directors and other corporate fiduciaries to invest in such opportunities without the obligation of offering them to the company beforehand.
Do your company’s corporate documents waive certain fiduciary duties? Depending on the state and entity type, such waiver may not be enforceable. Operating agreements should always be drafted or negotiated with the assistance of seasoned legal counsel for optimal results.
This Blog is made available by Romano Law PLLC for general informational and educational purposes only, not to provide specific legal advice. By using this Blog you understand that there is no attorney client relationship between you and Romano Law PLLC or any individual contributor. You should consult a licensed professional attorney for individual advice regarding your own situation.