The limited liability corporation (LLC) is a business structure often favored by real estate investors. The attractions of an LLC include permitting members to be taxed as if the entity were a partnership or a sole proprietorship, and shielding members against personal liability for corporate debts to third parties. An LLC also has fewer limitations on who and what types of entities can be members.
If properly established, adequately funded and operated in a nonfraudulent manner, members of an LLC are generally protected against losses that exceed their capital investment. Entities doing business with an LLC will often ask for additional protection to overcome the corporate shield if the LLC is new or the relationship is a long-term one. For example, landlords may request a personal guarantee or a larger security deposit.
But what happens when the losses arise from an internal dispute between the members? Those are quite common and often acrimonious — and not subject to the limited liability protections afforded to members against outsiders, unless the member is itself an LLC.
The obligations between members of an LLC are defined by statute and by written agreement between the members, called an operating agreement. Since an LLC is formed under state rather than federal law, statutory obligations may be different if the entity is incorporated in Nevada or Delaware (two popular choices), instead of New York. Obligations may also be different if the entity is a professional limited liability corporation or a limited liability partnership, rather than a limited liability corporation.
The operating agreement for an LLC will generally provide for one or more members to hold the position of a “managing member,” define what obligations the managing member has and define how the managing member is selected or removed from that position.
Generally, a managing member has a fiduciary duty to the other members of the LLC. Fiduciary duties are significant. They include a “duty of care” and a “duty of loyalty” to both the corporate entity and the other members.
For example, a managing member is typically precluded from placing their personal business interests ahead of the LLC’s business interests, and cannot usurp business opportunities available to the LLC for their own personal gain.
There are protections afforded to the managing member, by both statute and court decisions. The “duty of care” is generally limited by a concept knows as the “business judgment rule.” Under that rule, a court will not second-guess a business decision made by the managing member of an LLC if the managing member’s decision was made in good faith, after a reasonable and rational examination of the relevant facts.
A court will reverse a managing member’s decision if it is made in bad faith or tainted by fraud or a conflict of interest. In those circumstances, the member may also face personal liability to outsiders or to other members.
In addition to the “business judgement rule,” the New York Limited Liability Company Act 409(b) provides a “safe harbor” for managing members who rely, in good faith, upon reports, financial statements and opinions provided to them by professionals such as public accountants and attorneys. Decisions made in good-faith reliance upon professionals will be protected.
Operating agreements often include a clause designed to limit the liability of a managing member to other members of the LLC. These clauses will be enforced, but are subject to limitations. For example, Section 417 of the state’s Limited Liability Company Act provides that exculpatory clauses in an operating agreement do not insulate a manager from liability involving (i) bad faith, (ii) intentional misconduct, (iii) a knowing violation of the law or (iv) personal gain, profit or other advantage to which the member was not legally entitled.
Court decisions interpreting and defining these four exceptions are limited but growing. In one case, a court refused to enforce an exculpatory clause in the operating agreement where the managing member was accused of “scaring off” potential investors while the company was in financial straits, in an attempt to buy the company for his own financial gain at a distressed price. The court found this conduct to constitute “bad faith” and “intentional misconduct.”
In a recent case, however, an appellate court dismissed claims against two members of an LLC accused of self-dealing by the third member of the LLC. The entity owned a six-story, multifamily apartment building, encumbered by a $2 million mortgage loan. When the loan matured, the members could not agree on whether they should pay it off, refinance with another bank or extend the loan with the existing lender. Faced with a stalemate, two of the members secretly set up a new LLC, had that LLC purchase the loan before it matured, and then defaulted their own LLC and commenced a foreclosure action.
The third member attempted to intervene in the foreclosure action but was denied. He also attempted to obtain a stay of the foreclosure, but again was denied. On the eve of the foreclosure sale, he reached an agreement with the two other members pursuant to which he contributed one-third of the mortgage debt to them. The loan was then deemed to be paid and the foreclosure action discontinued.
The third member sued the other two, claiming that their secret purchase of the mortgage and subsequent foreclosure were undertaken in bad faith and constituted self-dealing and a conflict of interest.
A lower court upheld the right of the third member to bring suit, but an appellate court dismissed the case, noting that the LLC did not sustain any damages by the secret conduct of the two members; the mortgage debt was paid and the LLC still owned the property.
A different decision may have been issued if the foreclosure had been completed and the property transferred to a new entity which excluded the third member, or if the LLC had suffered some actual damage, such as payment of a default rate of interest or the loss of tenants or income stemming from the foreclosure.
In sum, disputes between members of an LLC can be limited by a well-drafted operating agreement, by disclosing business opportunities and conflicts to fellow members, by relying upon the advice of professionals and by making decisions based upon the business judgment rule.