Monthly Archives: April 2015

Since adoption of the Arizona Limited Liability Company Act (Arizona Act) in 1992, limited liability companies (LLCs) have become the business entity of choice for business people and their lawyers. This popularity is similarly evidenced in all jurisdictions across the United States. Yet, notwithstanding the widespread adoption of the LLC, in Arizona an important question remains unsettled. Namely, what fiduciary duties exist within the LLC?

Corporate and partnership law have long included the concept of fiduciary duties owed among partners, and by officers and directors to a corporation and its shareholders. Both statutes and case law are informative. However, statutes and case law do not similarly provide the same level of certainty regarding LLCs, leaving open the questions of whether managers owe fiduciary duties to the company and its members, and whether members owe fiduciary duties to each other.

Arizona: No Statutory Guidance

By design, the Arizona Act permits flexibility in structuring an LLC. The Arizona Act did not adopt the fiduciary duty language of either the Uniform Partnership Act (UPA) or Uniform Limited Liability Company Act (ULLCA). The Arizona Act does not state whether any fiduciary duties exist in an LLC it is silent and imposes no express fiduciary duties on LLC members or managers.

 Why this lack of certainty? Arizona law in this area is still relatively new, and thus case law has not developed over time to give much guidance. Some argue that the Legislature intended for LLCs to be governed solely by the operating agreement; thus, if the articles of organization or operating agreement do not provide for a fiduciary relationship, then none exists. Others assert that a fiduciary duty is implied in the statute and exists co-extensively with the law for corporations and partnerships, unless the operating agreement specifically limits or changes a duty.

Case Law and Legislative Intent

Although Arizona case law on this issue is scarce, an unreported Arizona Court of Appeals case from 2008 suggests that Arizona courts may imply duties where the operating agreement is silent.

In the case, the Arizona Court of Appeals recognized and concluded that a co-manager in an LLC could be liable for breaching fiduciary duty. Citing to the Restatement (Second) of Torts ( 874 cmt. a), the court defined when a fiduciary relationship exists: “A fiduciary relation exists between two persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relation.” The court went on to reason that while a co-manager may not be required to exercise fiduciary duties pursuant to a statute and/or an operating agreement, a co-manager by his conduct may nonetheless be required to exercise fiduciary duties if the co-manager assumes such duties.

In addition, an analysis of the legislative intent demonstrates that both the Arizona House and Senate passed the LLC statute with the intent that LLCs have the same liability as a corporation. This provides strong support that a limited liability company manager or member could be liable for failure to observe fiduciary obligations when acting on behalf of the company, just as an officer or director may be liable for failure to act as a fiduciary for a corporation.

Continue reading Part 2: here.

When business owners are in conflict, they must be aware of their fiduciary duty obligations to the company and the other owners. As conflict builds, an owner’s management is more critically reviewed, decisions questioned, and unpopular results criticized. Many business decisions are protected by the Business Judgment Rule. It is important for business owners to know and distinguish their fiduciary duties and understand the application of the Business Judgment Rule.

The fiduciary duty arises out of a confidential business relationship of trust. Owners who are employed and/or manage the business are put in a position of trust by all owners and the company. This trust duty encompasses acting in the best interest of the company and its owners, protecting the assets of the company, and making the most of those assets for the benefit of the owners. Because fiduciaries are in the position of control, they are charged with the highest duty recognized in law, the fiduciary duty.

The fiduciary duty requires the exercise of utmost good faith, fair dealing, disclosure and avoiding even the impropriety of self-interest or self-dealing. If you owe to another a fiduciary duty you must exercise honesty, fairness, and be reasonable, and recognize the reasonable expectations of those to whom you owe that fiduciary duty.

Generally speaking, the fiduciary duty is divided between the duty of loyalty, the duty of care and the duty of disclosure. This duty of care is well set forth in the Arizona Business Corporations Act which requires directors and officers to exercise their duties in good faith, in what they believe to be in the best interests of the company, and as a reasonable director or officer would act. Thus, a duty of care does encompass a “negligence” standard subject to the Business Judgment Rule discussed below.

The duty of loyalty requires that the fiduciary put the interests of those to whom the duty is owed ahead of their own interests. When a fiduciary is faced with a choice to benefit themselves or the company/owners, the fiduciary must choose the company/owners. Corporate opportunities must be preserved for the company. Conflicts of interest must be avoided where the fiduciary may have an interest in a company transaction. But if certain disclosures are made and approvals obtained, safe harbors exist for fiduciaries to participate in conflicting interest transactions. If the fiduciary faces accusations of self-interest or self-dealing, the Business Judgment Rule does not apply.

The duty of disclosure requires, with some limitations, the fiduciary to be open, forthright, and disclose to whom a fiduciary duty is owed all important and relevant information. This follows from the fact that a person who puts trust and confidence in their fiduciary should be advised on material matters so that fiduciary actions are well known and proper decision making is made. But disclosure could be avoided if the proprietary information passed on would be used for an improper purpose.

Courts will not interfere with the decision making of company management if the duty of due care is properly exercised by those making an informed, reasonable decision in the best interests of the company. If directors and officers in an Arizona corporation demonstrate that they met the standard of care in A.R.S. §§ 10-830 and 10-842 of good faith, acting in what they believe to be in the best interests of the corporation and as a reasonable director and officer would do, a decision will likely be protected by the Business Judgment Rule. In fact management has the right to rely on knowledgeable experts to assist them in making good business judgment decisions. An objecting party is required to demonstrate by clear and convincing evidence the director or officer failed to discharge their duties, rebutting the presumption such duties were properly discharged.

If the business decision is questioned as not being in the best interests of those to whom the fiduciary duty is owed, the business decision may not be protected by the Business Judgment Rule. If the decision is being attacked because the fiduciary has arguably made a decision in his or her best interest, ignoring others, protections of the Business Judgment Rule vanish.

The fiduciary duty and Business Judgment Rule are actively utilized in business divorce. Currently these legal principles are entrenched in corporate law where directors and officers owe fiduciary duties to the corporation and its shareholders. In the partnership context, a managing partner owes fiduciary duties to the partnership and the partners. It is generally accepted that fiduciary duties exist between shareholders in a corporation and partners in a partnership. In Arizona there is no statute nor published case establishing a fiduciary duty in an LLC. The fiduciary duty concept and Business Judgment Rule create leverage for negotiation, potential liability or liability avoidance. With leverage and potential liability, economic decisions causing alleged economic losses, perhaps protected by the Business Judgment Rule, assist the practitioner in arguing a settlement when owners conflict. These legal principles are essential in settling the business divorce.

Who Decides Indemnification

A company may not indemnify a director or officer under permissive indemnification without a determination regarding the individual’s conduct of meeting the good faith in the best interests standard. This determination is made by a majority vote of the directors not parties to the proceeding; legal counsel selected by the disinterested directors; or by shareholders who independently vote their shares. Fortunately, no liability attaches to such a vote. The director may also apply for indemnification to the court where the proceeding was being conducted or to any other court for indemnification. An outside director must establish they are entitled to mandatory indemnification under A.R.S. S 10-852 or that the director is fairly and reasonably entitled to indemnification even if the director has not met the standard of conduct referenced above, was adjudged liable and in which case their indemnification is limited to reasonable expenses, not the amount of judgment or settlement.

Insurance and Key Issues

While the Articles of Incorporation may limit the ability to indemnify, most often, indemnification is sought to the broadest extent provided by law. Hopefully, insurance has been procured by the company to protect the company coffers from the large expense of defense costs and paying any settlement or judgment for directors or officers in litigation.

Indemnification is available when the person is acting in their “official capacity” relating to action taken with respect to the office of the director or officer of the corporation involved.Indemnification “against liability” as that term is used in the statutes means any obligation to pay a judgment, settlement, penalty or a fine, broadly covering the damages arising out of a proceeding that a director or officer may incur. Permissive and mandatory indemnification only applies to directors or officers serving the corporation.

The key issues of indemnification arise from whether the person was actually acting in their official capacity within the scope of their duties as a director and officer and whether in their actions they really had a reasonable belief that they were acting in the best interests of the company and in good faith. Other important issues related to indemnification arise from whether there was an improper financial benefit received and if truly disinterested persons properly authorized indemnification.

The LLC statutes do not expressly provide for or set the rules of indemnification. The statutory structure is geared to having such matters put into the Operating Agreement and giving counsel an opportunity to write indemnification provisions as they deem proper, without violating Arizona law. Presumably, judges would accept guidance from Arizona corporate statutes when deciding issues related to LLC indemnification

When litigating business divorce, a shareholder, director or officer bringing claims must recognize that any judgment or settlement they may obtain may still be subject to payment by the company, that they may never have the company recover the expenses of the defense, and that a culpable director or officer may escape personal payment.

In my last article I reviewed how directors, officers and employees may receive an advancement of their attorney fees prior to judgment when they are brought in to a proceeding based on actions taken in their official capacities for the company. However, the ultimate authority to indemnify, allowing the person to keep their advancement and further obtain from the company payment for any judgment or settlement, is governed by the indemnification statutes in Arizona. If litigation is settled or goes to trial, indemnification requires that the company pay the judgment or settlement, including expenses, again providing the company’s financial support for actions taken on behalf of the company if certain conditions are met.

Authority to Indemnify

A company may indemnify a director or officer, made a party to a proceeding if the individual’s conduct was in good faith and, the individual reasonably believed that while acting in their official capacity the conduct was in the company’s best interest or in all other cases the conduct was at least not opposed to the company’s best interest. In criminal proceedings, if the individual had no reasonable cause to believe their conduct was unlawful they may obtain indemnification. A second basis allowing such permissive indemnification is if the director or officer engaged in conduct for which broader indemnification allowances exist in the Articles of Incorporation.

Permissive indemnification is not available when a director or officer receives a financial benefit to which the person is not entitled, intentionally inflicts harm on the corporation or shareholders, intentionally violates criminal law, or unlawfully makes a distribution of company funds. In addition, the company may indemnify after the termination of a proceeding resolved by judgment, order, settlement or conviction if it is not itself determinative of whether the director met the good faith, best interest standard of conduct.

Required Indemnification

The company is required to indemnify a director or officer who was a prevailing party in the defense of any proceeding to which a person was a party in their official capacity for the reasonable expenses incurred by another person in connection with that proceeding. If a director was not an officer, employee or stockholder holding more than 5%, who then qualifies as an outside director, they are entitled to receive mandatory indemnification. But an outside director shall not receive indemnification if the director did not meet the standard of good faith and acting in the best interests or not opposed to the best interests of the company as described above.