By Gerald P. Burleson, Member of the California Bar, and Dylan Contreras, J.D., 2019, California Western School of Law, and 2019 candidate for the California Bar
© 2019 by Gerald P. Burleson, all rights reserved
On January 1, 2014, the Revised Uniformed Limited Liability Company Act (“RULLCA”) went into effect, replacing the Beverly-Killea Limited Liability Company Act (the “Beverly Act”). Different from the Beverly Act, RULLCA now specifies what fiduciary duties a member and manager owe to an LLC and its members.
Under RULLCA, members of a member-managed LLC and managers of a manager-managed LLC owe the fiduciary duties of care and loyalty to the LLC and its members. In comparison, members of a manager-managed LLC do not owe the fiduciary duties of care and loyalty to the LLC or its members solely by being a member. However, members and managers owe the obligation of good faith and fair dealing to the LLC and its members, whether the LLC is manager-managed or member-managed. Cal. Corp. Code §17704.09.
Like the Beverly Act, RULLCA still allows members and managers to modify—but not eliminate all together—the fiduciary duties of care and loyalty, and the obligation of good faith and fair dealing. Cal. Corp. Code § 17701.10. RULLCA specifically provides that: (1) the duty of care cannot be unreasonably reduced, (2) the duty of loyalty must specify acts that do not violate the duty of loyalty, provided the limitation is not manifestly unreasonable; and (3) the obligation of good faith cannot be unreasonably reduced. The result is that courts will turn to the LLC’s operating agreement to determine if the manager’s actions, including the actions of a member in a member-managed LLC, were proper under the terms of the operating agreement. If the operating agreement does not contain any modifications, then courts will rely on RULLCA to determine whether a manager, or member in a member-managed LLC, breached the fiduciary duties of care and loyalty, or the obligation of good faith.
To start, let’s first discuss the duty of loyalty under RULLCA. The duty of loyalty requires managers, including members of member-managed LLCs, to: (1) refrain from conducting LLC business with a person or business that has an adverse interest to the LLC; (2) refrain from directly competing with the LLC; and (3) account to the company for any profit or benefit derived from the LLC or its dealings. Often, managers contend they did not breach the fiduciary duty of loyalty because their actions merely “furthered their own interests” relying solely on sub-section (e) of Cal. Corp. Code, § 17704.09. Subsection (e) undermines the fiduciary duty of loyalty and, at first glance, seems to protect a manager’s impropriety. Recently, the California Appellate Court was confronted with this issue in the case of Feresi v. The Livery, LLC (2014) 232 Cal.App.4th 419.
In that case, Feresi, the plaintiff, and her ex-husband, Mesa, acquired a 25% interest in The Livery, LLC, a member-managed LLC, while married. In 2002, Feresi and Mesa separated, and the court awarded Feresi and Mesa each a 12.5% interest in the LLC and ordered Mesa to pay Feresi’s mortgage. Mesa’s financial obligation to Feresi was secured by his 12.5% interest in the LLC. Shortly thereafter, Mesa fell behind on his obligation to Feresi and he received a large loan from Hartley, the controlling-member of the LLC, that was secured by Mesa’s 12.5% interest in the LLC. At the time of the loan, Hartley knew that Mesa’s financial obligation to Feresi was secured by Mesa’s 12.5% interest in the LLC and that Feresi had failed to file a UCC financing statement that would assure that her lien had priority over Mesa’s interest in the LLC. Ultimately, Mesa failed to uphold his obligation, and Feresi petitioned the court to convey Mesa’s interest in the LLC to her. After learning of Feresi’s intentions, Hartley took advantage of Feresi’s mistake and filed a UCC financing statement that ensured his lien over Mesa’s interest in the LLC had priority over Feresi’s lien.
On appeal, Hartley argued that he did not breach his duty of loyalty or the obligation of good faith because his actions merely “furthered his own interest,” relying upon sub-section (e) of Cal. Corp. Code, § 17704.09. The court disagreed, finding that Cal. Corp. Code, § 17704.09 (e) is intended to protect managers, who receive “incidental benefits in the course of [company] activities,” whether the LLC is manager-managed or member-managed. Id. at 426. Here, the court stated, Hartley’s benefits were not incidental but rather planned. Hartley knew that Feresi had an unperfected security interest in Mesa’s membership interest in the LLC, yet he still made a large loan to Mesa securing the loan with a lien on Mesa’s 12.5% interest in the LLC. Then, Hartley attempted to “perfect” his security interest at Feresi’s expense by filing a UCC financing statement that would assure his lien had priority over Feresi’s. The court held that Hartley “betrayed [Feresi’s] trust and confidence” and therefore, breached his fiduciary duty of loyalty and the obligation of good faith. Id.
The holding in Feresi teaches us that California courts will find that managers, including members in a member-managed LLC, breach their fiduciary duty of loyalty and their obligation of good faith when they receive a personal benefit at another member’s expense. To avoid such a finding, a manager, or member in a member-managed LLC, must prove the benefit received was, in fact, incidental and unplanned—a standard most managers and members will have a difficult time meeting.
Turning to the fiduciary duty of care, RULLCA requires managers, including members of a member-managed LLC, to refrain from “engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.” Cal. Corp. Code, § 17704.09. In some cases, courts may find that a manager breaches the duty of care by knowingly violating the company’s operating agreement. The case of Melvin v. Harkey (Cal. Ct. App., July 30, 2018, No. G049674) illustrates this point.
In Melvin, the defendant, Harkey, created an LLC investment vehicle that would lend money to land developers. The LLC’s operating agreement stated that no loans could be made to the manager—Harkey—or his affiliates, no loan could exceed five million dollars, and the members would not be charged any additional fees. The operating agreement also expressly stated that Harkey was required to refrain from “gross negligence, intentional misconduct, or a knowing violation of law,” which mirrors the duty of care outlined in RULLCA. Id. at 8. The court found that Harkey breached his fiduciary duty of care in more ways than one. Harkey used the members’ investments to run a ponzi scheme and in doing so, approved loans exceeding the five-million-dollar loan cap, loaned money to a company he personally owned, and improperly charged the other members numerous fees. The court found that Harkey “looted the plaintiffs’ investment funds,” and knowingly violated the operating agreement in breach of his fiduciary duty of care. Id. at 9.
Based on the foregoing, California courts have and will continue to closely scrutinize a manager’s actions, including the actions of a member in a member-managed LLC, to determine if a breach of the fiduciary duties of care and/or loyalty has occurred. California courts will not allow managers, including members in a member-managed LLC, to escape liability by contending their actions “merely furthered their own interests.” Taken together, these holdings show that California courts will protect LLC members from abuse by managers of an LLC.