Nearly unanimously, the New Jersey Legislature recently passed the New Jersey Revised Uniform Limited Liability Company Act (RULLCA). While this near unanimity may lead many to assume that the RULLCA is noncontroversial, with regard to fiduciary duty it is a great departure from current law. Practitioners should be welladvised of the changes and plan accordingly. In understanding this recent development, it is helpful to first understand the history of LLC law in New Jersey.
In business entity issues, there is a longstanding judicial tradition that a New Jersey court “regards the decisions rendered by Delaware courts as a germane source of reference.” In re D’Amore, _ B.R. _ (D.N.J.Bkrpt. 2012). The Delaware Department of State has concluded that New Jersey is not alone in its affections, stating in a recent publication that Delaware attorneys often “bask in the reflected admiration that [out of state attorneys] feel for the Court of Chancery.” While that may be overstating the issue, considering Delaware’s history as the preeminent worldwide jurisdiction for the adjudication of business entity issues, New Jersey’s deference is not without merit.
In enacting the New Jersey LLC Act in 1993, our state legislature recognized our historical alliance with Delaware and chose to model the act directly on the corresponding Delaware act. One of the overarching principles we inherited from Delaware was to give “maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.” N.J.S.A. 42:2B66(a), taken directly from 6 Del. C. 181101(b). Contained within this freedom of contract is the explicit authorization that fiduciary duties may be “expanded or restricted by provisions in the operating agreement.” N.J.S.A. 42:2B66(b), taken from 6 Del. C. 181101(c). Rather than be governed by common law fiduciary duties of good faith, fair dealing and loyalty among the parties, LLC law would recognize that it is desirable for sophisticated commercial actors to be able to define the terms of their own relationships.
The concept of “contract over common law” in the Delaware and corresponding New Jersey acts is so strong that there is one school of thought, led by Chief Justice Myron Steele of the Delaware Supreme Court, that believes that if the parties do not specify fiduciary duties in an operating agreement they do not owe each other any at all. This view was expressed by the Chief Justice in a 2009 article in the American Business Law Journal. The Chief Justice was speaking in that article only for himself and not for the Delaware Supreme Court, and his view seems to be a minority one. Neither the Delaware nor New Jersey LLC Acts addresses the issue, and, to date, the Delaware Court of Chancery has generally held the opposite of the Chief Justice’s position; that absent any provisions addressing fiduciary duty in an operating agreement the parties owe each other common law fiduciary duties. In In re D’Amore, the Bankruptcy Court for the District of New Jersey agreed with the Delaware Chancery decisions in applying New Jersey law.
Even if Chief Justice Steele’s position is controversial, it is not controversial that under N.J.S.A. 42:2B66(b) if the parties explicitly agree to restrict traditional fiduciary duties, that agreement is binding. The corresponding Delaware provision was cited in Fisk Ventures LLC v. Segal to go so far as to permit the parties to waive any and all code of conduct. 2008 WL 1961156 at *11 (Del.Ch. 2008); aff’d 982 A.2d 124 (Del. 2009). Due to the clear language of N.J.S.A. 42:2B66(b), it is unlikely a New Jersey court would have held differently.
This ability to freely contract fiduciary duties simply makes sense. Operating agreements are not consumer contracts where the parties are in drastically uneven positions. They are commercial agreements among business partners. While many worry about the case of “mom and pop” businesses, it should be noted that if the parties are not sophisticated enough to explicitly contract their fiduciary duties, the majority view is that all of the traditional common law duties apply to “fill the gaps.” This will protect the reasonable expectations of most businesses of that nature. It should also be noted that under the Delaware act, while the parties can eliminate the fiduciary obligation of good faith and fair dealing (along with other fiduciary duties), they cannot eliminate the lesser contractual obligation of good faith and fair dealing. The New Jersey act doesn’t state this as explicitly as Delaware, however it is likely implied under traditional contractual principles. This lesser obligation is generally successful in preventing parties from using contracts to intentionally injure one another.
Over time the New Jersey LLC Act became out of date, as it wasn’t amended to keep up with the many Delaware amendments since 1993. Instead of passing amendments to bring our act back in line with Delaware’s, the legislature passed the RULLCA.
The RULLCA has not been one of the great successes of the National Conference of Commissioners on Uniform State Laws. To date, it has been passed in only five other states (all far less populated and with far smaller business communities than New Jersey) and the District of Columbia.
While a more modern statute, the RULLCA divorces New Jersey from the Delawarian presumption of contractual freedom. The current statute’s “maximum effect to the principle of freedom of contract and to the enforceability of operating agreements” is gone. Instead, the new act creates a presumption that “an operating agreement may not … eliminate the duty of loyalty, the duty of care, or any other fiduciary duty” unless the act’s requirements are met. NJRULLCA 111(c)(4). The old act started at contractually defined duties and resorted to common law only to “fill gaps.” This system has been replaced by a starting point of common law duties only to be modified when the RULLCA deems appropriate.
Under the RULLCA, restriction or elimination of common law fiduciary duties is only permitted if not “manifestly unreasonable.” NJRULLCA 111(d). This is a necessarily ambiguous standard. This new requirement that any modification to common law duties not be “manifestly unreasonable,” along with the reversal of primacy between contractual and common law fiduciary duties, has created ambiguity in LLC governance where there was once certainty.
As an illustration, imagine Joe and Steve form an LLC to operate a pizzeria. While neither party owns any other pizzerias, Steve owns various fast food and other business ventures in the region. Joe, on the other hand, doesn’t have Steve’s money or entrepreneurial experience. Joe knows pizza. Joe and Steve specify in their operating agreement that as a passive investor Steve is a “Class B Member” and that Class B Members owe no duty of loyalty to the company. This allows Steve to invest in Joe’s dream of owning a pizzeria while not restricting his future investments. The pizzeria opens. In the beginning, due to Joe’s limited business acumen, Steve gets a little more involved in operations than he originally desired in order to get Joe on track. Soon after things settle down at the pizzeria, Steve becomes aware of another pizzeria for sale two towns away, and as permitted under the operating agreement purchases it. Joe is angry, and feels betrayed.
Under the old act, it’s extremely clear that Joe has no grounds to sue Steve for breach of loyalty. To quote the Court of Chancery, because “fiduciary duties … were limited by the LLC Agreement, the Plaintiffs cannot bring a straightforward duty of loyalty claim.” Dawson v. Pittco Capital Partners, 2012 WL 1564805 at *15 (Del.Ch. 2012). Because the issue is so clear, it is unlikely that Joe’s anger will result in litigation.
On the other hand, under the RULLCA, Steve must deal with the issue of whether the waiver of duty was “manifestly unreasonable.” The fact that Steve was at one point involved in the LLC’s management (even against his desire and through no fault of his own) may make Joe’s claim that the waiver was “manifestly unreasonable” not wholly frivolous. While it should be likely that Joe would lose on this point in court, the starting presumption of the common law fiduciary duty of loyalty, combined with the imposition of a reasonableness standard on the waiver of that duty, have at least given Joe a “leg to stand on” to bring a claim. This may result in costly and unnecessary litigation for Steve. Because such a reasonableness standard leaves much to judicial discretion, despite the clear language of the operating agreement there is still a possibility (however small) that Joe could prevail.
While more sophisticated actors undertaking business ventures may not “feel betrayed” like Joe, they may also resort to litigation even in the face of a clear waiver of fiduciary duty. A sophisticated actor may feel it has nothing to lose by taking a shot in court at a joint venturer after the relationship has broken down.
This discussion raises the obvious question of what New Jersey practitioners can do to bring Delawarian certainty back into relationships among LLC members. In situations where members desire duties different from those provided under common law, such certainty can be regained by simply forming the LLC in Delaware rather than New Jersey. Even if the entity has no dealings in Delaware whatsoever, the internal affairs doctrine ensures that all disputes between members will be settled under Delaware, rather than New Jersey, law. Delaware imposes very minimal fees and filing requirements on its domestic LLCs not operating within its boundaries, so this is a viable option even for very small enterprises.
All practitioners, no matter where filing, would be well advised to spell out at great length and with explicit detail any deviations from traditional common law fiduciary duties. Those practitioners electing to file in New Jersey should take additional precautions. Due to the imposed reasonableness standard, it is advisable that not only the restriction on fiduciary duty be stated explicitly, but also the reasons the parties desire the restriction, and the reasons the parties believe the restriction is reasonable.