August 3, 2020
At the start of a business venture, especially when the entity is formed with family or friends, independent greed or oppression is rarely at the forefront of planning. Indeed, in today’s fast-paced world, parties focus more on business development, building relationships and protecting their assets than they do on corporate governance. To achieve their primary goals in the most efficient manner, parties often assign roles based upon prior experience and expertise, entrusting partners with extensive authority to carry out business activities. In some cases, the parties will go as far as to grant a partner “sole discretion” in making business decisions on behalf of the company, without limitation. If the business venture is organized as a limited liability company, the parties may – and should – memorialize these broad powers in the company’s operating agreement.
In drafting expansive language granting an LLC manager “sole discretion” in making business decisions, parties intend to mitigate the risk of a lawsuit from a business partner second-guessing a routine transaction. However, a recent New York appellate decision – the reasoning of which applies equally to established New Jersey law – held that even unfettered contractual discretion might be defeated by an allegation that the fiduciary is self-dealing or has otherwise acted in bad faith.
In Shatz v. Chertok, 180 A.D.3d 609 (1st Dept. 2020), the parties created an LLC, named Vast VI, that was structured to engage in various investments. Vast VI’s operating agreement gave the company’s manager, Vast Ventures, “sole and absolute discretion” over company investment decisions. In or about 2013, Vast Ventures advised the other members of Vast VI of an opportunity to invest in a startup called Ripple. In support of that investment opportunity, Vast Ventures issued a capital call, which was paid by all members of Vast VI. Notwithstanding their attempt to invest, Ripple withdrew its offer and the capital calls were returned to the members of Vast VI. Later that year, a second, near identical, opportunity to invest in Ripple arose, and a different company controlled by Vast Ventures made that investment. Although the members of Vast VI had previously expressed an interest in investing in Ripple, Vast Ventures did not advise the members of Vast VI of this second opportunity and, consequently, Vast VI did not invest in Ripple. After a non-managing member of Vast VI learned that Vast Ventures’ investment in Ripple with its other company generated significant profits, he brought a lawsuit against Vast Ventures and its principal.
Vast Ventures immediately moved to dismiss, relying upon the broad discretion in the parties’ operating agreement that granted Vast Ventures “sole discretion” over Vast VI’s investment choices. While the plain language of the operating agreement largely protected Vast Ventures and defeated the majority of the non-managing member’s claims, the New York Supreme Court declined to dismiss all claims against Vast Ventures. Affirming the trial court’s decision, the appellate court relied upon the basic principal of contract, that a right to discretion contained in an agreement cannot be exercised in bad faith “so as to deprive the other party of the benefit of the bargain.” The matter was then remanded to the trial court for further proceedings, to determine whether Vast Ventures had deprived Vast VI and its members of their reasonable expectations under the company’s operating agreement.
On its face, it may appear that the court in Shatz limited the freedom of LLC members to independently determine their responsibilities under an operating agreement, and imposed new, unforeseen duties upon LLC managers. That interpretation, however, is not correct. Rather, the New York courts affirmed the application of law that applies to LLCs in New York, New Jersey, and across the country. Namely, LLC operating agreements are contracts by, among and between the company and its members. Those operating agreements are, therefore, subject to the basic principles and laws governing contracts.
In that light, operating agreements, like all contracts, contain an implied covenant of good faith and fair dealing. The duty of good faith and fair dealing requires that the parties to an agreement refrain from taking action that would have the effect of destroying or injuring the rights of the other parties to the agreement. In other words, while a managing member’s conduct may not technically constitute a breach of the operating agreement, the manager is nonetheless required to act in a manner that promotes the best interests of the LLC and its members, so as to not deprive any party of the benefits of their ownership interests.
The application of the duty of good faith and fair dealing to LLC operations sends a strong message to LLC managers. When complex transactions are perceived to enrich decision makers at the expense of investors, litigation may ensue. Even with the protection of contractual clauses affording them discretion in the operation of the business, the efficacy of the clause is not without limits. Thus, to avoid the expense and costs of prolonged litigation, LLC managers must repeatedly evaluate the nature of their actions, and whether their conduct is contrary to the reasonable expectations of the company’s members.
Jordan B. Kaplan is an attorney in the Morristown office of Fox Rothschild LLP. He represents businesses in litigation involving partnership and corporate conflicts, trade secret and employment issues, unfair competition claims, consumer fraud actions, shareholder matters, director/officer claims, real estate disputes and breach of contract actions.