Limited Liability Companies (LLC’s) are functional and flexible forms of ownership for operating companies as well as investment vehicles. As common as LLC’s are today, we ought to remember that relative to other forms of legal entities, LLC’s are still very new. It was only as recently as 1996 that all fifty states had enacted limited liability company statutes, so in many states these forms of ownership are less than 30 years old. For instance, the Virginia Limited Liability Company Act (VLLCA) was only originally passed in 1991, making it only 29 years old. Thus, the body of law governing LLC’s is much less robust than that of corporations or partnerships.
Twice in the last few months, we have been asked by clients to look into issues regarding the duties of managers of a Virginia LLC, and it’s illustrative of a key difference of the two entity structures, and the much smaller body of case law regarding limited liability companies versus corporations. The key statutory provision outlining the duty a director owes a corporation is Virginia Stock Corporation Act (VSCA) Section 13.1-690, which states that “A director shall discharge his duties as a director, including his duties as a member of a committee, in accordance with his good faith business judgment of the best interests of the corporation.” The key statutory provision outlining the duty a manager owes a limited liability company is VSCA Section 13.1-1024.1, which states that “A manager shall discharge his or its duties as a manager in accordance with the manager’s good faith business judgment of the best interests of the limited liability company.”
They seem almost identical, right? Perhaps, but a body of case law in Virginia has confirmed that corporate directors have a common law duty of care and a duty of loyalty to the corporation underpinning Section 13.1-690 (See Willard v. Moneta Bldg. Supply, 515 S.E.2d 277 (Va. 1999), Feddeman & Co. v. Langan Associates, 260 Va. 35, 530 S.E.2d 668 (2000), Simmons v. Miller, 261 Va. 561, 544 S.E.2d 666, (2001)). In contrast, there is no case law in Virginia establishing a common law duty of loyalty by managers to the LLC. To the contrary, limited case law applying Virginia law indicates that managers affirmatively do not have a duty of loyalty to their LLC. (See In re Virginia Broadband, LLC, 2014 BL 313170 (Bankr. W.D. Va. 2014)).
The VSCA also contains Section 13.1-691, titled “Director conflict of interests”. Section 13.1-691 defines certain transactions that would cause a conflict of interest with a director, and creates something akin to a safe harbor for a corporation’s board of directors engaging in such a transaction if certain information is disclosed and certain procedures are followed. While this statute does govern specific acts of potential self-dealing, the duty of loyalty of a director to their corporation is more generally governed by Section 13.1-690 and the common law described above. Stated differently, while Section 13.1-691 only covers transactions between a director and their corporation, the general duty of loyalty underpinning Section 13.1-690 covers a far broader set of possible actions by a director. (See Goolsby & Haas on Virginia Corporations, 6th Ed., Section 9.8, p. 247).
Despite this seemingly large gap of protection for limited liability companies, all is not lost. Another major difference between corporations and limited liability companies is the flexibility, as mentioned at the top of this post, that LLC members may contract, via an operating agreement, for a set of governance provisions customized to their specific needs, as long as those contracted provisions do not violate the Virginia Limited Liability Company Act. The members could agree that managers have a duty of loyalty to the LLC, and they could also define its parameters. They could choose to limit the duty of loyalty to the equivalent of Section 13.1-691 of the VSCA, or they could state that managers are subject to the same standards applicable to directors of a corporation.
It is very important to note that these comments are only applicable to Virginia LLC’s and the law applicable in other jurisdictions may be quite different. For instance, in Delaware, by far the most popular jurisdiction for forming LLC’s, the default rule is the complete opposite. In the absence of a provision in the operating agreement to the contrary, managers and controlling members of an LLC owe a duty of care and a duty of loyalty to the LLC. (Delaware Limited Liability Company Act, Sections 18-1104 and 18-1101(c)).
The examples described in this post is just one of a number of important considerations when forming a limited liability company. Do not rely on a form downloaded from the internet. The corporate attorneys at GreeneHurlocker commonly assist clients with the formation of corporations, limited liability companies and partnerships, so please contact me or one of the other members of our corporate team to discuss these issues if you are considering forming a new company.