G&K attorney Terry Thompson authored “Thinking of Starting an LLC in Arizona? Here are Five Duties You’ll Need to Follow” for the Phoenix Business Journal.
At age eleven, the future Queen Victoria learned she stood next in line to the throne. When her governess showed her the long line of England’s monarchs with her own name at the end, the implications of her future obligations sank in, and the child Victoria cried. She then composed herself and said, “I will be good.”
A member or manager of an Arizona limited liability company might similarly be given pause when told of the five types of duties imposed on them by Arizona statute.
1. Contractual duties. For an Arizona limited liability company (LLC), the operating agreement (OA) governs, among other things, relations between the members and the company, the rights and duties of managers, and the activities of the company. At the heart of every company, the OA is a contract, and that means promises.
The existence of the contract binds certain persons to comply with its provisions – even if the company has not signed the OA. A duty or obligation arising under a contract is referred to as a “contractual obligation,” “contractual duty,” or a “duty to perform.” Obligations might be vast or scant, but an inescapable duty is what the statute refers to as the “contractual obligation of good faith and fair dealing.”
Arizona statute sets forth certain special contract rules for the OA. Thus, the nature and scope of express contractual obligations arising under the OA are determined by the contract itself and the general principles of contract law, with the statute providing only a few special rules here and there.
In short, when it comes to the parties to the OA, everybody – even the company itself – owes everybody else the duty of good faith.
2. Duty of care. In a member-managed company, the duty of care is owed by each member to the company and the other members. In a manager-managed company, duty of care is owed by each manager to the company and to the members. The Arizona LLC act frames this duty in terms of “don’t be bad.” However, the duty can be phrased in a positive way, much like Victoria’s vow to “be good,” to act with the care of a prudent person.
First, the corporate duty to act in good faith is an analog of the duty to refrain from intentional misconduct and abide by the contractual obligation of good faith and fair dealing.
Second, the corporate standard of “an ordinarily prudent person in a like position under similar circumstances” comports with the first element of recklessness: a necessary, but not sufficient, condition that at least mere negligence exists.
Third, the corporate requirement that the duty be discharged in a manner the director or officer believes is in the “best interests of the corporation” is similar to the LLC requirement that members and managers owe duties to “the company and the other members.”
Fourth, the corporate “business judgment rule” forestalls the second-guessing of decisions by an entity’s management and presumes that the decisionmaker acted in accordance with the applicable standard of care.
Three basic rationales underlie the business judgment rule:
1) Repeated second-guessing of decisions by members and the judicial system would chill the risk-taking necessary for the success of the undertaking and undermine an economic system desiring growth and philanthropy.
2) Courts are not designed to assess the risks and circumstances associated with a particular business decision, nor do they have the time or expertise to engage in day-to-day management of an enterprise; a task that would be the natural consequence of having the right to review every decision made by every enterprise.
3) Recruiting qualified individuals for decision-making roles is aided by a legal system honestly acknowledging that humans in the context of risk-taking enterprises are prone to error and assuring that those persons have the benefit of limited liability.
In short, the duty of care in the context of an LLC is the duty to refrain from “grossly negligent or reckless conduct or willful or intentional misconduct.”
3. Duty of loyalty. The statute refers to the duty of loyalty owed to the company as a “fiduciary” duty. The general idea is that a member or manager should act loyally for the company’s benefit in all matters within the scope of the relation.
A person owing the duty of loyalty must, at a minimum, abide by four special duties.
1) Account for any personal benefit arising from using company property or seizing a company opportunity. Generally, this means that the person cannot keep any benefit derived from conducting the company’s activities, use company property for oneself, or usurp a company opportunity.
2) Refrain from conflicts of interest. The duty-holder must not be adverse to the company in the course of conducting the company’s activities. In this context, “adverse” means being on the other side of the negotiating table in a transaction with the company.
3) Refrain from competing with the company.
4) Disclose a conflict of interest. When members or managers are considering a matter, the duty-holder must disclose any material conflict of interest with respect to the decision or transaction; and if a conflict exists, disclose all relative facts within their knowledge.
In general, a member or manager should act loyally for the company’s benefit in all matters within the scope of its role.
4. Duties of agency. In a member-managed company, each member is an “agent” of the company and owes to the company the duties of an agent. Similarly in a manager-managed company, each manager is an “agent” of the company and owes to the company the duties of an agent. Also in a manager-managed company, if a manager has delegated authority to a member, that member is also an agent of the company (“co-managing member”) and owes the duties of an agent.
The law of agency addresses the duties of an agent at great length. However, if and to the extent the statute expressly addresses a duty, the law of agency cannot be read as creating a second common-law duty on the same subject.
In some cases, the statute’s displacement of the law of agency is obvious. For example, the statute expressly provides for a manager’s duty to refrain from competing with the company. That provision thus may well displace the corresponding duty in the law of agency.
At the opposite extreme, consider the case of a co-managing member in a manager-managed company as described above. The statute says that a co-managing member’s fiduciary duties to the company or the other members will depend on the “policies” underlying the statute and on other laws. In other words, the statute does not displace any of the duties of the law of agency.
In short, consider the advice found in the Russian proverb “Doveryai, no proveryai” and restated by President Reagan: “Trust, but verify.”
5. Special statutory duties. Aside from these duties, the Arizona LLC statute imposes special duties on a person in certain situations intended to facilitate the Arizona Corporation Commission’s orderly administration of the statute.
For example, if a member of a member-managed company or a manager of a manager-managed company knows that information in the articles of organization filed with the Commission was inaccurate, the member or manager must take action to correct the information.
In many cases, special statutory provisions not only state that an action must be taken or avoided but also indicate who is obligated to do so. For instance, to amend its articles of organization, a company must file an amendment with the Commission stating the name of the company and the text of the amendment.
Similarly, in some cases, the statute indicates who is an intended beneficiary of that obligation and the circumstances under which an aggrieved person can seek a remedy for failure to honor the obligation.
These five “types” of duties for Arizona limited liability companies have many nuances and qualifications. The Arizona Corporation Commission administers these special laws for one million LLCs. Lacking divinity, the Commission perhaps cannot be expected to ensure that all Arizona LLCs are in orderly compliance with each and every of the statute’s administrative provisions.
Perhaps that is the aspect of duty that daunted young Victoria: One can foresee situations in which the path of one’s duty will be unclear.
This article describes in broad strokes some of the nuances of each duty. It is important that entrepreneurs and startups seek qualified legal counsel when forming their companies and drafting operating agreements.