If you read most any operating agreement for a manager-managed LLC, chances are you’ll find somewhere in it a grant of decision-making authority in the manager’s “sole and absolute discretion” or verbiage to similar effect. Sometimes the grant of authority is cast generally; sometimes it’s limited to specified actions.
Giving each of the words their ordinary dictionary meaning, the phrase “sole and absolute discretion” sounds, well, pretty darn sole, absolute, and discretionary. No room for disagreement or legal challenge by the non-managing members, right?
In many if not most instances, that would be correct. But not all. So when is “sole and absolute discretion” not the final word on manager decision-making?
According to a recent decision by the Manhattan-based Appellate Division, First Department, in Shatz v Chertok, __ AD3d __, 2020 NY Slip Op 01383 [1st Dept Feb. 27, 2020], a “sole and absolute discretion” clause in the operating agreement does not by itself defeat a claim by a non-managing member for breach of fiduciary duty when the managing member allegedly exercises its discretion “in bad faith so as to deprive the other party of the benefit of the bargain.”
The Operating Agreement
Shatz involves a dispute between co-members of a New York limited liability company called Vast Ventures VI LLC. The LLC’s operating agreement’s purpose clause begins with broad, any-lawful-purpose language but then adds, “Specifically, the LLC’s objective shall be to identify and invest in private equity funds whose primary focus is to invest in technology companies.” The next sentence, upon which the subsequent litigation focused, states:
The LLC may invest in as many such private equity funds as the Managing Member elects in its sole and absolute discretion; provided, however, that no investments shall be made in funds or other accounts in which the Managing Member has an ownership interest outside of the LLC or in which the Managing Member receives any sort of management fee (however characterized).
The LLC being manager-managed, as one would expect it included the following provision granting the managing member plenary powers:
The Managing Member shall have sole and exclusive control of the management of the LLC and shall manage the LLC exclusively in its capacity as a Member. Except as provided in this Agreement, Members other than the Managing Member shall have no control of the management of the LLC, and shall have no rights or powers to carry on the affairs of the LLC.
The Alleged Fiduciary Breach
In 2018, the plaintiff 50% non-managing member, Shatz, filed a complaint against the 50% managing member, Chertok, asserting a number of claims including a derivative claim for breach of fiduciary duty in connection with an investment made five years earlier, not by their jointly owned LLC, but by another company solely owned by Chertok.
The investment was not in a private equity firm. Rather, Chertok made a seed round investment directly in a start-up company in the blockchain and cryptocurrency industry known as Ripple. Shatz alleged that Chertok previously had proposed to Shatz to make the investment in Ripple through their LLC; that Shatz made a capital contribution for that purpose; that Chertok then informed Shatz that the investment round was “postponed”; and that, without telling Shatz that the investment round had reopened, Chertok later made the investment in Ripple through his separately owned company.
Chertok moved to dismiss the complaint, arguing that Shatz’s sole grievance was the LLC’s failure to invest in Ripple, and that such grievance stated no cognizable claim under any legal theory because Shatz agreed in the operating agreement that the Managing Member would have “sole and absolute discretion” over choosing investments for the LLC, and that Shatz would have no say in such decisions.
The Lower Court’s Ruling
The case was assigned to Manhattan Commercial Division Justice Jennifer G. Schecter who, for the reasons stated on the record at oral argument, issued a one-page order dismissing all claims save Shatz’s derivative claim for breach of fiduciary duty. In a subsequent Decision and Order denying Chertok’s motion to reargue, Justice Schecter wrote that, while the “sole and absolute discretion” provision “ordinarily” would be an “absolute bar to plaintiff’s claims,”
plaintiff’s well-pleaded, plausible allegations of bad faith and express misrepresentations–made for the purpose of diverting the investment opportunity in a company in which defendants had an undisclosed interest to another fund managed by them–states a claim for breach notwithstanding the absolute discretion clause. . . . [¶] Indeed, these sophisticated parties surely understood that while freedom of contract is paramount and that LLCs are creatures of contract that can modify or eliminate default fiduciary duties, the implied covenant of good faith and fair dealing can never be waived.
The Appellate Court’s Affirmance
Chertok appealed from the denial of his motion to dismiss the fiduciary breach claim, pressing his argument that his “sole and absolute discretion” as manager denied Shatz the right to demand that the LLC make a particular investment. Among other precedents, Chertok relied on the First Department’s 2012 opinion in Sullivan v Harnisch in which the court held that a sole-discretion provision in the operating agreement of an investment fund “clearly and unambiguously provided that [the manager] had the sole discretion to determine plaintiff’s ‘Sharing Ratio,’ which would be used to determine his allocation of the bonus pool comprised of 75% of the funds’ profits.”
The appellate panel disagreed and affirmed Justice Schecter’s order allowing the fiduciary breach claim to proceed. As had Justice Schechter in her decision denying Chertok’s motion to reargue, the panel’s decision relied heavily on the First Department’s 2003 opinion in Richbell Information Services, Inc. v Jupiter Partners, L.P., in which the court upheld a shareholder’s fiduciary breach claim concerning an aborted IPO notwithstanding the absence from the stockholder agreement of any explicit limitation on the defendant’s right to veto the IPO. Likening Shatz’s complaint’s allegations to those in Richbell, and notwithstanding the absence from Richbell of an express sole-discretion provision, the panel wrote:
Here, although defendants possessed sole discretion over investment decisions, the complaint sufficiently alleges that they exercised that discretion in bad faith and to self-deal. Thus, the fiduciary duty claim was properly sustained, despite the existence of the sole discretion clause.
A Contractually-Infused Fiduciary Duty?
What’s striking about the courts’ rulings in Shatz and Richbell is the courts’ infusion of contract-based principles undergirding the implied covenant of good faith and fair dealing into their analyses of common-law claims for fiduciary breach. Justice Schecter expressly bottomed her ruling denying reargument on her statement that the covenant “can never be waived,” even though her prior ruling on the underlying motion dismissed Shatz’s separate claim for breach of the implied covenant.
The Shatz appellate panel, quoting Richbell, likewise invoked the implied covenant when it wrote that “even an explicitly discretionary contract right may not be exercised in bad faith so as to frustrate the other party’s right to the benefit under the agreement” — a principle the Richbell court referred to as a “purely contractual rule.” Making things even more confusing, the Appellate Division’s decision also reinstated Shatz’s implied covenant claim, stating that “plaintiff sufficiently pleaded a claim for breach of the covenant of good faith and fair dealing, and was entitled to plead it in the alternative or in addition to the fiduciary duty claim.”
Interestingly, the Richbell court expressly acknowledged “that there is clearly some tension between, on the one hand, the imposition of a good faith limitation on the exercise of a contract right and, on the other, the avoidance of using the implied covenant of good faith to create new duties that negate explicit rights under a contract.”
A couple of years ago I posted on this blog a piece entitled Will Someone Please Re-Name the Implied Covenant of Good Faith and Fair Dealing? in which I lamented the confusion caused by the implied covenant’s name and its resulting misapplication outside the context of construing the parties’ intent when they leave a “gap” in their contract, and instead treating it as a species of common-law fiduciary duty. Do cases such as Richbell and Shatz dispel or propagate the confusion? You be the judge.
There is, of course, a way to pack more punch into an LLC manager’s contractually authorized sole-discretion: form the LLC in Delaware and include in the operating agreement a provision as authorized by Delaware’s LLC Act — for which New York’s LLC Law has no counterpart — expressly waiving all of the manager’s fiduciary duties.
Update May 19, 2020: A little over a month after issuing its Shatz decision, the First Department decided Seeking Valhalla Trust v Deane in which it affirmed the lower court’s pre-answer dismissal of a complaint similar to the one in Sullivan v Harnisch, holding that the defendant LLC manager “did not breach the operating agreement or the covenant of good faith and fair dealing by exercising her express sole discretion to reallocate sharing ratios, even down to zero, at any time” and further commenting that the manager “merely exercised the very power given to her by the operating agreement (cf. Shatz v Chertok 180 AD3d 609 [1st Dept 2020]).” The appellate decision doesn’t mention Richbell although the lower court’s decision distinguished it, stating that “Richbell is inapposite because the conduct there included fraud, collusion and illegality. None of that conduct is alleged here.”