There’s a ton of Delaware caselaw enforcing Section 18-1101 (c) of that state’s LLC Act as amended in 2004, authorizing LLC agreements to eliminate the members’ and managers’ liability for breach of fiduciary duty, the only specified carve-out being the narrowly construed implied contractual covenant of good faith and fair dealing.

In New York, which at least superficially offers the same contractual shield, not so much.

New York’s analog to the Delaware statute is found in Section 417 of the LLC Law. Section 417 (a) (1), like the Delaware statute, authorizes members to adopt an operating agreement “eliminating or limiting the personal liability of managers to the limited liability company or its members for damages for any breach of duty in such capacity.”

Unlike Delaware’s statute, however, an expansive proviso immediately follows the quoted language, stating that no such provision shall eliminate or limit

the liability of any manager if a judgment or other final adjudication adverse to him or her establishes that his or her acts or omissions were in bad faith or involved intentional misconduct or a knowing violation of law or that he or she personally gained in fact a financial profit or other advantage to which he or she was not legally entitled or that with respect to a distribution the subject of subdivision (a) of section five hundred eight of this chapter his or her acts were not performed in accordance with section four hundred nine of this article.

The cross-referenced Section 508 (a) preserves member liability for knowing receipt of distributions which, in so many words, render the LLC technically insolvent — not of interest for present purposes.

Of greater interest is the other cross-referenced statute, Section 409. It provides that a manager “shall perform his or her duties as a manager . . . in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances.” As I’ve previously written, Section 409’s language is lifted almost verbatim from the standard for director conduct in Section 717 of the Business Corporation Law, and the courts have construed both statutes as imposing traditional fiduciary duties of loyalty and care.

Between Section 417 (a) (1)’s express carve-out for bad faith acts or omissions, intentional misconduct, etc., plus the cross reference to Section 409 which looks like nothing so much as the exception swallowing the rule, what efficacy does the statute retain as a means of insulating LLC managers and members from having to litigate through discovery and trial their personal liability for alleged managerial misconduct?

As it turns out, very little if any.

The Few New York Decisions Applying Section 417 (a) (1)

I’ve yet to come across a reported New York court decision involving a New York LLC, granting dismissal at the early stage of a fiduciary breach claim against a manager based on provision in the operating agreement eliminating the manager’s fiduciary duties.

What I have found are a handful of decisions going in the opposite direction, that is, denying pre-answer motions to dismiss, or adjudicating liability post-trial, where the operating agreements contained provisions purporting to eliminate the managers’ fiduciary duties. In chronological order:

• Beatrice Investments, LLC v 940 Realty LLC. In this 2018 decision by the New York County Commercial Division, the plaintiff LLC member brought a derivative action against the managers for breach of fiduciary duty involving various alleged financial misconduct. Defendants moved pre-answer to dismiss, based in part on an exculpatory provision in the operating agreement relieving the manager from any “duty or obligation to consider any interest of or factors affecting some or all the Members so long as the Manager acts in good faith and in a manner which he reasonably believes is in or not opposed to the best interest of the Company.” The court denied the dismissal motion, finding that under LLC Law Section 409 (a) the managers owed fiduciary duties to the LLC and its members, that Section 417 (a) (1) “prohibits an operating agreement from limiting a manager’s liability for bad faith, intentional misconduct, knowing violation of law, and receipt of personal gain to which the manager is not legally entitled,” and that the complaint sufficiently alleged the managers’ bad faith and self-dealing.

• Howard v Pooler. This 2020 decision by the Appellate Division, Fourth Department, involved a two-member LLC formed to develop real estate. The lower court granted plaintiff summary judgment of liability on his derivative claim for breach of fiduciary duty based on allegations of defendant’s self-dealing, commingling of assets, and misappropriation of LLC revenue. The lower court also granted plaintiff summary judgment of liability on plaintiff’s direct claim for breach of the implied covenant of good faith and fair dealing. On appeal from a post-trial judgment awarding the plaintiff damages, the defendant urged reversal based on the operating agreement’s provision precluding personal liability for damages for actions taken by the defendant in his managerial capacity. The Appellate Division affirmed the judgment, citing Section 417 (a) for the proposition that, “inasmuch as the [lower] court found that the defendant acted in bad faith, defendant cannot claim immunity from personal liability …”

• John v Varughese. In this 2021 decision by the Appellate Division, Second Department, which was previously featured on this blog, the plaintiff non-managing member of the LLC appealed from the lower court’s judgment following a bench trial dismissing, inter alia, his derivative claim against the managing member for breach of fiduciary duty. The Appellate Division modified the order, finding that the plaintiff established his entitlement to judgment on the claim, in part, notwithstanding the operating agreement’s provision exculpating a managing member from liability for breach of fiduciary duty, except as to actions or omissions that were “in bad faith or involved intentional misconduct or a knowing violation of law or that he personally gained in fact a financial profit or other advantage to which he was not legally entitled.” The appellate court cited evidence at trial showing that the defendant intentionally breached a fiduciary duty to the company by transferring the sum of $50,000 from the company’s funds to another entity in which he had an interest, without authority and without any benefit to the company. The appellate court affirmed the judgment dismissing plaintiff’s additional claim that the defendant overpaid himself for professional services or overpaid a property manager, not based on the operating agreement’s exculpation provision but, rather, for lack of evidence that the defendant breached any fiduciary duty to the company.
• Agarwal v Jain. Last but not least, in this decision handed down last summer by the New York County Commercial Division involving a three-member LLC engaged in the wholesale jewelry business, the court addressed a motion by the two defendant members seeking dismissal of the third member’s claims, inter alia, for breach of fiduciary duty for self-dealing and intentional waste. The defendants pointed to the operating agreement’s exculpatory provision (which they characterized as a “waiver” of plaintiff’s right to pursue a claim against defendants for breach of fiduciary duty) stating that “the members agree that to the fullest extent permitted by the LLC Law, no Member or Managing member shall have any fiduciary duties to [the LLC], the Members or any other Person in taking any action hereunder.” The court rejected defendant’s argument, citing Section 417 (a) (1)’s proviso and finding that the complaint’s allegations that defendants “conspired to gut [the LLC’s] revenue by providing ‘sweetheart’ arrangements to competitors and by covertly working for these competitors . . . sound of intentional misconduct by [defendants]” and therefore do not help the defendants in evading liability.

To Foster Manager Exculpation or Not, that is the Question

New York enacted its LLC Law 30 years ago. The scarcity of court decisions since then addressing exculpatory provisions in operating agreements and, as illustrated by the cases highlighted above, the ease with which a complaining LLC member can plead a claim that falls within Section 417 (a) (1)’s broad exceptions to exculpation, do not speak highly of the statute’s efficacy as a shield against manager liability for actions taken within the scope of their managerial duties.

The toothlessness of New York’s liability shield compared to Delaware’s is one of a number of reasons sophisticated practitioners recommend LLC formation in Delaware. Still, the question whether the Delaware approach is preferable to New York’s is open to legitimate debate.

Immunizing LLC managers from personal liability for breach of fiduciary duty, at least in theory, can encourage talented individuals who may or may not have significant equity in the company to take on management roles, pursue growth strategies, and make hard decisions without fear of exposing themselves to potential dissident and litigious members. That model perhaps is best designed for LLCs with a corporate governance structure featuring a board of managers and some number of inactive members-investors.

Even without being able to cite empirical evidence in support, I’m comfortable saying that the majority — perhaps the great majority — of multi-member New York LLCs are smaller, owner-operated, member-managed companies. Such companies typically eschew formalities and operate more like partnerships based on personal relationships of trust and shared incentives. Providing near-total exculpation of managing members à la Delaware arguably is not the best fit for such companies.

The Revised Uniform LLC Act takes a more nuanced approach that puts it somewhere between the Delaware and New York statutes. Among other differences, RULLCA Section 105 permits the operating agreement to specify the method by which conduct that would otherwise violate the duty of loyalty to be authorized or ratified by disinterested or independent persons after full disclosure of all material facts; eliminates any fiduciary duty of a member of a member-managed LLC who is relieved of responsibility where the responsibility is imposed on other members; and if not “manifestly unreasonable,” to identify specific types or categories of activities that do not violate the duty of loyalty, or to alter or eliminate “any other fiduciary duty.”

For anyone who thinks New York should follow the lead of Delaware or RULLCA by amending Section 417 (a) (1), all I can say is, don’t hold your breath. While many if not most other states have significantly updated their original LLC statutes enacted in the 1980’s and 1990’s, including over 20 states that have adopted RULLCA in some form, New York’s legislature shows not a flicker of interest in updating the LLC Law.