How do Limited Liability Company Operating Agreements affect the fiduciary duties owed to co-Members of the LLC? That issue was decided in the case of Butts v. Freedman, which also involved Boston Equity Advisors LLC (“BEA”) and Outcome Capital, LLC (“Outcome”).
Mr. Butts and Mr. Freedman co-owned BEA. They were the founders and held equal ownership. A third defendant, Mr. Ben-Joseph worked at BEA as an independent contractor. Butts and Fredman began having disagreements with one another, mostly about Ben-Joseph’s compensation. Freedman and Ben-Joseph decided to leave BEA and join Outcome, a competing enterprise.
At first, there were discussions of merging BEA and Outcome. Freedman and Ben-Joseph did not inform Butts of their meeting and discussions with Outcome. After Butts found out that Freedman and Ben-Joseph joined Outcome, he/BEA sued for breach of fiduciary duty against Freedman (and another claim not relevant to this post against both Freedman and Ben-Joseph).
Why Butts/BEA Lost:
The Appeals Court agreed that Freedman owed Butts and BEA fiduciary duties. The Appeals Court explained that under Massachusetts law “fiduciaries may plan to compete with the entity to which they owe allegiance, provided that in the course of such arrangements they do not otherwise act in violation of their fiduciary duties.”
The question of whether Freedman “otherwise acted in violation of [his] fiduciary duties” depended on the interpretation of the Operating Agreement. Specifically, the Operating Agreement of the LLC broadly provided that Members may engage in other business ventures and investment opportunities. Notably, there was not a non-compete provision in the Operating Agreement or otherwise.
The Appeals Court ruled that the language of the Operating Agreement limited the fiduciary duty of Freedman such that he had no duty to disclose the Outcome opportunity or to share the Opportunity with Butts or BEA.
Freedman made cogent arguments that the language was just boilerplate and that literal application would allow members to take corporate opportunities away from their LLC. However, the Appeals Court essentially ruled that the freedom to contract overrode those concerns. Freedman prevailed in his defense.
The lesson here is that the words of an Operating Agreement matter. Some people think that they are “standard” and that they are all boilerplate. But what do you think will happen when your business partner has disagreements and they go to a lawyer? The lawyer will parse through each sentence of the Operating Agreement to find language that will support your opponent in a lawsuit. So Operating Agreements don’t matter. Until they do.
If you are are going into an LLC, read the proposed Operating Agreement carefully and strongly consider having a lawyer review it with you. It’s important to understand your business and your goals because each situation is unique. I get that it seems like an unnecessary expense when you are starting a business, but you could be dooming yourself for failure if you don’t pay attention to the details.
If you already have an Operating Agreement and you are having disputes with your co-owners, have a qualified lawyer review the language to see what leverage you have. Or, maybe you can renegotiate and enter a new Operating Agreement.
Adam P. Whitney
Fine print: the above is not legal advice, but general information. I cannot provide legal advice without a written fee agreement and a full review of your legal matter.