Freedom of contract is one of the principal principles in the law of limited liability companies. That is, limited liability companies were legislatively created to enable the equity owners of such companies to contractually define their relationship vis-à-vis their company and each other to the fullest extent reasonably possible. The limited liability company operating agreement provides the vehicle for the exercise of that freedom. Unfortunately, such freedom can make trust more expensive where the members aren’t careful in drafting an operating agreement which affords protection of their interests from self dealing by other members or managers.
Freedom of contract for limited liability companies encompasses the fiduciary duties which a member or manager owes to the company itself and to the members or managers of the company. Although certain fiduciary duties such as the duty of loyalty can’t be wholly eliminated from an Oregon limited liability company, they can be contractually narrowed to effectively permit conduct which would otherwise be a breach of that duty and a basis for liability in the context of a partnership, corporation or joint venture.
In Synectic Ventures I, LLC v. EVI Corp., 241 Or App 550 (2011) the Oregon Court of Appeals explored how far the parties to a limited liability company operating agreement can go towards limiting a manager’s duties of loyalty, due care and fair dealing in the operating agreement.
In Synectic Ventures the manager of the plaintiff limited liability company, Berkman, was also a director, officer and investor in the defendant corporation. The plaintiff’s operating agreement specifically allowed its members and their affiliates to engage in business and invest in other business ventures “of every nature and description” without “obligation to account to the Company for such business or investments or for business or investment opportunities.” More specifically, the plaintiff’s operating agreement also stated that:
“The Members acknowledge that each Member may own securities issued by or participate in the management of companies in which the Company may invest and that neither the other Members nor the Company shall have any claim or cause of action against such Member arising from such ownership or participation.”
Synectic, along with other investment companies which Berkman managed, had loaned over $3 million to the defendant corporation subject to a loan agreement which required the defendant to repay the loan in full on December 31, 2004 unless defendant received additional investments of at least $1 million prior to that deadline in which event the defendant could, at its option, convert the debt to equity in the form of defendant’s stock. Before the deadline, Berkman signed an agreement on plaintiff’s behalf with the defendant extending the repayment date for another year. A year later, before the extended deadline, Berkman caused another company he managed to invest the $1 million in defendant after which the defendant ostensibly converted the plaintiff’s loan into shares of defendant’s stock. Defendant’s avoidance of default to the plaintiff was, moreover, significantly beneficial to Berkman personally though costly to plaintiff. After plaintiff removed Berkman as its manager, it sued him claiming he’d breached his duties of loyalty, due care, and good faith as manager.
The court of appeals held that the plaintiff’s operating agreement’s terms governed both the extent of Berkman’s authority to extend repayment of the defendant’s loan obligation on plaintiff’s behalf and to engineer fulfillment of the condition allowing defendant to convert its debt to plaintiff into shares of defendant’s capital stock. Reviewing the operating agreement, the court found that Berkman had express authority to execute the loan extension agreement on plaintiff’s behalf and to orchestrate the $1 million investment in the defendant through another company he controlled; resulting in conversion of the plaintiff’s investment in defendant from debt to equity. In short, plaintiff lost.
There are many lessons one could arguably draw from this saga; many of which would necessarily ignore the fundamental premise of the limited liability company itself: i.e., the operating agreement governs the members’ rights and responsibilities. The freedom of the parties to a limited liability company’s operating agreement to define their rights and duties imposes a corresponding obligation on those parties to contractually protect themselves.
The decision in Synectic is a reminder that contracts and their words both can and do make a difference. Anyone considering such a business relationship should carefully consider the terms of the operating agreement before committing themselves to the company. Those terms will, in all probability, ultimately control the rights and responsibilities of the members and managers, for better or for worse.