LLC Managers have broad fiduciary duties when managing an LLC. Even when they are given “sole and absolute discretion” in the operating agreement to take certain actions for the LLC, they cannot exercise that right in bad faith, for personal gain, and in such a way as to deprive the LLC of a reasonably expected business opportunity.
Usually, if an agreement gives one party the “sole and absolute discretion” to decide on a course of action, for example, whether to terminate a contract or not, that party can make that decision as she pleases. Courts have put no limit on that power. The old standby of “good faith and fear dealing,” which is inherent in every contract, cannot create new obligations when the contract already explicitly states that a person has an absolute right.
Not so, when a party is in a fiduciary relationship to the other party. A typical example of a fiduciary relationship is the relationship between an LLC and its manager.
The LLC Manager, even when given “sole and absolute discretion” in the Operating Agreement, cannot exercise that right in bad faith and for purposes of self-dealing.
This law recently helped the plaintiff in Shatz v. Chertok to survive a motion to dismiss (even through appeal), but ultimately the court now found after trial that Shatz had failed to prove the elements of the above-described law.
Here is (somewhat simplified) what happened:
Shatz and Chertok formed an LLC for the purpose of investing in technology companies. Chertok was the manager and according to the operating agreement he had the sole and absolute discretion to pick the investments for the LLC.
In 2013, Chertok presented an opportunity to Shatz and the LLC to invest in a Series A round of a cryptocurrency company. Shatz went so far as to send a check for 75k to make that investment happen.
Unbeknownst to Shatz, the series round was not ready to proceed because the lead investor pulled out. Chertok kept that to himself and just told Shatz that it wasn’t meant to be at the moment.
The cryptocurrency company then decided to raise capital not via a series round, but through a convertible note. Despite Shatz repeatedly asking if there was another opportunity to invest in the cryptocurrency company, Chertok did not mention the convertible note investment to Shatz and their mutually owned LLC. Chertok decided to do that investment through another LLC which was solely owned by him.
Thus Shatz never got a chance to invest in the cryptocurrency company via their mutually owned LLC. By 2018, the crypto company’s value had gone through the roof. If the LLC had invested in the crypto company through the convertible note, the 75k would have been in the hundreds of millions of dollars. Of course, when that much money is involved, someone will sue. Shatz sued Chertok, derivatively on behalf of their mutually owned LLC for breach of fiduciary duty for failing to allow their LLC to make the cryptocurrency company convertible note investment.
After trial, the court dismissed the complaint.
What was the court’s reasoning?
The court ruled that despite the sole and absolute discretion of Chertok to pick investments for the LLC, Chertok, in theory, had a duty to not withhold an opportunity from the LLC, if the LLC had a tangible expectancy for such opportunity and Chertok, in diverting that opportunity, acted in bad faith and for the purposes of self-dealing.
The court did not see that these elements were satisfied.
Was it an opportunity that belonged to the LLC? No, it was not. The LLC might have had an expectancy to participate in the Series A investment if it had gone forward not long after it was initially postponed because the LLC had already committed to the investment and the member had issued checks to the LLC for that purpose. But, the court said, the investment that did actually happen and which Chertok lied about, the convertible note, was a different investment. In the same company, but still a different transaction. Shatz and the LLC didn’t know about that transaction and thus had no expectancy. This is especially so because Chertok had the discretion to pick what he thought was right for the LLC. Only after he had identified the Series A investment and everything was ready to go, was he bound to not lie about it and let the LLC participate if the same transaction had materialized after all. But it didn’t happen.
Was Chertok in bad faith?
No. The court found that even if the convertible note had been a corporate opportunity for which the LLC had a legitimate expectancy, Chertok did not act in bad faith or to enrich himself at the expense of Shatz and the LLC. He had the choice to make that investment through either the LLC or his LLC, he had loyalty to both LLCs, and thus choosing one over the other did not show the requisite bad faith. In addition, it was not clear that the choice to invest with his own LLC offered him a clear benefit over making the investment with Shatz and the mutually owned LLC.