Crowdfunding Lawyers

Understanding Your Liabilities in LLCs

October 21, 2022
Understanding Your Liabilities in LLCs

Business owners are exposed to a lot of risks, all the time. It’s critical to understand those risks and liabilities. This is particularly true for anyone who manages an LLC and raises capital through investment deals. In this post, we’ll explore the liabilities in LLCs and securities offerings so that you can be prepared.

A Real-World Example

One day, I was sitting in my office and my phone rang. It was an attorney for the SEC. My heart skipped multiple beats, but I managed to force myself to ask what I could do for him. The attorney bluntly answered, “I wanted to give you a heads-up that you’ll be receiving a subpoena for one of your clients soon.”

Ultimately, the story ends with a well-known client spending the rest of his life in a jail cell. Even key team members ended up going to prison. How did it all start?

It started like so many successful ventures do – my client wanted to create an opportunity and then bring investors to the table. I informed him that what he was attempting to create was a security, so it fell under specific rules. I gave him all the securities regulations, as well as provided him with guidance on what he needed to do to make everything legal.

Well, that client decided he would be better off with a franchise attorney who told him that he could create the deal not as a security. That meant my ex-client didn’t have to worry about securities laws or any of the other issues. It looked like smooth sailing.

The team developed a passive franchise and did all the right things according to the franchise laws, but that didn’t change the fact that the opportunity met the securities test. It might have been dressed up like a franchise, but it involved stacking businesses on top of one another, all of which were managed by someone else raising capital for multiple franchises.

In the end, the state stepped in, stopped all operations, and started filing lawsuits. That was the beginning of the end for this client. He saw the writing on the wall, jumped ship, moved on to the next business, and came to me with another “opportunity”. However, he decided to follow my advice when I told him that what he wanted to create was a security and that he needed to prepare a private placement memorandum (PPM) for it under Regulation D.

Of course, it wasn’t that simple. Everything seemed to be going along just fine, except the client threw away the draft PPM and went back to his old habits. He went searching for alternative legal counsel and found an attorney who was not an expert in securities law who was willing to tell him what he wanted to hear – that he didn’t have to market his opportunity like a security or follow any of the required steps.

Fast-forward 6+ years and my ex-client found himself in court. However, his defense is that he was just doing what his attorney told him to do. The problem here is that this type of defense means that attorney-client privilege is no more, and it even opens all the communication between him and I. In the end, not only did this stunt come back to bite him, but I ended up as a key witness. My ex-client and the team he’d roped into helping him went to prison.

There is a twofold moral to this story:

  • First, follow the advice of your securities attorney, always.
  • Second, don’t go looking for someone to tell you what you want to hear. You’ll always find them, and they’ll almost always be wrong.

Exploring Rules, Regulations, and Liabilities for LLCs

With that introductory story out of the way, we must turn our attention to the meat of the subject – the risks, regulations, and liabilities you face as someone who manages an LLC. Do not take any of the following information as legal advice. This is nothing more than a 10,000-foot view of an incredibly complex topic. Hire an expert securities attorney and follow their guidance.

Fiduciary Duties

What is a fiduciary duty? If you ask around, you will get a dozen different opinions. However, they all come down to one thing: a fiduciary duty is an affirmative duty to act in the best interest of someone else. You were put in a position not to look after another person’s interests rather than your own. Below are a few examples of people who have fiduciary duties:

  • Lawyers have fiduciary duties to their clients.
  • Doctors to their patients.
  • Accountants to their clients.
  • Trustees to their beneficiaries. 
  • Executors to the heirs and the estate that they’re representing.
  • Investment advisors to their clients.

Another one that often flies under the radar is that employees often have a fiduciary responsibility to their employer. There have been numerous cases where employees have been found in breach of their fiduciary duties to their employers, such as sharing trade secrets, engaging in unfair competition, and the like.

What do fiduciary duties look like within the setting of an LLC? Some of the more common ones include:

  • Duty of care: You must consider options that are available and exercise sound judgment.
  • Duty of loyalty: This means putting the beneficiary’s interests above your own and not doing anything for personal gain at the beneficiary’s expense. 
  • Duty of good faith: This blends the two previous duties. It requires acting within the law, always for the best interest of the beneficiaries. In other words, you must do everything aboveboard.
  • Confidentiality: You must keep sensitive information confidential and refrain from using someone’s personal information to benefit yourself. Insider trading might come to mind.
  • Duty of prudence: Depending on your position, this might mean exercising the highest level of professional skill in carrying out your responsibilities. The more educated or skilled you are, the higher that standard becomes. 
  • Duty to disclose: This means you must share relevant information that impacts your beneficiary or your ability to serve in your fiduciary capacity. 

Where Do Fiduciary Duties Come From?

Fiduciary duties originate in many places. Sometimes they’re built into the letter of the law, such as statutes and regulations. However, most of the time they are just referenced generally. The courts are responsible for determining what duties apply in each situation. This results in many court-made laws.

In other cases, fiduciary duties stem from the underlying principle of equity. Equity means “the quality of being fair and impartial”. One example would be a situation where someone has a position of trust or confidence regarding someone else or a legal right to control someone’s investments or money. Another would be someone with insider knowledge about another person’s dealings would have a fiduciary duty to protect that knowledge.

Fiduciary Duties and LLCs

With a better understanding of fiduciary duties, it’s time to turn our attention to the matter of LLCs. More specifically, we must address members and their fiduciary duties.

LLCs always have a purpose. It could be performing activities, making investments, or owning assets. There is a reason for the organization’s existence. However, the name is just a formalization. It just represents a group of owners, although they’re called “members”. All members exercise some degree of control over the LLC and have fiduciary duties to one another and others.

Managing Members

In a situation where it is only the members, they’re called “managing members”. They usually have fiduciary duties to the organization itself, as well as to one another. This is particularly true when someone controls a majority (51% or more) of the organization. That individual will almost certainly have a fiduciary duty to the other members because of their position of trust, their insider knowledge, and their degree of control.

In the investment world, the situation is often different. There’s a manager on one side and members on the other. The members are the ones who put money into the opportunity and the manager is the individual tasked with making decisions with the money entrusted to them.

The fiduciary duties of the manager should be clear because of the trust, the legal right of control, and the possession of insider information. This is a clear-cut situation, although it flies against the common misperception that LLCs (limited liability companies) are created to mitigate liability and risk.

There’s good news. LLCs are inherently flexible. They empower you to change the paradigm and create agreements that allow you to step outside the default rules when it comes to certain fiduciary duties and the liabilities they entail. However, to benefit from that flexibility, you must do more than just pay your fee to the Secretary of State’s office. You need a company agreement governing how the LLC will operate according to your needs.

Limiting Your Fiduciary Duties within an LLC

Limiting your fiduciary duties within an LLC is possible, but it will vary from state to state. For instance, Texas allows you to expand or restrict any duties, including fiduciary responsibilities, within the company agreement. It’s possible to take all the duties we’ve discussed thus far and reduce them to near nothing.

In contrast, California takes a very different stance. The state’s LLC Act says an operating agreement shall not eliminate the duty of loyalty, care, or any other fiduciary duty, with a handful of exceptions.

It goes deeper than just minding the rules outlined in an individual state, though. For instance, it’s possible to create an LLC in one state and then operate in multiple states. That introduces considerable complications when it comes to fiduciary duties and how you’re required to handle them. Working with an experienced securities attorney is critical.

The Business Judgment Rule

The business judgment rule recognizes that there may be fiduciary duties, but also tries to avoid outcome-based second guesses. The underlying principle here is that managers are human. You cannot expect them to bat 1,000. They will not always make the best possible decision every single time. The business judgment rule recognizes that inherent fact and builds some flexibility into the situation.

Essentially, it prevents challenges to business decisions made in good faith and with reasonable prudent care. If the manager made what would be considered a reasonable decision with the information they had at the time and that decision was in the best interests of the LLC or a fiduciary duty beneficiary, this rule provides leniency. However, it does not prevent managers from being held liable.

Here’s a quote from the Delaware Supreme Court that says the same thing,

“To rebut the business judgment rule, you’ve got to show that they breached one of the triads of their fiduciary duty: good faith, loyalty, or due care.”

In Conclusion

Ultimately, risks abound when it comes to securities, as well as LLCs. However, they can be mitigated. The single most important takeaway from the discussion here is this: hire an experienced attorney and then follow their advice consistently. An experienced securities attorney can help you navigate these murky waters while keeping your feet on the straight and narrow. Prison is a very real possibility if you try to go your own way against the advice of your attorney.

Another important takeaway is to understand your fiduciary duties and to whom you owe them. Those will vary depending on the situation – are you a deal manager? A managing member within an LLC? Understand your role and your specific fiduciary responsibilities.

Finally, breaching fiduciary duty is a serious thing and can have long-lasting consequences. We’ll explore those in a separate article to provide you with the critical information that you need to make informed, data-driven decisions.

Source: Client Supplied

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