By Daniel W. Glasser on March 24, 2022.
For litigators involved in limited liability company disputes, some legal issues are perennial. Chief among them is the question of whether members and managers owe fiduciary duties either to each other or to the company. But there are secondary issues that frequently bloom around this primary question. For example, if a party owed fiduciary duties, can those duties be waived? Or, if the legal duty does not arise from a party’s connection to the business, can the court find it elsewhere—for example, in duties “implied” in every contractual relationship?
A recent North Carolina case called Klos Constr., Inc. v. Premier Homes & Properties, LLC[1] illustrates why questions like waiver and implied duties can become the “tail that wags the dog.” In Klos, two members of a three-member limited liability company decided to form a separate entity, use a nearly identical name for their “new” business, and cut their soon-to-be-former partner out of the real estate project where he had been building homes for several years. Because the original operating agreement anticipated members might engage in some degree of competitive business activity, the court found that they had waived the duty of loyalty. Perhaps recognizing the severity of this conclusion, however, the court suggested that the implied covenant might fill the hole left by the waiver. This hopeful suggestion, however, is dubious. Nevertheless, the Klos case illustrates why waiver and implied duties are important issues in limited liability company litigation.
Factual Overview
In late 2008, Klos Construction, Inc. (“Klos”), a general contractor, formed a three-member limited liability company called Premier Homes and Properties, LLC (“Premier Homes”). The three members of Premier Homes were Klos, the general contractor; Key Marco Consulting and Marketing, Inc. (“Key Marco”), a real-estate consulting firm; and Alpat Properties, LLC (“Alpat”), a real estate investment company. This combination of members brought together expertise in construction, marketing, and real estate finance. Each member of Premier Homes served as a manager and owned an equal one-third share of the company.
Not long after the entity was formed, Premier Homes entered into a contract that gave it the right to purchase lots and to build custom homes in a development called Mott’s Landing. Alpat would provide funding, Key Marco would oversee the marketing of the project, and Klos would handle the construction of the homes. Because each of the members were already involved in other real estate development projects, the Premier Homes operating agreement provided that the members could engage in business activities that competed with Premier Homes. Key Marco, for example, could continue to provide marketing and consulting services to other builders. Alpat could finance other developments. And Klos could build homes elsewhere. But the operating agreement went further than merely waiving the duty of loyalty—it said the members intended to waive duties to the fullest extent allowed by the North Carolina Limited Liability Company Act (the “Act”). And, on January 1st, 2014, the Act was amended to permit parties to an operating agreement waiving a manager’s duty of loyalty.
During the first six years of development at Mott’s Landing, Premier Homes worked with a local a real estate broker named Terrance Ando. In addition to selling homes on behalf of Premier Homes, Mr. Ando owned his own construction company and had worked on other real estate developments with the owner of Key Marco.
In the spring of 2015, Mr. Ando and Key Marco decided it was time to cut Klos out of the Mott’s Landing development. To that end, they formed a new limited liability company with a name nearly identical to Premier Homes, calling it Premier Homes and Communities, LLC (“Premier Homes II”). They later testified that Klos was not invited to be a member of this new entity because they thought Klos was already “at capacity” with the existing work at Mott’s Landing.
Without telling Klos about Premier Homes II, Key Marco and Mr. Ando set about transferring the contractual right to build homes at Mott’s Landing. In short, they sought to secure for Premier Homes II the very same contract rights then held by Premier Homes (and on which Klos relied to secure lots and build custom homes at Mott’s Landing). On June 8th, 2015, Premier Homes II entered into an “amendment” to the contract Premier Homes had signed with Mott’s Landing roughly six years prior. The impact of this amendment was to divert from Premier Homes to Premier Homes II the right to purchase and build upon lots within Mott’s Landing. Where Mr. Klos was previously identified as member-manager, the name was changed to Mr. Ando, and Premier Homes II replaced Premier Homes throughout the contract. Since the names of the entities were nearly identical, it appears the owner of Mott’s Landing did not even notice he was dealing with a different company. Nevertheless, once the amendment was signed, Klos was off the project within a matter of weeks and Mr. Ando’s company took over construction.
Klos eventually filed suit against its fellow member in Premier Homes, Key Marco. Klos asserted that, as a member-manager of the limited liability company, Key Marco violated a duty of loyalty and breached the implied covenant of good faith and fair dealing.
Procedure
After completing discovery in the litigation, both sides moved for summary judgment. The first question was whether the duty of loyalty barred Key Marko from competing with a limited liability company in which Key Marko was both member and manager. Put differently, were these duties waived by the terms of the operating agreement? Second, if the court found a waiver, did Key Marco owe any other duties that might prohibit the same conduct?
Analysis
Fiduciary Duties Waived
The court found that Key Marco owed no fiduciary obligations to its fellow members or to Premier Homes. According to the Klos court, those obligations were expressly waived by the operating agreement. Indeed, the court concluded that the members of Premier Homes intended their waiver of duties to be as broad as possible under the Act. And, since the Act was amended to allow for a waiver of loyalty obligations, the duty of loyalty was waived.
As a practical matter, this waiver finding meant that Key Marco was free to do whatever it wanted to compete with Premier Homes. Key Marco could create a business with a nearly identical name and then transfer valuable corporate opportunities to the new entity. Moreover, it could do these things for the rather obvious purpose of harming Key Marco’s fellow members and managers in Premier Homes.
Regardless of what one might say about the court’s interpretation of the contract, this outcome does not seem particularly “equitable.” The parties who entered into the Premier Homes venture obviously expected some degree of competitive activity—such as the real estate broker/member selling houses in other developments—but it is unlikely that Klos ever dreamed his business partners would do what they did here. One of the three members of a real estate development venture intentionally diverted, for its own benefit, the very real estate project the company was formed to exploit. If one were to stand in Klos’s shoes, this level of backstabbing would likely call to mind the final words of Julius Caesar: “Et tu, Brute?”
Implied Covenant of Good Faith and Fair Dealing
For this reason, the Klos court went out of its way to suggest that the plaintiff might have an alternative legal remedy, one based on the implied covenant of good faith and fair dealing. Like many other states, this duty is implied in every contract as a matter of North Carolina law,[2] requiring contracting parties to act on principles of good faith and fair dealing to accomplish the purpose of their agreement.[3] The limited liability statute at issue in Klos prohibits members from waiving this covenant.[4] Hence, Key Marko had a duty to act in a manner consistent with the purpose of the agreement.
The challenge in the Klos case, of course, was to figure out whether the implied covenant of good faith and fair dealing was somehow distinct from the duty of loyalty (which was waived in the operating agreement). In other words, since the members had no contractual right to demand loyalty from each other, could competitive activities breach the implied covenant? Legally, this question is tricky because the implied covenant cannot conflict with the express terms of the contract.
The Klos court did little to explain how the operating agreement could simultaneously allow Key Marko to compete while prohibiting competition because it would violate the implied covenant. Instead, the court began with a seemingly misplaced excuse: It said that the facts relating to Key Marko’s breach of the implied duty of good faith were “heavily disputed.”[5] In reality, of course, the facts were uncontested. The problem was that those largely undisputed facts were ugly. As the Klos court put it, “Key Marco’s participation in the diversion of the Motts Landing Contract from [Premier Homes] to [Premier Homes II] may have been carried out with the intent to ‘wrongfully deprive’ [Klos] of ‘the benefits to which [Klos was] entitled.’”[6]
But the law requires more than proof that a contracting party behaved badly. To violate the implied covenant, the conduct must flout the reasonable expectations of the other contracting party.[7] Here, the Klos court made clear that every member of Premier Homes should expect competition from fellow members because the members expressly waived the duty of loyalty. So how can competition—even if undertaken with ugly motives—do violence to the parties’ reasonable expectations?
Practical Lessons
While the Klos court fails to explain how the implied covenant can prohibit activity the contract expressly allows, this kind of contorted reasoning is at least understandable. The outright theft of contractual rights from one’s business partner is bad. Really bad. And the court seemed to be casting about for a remedy that would redress the harm Klos suffered. The solution the Klos court came up with is not the stuff of legendary legal analysis, but it teaches at least two important lessons. First, when business partners engage in willful bad acts—especially bad acts aimed at harming co-owners—those actions should have center-stage in the subsequent litigation. In other words, lawyers need to shine a spotlight on the wrong-doer’s dirty deeds. Second, every fiduciary duty case should include a claim for breach of the implied covenant. Regardless of whether the Klos court correctly applied this doctrine, its embrace of the implied covenant reminds us to never ignore a claim whose name includes the word “covenant.” Even if prior cases have narrowly construed this duty, Klos shows that the concept of an “implied covenant” is inherently flexible. When the facts paint a picture of obvious wrongdoing, you never how the court will construe words like “implied,” “covenant,” or “good faith.”
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