By: Thomas S. Tripodianos Published: February 2011

Limited Liability Company Fiduciary Duty Improprieties

Question. A & B formed a limited liability company (LLC). Both A & B were managers of the LLC. A accuses B of breaching his fiduciary duties by taking improper cash payments from the LLC distributors, diverting funds to himself, and otherwise looting the LLC. Can A sue B directly for these alleged improprieties?

Answer. No, at least not under these facts.   Under New York law the claims belong to the LLC, rather than a LLC member. Additionally, the harm that the LLC member suffered due to a diminution of value in his ownership interest was indirect harm resulting from the managers' alleged breach of their fiduciary duty to faithfully represent the LLC's financial condition, and thus could be remedied only through a derivative claim.

There is no dispute that members and managers of limited liability companies owe fiduciary duties not just to the LLC, but also directly to the members of the LLC. Since fiduciary duties are owed both to an LLC and its members, a court must apply the "direct injury test" to discern whether a breach of these duties gives rise to a claim that may be asserted directly by an LLC member, or that must be asserted on behalf of the LLC. The critical question posed by the direct injury test is whether the damages a plaintiff sustains are derivative of an injury to a third party. If so, then the injury is indirect; if not, it is direct. However, the mere fact that a corporation may also bring an action based on acts that caused an independent injury to a shareholder does not make the shareholder's suit derivative.

The allegation that B breached his fiduciary duties by (1) taking improper cash payments from LLC distributors, (2) diverting funds to himself, and (3) otherwise looting the LLC, properly belongs to the LLC. Assuming the truth of A's allegations, Bs' acts harmed the LLC directly by decreasing its value, and only harmed A indirectly by reducing the worth of his ownership stake in LLC. This is a quintessentially derivative claim.

The issue of whether A may assert a claim for breach of fiduciary duty based on Bs' alleged failure to faithfully represent the financial condition of the LLC is more complicated. As a general matter, members and managers of an LLC under New York law owe a specific fiduciary duty to other LLC members to fully disclose all information concerning the limited liability company. Thus, under the case law, Bs' alleged misrepresentations to A of the value of the LLC would ordinarily provide a basis for a direct claim.

However, A expresses a theory of damages that is derivative. He alleges that Bs' misstatements of the value of the LLC caused A "to suffer damages from the diminution of the value of his company in the amount of $5 million." Harm that a plaintiff suffers only due to a diminution of value in his ownership interest of an entity is indirect harm, and must be remedied through a derivative claim.

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