Drafting LLC Agreements

February 19, 2014

When drafting a LLC agreement, you should consider numerous issues, including the respective capital and sweat equity contributions, retained ownership of intellectual property, voting control, sharing of compensation, the effects of any withdrawals or other break-ups (including how such events would affect the value of theretofore invested, or committed, seed capital), dealing with failures and breaches, estate planning consequences, etc. A recent Delaware case reminds us of one such consideration – If the LLC agreement does not contain a covenant not to compete, one cannot always be supplied by (a) fiduciary duties, (b) the implied covenant of good faith and fair dealing, or (c) claims of conversion.

In Touch of Italy Salumeria & Pasticceria, LLC v. Bascio [1], a LLC member quit and shortly thereafter started a competing business. Although that case deals with a restaurant, its lessons apply to tech companies. In that case, the Court held:

(a) Since the LLC agreement in that case did not contain a covenant not to complete, much less one that purportedly survived the member’s withdrawal, the withdrawing member was held not in breach of that agreement.

(b) During the period from the time he gave notice of withdrawal until the time he actually withdrew, the withdrawing member allegedly lied by stating that he did not intend to open a competing business. The Court found that the remaining members did not show that they relied upon those alleged lies or suffered any damage as a result thereof per se. Thus, the Court dismissed the claims, for fraud and misrepresentation.

(c) The Court refused to hold the implied covenant of good faith and fair dealing includes a covenant not to complete.

(d) The remaining members alleged that the withdrawing member breached his fiduciary duties because he was “planning” to open a competing business while he was still a member of the LLC. However, the Court held that the remaining members did not plead sufficient facts, as opposed to simply conclusions. Thus, the Court did not analyze what fiduciary duties a member has to his/her LLC while he/she is still a member. Presumably, such facts may have included actions such as encouraging employees and customers to follow him, not pressing suppliers for deals favorable to the LLC, or not encouraging prospective customers. I find it hard to believe that mere planning, without such actions, would amount to a breach of fiduciary duty. The Court also held that any fiduciary duties ended once the withdrawing member’s membership terminated.

(e) However, the Court did allow the remaining members to claim that the withdrawing member was liable for conversion by taking specific (as distinguished from categories of) LLC property with him. Presumably, such property would include such matters as customer lists and trade secrets.

In summary, the case teaches us that persons forming an LLC should address the consequences of various possible scenarios and not simply hope that the court will, in all cases, fill-in unaddressed points in a favorable way.

[1] Touch of Italy Salumeria & Pasticceria, LLC v. Bascio, 2014 Del. Ch. LEXIS 2, 2014 WL 108895 (Chancery, Sussex, 2014) Opinion not released for publication, and, therefore, is subject to revision or withdrawal.