LLCs and LPs Must Follow Their Own Rules

Entrepreneurs and fund managers appreciate the flexibility that comes from organizing as a limited liability company (“LLC”) or a limited partnership (“LP”).  In contrast to C Corporations which have specific rules under the Delaware Corporations Code and similar state statutes, LLCs and LPs have the ability to write into their own operating agreements or partnership agreements their own rules regarding the governance of the entity, the duties of management, and rights of investors.

However, when an LLC or LP sets its own rules, it is bound by them.  And not complying with its own rules can have disastrous consequences.

Recently, the Delaware Chancery Court held that a general partner of an LP was liable to the limited partners for the way in which the general partner engaged in related party transactions.  The fact that there were related party transactions is not the issue — the partnership agreement waived the common law fiduciary duties.  Instead, the partnership agreement required that those transactions be reviewed by a committee under a specific standard of review, which was not done in this case.

So why is this important?  LLC operating agreements and partnership agreements typically require that certain transactions, such as entering contracts valued over a specific dollar amount or admission of members or partners, be put to a vote or require some other exact procedure.  If that vote or procedure does not take place, the transaction may be void and the managing member of the LLC or general partner of the LP may be liable for damages.

This goes for single manager LLCs or LPs with a single general partner.  When the entity’s own documents provide for the exact means that an action must be taken, then that is the way it must be done and not be done at the whim of the individual managing the entity.  Ratifying a decision after the fact may work in some instances, but it is always better to formalize decisions in accordance with the required procedure on a contemporaneous basis rather than reconstructing decision-making that previously occurred.

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