Founder and Equity Disputes · Memo

Operating Agreement Breach Claims vs. Fiduciary Duty Claims

In a member dispute, counsel often plead both contract and fiduciary breach. The remedies, the statute of limitations, the burden of proof, and the discovery posture diverge in ways that matter to case strategy.

The California Revised Uniform Limited Liability Company Act, Corp. Code section 17701.01 et seq., governs LLC operations and provides statutory fiduciary duties at section 17704.09. Those duties run from members and managers, depending on the LLC's structure, to the LLC and the other members. The operating agreement is a contract between the members and, often, between the members and the LLC. Most disputes between members involve allegations that the other party has breached both the agreement and the fiduciary duty. The plaintiff's lawyer pleads both. The defendant's lawyer answers both. The strategic choices about which claim drives the case are usually made too late.

What the statute provides

Section 17704.09 codifies the duties of loyalty and care for members in member-managed LLCs and for managers in manager-managed LLCs. The duty of loyalty includes (a) accounting to the LLC for any property, profit, or benefit derived from the conduct of the LLC's activities or the use of LLC property; (b) refraining from dealing with the LLC as or on behalf of an adverse party; and (c) refraining from competing with the LLC. The duty of care requires the manager or member to refrain from gross negligence, reckless conduct, intentional misconduct, or knowing violation of law. The operating agreement may modify or eliminate certain duties under section 17701.10, subject to limits (the duty of loyalty cannot be eliminated entirely; the implied covenant of good faith cannot be eliminated).

The operating agreement claim

The contract claim is constrained by the contract's terms. If the operating agreement has been carefully drafted, many duties that would otherwise be statutory have been narrowed or eliminated. The agreement may permit certain self-dealing transactions, may waive corporate-opportunity claims, may modify the duty of care to a higher threshold of misconduct, and may include a broad exculpation clause. Each of these provisions, if enforceable under section 17701.10, narrows the contract claim and the remedies available under it.

The advantages of the contract framing: the cause of action is clear, the elements are familiar to a jury (formation, breach, damages, causation), the damages model is typically expectation damages or restitution, attorney's fees are recoverable if the agreement has a fee-shifting clause, and the statute of limitations is four years under Code of Civil Procedure section 337 for written contracts.

The fiduciary duty claim

The statutory claim sounds in tort. The elements are different: the existence of a fiduciary relationship, breach of the duty, and harm. Damages can include disgorgement of benefits obtained in breach, which is broader than contract expectation damages in some matters. Punitive damages are available under Civ. Code section 3294 for malice, oppression, or fraud, which is not available under a pure contract claim. The statute of limitations is generally four years under section 343 (the catch-all for statutory liabilities not otherwise specified), though some specific breach types have shorter limitations.

The disadvantages: the operating agreement may have narrowed or eliminated the duty, and the agreement's exculpation clause may bar individual liability. Pleading the fiduciary claim where the agreement has modified the underlying duty invites a demurrer or motion for summary adjudication. Counsel should read the agreement before drafting the complaint.

Strategic differences

For plaintiffs, three reasons to prefer the fiduciary framing.

• Remedies. Disgorgement of secret profits, accounting, constructive trust, and injunctive relief are more naturally available under a fiduciary claim. Punitive damages are available where conduct rises to malice or oppression.
• Discovery. The fiduciary framing supports broad discovery into the defendant's parallel business activities, communications, and decisions. The contract framing tends to focus discovery on the four corners of the agreement and the events surrounding the breach.
• Persuasion. A jury responds to a fiduciary breach differently than to a contract breach. The narrative of betrayed trust persuades a jury more readily than the narrative of an unmet contractual term.

For defendants, three reasons to prefer the contract framing.

• Exculpation and modification. If the operating agreement has narrowed or eliminated the underlying fiduciary duty, the contract framing limits the analysis to the modified duty. The fiduciary framing invites argument about whether the modification is enforceable.
• Damages limitation. Contract damages are typically expectation damages. The fiduciary framing opens disgorgement and punitive damages. The contract framing is the lower-exposure framing.
• Procedural posture. A demurrer attacking the contract claim has to engage with the specific contract language. A demurrer attacking the fiduciary claim can be broader, attacking the existence of the duty, the standing of the plaintiff, the operating agreement's exculpation, and the statute of limitations.

The implied covenant in the middle

The implied covenant of good faith and fair dealing under California law applies to operating agreements as it does to other contracts. Carma Developers (Cal.) Inc. v. Marathon Development California Inc., 2 Cal. 4th 342 (1992), is the standard citation. The implied covenant prevents one party from depriving the other of the benefit of the bargain. For LLC disputes, the implied covenant is the contractual analog of the fiduciary duty of loyalty: a member cannot exercise discretionary authority under the operating agreement in bad faith to disadvantage the other members.

The drafting note: section 17701.10(c) provides that the implied covenant of good faith and fair dealing cannot be eliminated by the operating agreement. The agreement can restate the duty or define what good faith requires in specific contexts, but cannot eliminate the duty entirely. Defense counsel who push to eliminate the duty are over-reaching. Plaintiff's counsel who fail to plead the implied-covenant breach as a separate cause of action are leaving leverage on the table.

The Cal. Corp. Code section 17707.01 dissolution overlay

For matters where the contract breach or fiduciary breach has rendered the LLC unworkable, the statutory dissolution remedy under section 17707.01 is in play. A member with a sufficient ownership interest can petition for judicial dissolution on grounds including (a) it is not reasonably practicable to carry on the business in conformity with the articles or operating agreement, (b) the managers in control are guilty of persistent fraud or mismanagement, or (c) dissolution is reasonably necessary to protect the rights or interests of the complaining members. The standard is high but the remedy is real.

The dissolution claim creates leverage even where the underlying merits favor the defendant. The defendant who is otherwise comfortable with the contract or fiduciary claims may not be comfortable with the prospect of the LLC being wound up. The remedy in section 17707.03, which provides for a buyout in lieu of dissolution, gives the parties a structured exit path. I will cover the buyout structure in a separate memo.

The pleading strategy I usually run

For a member-versus-member dispute where the operating agreement has been modestly drafted (not heavily customized), I typically plead in the following order:

1. Breach of operating agreement, identifying the specific sections breached.
2. Breach of fiduciary duty (loyalty), if the conduct involves self-dealing, competing business, or appropriation of LLC opportunities.
3. Breach of fiduciary duty (care), if the conduct involves gross negligence, reckless mismanagement, or knowing legal violations.
4. Breach of the implied covenant of good faith and fair dealing.
5. Accounting, demanding a formal accounting of LLC financial activity.
6. Declaratory relief, if the parties dispute the meaning of contract provisions.
7. Dissolution and buyout, if the matter cannot be resolved without unwinding or restructuring the LLC.

Not every count survives a demurrer in every case. The pleading strategy is to give the court enough alternative framings that the case progresses on at least one cause of action. The discovery and the leverage flow from there.

Sergei Tokmakov, Esq., CA Bar #279869. This memo is attorney commentary on legal questions and is not legal advice. Reading it does not create an attorney-client relationship. Past matter outcomes depend on facts and the responding party; nothing here is a prediction of result.