November 2015

This post concludes the Contract Is King, But Can It Govern Its Realm? Micro-symposium.  The symposium was hosted as part of the AALS section on Agency, Partnership, LLCs and Unincorporated Associations in advance of the section meeting on January 7th at 1:30 where the conversation will be continued.

I summarized the conversation and provided links to all of the individual posts.  Bookmark this page– there is great commentary at your finger tips on a range of topics.  Please keep reading (and commenting) on these great contributions by our insightful participants to whom we are very grateful.

Jeffrey Lipshaw kicked off the symposium conversation with his post (available here) questioning, in practice, how different LLCs are from traditional corporations.  He used a great map analogy to talk about the role of formation documents and default rules as gap fillers. 

“The contractual, corporate, and uncorporate models are always reductions in the bits and bytes of information from the complex reality, and that’s what makes them useful, just as a map of Cambridge, Massachusetts that was as complex as the real Cambridge would be useless.” 

After asserting that LLCs differ from corporations only in matters of degrees, Jeff went on to…

Guest Post by Daniel Kleinberger

Part IV– Delaware’s Implied Contractual Covenant of Good Faith and Fair Dealing

Delaware case law applying the implied contractual covenant of good faith and fair dealing to a limited partnership dates back to at least 1993,[i] and Delaware’s limited partnership and limited liability company acts have expressly recognized the covenant since 2004.[ii] However, the contents of the implied covenant have not always been crystal clear.[iii]

     A passage from a 2000 Chancery Court decision is illustrative:

The implied covenant of good faith requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the contract.  This doctrine emphasizes faithfulness to an agreed common purpose and consistency with the justified expectations of the other party.  The parties’ reasonable expectations at the time of contract formation determine the reasonableness of the challenged conduct.  [C]ases invoking the implied covenant of good faith and fair dealing should be rare and fact-intensive.  Only where issues of compelling fairness arise will this Court embrace good faith and fair dealing and imply terms in an agreement.[iv]

     This…

Last week was the 30th anniversary of the Delaware Supreme Court’s decision in Moran v. Household International, Inc., 500 A.2d 1346 (Del. 1985). In Moran, decided on Nov. 19, 1985, the Delaware Supreme Court upheld what has become the leading hostile takeover defensive tactic, the poison pill.

Martin Lipton, the primary developer of the pill, even makes an appearance in the case—and obviously a carefully scripted one: “The minutes reflect that Mr. Lipton explained to the Board that his recommendation of the Plan was based on his understanding that the Board was concerned about the increasing frequency of ‘bust-up’ takeovers, the increasing takeover activity in the financial sector industry, . . . , and the possible adverse effect this type of activity could have on employees and others concerned with and vital to the continuing successful operation of Household even in the absence of any actual bust-up takeover attempt.”

I’m not sure the takeover world would be that different today if Moran had rejected poison pills. I’m reasonably confident the Delaware legislature would have amended the Delaware statute to overturn the ruling, as they effectively did with another ruling decided earlier that same year, Smith v. Van Gorkom…

… but going back to corporations for a moment – a while ago, I speculated that corporate forum-selection bylaws could unfairly work to favor management, because management can choose to invoke them at will – they can deploy them to dismiss cases when it will benefit them, but also can refuse to invoke them when it would work to their advantage to have plaintiffs’ firms compete with each other in different jurisdictions.

Alison Frankel now reports that the FX company is doing just that.  According to her report, FX enacted a forum-selection bylaw choosing Utah as the forum; but now, faced with shareholder lawsuits in Nevada and Utah, it is choosing not to enforce the bylaw – precisely because, according to the Utah plaintiffs, it benefits management to have the plaintiffs compete for the opportunity to settle the case on sweetheart terms.

The basic problem is that these bylaws do not resemble contractual forum selection clauses, in that they can only be invoked by management – not plaintiffs.  And at least according to Delaware, they are only valid because they allow management the freedom to choose whether to invoke them (i.e., they contain a fiduciary out).  As a…

The micro-symposium has generated interest in a broad range of topics, so we are adding the following post by Peter Molk & Verity Winship discussing their recent scholarship on dispute resolution in LLC operating agreements and its intersection with the “contract is king” discussion this week.

Guest post by Peter Molk & Verity Winship:

This post highlights a particular area of private ordering within the LLC and other alternative entities: contractual provisions within the operating agreement that set the rules for resolving internal disputes.  These terms determine how disputes are resolved, such as by specifying when claims must be submitted to arbitration, where disputes can be heard, and whether parties waive the jury right or impose fee-shifting of litigation costs.  They apply to internal disputes, meaning they govern the dispute process among the LLCs’ members, managers, and the LLC itself.

How do these provisions fit with the debate over whether contract should be king?  The broadest connection is straightforward.  Dispute resolution provisions allocate rights and duties within LLCs, so the debate about the proper bounds of freedom of contract in the LLC space has implications for them as well.  But how firms set the rules for internal disputes is also…

The title of this post undoubtedly promises too much.  But that won’t prevent me from trying to establish a few points that approach the many topics that could be discussed under a title that includes this much great stuff.  I make that attempt here.

I start with contract law.  As I noted in my prior post for this micro-symposium, one of my appearances at last week’s ABA LLC Institute included a debate on whether an operating agreement is a common law contract.  This question arose in connection with my teaching of operating agreements (and also has arisen in my teaching of partnership agreements) in Business Associations.  Of course, lawyers understand that not all agreements are contracts.  A significant amount of energy is spent on this matter in the beginning of the standard contracts course in law school.  

Is an LLC operating agreement a contract?  I like the question not just for its face value, but because I believe that the answer does or may matter for purposes of resolving other questions arising in and outside LLC law.  I captured some thoughts about this question in a draft essay soon to be published in revised form in the SMU Law Review.  (I blogged about it here over the summer.)  Among other things, with judicial and legislative attention on freedom of contract in the LLC, the status of the LLC as a matter of contract law may shed light on the extent to which contract law can or should be important or imported to legal issues involving LLC operating agreements.

I would like to thank the Business Law Professor Blog for this very important symposium. My brief thoughts are filling in for Marcia Narine. I became well acquainted with LLCs when I practiced in the alternative entities group of a Delaware law firm. What most stood out during my time there was the freedom enjoyed by LLCs and LPs to abridge fiduciary duties and deviate from other corporate orthodoxies. I constantly thought about whether this freedom of contract was a good thing; after all, case law tells only the tragic stories.

As mentioned in other posts, contractual freedom is ideal when sophisticated parties of comparable strengths are allowed to define their relationships. And generally, few problems arise from the LLC form. Law firms typically provide those seeking to form an LLC one of their standard, boilerplate operating agreements, which includes fiduciary duties. In turn, business owners are able to enjoy limited liability while avoiding many of the formalities, transactions costs, and tax burdens associated with traditional corporations. However, there seems to be an increasing number of cases where operating agreements resemble adhesion contracts, creating opportunities for abuse. Is it wise that unsophisticated are more at risk for contractual related harms so…

Regular readers of this blog know that I am fervent that the distinction between entities matters, particularly when it comes to LLCs and corporation.  I’m happy to be a part of this micro-symposium, and I have enjoyed the input from the other participants. 

My comments relate primarily to the role of contract in LLCs and how that is different that corporations. Underlying my comments is my thesis that LLCs and corporations are meaningfully distinct. This view is in contrast to Jeff Lipshaw, who argued in his post:

[I]f uncorporations differ from corporations, it’s more a matter of degree than of any real difference.  Both are textual artifacts.  We have created or assumed obligations pursuant to the text at certain points in time, and we use the artifacts and their associated legal baggage opportunistically when we can.  I am not convinced that organizing in the form or corporations or uncorporations makes much difference on that score.

I tend to be more of a Larry Ribstein disciple on this, and I wish I had the ability to articulate the issues as eloquently and intelligently as he could.  Alas, you’re stuck with me. (Editor’s note: As Jeff Lipshaw says in his comment below, he did not say the forms of LLCs and corporations are not distinct. He is, of course, correct, and I know very well he knows the difference between the forms. In fact, a good portion of what I understand of the practical implications of the LLC comes from him. I do believe that the choice of form matters, and at least should matter in how courts review the different entities, as I explain below. And I do think the LLC is better, or should be (if courts will allow it), because of what the form allows interested parties to do with it. The flexibility of the LLC form creates opportunity for highly focused, nimble, and more specific entities that can be vehicles that facilitate creativity in investment in a way that corporations and partnerships, in my estimation, do not.]

In his book, The Rise of the Uncorporation, Ribstein stated, “Uncorporations [his term for noncorporate entities] come in all shapes and sizes, and are increasingly encroaching on traditionally ‘corporate’ domain.  The thesis is that form matters.” He goes on to explain that the differences between corporations and noncorporate entities have practical implications for those in business (and their lawyers).  I think he was right. 

It seems that some view the limited liability protection that comes with both an LLC and a corporation as the main, if not sole, defining function of the firm. If that were true, then it would be accurate that LLCs and corporation are functionally the same. I think the evolution and purposes of the limited partnership, the LLC, and the corporation suggest that these entities at least should (if they don’t in fact) serve different purposes and roles for those who create them.

The LLC Revolution helped facilitate formation of entities with pass-through taxation and limited liability protection. And it is true, that limited liability one chief benefit of the corporation, and the rise of the corporation can be tracked to that benefit.  But, entity choice is more that just liability and taxation, too, at least where there are real entity choices that provide options. 

Corporations are far more off-the-rack in nature, and they have a tremendous number of default rules. These rules facilitate start up, and help skip a number of conversations that promoters and initial investors might otherwise need to have. (Of course, they probably should have these conversations, but if they don’t, there are more significant gap fillers than for other entities.) 

Ribstein observed, “Uncorporations not only explicitly permit, but also indirectly facilitate contracts.  A firm’s contractual freedom should be evaluated not only in terms of the flexibility permitted by a given business association statute, but in light of the alternative available standard forms.”  As such, the clearer and more distinct the terms of the various entity-form statutes are, the more significant a firm’s choice of form can be.  And if the choice is an LLC, that choice should be respected.

As my countless posts lamenting the fact that courts can’t seem to get the distinction between LLCs and corporations clear, there’s evidence that Lipshaw is right as to the current state of the law, or some meaningful portion of it. But that doesn’t make it right.