Business Associations

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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…

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.

Part III Another Major “Not” and the Uniform Act’s More (!) Contractarian Approach

C. Not Whatever is Meant by a Contractual Provision Invoking “Good Faith”

Some limited partnership and operating agreements expressly refer to “good faith” and define the term.[1] As the Delaware Supreme Court held in Gerber v. Enter. Products Holdings, LLC (Gerber), such “express good faith provisions” do not affect the implied covenant.[2] In Gerber, the Court rejected the notion that “if a partnership agreement eliminates the implied covenant de facto by creating a conclusive presumption that renders the covenant unenforceable, the presumption remains legally incontestable.” [3]

The rejected notion arose from on an overbroad reading of Nemec v. Shrader [4] – namely that “under Nemec, the implied covenant is merely a ‘gap filler’ that by its nature must always give way to, and be trumped by, an ‘express’ contractual right that covers the same subject matter.”[5] Invoking Section 1101(d) of the Delaware Revised Uniform Limited Partnership Act,[6] the Gerber opinion stated: “That reasoning does not parse. The statute explicitly prohibits any partnership agreement provision that eliminates the implied covenant. It creates no exceptions for contractual eliminations that are ‘express.’”[7] 

Some agreements contain express good faith provisions but omit…

I so appreciate the opportunity to be a part of this micro-symposium, in which we can explore important issues at the intersection of contract law and fiduciary duties in the fastest growing form of business entity in the United States: limited liability companies (LLCs).  Today, I contribute some foundational information relating to, but not directly responding to, the micro-symposium questions.  These observations come from a panel discussion at the 2015 ABA LLC Institute in Washington, DC in which I was a participant.  I blogged from the Institute last week and promised this post in that first post.

The session at the Institute that I feature in today’s post explored the legal and practical nature of an operating agreement (a/k/a, a limited liability company agreement).  Since the operating agreement is the typical locus of private ordering in the LLC form, its status under LLC and other law should be of interest to us.  Among other things, understanding the operating agreement may better enable us to understand when it is a valid, binding, and enforceable obligation among the parties.  That’s an issue I have been exploring in some of my work.  But there is more in the legal status of the operating agreement than meets the eye . . . .

I recently received the following call for papers via e-mail

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Law and Ethics of Big Data

Co-Hosted and Sponsored by:

Virginia Tech Center for Business Intelligence Analytics

The Department of Business Law and Ethics, Kelley School of Business

Co-Sponsored by:

The Wharton School

Washington & Lee Law School

 

April 8 & 9, 2016

Indiana University- Bloomington, IN.

Abstract Submission Deadline: January 17, 2016

We are pleased to announce the research colloquium, “Law and Ethics of Big Data,” at Indiana University-Bloomington, co-hosted by Professor Angie Raymond of Indiana University and Professor Janine Hiller of Virginia Tech.

Due to the success of last year’s event, the colloquium will be expanded and we seek broad participation from multiple disciplines; please consider submitting research that is ready for the discussion stage. Each paper will be given detailed constructive critique. We are targeting cross-discipline opportunities for colloquium participants, and the IU community has expressed interest in sharing in these dialogues. In that spirit, the Institute of Business Analytics plans to host a guest speaker on the morning of April 8.th Participants are highly encouraged to attend this free event.

Submissions: To be considered, please submit an abstract of 500-1000…

Guest post by Mohsen Manesh:

In my previous post, I suggested that we are unlikely to see Delaware ever step back from its statutory commitment to freedom of contract in the alternative entity context. And that is true even if Chief Justice Strine, Vice Chancellor Laster, and others might believe that unlimited freedom of contract has been bad public policy.

Why? To be cynical, it’s about money.

It is well known that Delaware, as a state, derives substantial profits, in the form of franchise taxes, as a result of its status as the legal haven for a majority of publicly traded corporations. In 2014 alone, Delaware collected approximately $626 million—that is almost 16% of the state’s total annual revenue—from corporate franchise taxes. (For scale, that’s almost $670 per natural person in Delaware.)

Less well documented, however, is that Delaware also now derives substantial—and growing—revenues as the legal home from hundreds of thousands of unincorporated alternative entities. My chart below tells the story. Over the last decade, while the percentage of the state’s annual revenue derived from corporate franchise taxes has been flat, an increasingly larger portion of the state’s annual revenue has been derived from the taxes paid…

 Guest post by Sandra Miller:

The ratio of LLC filings to corporate filings in Delaware from 2010 to 2014 was over 3 to 1.  Alternative business entities are no longer the province of a relatively small number of sophisticated investors.  Increasingly, corporations are becoming the “alternative” and LLCs and other unincorporated entities the norm.  Mom and Pop business as well as sophisticated real estate syndicators use alternative business entities.  Additionally, as discussed below, publicly-traded limited partnerships and LLCs are now being aggressively marketed. 

Accordingly, the assumptions that might once have justified greater reliance on private ordering in LLCs and alternative business entities should be revisited.  Not all investors are highly sophisticated parties and a relentlessly contractual approach to business entity governance is not appropriate for unsophisticated parties.   Nor is it appropriate for those without sophisticated legal counsel.  In backhanded fashion, this point was recognized by Larry E. Ribstein who advocated the removal of restrictions on waivers of fiduciary duties in limited partnerships when these entities were used by sophisticated firms that were unlikely to be publicly traded.   Ribstein expressly stated that limited partnership interests may be less vulnerable than corporate shareholders and are unlikely to be publicly traded.  (…