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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…

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.  (…

Guest post by Daniel Kleinberger:

Part I – Introduction

My postings this week will seek to delineate Delaware’s implied contractual covenant of good faith and fair dealing and the covenant’s role in Delaware entity law

An obligation of good faith and fair dealing is implied in every common law contract and is codified in the Uniform Commercial Code (“U.C.C”). The terminology differs:  Some jurisdictions refer to an “implied covenant;” others to an “implied contractual obligation;” still others to an “implied duty.”  But whatever the label, the concept is understood by the vast majority of U.S. lawyers as a matter of commercial rather than entity law.  And, to the vast majority of corporate lawyers, “good faith” does not mean contract law but rather conjures up an important aspect of a corporate director’s duty of loyalty.

Nonetheless, Delaware’s “implied contractual covenant of good faith and fair dealing” has an increasingly clear and important role in Delaware “entity law” – i.e., the law of unincorporated business organizations (primarily limited liability companies and limited partnerships) as well as the law of corporations.

Because to the uninitiated “good faith” can be frustratingly polysemous, this first blog “clears away the underbrush” by explaining what Delaware’s…

Guest post by Mohsen Manesh:

First, I want to give a big thanks to Anne and the rest of the Business Law Professor Bloggers for graciously hosting this mirco-symposium! As a longtime BLPB reader, it is a privilege to now contribute to the online conversation.

In this post, I want to explore the boundaries of the proposal recently made by Delaware Chief Justice Strine and Vice Chancellor Laster to address the problem, as they see it, that has been created by the unbound freedom of contract in the alternative entity context.  In their provocative “Siren Song” book chapter, the judicial pair advocate limits on the freedom of contract by making the fiduciary duty of loyalty mandatory.[1] But, importantly, they limit their proposal to publicly traded LLCs and LPs. [2]

This limitation is striking because it makes their proposal, in one respect at least, so very modest. There exists literally hundreds of thousands of Delaware LLCs and LPs. (121,592 LLCs were formed in Delaware in 2014 alone!) Only around 150 are publicly traded. [3] Thus, the Strine and Laster proposal for curtailing the freedom of contract affects only a tiny fraction of the alternative entity universe.

But in…

Guest post by Jeffrey Lipshaw:

I’m honored to be asked to participate in this micro-symposium, and will (sort of) address the first two questions as I have restated them here.

  1. Does contract play a greater role in “uncorporate” structures than in otherwise comparable corporations and, more importantly, do I care?

                  Yes, as I’ll get to in #2, but indeed I probably don’t care. My friend and casebook co-author, the late great Larry Ribstein, was more than a scholar-analyst of the non- or “un-” corporate form; he was an enthusiastic advocate. It’s pretty clear that had to do with his faith in the long-term rationality of markets and their constituent actors and a concomitant distrust of regulatory intervention. Indeed, he argued the uncorporate form, based in contract, was more amenable than the regulatory-based corporate form to the creation of that most decidedly immeasurable quality, trust, and therefore the reduction of transaction costs. I confess I never quite understood the argument and tried to explain why, but only after Larry passed away, so I never got an answer. 

                  Unlike Larry (and a number of my fellow AALS Agency, Partnership, & LLC section members), I was never able to…

Next week, the BLPB is hosting a micro-symposium organized by the AALS section on Agency, Partnership, LLCs, and Unincorporated Associations.  Confirmed participants include Joan MacLeod Heminway (BLPB editor), Dan Kleinberger, Jeff Lipshaw, Mohsen Manesh, and Sandra Miller.

The micro-symposium will explore the role of private ordering in LLCs and other alternative business entities, a broad topic that encompasses many interesting questions:

(1) To what extent, and in what ways, does contract play a greater role in LLCs and LPs than in otherwise comparable corporations? Is it helpful to conceptualize private ordering in this context as contractual?

(2) Does unfettered private ordering reliably advance the interests of even the most sophisticated parties? Does it waste judicial resources? In their book chapter, The Siren Song of Unlimited Contractual Freedom, two distinguished Delaware jurists, Chief Justice Leo Strine and Vice Chancellor J. Travis Laster, raise these concerns and argue in favor of more standardized fiduciary default rules. 

(3) Should the law impose fiduciary duties of loyalty and care as safeguards against abuse of the unobservable discretion managers enjoy because those duties reflect widely held social norms that most investors would expect to govern the conduct of managers?

(4) If…

Christine Hurt has written an interesting article on limited liability partnerships in bankruptcy. It’s available here.

Here’s the abstract:

Brobeck. Dewey. Howrey. Heller. Thelen. Coudert Brothers. These brand-name law firms had many things in common at one time, but today have one: bankruptcy. Individually, these firms expanded through hiring and mergers, took on expensive lease commitments, borrowed large sums of money, and then could not meet financial obligations once markets took a downturn and practice groups scattered to other firms. The firms also had an organizational structure in common: the limited liability partnership.

In business organizations classes, professors teach that if an LLP becomes insolvent, and has no assets to pay its obligations, the creditors of the LLP will not be able to enforce those obligations against the individual partners. In other words, partners in LLPs will not have to write a check from personal funds to make up a shortfall. Creditors doing business with an LLP, just as with a corporation, take this risk and have no expectation of satisfaction of claims by individual partners, absent an express guaranty. In bankruptcy terms, creditors look solely to the capital of the entity to satisfy claims. While bankruptcy proceedings involving…

This post is related to another great post from Tom Rutledge at the Kentucky Business Entity Law Blog, Diversity Jurisdiction and Jurisdictional Discovery: The Third Circuit Holds That “Hiding The Ball” Will Not Work. Tom’s post is about Lincoln Benefit Life Company v. AEI Life, LLC, No. 14-2660, 2015 WL 5131423, ___ F.2d__ (3rd Cir. Sept. 2, 2015), which is available here. 

Lincoln Benefit allows a plaintiff, after a reasonable inquiry into the resources available (like court records and public documents), to allege complete diversity in good faith, if there is no reason to believe any LLC members share the same state of citizenship.  Thus, the diversity claim can be made on “information and belief.”  Tom explains that

While it may do nothing to address the fact that diversity jurisdiction may be unavailable consequent to de minimis indirect ownership  . . .  it does limit the ability of a defendant to “hide the ball” as to its citizenship while objecting that the other side has not adequately pled citizenship and therefore diversity. 

This concern arises out of the fact that LLCs, as unincorporated associations, are treated like partnerships for purposes of federal diversity jurisdiction, meaning that an…