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 that sophisticated parties can contract freely?

The above narrative suggests that sophisticated parties benefit and enjoy the organizational flexibilities provided by the LLC form. It goes unnoticed, though, that sophisticated parties often reject this freedom of contract. Without question the trend in Delaware is towards the formation of LLCs and LPs versus corporations (at seemingly a 3:1 rate). But that doesn’t mean alternative entities always choose to keep their form. I was discussing this issue with a friend and practicing lawyer who mentioned that, in his transactional practice, when Delaware LLCs become big, and attract big funds, a condition of investment almost always requires an LLC to convert into a Delaware corporation. It seems that the lack of predictability associated with the freedom of contract scares potential investors who prefer the comforts of fiduciary duties, among other corporate staples. Upon some reflection, this anecdotally lines up with my experience as best as I can remember. So the parties who ostensibly are best served by contractual freedoms—i.e., sophisticated parties—appear to be the ones most likely to demand the traditional corporate form. And on a related note, this helps to explain why such a paltry number of LLCs and LPs have become public companies.

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.

Continue Reading Exalting the Distinct Nature of the LLC (Contract Is King Micro-Symposium)

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 to define the concept.[8] Such omissions render the agreement ambiguous [9] and impose on the courts an interpretative task that involves looking not only to other, related provisions in the agreement [10] but also to the negotiations, if any, and other circumstances that led up to the agreement being made.[11]  A few Delaware cases have even resorted to the corporate fiduciary duty concept of good faith.[12] In any event, if, as held in Gerber, an agreement that expressly defines “good faith” cannot affect the implied covenant, a fortiori neither can an agreement that uses the term but omits to define it.

D. Uniform Limited Liability Company Act (ULLCA) Approach – More Contractarian than Delaware (!)

Perhaps ironically (or some might even say “counter-intuitively”), the Uniform Limited Liability Company Act (2006) (Last Amended 2013) permits an ULLCA operating agreement to go where a Delaware operating agreement cannot. Although an ULLCA operating agreement may not “eliminate the contractual obligation of good faith and fair dealing …., [it] may prescribe the standards, if not manifestly unreasonable, by which the performance of the obligation is to be measured.”

This provision entered uniform laws with the Revised Uniform Partnership Act, which took the concept from the Uniform Commercial Code. ULPA (2001) followed suit, as did ULLCA (2006). In my opinion, this importation was a bad idea. But, in any event, the comment to ULLCA (2013) § 105(c)(6). at least provides examples:

EXAMPLE: The operating agreement of a manager-managed LLC gives the manager the discretion to cause the LLC to enter into contracts with affiliates of the manager (so-called “Conflict Transactions”). The agreement further provides: “When causing the Company to enter into a Conflict Transaction, the manager complies with Section 409(d) of [this act] if a disinterested person, knowledgeable in the subject matter, states in writing that the terms and conditions of the Conflict Transaction are equivalent to the terms and conditions that would be agreed to by persons at arm’s length in comparable circumstances.” This provision “prescribe[s] the standards by which the performance of the [Section 409(d)] obligation is to be measured.”[13]

EXAMPLE: Same facts as the previous example, except that, during the performance of a Conflict Transaction, the manager causes the LLC to waive material protections under the applicable contract. The standard stated in the previous example is inapposite to this conduct. Section 409(d) therefore applies to the conduct without any direct contractual delineation. (However, other terms of the agreement may be relevant to determining whether the conduct violates Section 409(d). See the comment to Section 409(d).)

EXAMPLE: The operating agreement of a manager-managed LLC gives the manager “sole discretion” to make various decisions. The agreement further provides: “Whenever this agreement requires or permits a manager to make a decision that has the potential to benefit one class of members to the detriment of another class, the manager complies with Section 409(d) of [this act] if the manager makes the decision with:

a. the honest belief that the decision: i. serves the best interests of the LLC; or ii. at least does not injure or otherwise disserve those interests; and

b. the reasonable belief that the decision breaches no member’s rights under this agreement.”

This provision “prescribe[s] the standards by which the performance of the [Section 409(d)] obligation is to be measured.” Compare Section 105(c)(6), with Nemec v. Shrader, 991 A.2d 1120 (Del. 2010) (considering such a situation in the context of the right to call preferred stock and deciding by a 3-2 vote that exercising the call did not breach the implied covenant of good faith and fair dealing).

Looking to Delaware law, the comment advises that “[a]n operating agreement that seeks to prescribe standards for measuring the contractual obligation of good faith and fair dealing … should expressly refer to the obligation.” The comment refers to Gerber v. Enter. Prods. Hldgs., L.L.C., 67 A.3d 400, 418 (Del. 2013) as distinguishing between the implied contractual covenant and an express contractual obligation of “good faith” as stated in a limited partnership agreement.

Coming Next to a Blog Near You: So, what is Delaware’s implied contractual covenant of good faith and fair dealing?

This posting is derived from Daniel S. Kleinberger, “Delaware’s Implied Contractual Covenant of Good Faith and “Sibling Rivalry” Among Equity Holders,” a paper presented at the 21st Century Commercial Law Forum: 15th International Symposium in Beijing, at Tsinghua University’s School of Law, November 1, 2015 (footnotes converted to endnotes).

 

ENDNOTES:

[1] E.g., DV Realty Advisors LLC v. Policemen’s Annuity & Ben. Fund of Chicago, 75 A.3d 101, 109 (Del. 2013) (stating that, “[i]f the parties wanted to use the UCC definition of good faith, they could have so provided in the [limited partnership agreement] or incorporated it as a defined term by reference.”); In re El Paso Pipeline Partners, L.P. Derivative Litig., No. CIV.A. 7141-VCL, 2014 WL 2768782, at *17 (Del. Ch. June 12, 2014) (“In this case, the LP Agreement supplies a definition of ‘good faith’ that governs whether the defendants have complied with provisions of the LP Agreement that utilize that term.”)

[2] Gerber v. Enter. Products Holdings, LLC, 67 A.3d 400 (Del. 2013), overruled on other grounds by Winshall v. Viacom Int’l, Inc., 76 A.3d 808 (Del. 2013)

[3] Id., at 420, n. 48.

[4] Nemec v. Shrader, 991 A.2d 1120 (Del. 2010).

[5] Gerber, 67 A.3d at 420, n. 48.

[6] Del. Code., tit.6, § 17-1101(d).  The subsection has been amended since then but the relevant language is unchanged: “the agreement may not eliminate the implied contractual covenant of good faith and fair dealing.”  Unlike the uniform partnership, limited partnership, and limited liability company acts, the Delaware statutes do not authorize a partnership or operating agreement to “prescribe the standards, if not manifestly unreasonable, by which the performance of the [implied contractual] obligation [of good faith and fair dealing] is to be measured.” UPA (2013) § 105(c)(6); ULPA (2013) § 105(c)(6); ULLCA § 105(c)(6) (identical wording in each).

[7] Gerber, 67 A.3d at 420, n. 48.  See also In re El Paso Pipeline Partners, L.P. Derivative Litig.:

The defendants … try to defeat the implied covenant claim by arguing that the LP Agreement expressly defines the term “good faith,” leaving no room for the implied covenant. According to the defendants, the implied covenant does not apply because the LP Agreement makes “good faith” the standard for evaluating whether the Conflicts Committee validly gave Special Approval and further defines “good faith” as subjective good faith. The defendants argue that when the parties have “agreed how to proceed under a future state of the world” (i.e., in the face of a conflict transaction), their bargain (i.e., the LP Agreement) “naturally controls.” The Delaware Supreme Court has rejected similar arguments.

No. CIV.A. 7141-VCL, 2014 WL 2768782, at *16 (Del. Ch. June 12, 2014) (citing and quoting Gerber v. Enter. Prods. Hldgs., LLC, 67 A.3d 400, 418 (Del.2013), overruled in part on other grounds by Winshall v. Viacom Int’l, Inc., 76 A.3d 808 (Del.2013) and DV Realty Advisors LLC v. Policemen’s Annuity and Benefit Fund of Chi., 75 A.3d 101, 109 (Del.2013) (recognizing that the agreement’s “contractual duty [of good faith] encompasses a concept of ‘good faith’ that is different from the good faith concept addressed by the implied covenant of good faith and fair dealing”)) (parentheticals in the original).

The El Paso opinion further explained: “In this case, the LP Agreement supplies a definition of ‘good faith’ that governs whether the defendants have complied with provisions of the LP Agreement that utilize that term. The definition is not a means of implying terms to fill contractual gaps, and the implied covenant does not turn on whether the counterparty acted in subjective good faith.” El Paso., at *17.

[8] E.g., DV Realty Advisors LLC v. Policemen’s Annuity & Ben. Fund of Chicago, 75 A.3d 101, 107 (Del. 2013); Allen v. Encore Energy Partners, L.P., 72 A.3d 93, 105 n.44 (Del. 2013) (referring to “the undefined term ‘bad faith’ in the LPA’s exculpation provision”); Norton v. K-Sea Transp. Partners L.P., 67 A.3d 354, 362 (Del. 2013) (noting that (i) “the LPA broadly exculpates all Indemnitees … so long as the Indemnitee acted in ‘good faith;’” but (ii) “the LPA regrettably does not define ‘good faith’ in this context”).

[9] DV Realty Advisors LLC v. Policemen’s Annuity & Ben. Fund of Chicago, 75 A.3d 101, 107 (Del. 2013) (noting that the failure of a limited partnership agreement to define the term resulted in “ambiguity”).

[10] See, e.g., Norton v. K-Sea Transp. Partners L.P., 67 A.3d 354, 362 (Del. 2013) (noting that “the LPA broadly exculpates all Indemnitees … so long as the Indemnitee acted in ‘good faith’ [but] regrettably does not define ‘good faith’ in this context;” dealing with “the parties’ insertion of a free-standing, enigmatic standard of ‘good faith’ by construing the term to be consistent with another, related provision; stating that “[i]n this LPA’s overall scheme, ‘good faith’ cannot be construed otherwise”).

[11] The ambiguity precludes application of the parol evidence rule.  Schwartz v. Centennial Ins. Co., No. CIV. A. 5350 (1977), 1980 WL 77940, at *5 (Del. Ch. Jan. 16, 1980) (stating that “[t]he parol evidence rule is unavailable to plaintiffs to bar the admission of [defendant’s] evidence to show the true meaning of the ambiguous term”).  In the Delaware Court of Chancery, the other circumstances may even include common drafting practices within the informal community of (mostly Delaware) lawyers whose practices regularly involve negotiating and drafting very sophisticated partnership and LLC agreements.  See In re El Paso Pipeline Partners, L.P. Derivative Litig., No. CIV.A. 7141-VCL, 2014 WL 2768782, at *22 (Del. Ch. June 12, 2014) (“[P]recedent suggests that if the drafters intended for a disclosure obligation to exist, they would have included specific language. A recent decision by this court interpreted a limited partnership agreement that utilized a similar structure for conflict-of-interest transactions, with four contractual alternatives including Special Approval. The language authorizing the Special Approval route stated that it would be effective ‘as long as the material facts known to the General Partner or any of its Affiliates regarding any proposed transaction were disclosed to the Conflicts Committee at the time it gave its approval.’ The inclusion of this condition in [that other] agreement indicates that without this language, a general partner and its affiliates would not have an obligation to disclose information.”) (citation and footnote omitted).

[12] DV Realty Advisors LLC v. Policemen’s Annuity & Ben. Fund of Chicago, 75 A.3d 101, 110 (Del. 2013) (“In our recent opinion in Brinckerhoff v. Enbridge Energy Company, Inc. [67 A.3d 369, 373 (Del.2013)], we defined the characteristic of good faith by its opposite characteristic – bad faith. We applied a traditional common law definition of the business judgment rule to define a limited partnership agreement’s good faith requirement. We used the formula describing conduct that falls outside business judgment protection, namely, an action ‘so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.’ That definition of good faith, as set forth in Brinckerhoff, is appropriately applied in this case as well.”).  Thus, no single definition exists for the meaning of “good faith” when a limited partnership or LLC agreement expressly includes the term.  The meaning depends first on what, if any, definition the agreement provides.  In the absence of a definition, uncertainty is initially inevitable; the term means whatever the court determines the term to mean.  In contrast, it is certain that the implied covenant is not a fallback definition for an undefined express good faith provision.  Opinions dealing with such provisions never use the implied covenant even as a frame of reference.  See, e.g., DV Realty Advisors LLC v. Policemen’s Annuity & Ben. Fund of Chicago, 75 A.3d 101, 107 (Del. 2013); Allen v. Encore Energy Partners, L.P., 72 A.3d 93, 105 n.44 (Del. 2013); Norton v. K-Sea Transp. Partners L.P., 67 A.3d 354, 362 (Del. 2013).  Moreover, using the implied covenant as a fallback definition would render the undefined provision duplicative, because the implied covenant exists in every limited partnership or LLC agreement as a matter of law.

[13] ULLCA (2013) § 105(c)(6).

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 . . . .

Continue Reading What is an LLC Operating Agreement, Anyway? (Contract Is King Micro-Symposium)

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

—-

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 words to Angie Raymond at angraymo@indiana.edu and/or Janine Hiller at jhiller@vt.edu by January 17, 2016. Abstracts will be evaluated based upon the quality of the abstract and the topic’s fit with the theme of the colloquium and other presentations. Questions may be directed to Angie Raymond at angraymo@indiana.edu or Janine Hiller at jhiller@vt.edu.

Authors will be informed of the decision by February 2, 2016. If accepted, the author agrees to submit a discussion paper by March 26, 2016. While papers need not be in finished form, drafts must contain enough information and structure to facilitate a robust discussion of the topic and paper thesis. Formatting will be either APA or Bluebook. In the case of papers with multiple authors, only one author may present at the colloquium.

TENTATIVE Colloquium Details:

  • The colloquium will begin at noon on April 8th and conclude at the end of the day on April 9th
  • Approximately 50 minutes is allotted for discussion of each paper presentation and discussion.
  • The manuscripts will be posted in a password protected members-only forum online. Participants agree to read and be prepared to participate in discussions of all papers. Each author will be asked to lead discussion of one other submitted paper.
  • A limited number of participants will be provided with lodging, and all participants will be provided meals during the colloquium. All participants are responsible for transportation to Indiana University Bloomington, IN.

The defense for Don Blankenship, former CEO of Massey Coal, rested today without putting on any witnesses.  Blankenship is on trial because he is charged with conspiring to violate federal safety standards. Investigators believe that Blankenship’s methods contributed to a mine disaster that killed 29 people at the Upper Big Branch mine in West Virginia.  

One part of the trial has an interesting business law component.  Prosecutors have tried to show the Blankenship’s interest in making more money was a key factor in cutting corners.  One West Virginia news paper reported it this way:

“The government is using his compensation package as an indication of how much production mattered to Don,” said Mike Hissam, partner at Bailey & Glasser. “They’re using his compensation to establish a motive for him lying and making false statements to investors, their theory being his compensation was so tied up with company stock he had a motive for lying to the SEC and the public to protect his own personal net worth.”

It’s possible that this is accurate, but I am leery of that line of thinking.  It’s not that I don’t think it’s possible Blankenship cut corners because it cost money, but it’s not clear to me that would be the main of even a significant reason, if he did. The problem with this line of thinking is that Don Blankenship has tons and tons of money.  So the risk is that the jury looks at and says, “Nope — he’s already rich. Why would that motivate him so much?” Further, while Blankenship stood to make money when things went well, his net worth was tied to company stock, so bad outcomes hurt him, too.  The incentive story is not as easy as it seems. 

My theory for the jury on this point would be more like this:  Blankenship played the game to win.  He liked winning, and he was used to winning, and he would not stop.  His winning made him rich.  And what was it that made him a winner?  More coal coming out of the ground. His coal. Coal, not money, earned points. Coal, not protecting lives, earned points. Safety measures and slow downs or shut downs lost points. And Blankenship was about scoring points. If the rules didn’t help him, he tried to change the rules.  And who was hurt along the way did not matter.  Because hurt people don’t score points.  Only coal matters in Blankenship’s game. 

Anyway, there’s a reason I’m not a prosecutor, but I put my theory forth because I am a little skeptical that the money-as-the-goal message will resonate with a jury the way prosecutors hope.  (To be clear, this is not the only theory prosecutors put forth — it’s just the one I am focusing on.) My colleague Pat McGinley explained the challenges with Blankenship this way:

“There are a considerable number of people who view Mr. Blankenship in his role as the Massey CEO as arrogant and dismissive of criticism,” he said. “But the jury hasn’t seen that side of him. And don’t forget he’s embraced by many people, including many powerful people; he’s not universally viewed as arrogant or in a negative light. What’s important here is what assessment is the jury going to have?

Had Blankenship testified, we’d have a better sense of what the jury might think of him, because we’d at least have his testimony to assess. We’d know at least part of what the jury knows.  But he didn’t. No witnesses for the defense, and no insight for those watching.  

It should be an interesting few days.   

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 by its domestic LLCs and LPs. Unsurprisingly, in Delaware, alternatives entities have been a real growth industry.

Given the state’s increasing dependence on revenues from domestic LLCs and LPs, it is highly unlikely that the state would undertake any reforms that risk eroding this emerging and increasingly important tax base. Evidence, as well as experience, suggests that businesses (and their lawyers) are drawn to Delaware, in part, because of its unlimited freedom of contract and the ability to tailor and eliminate all fiduciary duties. [1] Thus, if Delaware were to alter its alternative entity law to curtail that freedom and impose some form of mandatory, unwaivable fiduciary duties, it would lose some number of LLCs. Too many other jurisdictions “give the maximum effect to the … freedom of contract”. [2]

Importantly, however, this concern is much less acute when the reform is one that is limited only to publicly traded alternative entities. For one, as I noted in my earlier post, Delaware’s 150 or so publicly traded LPs and LLCs represent a tiny sliver of the hundreds of thousands of alternative entities domiciled in Delaware. Moreover, those few publicly traded firms contribute only a nominal portion to Delaware’s overall revenues collected from alternative entity taxes.

As I have shown in earlier work, unlike Delaware’s corporate franchise tax, which is scalable based on a formula that tends to charge most to large, publicly traded firms (up to $180,000 annually), Delaware’s annual tax charged to alternative entities is flat. All LLCs and LPs, no matter how large or small, whether publicly traded or closely held, pay the state only $300 annually for the privilege of being a Delaware entity. Thus, unlike the corporate context, where Delaware’s business is dependent on attracting large, publicly traded corporations, in the alternative entity context, Delaware’s business depends on volume alone. And publicly traded alternative entities represent a negligible part of the state’s overall volume—accounting for approximately $45,000 of the total $195 million that Delaware collected from its domestic alternative entities last year.

The upshot is that although Delaware might be quite sensitive economically to curtailing the freedom of contract for all alternative entities, lest it loses some if this thriving tax base, the state may be relatively indifferent to losing the approximately $45,000 annually that it gets from its few publicly traded LPs and LLCs. 

Whether this indifference can be transformed into a willingness to amend its law to impose mandatory fiduciary duties in publicly traded alternative entities depends on whether Strine, Laster, and others can make a convincing policy case for making this change. Or more cynically yet, it might depend on whether Delaware’s legislature fears that in the absence of state-level regulation, the federal government might step in to preempt Delaware law on behalf of public investors. [3]

-Mohsen Manesh

* * * * *

[1] See Franklin Gevurtz, Why Delaware LLCs?, 91 Or. L. Rev. 57, 105 (2012).

[2] See, e.g., Ark. Code Ann. § 4-32-1304 (2001); Colo. Rev. Stat. § 7-80-108(4) (2009); Conn. Gen. Stat. Ann. § 34-242(a) (West 2005); Ga. Code. Ann. § 14-11-1107(b) (2003 & Supp. 2010); Kan. Stat. Ann. § 17-76,134(b) (2007); Ky. Rev. Stat. Ann. § 275.003 (West, Westlaw through 2010 legislation); La. Rev. Stat. Ann. § 12:1367(B) (2010); Miss. Code. Ann. § 79-29-1201(2) (2009); Mo. Rev. Stat. § 347.081(2) (2001 & Supp. 2010); Nev. Rev. Stat. § 86.286(4)(b) (2010); N.M.Stat. Ann. § 53-19-65(A) (LexisNexis 1978 & Supp. 2003); N.C. Gen. Stat. Ann. § 57C-10- 03(e) (2009); Okla. Stat. Ann. tit. 18, § 2058(D) (West 1999 &  Supp.  2010);  Utah Code Ann. § 48-2c-1901 (LexisNexis 2007); Va. Code Ann. § 13.1-1001.1(C) (2006); Wash. Rev. Code Ann. § 25.15.800(2) (West 2005); Wis. Stat. Ann. § 183.1302(1) (West 2002).

[3] Cf. Gerber v. Enterprise Prods. Holdings, LLC, 2012 WL 34442, *10 n.42 (Del. Ch. Jan. 6, 2012) (Noble, V.C.) (“This [case] raises the issue of just what protection Delaware law affords the public investors of limited partnerships that take full advantage of [the freedom of contracting.] If the protection provided by Delaware law is scant, then the LP units of these partnerships might trade at a discount or another governmental entity might step in and provide more protection to the public investors in these partnerships.”) (emphasis added).

 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.  (See Fiduciary Duties and Limited Partnerships)

Master limited partnerships (e.g. publicly-traded limited partnerships and publicly-traded LLCs) provide an important example of how capital from unsophisticated investors now flows readily into alternative investments.  According to the National Association of Publicly-Traded Partnerships (NAPTP) most MLP investors are individuals, the vast majority of whom are over age 50.  Many investors are individuals, estates, and retirement plans – unsophisticated economic players.  Thus, there are asymmetries in the marketplace that make it unlikely that the marketplace will efficiently discount the effects of waivers.  Given the investor profile, at a very minimum, the duty of loyalty should be non-waivable for publicly-traded entities.   (See Toward Consistent Fiduciary Duties)

            There are even strong arguments in favor of reinstating mandatory minimum fiduciary duties for all business entities, public or private.  Contractarians pre-suppose a level contractual playing field.  Yet, repeat players who structure similar transactions repeatedly are at a distinct advantage.  Moreover, there may not be equal legal representation of majority and minority investors.  (See A New Direction for LLC Research in a Contractarian Legal Environment) Moreover, it is total madness to think that a contractual approach to business entity governance reduces costs.  If anything, costs are increased by the lack of standard terms under a contractual regime. 

     In short, we have empirical data and years of experience with waivers that expose serious inefficiencies and injustices in a system that permits the waiver of all fiduciary duties.  It is time to reconsider the benefits of a mandatory duty of loyalty for all entities, public or private. 

-Sandra Miller

 

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 implied covenant’s “good faith” is not.

Part II – A Couple of Major “Nots”

  1. Not the Looser Approach of the Uniform Commercial Code

The Uniform Commercial Code codifies the common law obligation of good faith and fair dealing for matters governed by the Code: “Every contract or duty within [the Uniform Commercial Code] imposes an obligation of good faith in its performance and enforcement.”  The Code defines “good faith” as “mean[ing] [except for letter of credit matters] honesty in fact and the observance of reasonable commercial standards of fair dealing.” An official comment elaborates: “Although ‘fair dealing’ is a broad term that must be defined in context, it is clear that it is concerned with the fairness of conduct rather than the care with which an act is performed.”

The UCC standard thus incorporates facts far beyond the words of the contract at issue and furthers a value (fairness) which in the entity context is usually the province of fiduciary duty.  The UCC  definition provides some constraint by referring to “reasonable commercial standards,” but “[d]etermining . . . unreasonableness inter se owners of an organization is a different task than doing so in a commercial context, where concepts like ‘usages of trade’ are available to inform the analysis.” ULLCA (2013) § 105(e), cmt.

The Delaware Supreme Court has flatly rejected the U.C.C. approach for Delaware unincorporated businesses.

  1. Not the Corporate Good Faith of Disney, Stone v. Ritter, and Caremark

An obligation to act in good faith has long been part of a corporate director’s duty under Delaware law, but the concept became ever more important following the landmark case of Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).  In Van Gorkom, the Delaware Supreme Court held directors liable for gross negligence in approving a merger transaction, a holding that “shocked the corporate world.”

 Spurred by the Delaware corporate bar, the Delaware legislature promptly amended Delaware’s corporate statute.  The amendment permits Delaware  corporations to essentially opt out of the Van Gorkom rule.  The now famous Section 102(b)(7) authorizes a Delaware certificate of incorporation to:

eliminat[e] or limit[] the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty …, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director’s duty of loyalty to the corporation or its stockholders; [or] (ii) for acts or omissions not in good faith….

In effect, the provision authorizes exculpation from damages arising from claims of director negligence, but for some time the exception “for acts or omissions not in good faith” was controversial.  Where plaintiffs could not allege breach of the duty of loyalty, they sought to equate “not in good faith” with extreme negligence.

Notably, the meaning of “not in good faith” was pivotal in the lengthy and costly litigation arising from the Disney corporation’s termination of Michael Ovitz.  However, the Supreme Court’s decision in In re Walt Disney Co. Derivative Litig. left the issue murky.  Eventually, in Stone v. Ritter, the court made clear that in this context “good faith” is an aspect of the duty of loyalty.  The Court then equated a lack of this type of good faith with a director’s utter failure to attend to his or her oversight obligations (the so-called Caremark I duties).

Thus, a Delaware director’s fiduciary duty of good faith has nothing to do with the “good faith” of the Delaware implied covenant of good faith and fair dealing.

This posting is derived from Daniel S. Kleinberger, “Delaware’s Implied Contractual Covenant of Good Faith and “Sibling Rivalry” Among Equity Holders,” a paper presented at the 21st Century Commercial Law Forum: 15th International Symposium in Beijing, at Tsinghua University’s School of Law, November 1, 2015 (all footnotes and most citations omitted).

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 another respect, the Strine and Laster proposal is quite audacious and radical. Imposing mandatory fiduciary duties fundamentally cuts at their state’s famously strong statutory commitment to freedom of contract and the reputation that that has fostered in legal and business circles. After all, there is a reason why our symposium and AALS program are titled “Contract is King.” As a pragmatic matter, it is hard to see how Delaware could back away from its commitment to the freedom of contract.

Certainly, there is reason to single out publicly traded entities for special treatment. The agreements governing publicly traded alternative entities bear all of the hallmarks of contracts of adhesion: prolix and confusing, often unread and unnegotiated, offered on a take-it-or-leave it basis, and arguably stuffed full of terms that favor the drafting party (the firm’s managers and sponsors) at the expense of often unsophisticated, public investors. Indeed, my own research has shown that these agreements commonly contain clauses that eliminate the default fiduciary duty of loyalty or exculpate for damages arising therefrom, replacing the default duty with less rigorous contractual obligations.

And anyone who closely follows Delaware case law knows how these agreements have played out in practice. In recent years, the Delaware Supreme Court and Court of Chancery have dismissed case after case in which the public investors of alternative entities have alleged self-dealing on the part of the managers or controllers of the entity.[3]  And it’s clear that oftentimes the courts are dismissing these cases begrudgingly, despite their own feelings of fairness. [4] 

So, there might well be reason to change the rules for publicly traded entities to limit the freedom of contract by imposing a mandatory fiduciary duty of loyalty. But on the other hand, as I suspect others in this micro-symposium will argue, many of critiques that Strine and Laster levy at publicly traded alternative entities– unsophisticated investors, the absence of true bargaining, and confusing contract terms that often unduly favor the managers—could be levied at many private entities as well. If so, then why should Strine & Laster’s proposal be limited to public entities?

Moreover, even if public investors do not read or understand the terms that they are agreeing to by investing, and even if those terms are unduly favorable to the managers of the entity, the units purchased by investors in a publicly traded alternative entity have been priced by a liquid market that is—to at least some degree—efficient, meaning that those management-friendly terms have been already priced into the units. So, to some extent, public investors are getting exactly what they pay for. [5] In contrast, the investors in private entities do not benefit from this kind of built-in market wisdom. So, don’t they deserve the judicial protection of a mandatory fiduciary duty even more so than their public investor counterparts?

Given all of this, even if one accepts Strine and Laster’s account of the problems created by the freedom of contract, does it makes sense to limit their solution to the narrow sliver of publicly held entities? Or is their proposed solution simply a pragmatic recognition that for better or worse “Contract is King” and that any reform to that bedrock principle must be modest and incremental.

As I’ll explain in my next post, from my perspective, it is hard to see Delaware stepping back wholesale from its commitment to the freedom of contract in the alternative entity context. But for publicly traded firms at least, I do see reasons why we might see a curtailment of the unlimited freedom of contracting.

-Mohsen Manesh

[1] The Siren Song of Unlimited Contractual Freedom, in Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations 13 (Robert W. Hillman & Mark J. Loewenstein eds., 2015) (“In light of these problems, it seems to us that a sensible set of standard fiduciary defaults might benefit all constituents of alternative entities…. For publicly traded entities, the duty of loyalty would be nonwaivable.”)

[2]  Id.

[3] See, e.g., In re Encore Energy Partners LP Unitholder Litig., 2012 WL 3792997 (Del. Ch. Aug. 31, 2012) aff’d 72 A.3d 93 (Del. 2013); Gerber v. EPE Holdings, LLC, 2013 WL 209658 (Del. Ch. Jan. 18, 2013); Brinckerhoff v. Enbridge Energy Co., Inc., 2011 WL 4599654 (Del. Ch. Sept. 30, 2011) aff’d 67 A.3d 369 (Del. 2013); In re K-Sea Transp. Partners L.P. Unitholders Litig. 2012 WL 1142351 (Del. Ch. Apr. 4, 2012) aff’d, 67 A.3d 354, 360-61 (Del. 2013). But see In re El Paso Pipeline Partners, 2015 WL 1815846 (Del. Ch. Apr. 20, 2015) (judgment for damages against general partner for breach of contractual duty).

[4] See, e.g., Encore Energy Partners, 2012 WL 3792997, *13 (Parsons, V.C.) (acknowledging the “near absence under the [LP agreement] of any duties whatsoever [owed] to the public equity holders,” and advising “[i]nvestors apprehensive about the risks inherent in waiving the fiduciary duties of those with whom they entrust their investments may be well advised to avoid master limited partnerships.”);  Gerber v. Enterprise Prods. Holdings, LLC, 2012 WL 34442, *13 (Del. Ch. Jan. 6, 2012) (Noble, V.C.) (“The facts of this case take the reader and the writer to the outer reaches of conduct allowable under [Delaware law]. It is easy to be troubled by the allegations.”); Gerber v. EPE Holdings, 2013 WL 209658, *10 (Noble, V.C.) (“It is not difficult to understand [the plaintiff-investor’s] skepticism and frustration, but his real problem is the contract that binds him and his fellow limited partners.”).

[5] See Gerber v. Enterprise Prods. Holdings, LLC, 2012 WL 34442, *10 n.42 (Del. Ch. Jan. 6, 2012) (Noble, V.C.) (“This [case] raises the issue of just what protection Delaware law affords the public investors of limited partnerships that take full advantage of [the freedom of contract]. If the protection provided by Delaware law is scant, then the LP units of these partnerships might trade at a discount….”).