Friday, November 27, 2015
I try to read everything Lyman Johnson writes, so my Thanksgiving break reading is his recent book chapter The Reconfiguring of Revlon. The abstract is below:
Three decades later, an irksome uncertainty still impedes a settled understanding of the Delaware Supreme Court’s landmark ruling in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. For such a towering doctrine, Revlon’s underlying rationales remain controversial, its exact contours and demands continue to be surprisingly unclear, and it holds out scant hope for remedial relief. In spite of these troubling features of today’s Revlon jurisprudence, however, Revlon is slowly being worked back into the larger fabric of Delaware’s fiduciary duty law and away from being a gangling, standalone doctrine. The organizing themes of this judicial project are strong deference in the deal context to decisions made by independent directors without regard to deal structure, the substantially reduced likelihood of equitable or monetary remedies in all types of deal-related lawsuits, and a nascent effort at harmonizing Revlon with Delaware’s more general, and ill-defined, doctrine on corporate purpose.
This chapter discusses the original Revlon decision and its rapid expansion before turning to lingering uncertainties surrounding the reach of Revlon, the decline of Revlon’s remedial clout, and where Revlon stands today in relation to Delaware’s overall fiduciary duty law. Revlon’s sharp focus on immediate value maximization was a breakthrough pronouncement on corporate purpose, a subject of longstanding national debate but one on which the Delaware Supreme Court had been strangely silent. However, grave reservations about whether and when corporate directors should be required to pursue short term goals found useful cover in sustained judicial murkiness over the boundaries of Revlon. Only if Delaware courts resolve the underlying issue of corporate purpose more generally will Revlon either be fitted into the larger body of Delaware law or continue to stand uncomfortably to the side as a doctrinal loner of diminished significance.
Tuesday, November 24, 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 to them illustrate how degrees of difference may still matter. He provided a good example of a situation where the ability to eliminate fiduciary duties may produce the right result—an option only available in alternative entities not corporations.
Mohsen argued that if contract is king, business revenue rules the reign in Delaware. Franchise taxes and revenues generated from being the business domicile of so many businesses, in all forms, is a source of riches, one that Mohsen argued will be protected by preserving a commitment to freedom of contract.
“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.”
In his first post, Mohsen also addressed Delaware Chief Justice Strine and Vice Chancellor Laster’s provocative “Siren Song” book chapter, where the pair advocate for mandatory fiduciary duties in publicly traded LLCs and LPs. Mohsen questioned the limitation arguing that
“[M]any 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?”
Sandra Miller blogged here about investor sophistication and its relationship to fiduciary duty waivers. She highlighted her scholarship in the area and provided helpful links to her papers discussing her points in greater detail.
“[T]here 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.”
Joan Heminway questioned whether LLC operating agreements are contracts, and if not the implication for fiduciary duties, statue of frauds, capacity and public policy challenges and enforceability against third parties.
“[W]ith 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...So, while contract may be king in LLC law, we may question whether a contract even exists under LLC law.”
Joan also highlighted her recent appearance at the ABA LLC Institute in a related post available here and shared the many functions of an operating agreement (whether contract or not!).
Daniel Kleinberger contributed to the conversation in four parts (appearing in three separate posts here (1), here (2) and here(3)). Daniel focused on Delaware’s implied contractual covenant of good faith and fair dealing and the covenant’s role in Delaware entity law. He carefully distinguished the covenant from the UCC implied covenant of good faith and fair dealing and from the corporate standards of good faith as articulated in Stone v. Ritter and Smith v. Van Gorkum. Thirdly he addressed waivers of good faith and fair dealing both in the governing agreement and arising from contract in Delaware and under the Uniform Limited Partnership Act.
“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.”
In his final post, available here, Kleinberger addressed interpretation questions with implied covenants analogizing the analysis to that used with impracticability.
“For impracticability or a breach of the implied covenant to exist, the situation at issue must have been fundamentally important to the deal and yet unaddressed by the deal documents. Put another way: the notion of a “cautious enterprise” means that only a condition that is egregious or at least extreme is capable of revealing a gap to be remedied by the implied covenant.”
BLPB editor, Joshua Fershee, was inspired by the topic and contributed his own post to the micro-symposium. In his post, he declared himself a Larry Ribstein devotee and highlighted how the structural differences in the LLC form, as opposed to the corporate form, provide business benefits for LLC members.
“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.”
Greg Day, another BLPB-generated contribution to the conversation, blogged about sophisticated parties’ utilization of freedom of contract in LLC, and sophisticated investors demand for the conformity of traditional corporate formation over LLCs.
“[W] hen 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. …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.”
Finally, Peter Molk & Verity Winship also contributed a last-minute addition to the symposium highlighting their empirical work on LLC operating agreement dispute resolution provisions as it relates to the question of contracting rights in unincorporated entities. They reported some of their early findings and linked it to the discussion about contractual freedom and the implications of mandatory fiduciary duties.
“More than a third of the agreements in our sample selected the forum for resolving disputes, primarily through exclusive forum provisions or mandatory arbitration provisions. The agreements also modified litigation processes through terms that imposed fee-shifting, waived jury trials, and, less commonly, through other means like books and records limitations.”
Participants in the Micro-Symposium were asked to respond to a series of questions (available here) that will be further discussed at the AALS section meeting. Joan MacLeod Heminway (BLPB editor), Dan Kleinberger, Jeff Lipshaw, Mohsen Manesh, and Sandra Miller.will be panelists at the AALS meeting and joined by Lyman Johnson and Mark Loewenstein.
Monday, November 23, 2015
Daniel Kleinberger: Delineating Delaware’s Implied Covenant of Good Faith and Fair Dealing (Contract Is King Micro-Symposium)
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 formulation was correct as far as it went, but it omitted the all-important frame of reference. In the “fact-intensive” inquiry, what types of facts matter? Where does the court look to determine “the agreed common purpose” and “the justified expectations of the [complaining] party”? What evidence is admissible to prove the expected “fruits of the bargain”?
The answers to these questions determine whether “implying obligations based on the covenant of good faith and fair dealing [remains] a cautious enterprise.”[v] The broader the frame of reference, the more likely is the covenant to become “a judge's roving commission for determining fairness.”[vi]
Fortunately, over the past five years the Court of Chancery and the Delaware Supreme Court have provided both clarity and context. The frame of reference is confined to the actual words of the agreement; the reasonable expectations must be gleaned from those words.[vii]
Thus, the actual words of the agreement control the application of the implied covenant, both as to “fair dealing” and “good faith”:
“Fair dealing” is not akin to the fair process component of entire fairness, i.e., whether the fiduciary acted fairly when engaging in the challenged transaction as measured by duties of loyalty and care …. It is rather a commitment to deal “fairly” in the sense of consistently with the terms of the parties' agreement and its purpose. Likewise, “good faith” does not envision loyalty to the contractual counterparty, but rather faithfulness to the scope, purpose, and terms of the parties' contract. Both necessarily turn on the contract itself and what the parties would have agreed upon had the issue arisen when they were bargaining originally.[viii]
When a court considers a fiduciary claim, the “court examines the parties as situated at the time of the [alleged] wrong…. [and] determines whether the defendant owed the plaintiff a duty, considers the defendant's obligations (if any) in light of that duty, and then evaluates whether the duty was breached.”[ix] In contrast, because the actual words of the agreement control the application of the implied covenant:
An implied covenant claim ... looks to the past. It is not a free-floating duty unattached to the underlying legal documents. It does not ask what duty the law should impose on the parties given their relationship at the time of the wrong, but rather what the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.[x]
A successful implied covenant claim depends on finding a gap in the contractual language; therefore, an implied covenant claim cannot override an express contractual provision.[xi] For example, if a limited partnership agreement creates options for limited partners under specified circumstances and not otherwise, the implied covenant will not extend the option right to circumstances not specified.[xii] Expressio unius est exclusio alterius.[xiii] There is no gap.
But inevitably gaps will exist:[xiv]
No contract, regardless of how tightly or precisely drafted it may be, can wholly account for every possible contingency. Even the most skilled and sophisticated parties will necessarily fail to address a future state of the world ... because contracting is costly and human knowledge imperfect. In only a moderately complex or extend[ed] contractual relationship, the cost of attempting to catalog and negotiate with respect to all possible future states of the world would be prohibitive, if it were cognitively possible. And parties occasionally have understandings or expectations that were so fundamental that they did not need to negotiate about those expectations.[xv]
For example, suppose that: (i) a limited partnership agreement authorizes the general partner to restructure the organization as the general partner sees fit provided a competent expert provides a “fairness opinion” stating that the restructuring is fair to the limited partners; (ii) a competent expert furnishes the opinion; but (iii) the expert omits to consider the value of certain contingent assets of the limited partnership, namely the value of pending derivative litigation.[xvi] Because the limited partnership agreement “[does] not specify whether the fairness opinion [has] to consider the value of derivative litigation,” the expert’s omission reveals “a gap for the implied covenant to fill.”[xvii] The gap is filled with what the court concludes “the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.”[xviii]
In this respect, the implied covenant analysis resembles the analysis for determining whether a party’s contractual duties are discharged by supervening impracticably. “In order for a supervening event to discharge a duty …, the non-occurrence of that event must have been a ‘basic assumption’ on which both parties made the contract.”[xix] For impracticability or a breach of the implied covenant to exist, the situation at issue must have been fundamentally important to the deal and yet unaddressed by the deal documents. Put another way: the notion of a “cautious enterprise”[xx] means that only a condition that is egregious or at least extreme is capable of revealing a gap to be remedied by the implied covenant.[xxi]
[i] Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1199, 1207 (Del. 1993) (“Desert Equities alleges that the defendants breached their implied covenant of good faith and fair dealing when they, in bad faith, breached the Partnership Agreement.”).
[ii] 74 Del. Laws, c. 265, §15 (revising Del. Code tit. 6, § 17-1101(d) to provide inter alia that “the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing”). The same change was made to the limited liability company act by 74 Del. Laws, c. 275, § 13 (revising Del. Code tit. 6, § 18-1101(c) to provide inter alia that “the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing”).
[iii] Cincinnati SMSA Ltd. P'ship v. Cincinnati Bell Cellular Sys. Co., 708 A.2d 989, 992 (Del. 1998) (stating that “[t]he articulation of the standard for implying terms through application of the covenant of good faith and fair dealing represents an evolution from previous Delaware case law” and that “Delaware Supreme Court jurisprudence is developing along the general approach that implying obligations based on the covenant of good faith and fair dealing is a cautious enterprise”). See also, e.g., Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1199, 1207 (Del. 1993) (reversing the Chancery Court’s dismissal on the pleadings of plaintiff’s implied covenant claim; accepting the seemingly redundant notion that bad faith breach of the partnership agreement could breach the implied covenant; and suggesting the general partner may have acted in bad faith by “act[ing] unreasonably”). For a decision that addresses the redundancy issue, see Painewebber R & D Partners, L.P. v. Centocor, Inc., No. C.A. 96C-04-194, 1998 WL 109818, at *4 (Del. Super. Feb. 13, 1998) (“The Court is satisfied that the payment obligations of Centocor are encompassed by the express terms of the PPA and, as a matter of law, cannot be the subject of any implied covenant.”)
[iv] Cont'l Ins. Co. v. Rutledge & Co., 750 A.2d 1219, 1234 (Del. Ch. 2000) (internal quotations and footnotes omitted).
[v] Cincinnati SMSA Ltd. P'ship v. Cincinnati Bell Cellular Sys. Co., 708 A.2d 989, 992 (Del. 1998).
[vi] Daniel S. Kleinberger, Two Decades of "Alternative Entities": From Tax Rationalization Through Alphabet Soup to Contract as Deity, 14 Fordham J. Corp. & Fin. L. 445, 469 (2009) (first presented as the keynote address at the 2lst Century Commercial Law Forum – Seventh International Symposium 2007 – sponsored by School of Law, Tsinghua University, Beijing, People’s Republic of China). See also Nemec v. Shrader, 991 A.2d 1120, 1128 (Del. 2010) (“Crafting, what is, in effect, a post contracting equitable amendment that shifts economic benefits from [one set of shareholders to another] would vitiate the limited reach of the concept of the implied duty of good faith and fair dealing…. The policy underpinning the implied duty of good faith and fair dealing does not extend to post contractual rebalancing of the economic benefits flowing to the contracting parties.”); Lonergan v. EPE Holdings, LLC, 5 A.3d 1008, 1019 (Del. Ch. 2010) (criticizing and rejecting attempts to “re-introduce fiduciary review through the backdoor of the implied covenant” of good faith and fair dealing). This point is precisely what divided the majority and dissent in Nemec. The core of the dissent is this statement: “[U]nder Delaware case law, a contracting party, even where expressly empowered to act, can breach the implied covenant if it exercises that contractual power arbitrarily or unreasonably.” Nemec, at 1131 (Jacobs, J. dissenting). The statement does not recognize that the frame of reference must be the words of the contract. Cf. ULLCA (2013) § 409(d), cmt. (stating that “the purpose of the contractual obligation of good faith and fair dealing is to protect the arrangement the members have chosen for themselves, not to restructure that arrangement under the guise of safeguarding it”). But cf. HB Korenvaes Inv., L.P. v. Marriot Corp., Del. Ch., C.A. No. 12922, Mem. Op. at 11, Allen, C., (June 9, 1993) (“Indeed the contract doctrine of an implied covenant of good faith and fair dealing may be thought in some ways to function analogously to the fiduciary concept.”) (quoted in Gale v. Bershad, No. CIV. A. 15714, 1998 WL 118022, at *5 n. 24(Del. Ch. Mar. 4, 1998); Gale v. Bershad, No. CIV. A. 15714, 1998 WL 118022, at *5 (“The function of the implied covenant of good faith and fair dealing in defining the duties of parties to a contract, is analogous to the role of fiduciary law in defining the duties owed by fiduciaries.”); Blue Chip Capital Fund II Ltd. P'ship v. Tubergen, 906 A.2d 827, 832 (Del. Ch. 2006) (stating that “[t]he court [in Gale v. Bershad] explained that the implied covenant of good faith and fair dealing defines the duties of parties to a contract and is analogous to the role of fiduciary law in defining the duties owed by fiduciaries”) (citing Gale v. Bershad, No. CIV. A. 15714,.1998 WL 118022 at *5, (Del.Ch. Mar. 3, 1998)).
[vii] These points are analogous to Professor Williston’s four corners approach to determining ambiguity for the purposes of the parol evidence rule. See, e.g., Wallace v. 600 Partners Co., 86 N.Y.2d 543, 548, 658 N.E.2d 715, 717 (1995) (stating that “[t]he question whether a writing is ambiguous is one of law to be resolved by the courts” and that “excursion beyond the four corners of the document” is warranted only when the wording is not “clear and complete”) (citing Williston, 4 Williston, Contracts, § 610A, at 513 [3d ed.]). The “roving commission” notion resembles Professor Corbin’s approach to the ambiguity question. “According to Corbin, the court cannot apply the parol evidence rule without first understanding the meaning the parties intended to give the agreement. To understand the agreement, the judge cannot be restricted to the four corners of the document.” Taylor v. State Farm Mut. Auto. Ins. Co., 175 Ariz. 148, 153, 854 P.2d 1134, 1139 (1993) (citation omitted). Delaware takes the Williston approach. GMG Capital Investments, LLC v. Athenian Venture Partners I, L.P., 36 A.3d 776, 781-84 (Del. 2012) Schwartz v. Centennial Ins. Co., No. CIV. A. 5350 (1977), 1980 WL 77940, at *5 (Del. Ch. Jan. 16, 1980) (stating that “parol evidence may not be used to show an ambiguity in the first place”).
[viii] Gerber v. Enter. Products Holdings, LLC, 67 A.3d 400, 418-19 (Del. 2013) (quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440–42 (Del. Ch. 2012), aff'd in part, rev'd in part on other grounds, 68 A.3d 665 (Del. 2013)) (footnotes omitted) (citations omitted) (internal quotations omitted without ellipsis by Gerber).
[ix] Gerber v. Enter. Products Holdings, LLC, 67 A.3d 400, 418 (quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440–42 (Del. Ch. 2012), aff'd in part, rev'd in part on other grounds, 68 A.3d 665 (Del. 2013)) Del. 2013). Gerber was overruled on other grounds by Winshall v. Viacom Int'l, Inc., 76 A.3d 808 (Del. 2013). See also Gilbert v. El Paso Co., 575 A.2d 1131, 1142-43 (Del. 1990) (enforcing express conditions pertaining to a tender offer; stating that “[a]lthough an implied covenant of good faith and honest conduct exists in every contract … such subjective standards cannot override the literal terms of an agreement”).
[x] Gerber v. Enter. Prods. Holdings, LLC, 67 A.3d 400, 418 (Del. 2013) (quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440–42 (Del. Ch. 2012), aff'd in part, rev'd in part on other grounds, 68 A.3d 665 (Del. 2013)) (emphasis added) (footnotes omitted) (citations omitted) (internal quotations omitted without ellipsis by Gerber). In this respect, the implied covenant parallels the contract law doctrine of unconscionability. See Restatement (Second) of Contracts § 208 (1981) (stating that the unconscionability analysis addresses whether “a contract or term thereof is unconscionable at the time the contract is made”) (emphasis added); UCC § 2-302 (stating that the doctrine applies only if “the court finds the contract or any clause of the contract to have been unconscionable at the time it was made”) (emphasis added).
[xi] Nemec v. Shrader, 991 A.2d 1120, 1127 (Del.2010) (“The implied covenant will not infer language that contradicts a clear exercise of an express contractual right.”).
[xii] See Aspen Advisors LLC v. United Artists Theatre Co., 843 A.2d 697, 707 (Del. Ch.) aff'd, 861 A.2d 1251 (Del. 2004) (“By specific words, the parties to the Stockholders Agreement and the Warrants identified particular transactions that would provide the Warrantholders with the right to receive the same consideration paid to common stockholders (e.g., in mergers involving United Artists) and the right (if they had exercised their Warrants) to tag along (i.e., in certain change of control transactions). Similarly, the parties also (by omission) defined the freedom of action other parties to those contracts (such as United Artists, the UA Holders, and Anschutz) had to engage in transactions without triggering rights of that nature.”).
[xiii] “[T]o express or include one thing implies the exclusion of the other.” EXPRESSIO UNIUS EST EXCLUSIO ALTERIUS, Black's Law Dictionary (10th ed. 2014).
[xiv] However, whether a gap matters depends on whether a party’s conduct makes the gap apparent – i.e., whether one party’s conduct exposes an issue on which the parties would have agreed had the issue arisen when the deal was being made.
[xv] Allen v. El Paso Pipeline GP Co., L.L.C., No. CIV.A. 7520-VCL, 2014 WL 2819005, at *11 (Del. Ch. June 20, 2014) (internal quotations and citations omitted).
[xvi] In simplified form, this example reflects one of the transactions – the 2010 merger – addressed in 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).
[xvii] Allen v. El Paso Pipeline GP Co., L.L.C., No. CIV.A. 7520-VCL, 2014 WL 2819005, at *14 (Del. Ch. June 20, 2014). The opinion refers to the omission “creating a gap,” id. but the author respectfully disagrees. The gap existed ab initio. It remained hidden until revealed by the expert’s omission.
[xviii] Gerber v. Enter. Prods. Holdings, LLC, 67 A.3d 400, 418 (Del. 2013) (quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440–42 (Del. Ch. 2012), aff'd in part, rev'd in part on other grounds, 68 A.3d 665 (Del. 2013)) (emphasis added) (footnotes omitted) (citations omitted) (internal quotations omitted without ellipsis by Gerber). It might be more consistent with actual practice to revise the quoted language so that the sentence read: “The gap is filled with what the court concludes the now complaining party would have insisted on as a condition to going forward with the deal, if the party had then considered the issue in the party’s original bargaining position at the time of contracting.”
[xix] Restatement (Second) of Contracts § 261, cmt. b (1981)
[xx] See n. 66.
[xxi] In this respect, the implied covenant is similar to the unconscionability doctrine of contract law. See Restatement (Second) of Contracts § 208. cmt. b (1981) (“Traditionally, a bargain was said to be unconscionable in an action at law if it was ‘such as no man in his senses and not under delusion would make on the one hand, and as no honest and fair man would accept on the other….”) (quoting Hume v. United States, 132 U.S. 406 (1889), which in turn was quoting Earl of Chesterfield v. Janssen, 2 Ves.Sen. 125, 155, 28 Eng.Rep. 82, 100 (Ch.1750)).
Thursday, November 19, 2015
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.
Tuesday, November 17, 2015
Mohsen Manesh: Delaware’s Financial Commitment to Unlimited Freedom of Contract (Contract Is King Micro-Symposium)
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.  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”. 
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. 
* * * * *
 See Franklin Gevurtz, Why Delaware LLCs?, 91 Or. L. Rev. 57, 105 (2012).
 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).
 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).
Sandra Miller: Un-Sophisticated Parties Require Mandatory Duties at least in Publicly-Traded Entities if Not in all Entities (Contract Is King Micro-symposium)
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.
Monday, November 16, 2015
Daniel Kleinberger: Delineating Delaware’s Implied Covenant of Good Faith & Fair Dealing (Contract Is King Micro-sympsium)
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”
- 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.
- 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).
Mohsen Manesh: Strine & Laster’s “Modest” Proposal to Limit Contract’s Realm (Contract Is King Micro-Symposium)
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. But, importantly, they limit their proposal to publicly traded LLCs and LPs. 
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.  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. And it’s clear that oftentimes the courts are dismissing these cases begrudgingly, despite their own feelings of fairness. 
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.  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.
 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.”)
 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).
 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.”).
 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….”).
Jeffrey Lipshaw: Regarding Uncorporations, Is Contract a King or Mere Pretender to the Throne? (Micro-symposium)
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.
- 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 generate a lot of normative fervor about the ultimate superiority of the non-corporate form. I view all organizational and transactional structures, including corporations, LLCs, and contracts, as models or maps. 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.
The difference between city maps and word maps is that the latter are artifacts we lawyers create to chart or control a reality that, in all its damnable uncooperativeness, insists upon moving forward through time and not necessarily respecting all that hard work we did trying to map its possible twists and turns. City maps may also become obsolete over time, but streets and buildings tend not to evolve and adapt quite as quickly or fluidly as human desires and relationships. So we have fewer issues with the gaps between physical maps and physical reality (notwithstanding the desire of my car’s GPS to sell me annual updates) than with the gaps between what we want now and what we wrote down some time ago (whether by way of bylaws, operating agreement, or supply contract) to see that we got it.
Hence, if 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.
- Is the unfettered ordering in LLCs and limited partnerships – like being able to eliminate wholly all fiduciary duties among the members or partners, as Delaware permits – a good thing? Or should there be some standardized (and I presume therefore mandatory) fiduciary obligations for uncorporations, as Chief Justice Strine and Vice-Chancellor Laster suggest?
Having now gotten my general curmudgeonly-ness out of the way about the whole subject, and believing that a foolish consistency is the hobgoblin of little minds, I want to point out an area where the corporate model and its baggage indeed don’t match up to what normal human beings would expect as reasonable. I confess it’s something that has been a bug up my backside for a number of years, in that I personally had to counsel on the dilemma, and would have loved it if we had organized this particular company as a Delaware limited partnership with only limited and specified fiduciary obligations.
Here’s the circumstance. ABC Corporation spins off one of its businesses into a majority-owned subsidiary, DEF Corporation, possibly as the first step in a complete divestiture. (There’s possibly a tax benefit doing it this way, but let’s not go there right now.) DEF is now publicly traded, with a substantial minority, but ABC controls it both as to ownership (a majority share percentage) and management (posit that ABC appoints a majority of the board of the subsidiary). Assume that DEF’s common stock is now trading at, say, $15 per share on the NASDAQ. A third party, XYZ Corporation, contacts ABC’s CEO, and says the following: “We are prepared to pay $32 per share for all of DEF, both yours and the public minority, but we view this as pre-emptive, and if you shop the bid, we will walk away.” ABC’s CEO’s visceral reaction is to tell XYZ that if it will send over the check, she will deliver the share certificate this afternoon. Indeed, were DEF still wholly owned, that’s probably what would happen soon, if not that afternoon.
But Delaware corporate law doesn’t like that at all when there’s a public minority. See McMullin v. Beran, 765 A.2d 910 (Del. 2000) and Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (Del. 2009). DEF’s board is going to have to create a special committee of the independent (i.e. public) directors to undertake diligence satisfying the duty of care obligation. That committee will feel obliged to hire independent counsel and its own investment banker. It may believe that its duty requires a shopping of the bid, which could cause the pre-emptive offer to go away. But how do we know that there isn’t a $35 per share offer just waiting out there? (I commented on this in connection with Lyondell back in 2008.) As any transactional lawyer knows, time means deal risk.
I’m not suggesting that the duty of care obligations imposed by the corporate law are wrong in change of control cases, but their imposition in Smith v. Van Gorkom (where the essence of the decision was that, regardless of the attractiveness of the offer, the board went too fast and wasn’t careful enough) provoked the adoption of §102(b)(7), exculpating the directors from monetary liability on account of any breach of the duty of care largely because they were held liable in a “devil if you do – devil if you don’t” circumstance. That is to say, §102(b)(7) is an implicit acknowledgment that broad and standardized fiduciary obligations are sometimes overbroad. But there’s really no way, at least logically, to tell a board when a bid is sufficiently pre-emptive as to trump the ordinary procedural precautions.
The great benefit of Delaware LLC and LP law, in providing that the usual fiduciary duties apply as a default matter, but permitting the parties to eliminate or modify them, as one cannot under the corporate law, is precisely the customization that would have been useful here. Assuming no penalty in the market for having organized as a public limited partnership or LLC (see Blackstone Group LP), that form would have allowed the governing organizational document to waive any fiduciary obligation of the board or the majority owner in connection with the consideration of a seemingly pre-emptive offer, and avoided delay and the associated risk to the deal.
With all due respect to Chief Justice Strine and Chancellor Laster, I still don’t believe this has anything to do with the magic of private ordering in contract. As I’ve written extensively, I think there’s significant illusion among lawyers and law professors about the extent to which any text capable of colorable competing interpretations actually reflects any mutual intention even if it was the subject of arm’s-length negotiation. That’s because I tend to believe that even sophisticated parties to sophisticated contracts put in a lot of boilerplate they hope maps accurately the twists and turns of future events or, more importantly, clearly favors them if there’s ever a dispute. And when there is a later dispute, they turn to the text and hope to hell there’s something helpful in it. So I’ve never been under the misapprehension that the operating agreement or partnership agreement of a publicly held LLC or LP reflects real intentions about the resolution of later disputes any more than corporate bylaws or the rights and preferences of a class of stock.
The LLC or LP form is just an alternative map or model, with alternative rights and obligations. In the case that bugged me, it would have been a way to avoid a problem the corporate model really couldn’t quite get right. Whether that’s “contract” or something else, reinstating standardized or mandatory fiduciary obligations strikes me as eliminating the very choice the different forms were meant to offer.
Thursday, November 12, 2015
I have spent the past week immersed in whistleblower discussions. On Saturday, I served on a panel with plaintiffs and defense counsel at the ABA Labor and Employment Law Mid-Year meeting using a hypothetical involving both a nursing home employee and a compliance officer as potential whistleblowers under the False Claims Act, Dodd-Frank, and Sarbanes-Oxley. My co-panelist Jason Zuckerman represents plaintiffs and he reminded the audience both through a recent article and his presentation that Dodd-Frank has not replaced SOX, at least for his clients, as a remedy. Others in the audience echoed his sentiment that whistleblower claims are on the rise.
A fellow member on the Department of Labor Whistleblower Protection Advisory Committee, Greg Keating, represents defendants, and has noticed a significant increase in claims by in house counsel, as he told the Wall Street Journal recently. More alarmingly, a San Francisco federal judge found last month that board members can be held personally liable for retaliation under Sarbanes-Oxley and Dodd-Frank when they take part in the decision to terminate a whistleblower. This case of first impression involved the termination of a general counsel who complained of FCPA violations, but it is possible that other courts may follow the court’s reasoning, even though the judge acknowledged that it was a close call.
As the SEC continues to award whistleblower bounties to compliance officers and auditors, and as law firms continue to see in-house counsel raising concerns about their own companies, board members will have to walk the fine line between exercising appropriate oversight and not enmeshing themselves in the decisionmaking process.
Wednesday, November 11, 2015
My recent article: Locked In: The Competitive Disadvantage of Citizen Shareholders, appears in The Yale Law Journal’s Forum. In this article I examine the exit remedy for unhappy indirect investors as articulated by Professors John Morley and Quinn Curtis in their 2010 article, Taking Exit Rights Seriously. Their argument was that the rational apathy of indirect investors combined with a fundamental difference between ownership of stock in an operating company and a share of a mutual fund. A mutual fund redeems an investor’s fund share by cashing that investor out at the current trading price of the fund, the net asset value (NAV). An investor in an operating company (a direct shareholder) exits her investment by selling her share certificate in the company to another buyer at the trading price of that stock, which theoretically takes into account the future value of the company. The difference between redemption with the fund and sale to a third party makes exit in a mutual fund the superior solution over litigation or proxy contests, they argue, in all circumstances. It is a compelling argument for many indirect investors, but not all.
In my short piece, I highlight how exit remedies are weakened for citizen shareholders—investors who enter the securities markets through defined contribution plans. Constrained investment choice within retirement plans and penalties for withdrawals means that “doing nothing” is a more likely option for citizen shareholders. That some shareholders are apathetic and passive is no surprise. The relative lack of mobility for citizen shareholders, however, comes at a cost. Drawing upon recent scholarship by Professors Ian Ayres and Quinn Curtis (Beyond Diversification), I argue that citizen shareholders are more likely to be locked into higher fee funds, which erode investment savings. Citizen shareholders may also be subsidizing the mobility of other investors. These costs add up when one considers that defined contribution plans are the primary vehicle of individual retirement savings in this country aside from social security. If the self-help remedy of exit isn’t a strong protection for citizen shareholders, then it is time to examine alternative remedies for these crucial investors.
Monday, November 2, 2015
Pat Haden is the athletic director at the University of Southern California. Until Friday, he was also a member of the College Football Playoff selection committee. And, according to this story in the L.A. Times, he is also a director of at least nine non-profits or foundations and three businesses.
According to the Times, Haden spends an average of 70 hours a week on his U.S.C. job. As a playoff selection committee member, he was expected to spend countless hours watching football games and evaluating teams.
So where does he find the time to serve as a board member? Not a problem, according to Haden. He has “never been to one meeting” of some of the nonprofits he serves. And he spends “very little” time on his board positions.
Haden’s attitude is representative of an earlier era when outside directors merely showed up at meetings and nodded their head to whatever the chairman said. Those days are long gone. Today, board members are expected to spend much more time on their board duties, at the risk of liability if they don't.
Mr. Haden, a former Rhodes Scholar, is a very bright guy, but even bright guys can say stupid things. I just hope he’s never sued. (At least one of the businesses he serves as a director is a public corporation.) A plaintiff’s lawyer could use quotes like this to mince him.
In the meantime, I suggest he read something on modern corporate governance. He has a law degree, so he shouldn’t have any trouble understanding it.
Sunday, November 1, 2015
I teach both Civil Procedure and Business Associations. As a former defense-side commercial and employment litigator, I teach civ pro as a strategy class. I tell my students that unfortunately (and cynically), the facts don’t really matter. As my civil procedure professor Arthur Miller drilled into my head 25 ago, if you have procedure on your side, you will win every time regardless of the facts. Last week I taught the seminal but somewhat inscrutable Iqbal and Twombly cases, which make it harder for plaintiffs to survive a motion to dismiss and to get their day in court. In some ways, it can deny access to justice if the plaintiff does not have the funds or the will to re-file properly. Next semester I will teach Transnational Business and Human Rights, which touches on access to justice for aggrieved stakeholders who seek redress from multinationals. The facts in those cases are literally a matter of life and death but after the Kiobel case, which started off as a business and human rights case but turned into a jurisdictional case at the Supreme Court, civil procedure once again "triumphed" and the doors to U.S. courthouses closed a bit tighter for litigants.
This weekend, the New York Times published an in depth article about how the corporate use of arbitration clauses affects everyone from small businesses to employees to those who try to sue their cell phone carriers and credit card companies. Of course, most people subject to arbitration clauses don’t know about them until it’s too late. On the one hand, one could argue that corporations would be irresponsible not to take advantage of every legal avenue to avoid the expense of protracted and in some cases frivolous litigation, particularly class actions. On the other hand, the article, which as one commenter noted could have been written by the plaintiffs bar, painted a heartbreaking David v. Goliath scenario.
I see both sides and plan to discuss the article and the subsequent pieces in the NYT series in both of my classes. I want my students to think about what they would do if they were in-house counsel, board members, or business owners posed with the choice of whether to include these clauses in contracts or employee handbooks. For some of them it will just be a business decision. For others it will be a question of whether it’s a just business decision.
Friday, October 30, 2015
Jill Fisch (Penn) recently posted an essay entitled The Mess at Morgan: Risk, Incentives and Shareholder Empowerment.
The entire essay is worth reading, but I think her argument can be summed up with this quote:
This essay argues that the effort to employ shareholders as agents of public values and, thereby, to inculcate corporate decisions with an increased public responsibility is misguided. The incorporation of publicness into corporate governance mistakenly assumes that shareholders’ interests are aligned with those of non-shareholder stakeholders. Because this alignment is imperfect, corporate governance is a poor tool for addressing the role of the corporation as a public actor. (pg. 651)
Jill Fisch argues that economic regulation may be a better solution to the problem of protecting the public than shareholder empowerment. (pg. 684).
While I acknowledge the essay's mentioned limitations on shareholder empowerment, I don't think economic regulation is the only alternative solution to the problem of protecting public values. As Jill Fisch notes "shareholder empowerment might be defended on the basis that it is less intrusive than direct regulation." Corporate governance mechanisms other than shareholder empowerment may be both less intrusive and more effective than direct regulation. For example, (non-shareholder) stakeholder empowerment may make sense, as I plan to explain in a future article that is currently in its very early stages.
Thursday, October 29, 2015
Kent Greenfield, Professor of Law and Dean’s Research Scholar at Boston College Law School, recently posted a provocative piece on the CLS Blue Sky Blog (here) in which he argues, among other things, that progressives have “flipped” from supporting “corporate citizenship” pre-Citizens United, to supporting “shareholder primacy” post-Citizens United. (Kent has stressed to me that he does not believe this characterization extends to progressive corporate law scholars.) The piece is short, so I recommend you go read it before continuing on to my comments below, because I will simply be taking some short excerpts from his post and providing some responses, which will likely benefit from the reader having reviewed Kent’s post first. As just one disclaimer, Kent’s post is based on his article, “Corporate Citizenship: Goal or Fear?” – and I have not yet read that paper. Also, I consider the following to be very much an in-progress, thinking-out-loud type of project, and thus welcome all comments.
1. In 2010, the Supreme Court decided Citizens United v Federal Election Commission, ruling that corporations had a First Amendment right to spend money from general treasury funds in support of political candidates. Though seen as victory for political conservatives, the decision was in some ways based on a progressive view of the corporation. In the Court’s reasoning, corporations act as “associations of citizens” with rights of free speech.
Kent argues that the historical divide between progressives and conservatives can be viewed as one of “shareholder primacy” versus “corporate citizenship,” with progressives advocating for corporate citizenship while conservatives advance the cause of shareholder primacy. A couple of caveats are in order here. First, we must distinguish “shareholder primacy” as an assertion that shareholders should have the dominant (or at least more) controlling power within the corporation, from “shareholder wealth maximization,” which posits that the goal of corporate control is shareholder wealth maximization, independent of where the decision-making power resides. Second, we should keep in mind the competing corporate personality theories: aggregate theory, artificial entity (concession) theory, and real entity theory. I have argued in the past (see, e.g., here) that both aggregate theory and real entity theory tend to view the corporation as more private than public, with aggregate theory equating the relevant “association of citizens” with shareholders, while real entity theory looks to the board of directors – in either case positing a group of natural persons who can assert constitutional rights against government regulation. Artificial entity theory, on the other hand, views corporations as more public, at least in part because it is essentially impossible to mimic the corporate form solely through private contracting, and thus the state is entitled to more leeway in regulating corporations than natural persons acting in their purely private capacity. In light of all this, it may be better to view progressives as opposing shareholder wealth maximization as the sole goal of corporate governance, while being flexible as to the means used to achieve that end – be it shareholder primacy, director primacy, or “state primacy.” (I am not suggesting that a shift to shareholder primacy as the favored means of achieving the ends of progressive corporate governance is insignificant. Rather, I argue merely that a shift in means is less dramatic than a shift in ends, and thus less appropriately characterized as an ideological flip.) To the extent Citizens United is viewed as having merely strengthened the associational, private view of corporations without challenging the shareholder wealth maximization norm – it is hard to view it as advancing a progressive view of the corporation. In fact, it arguably stands simply as an opinion that gives more political power to corporations to pursue shareholder wealth maximization (or for managers to use shareholder wealth maximization as a justification for self-dealing) at the expense of other stakeholder concerns.
2. The biggest impediment to using the Citizens United moment to change corporate governance for the better is the progressive left.
In light of my comments above, I think there is a stronger argument to be made that the biggest impediment to changing corporate governance for the better is the continuing identification of corporations as purely private entities. It has been said that the greatest trick the devil played was convincing the world he didn’t exist. In this context, we might say the greatest trick played on progressives was convincing them their only viable choices are contractarian.
3. Justice John Paul Stevens’s dissent in Citizens United …. (perhaps unwittingly) bolsters shareholder supremacy by arguing that corporate speech should be limited in order to protect shareholders’ investments.
It may be better to view this part of Justice Stevens’s dissent as challenging the majority’s view that opening the corporate political contribution floodgates is not problematic because “corporate democracy” will address any problems. Meanwhile, Justice Stevens quotes Dartmouth College approvingly, and states that “corporations have been ‘effectively delegated responsibility for ensuring society's economic welfare,’” both of which place him squarely in the concession theory camp – despite his protestations to the contrary.
4. The irony runs the other way as well. In the 2014 Hobby Lobby case, the Court granted corporations the statutory right under the Religious Freedom Restoration Act to object to otherwise applicable regulations on religious grounds. Writing for the Court, Justice Samuel Alito recognized that corporations need not maximize the bottom line ….
Go here for my take on whether Hobby Lobby changed anything in terms of the ability of those who control corporations to pursue “socially responsible” ends. It is worth noting that a corporation’s ability to pursue “socially responsible” ends as part of an overall shareholder-wealth-maximizing strategy in light of the business judgement rule is not necessarily the same thing as concluding corporations will pursue some optimal level of “corporate citizenship,” which may rather require recognizing state power to require such activity or prohibit related harmful activity.
5. The world is flipped. Progressives are championing shareholder rights. Conservatives are planting their ideological flag on the summit of corporate citizenship.
As noted above, to the extent one views progressives as seeking more corporate social responsibility, and being willing to consider alternative methods to that end – be it shareholder primacy, director primacy, or state primacy – I do not see a significant flip here. Meanwhile, to the extent conservatives can be viewed as having supported shareholder wealth maximization as the optimal, but not sole, means to the end of lifting all ships via a rising tide, in addition to being consistently united against government regulation, there is also arguably nothing here that constitutes a significant “flip.”
Of course, generalities like “progressive” and “conservative” typically suffer from significant amounts of imprecision, and it may be that the “flip” characterization is more or less appropriate given the strand of progressive or conservative one is considering.
Wednesday, October 28, 2015
I had the honor of being invited to speak at the annual symposium for the Wayne Law Review two weeks ago. The event, which focused on Corporate Counsel as Gatekeepers, was well organized and attended--and also very stimulating. Speakers included Tony West as a keynote, a few of us academics, and a bunch of current and former practitioners--prosecutors, in-house counsel, and outside counsel.
My presentation focused on a story that bugs me--a story built on an experience I had in practice. In the story (which modifies the true facts), an executive flagrantly violates a securities trading compliance plan that I drafted in connection with a subsequent transaction that I worked on for the executive's firm. Specifically, the executive informs a friend about the transaction the day before it is announced, believing that the friend will never trade on the information. The friend trades. The incident results in a stock exchange and Securities and Exchange Commission (SEC) inquiries. No enforcement is undertaken against the firm. However, the executive signs a consent decree with--and pays a cash penalty to--the SEC and, together with the firm, suffers public humiliation via a front-page article in the local newspaper (since the SEC would not agree to forego a press release). This fact pattern gnaws at me because I wonder whether there is anything more legal counsel can do to prevent an executive from violating a compliance policy to the detriment of himself and the firm . . . .
Earlier this month BLPB editor Ann Lipton wrote about the Delaware Supreme Court opinion in Sanchez regarding director independence (Delaware Supreme Court Discovers the Powers of Friendship). On the same day as the Del. Sup. Ct. decided Sanchez, it affirmed the dismissal of KKR Financial Holdings shareholders' challenge to directors' approval of a buyout. The transaction was a stock-for-stock merger between KKR & Co. L.P. (“KKR”) and KKR Financial Holdings LLC (“Financial Holdings”). Plaintiffs alleged that the entire fairness standard should apply because KKR was a controlling parent in Financial Holdings. The controlling parent argument hinged on the facts that:
Financial Holdings's primary business was financing KKR's leveraged buyout activities, and instead of having employees manage the company's day-to-day operations, Financial Holdings was managed by KKR Financial Advisors, an affiliate of KKR, under a contractual management agreement that could only be terminated by Financial Holdings if it paid a termination fee.
Chief Justice Strine, writing an en banc opinion for the Court, upheld Chancellor Bouchard's finding that KKR could not be considered a controlling parent where "KKR owned less than 1% of Financial Holdings's stock, had no right to appoint any directors, and had no contractual right to veto any board action."
The Delaware Supreme Court upheld the familiar standard of effective control, absent a majority, which focuses on "a combination of potent voting power and management control such that the stockholder could be deemed to have effective control of the board without actually owning a majority of stock."
Chancellor Bouchard had noted that plaintiff's complaint stemmed from dissatisfaction at the contractual relationship between KKR and Financial Holdings which limited the growth of Financial holdings. Chancellor Bouchard wrote:
At bottom, plaintiffs ask the Court to impose fiduciary obligations on a relatively nominal stockholder, not because of any coercive power that stockholder could wield over the board's ability to independently decide whether or not to approve the merger, but because of pre-existing contractual obligations with that stockholder that constrain the business or strategic options available to the corporation.
Sometimes a "nothing new" case provides a good reminder of an established standard and provides clear language for recapping the concept to students. This will become a note case on "effective" control in my ChartaCourse corporations casebook and also a good illustration of the role of private agreements in shaping how legal standards are applied.
You can read the opinion at: Corwin et al. v. KKR Fin. Holdings et al., No. 629, 2014, 2015 WL 5772262 (Del. Oct. 2, 2015).
Thursday, October 22, 2015
Regular readers know that I write a lot about business and human rights and that I have posted about a number of lawsuits brought in California alleging violations of consumer protection statutes and false advertising claiming that companies fail to disclose the use of child slavery on their packaging. The complaints allege that consumers are deceived into "supporting" the child slave labor trade. The latest class action has been filed against Hershey, Mars, and Nestle. Back in 2001, these companies and several others signed the Engel-Harkin Protocol (drafted by Congressman Engel) in an effort to avoid actual FDA legislation regarding "slave-free" labeling. Nestle has touted its work with some of the world's biggest NGOs to help clean up its supply chain for all of its human rights issues, not just in the cocoa industry. Nestle denies the allegations and actually has an extensive action plan related to child labor. Mars and Hershey also denied the allegations.
I am curious as to whether shareholders demand action from the boards of these companies or if the steady stream of litigation being filed in California causes companies to invest more in supply chain due diligence or to change where and how they source their materials. The real question is whether consumers actually care. Today I conducted an unscientific poll. I asked my business associations and civil procedure students to vote on whether they would continue to buy their favorite chocolate if they knew that child slaves were used in the cocoa harvesting. I made them close their eyes so they wouldn't feel self-conscious about their answers and asked for their honest feedback. About 90% of students in both classes said that they wouldn't buy the products. We will see what happens to their moral outrage if I bring in Halloween candy next week. My business associations students also believed that shoppers who saw signs in grocery stores about child slaves wouldn't buy the candy either. This is in fact the theory behind many of the name and shame campaigns such as Dodd-Frank conflict minerals.
Maybe it does work. I am against the Dodd-Frank legislation for a variety of reasons, but when one of my students came in my office a few minutes ago and pointed out my Soda Stream bottle she said "you know that there is a huge conflict with that company and Israel, right"? I admitted that I knew. And yes, I am going to Bed, Bath, and Beyond this weekend to buy another brand. I have been shamed, even if she didn't intend to so do.
Wednesday, October 14, 2015
Fellow BLPB editor Haskell Murray highlighted Laureate Education's IPO (here on BLPB) last week as the first publicly traded benefit corporation. Steven Davidoff Solomon, the "Deal Professor" on Dealbook at NYT, focused on the interesting issues that can be raised by public benefit corporations in his article, Idealism That May Leave Shareholders Wishing for Pragmatism, which appeared yesterday. Among the concerns he raised were the vagueness of the "benefit"provided by the company, the potential laxity or at least untested waters of benefit auditing, and the potential for management rent seeking at the expense of shareholder profit in the new form. Davidoff Solomon, who (deliciously and derisively) dubs benefit corporations the "hipster alternative to today’s modern company, which is seen as voracious in its appetite for profits," is certainly skeptical. But the concerns are valid and will have to be worked out successfully for this hybrid form to carve out a place in the securities market. What I found particularly interesting was his focus on the role of institutional investors, who as fiduciaries for their individual investors, have fiduciary obligations to pursue profits which may be in conflict with or at least require greater monitoring when investing in these alternative firms. The question of institutional investors' appetite for alternative purpose firms, like benefit corporations, is the focus of a recent article of mine, Institutional Investing When Shareholders Are Not Supreme, and a big question for the future success of these firms.
For those of you wanting to highlight alternative firms in a general corporations course or a seminar, this article would be a good introduction and an accessible summary of the issues on the forefront. I will be including this in my seminar reading next semester as it is surely to generate discussion.
Sunday, October 11, 2015
Between the US Supreme Court's decision to let Newman stand and the Delaware Supreme Court's Sanchez decision, the intersection of friendship and corporate governance has been a hot topic this past week. While the commentary has been enlightening, it's always good to reflect on the primary sources. To that end, I have collected below a series of what I perceive to be interesting quotes from the relevant opinions as follows (I also included an excerpt from a law review article referencing Reg FD, which has something to say about the extent to which we need to protect insider communications with analysts):
1. Dirks v. S.E.C.,
2. United States v. Newman,
3. United States v. Salman,
4. Delaware Cnty. Employees Ret. Fund v. Sanchez,
5. Dirks v. S.E.C. (dissent, excerpt 1),
6. Dirks v. S.E.C. (dissent, excerpt 2), and
7. Donna M. Nagy & Richard W. Painter, Selective Disclosure by Federal Officials and the Case for an Fgd (Fairer Government Disclosure) Regime.
Obviously, Sanchez may be viewed as an outlier here, but perhaps this will spur some creative work on how the standard for director independence might inform the standard for improper tipping or vice versa.