Saturday, May 28, 2016
A former law student of mine who practices in Delaware just alerted me to this Delaware Online article.
The article describes the proposed bill as follows:
House Bill 371 would restrict the number of corporate shareholders who can petition the court for a stock appraisal to only those who own $1 million or more of a company's stock or 1 percent of the outstanding shares, depending on which is less. Currently, any shareholder can ask the court to appraise their shares. Those motions are typically filed when a company is the target of an all-cash acquisition and the shareholder wants to ensure the buyer is paying a fair price for the stock. (emphasis added)
Corporate governance expert Charles Elson is quoted as saying:
. . . he understands the argument on both sides. "Anytime you attempt to restrict the rights of a smaller shareholder, it is going to be controversial whether or not the approach is warranted"
The article cites co-authored work by my Nashville neighbor, Randall Thomas (Vanderbilt Law):
A study published earlier this month by four noted corporate law professors, including Wei Jang of Columbia Business School and Randall S. Thomas of Vanderbilt Law School, found that hedge funds have accounted for nearly 75 percent of the amount awarded in all appraisal actions over the last few years. The study also found that 32 percent of the cases involved stakes below $1 million or 1 percent of a company's stock.
Go read the entire article.
Wednesday, May 4, 2016
In follow up to my post yesterday, my trusted and valued co-blogger Joan Heminway asked a good question (as usual) based one of my comments. My response became long enough that I thought it warranted a follow-up post (and it needed formatting). Joan commented:
you say: "there should be no problem if, for example, Delaware corporate law did not allow a for-profit entity to exercise religion for the sole sake of religion. I think that is the case right now: that’s not a proper corporate purpose under my read of existing law." Are you implying that a corporate purpose of that kind for a for-profit corporation organized in Delaware would be unlawful? Can you explain?
My response: I am suggesting exactly that, though I concede one might need a complaining shareholder first. My read of eBay, and Chief Justice Strine’s musing on the subject, suggest that an entity that is run for purposes of religion (not shareholder wealth maximization) first and foremost, is an improper use of the Delaware corporate form. (“I simply indicate that the corporate law requires directors, as a matter of their duty of loyalty, to pursue a good faith strategy to maximize profits for the stockholders.”) Chancellor Chandler explained in eBay:
The corporate form in which craigslist operates, however, is not an appropriate vehicle for purely philanthropic ends, at least not when there are other stockholders interested in realizing a return on their investment.
I think this definition of philanthropic easily includes religious ends (or should).
Chancellor Chandler continued:
Jim and Craig opted to form craigslist, Inc. as a for-profit Delaware corporation and voluntarily accepted millions of dollars from eBay as part of a transaction whereby eBay became a stockholder. Having chosen a for-profit corporate form, the craigslist directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders.
I don’t see how this should play any differently if it applied to religion. Consider, for example, this possible spin:
Jane and Carrie opted to form Religion, Inc., as a for-profit Delaware corporation and voluntarily accepted millions of dollars from BigCo as part of a transaction whereby BigCo became a stockholder. Having chosen a for-profit corporate form, the Religion directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders.
Further to the point, Chancellor Chandler added:
I cannot accept as valid . . . a corporate policy that specifically, clearly, and admittedly seeks not to maximize the economic value of a for-profit Delaware corporation for the benefit of its stockholders—no matter whether those stockholders are individuals of modest means or a corporate titan of online commerce.
Thus, a for-profit business can be religious in nature—e.g., make religious books or products or sponsor religious seminars—but as a Delaware corporation, the purpose of the entity must be to “promote the value of the corporation for the benefit of its stockholders.”
This is the potential problem with the Hobby Lobby case as to Delaware law. There, the companies had a lot to lose:
If they and their companies refuse to provide contraceptive coverage, they face severe economic consequences: about $475 million per year for Hobby Lobby, $33 million per year for Conestoga, and $15 million per year for Mardel. And if they drop coverage altogether, they could face penalties of roughly $26 million for Hobby Lobby, $1.8 million for Conestoga, and $800,000 for Mardel.
These losses were justified in that case as being necessary to exercise religion, and not to further a corporate purpose. Of course, they had to make that claim, because otherwise they couldn’t get the benefit of RFRA, which requires demonstrating “an honest conviction,” which could be problematic if the reason was couched in business terms, and not religious ones.
Incidentally, I think the business judgment rule should probably protect this decision, anyway, but I don’t know that Delaware law would support that view. In fact, it shouldn't based in recent case law, and I think plainly eBay says no on that one. The Supreme Court says RFRA protects the right to pursue religious ends. It doesn't mean Delaware law does. (Note: Hobby Lobby is not a Delaware entity, so the rules are admittedly different.)
Thus, my fix seek to balance these competing possible outcomes. Tell shareholders your plan, and they can’t question it later, even if that plan costs the company $475 million in losses. Where the law has evolved, I don't think it's fair to suggest it was part of the bargain for all companies, thought maybe investors in Hobby Lobby did know. But it doesn't matter. I thought craigslist’s long-standing business plan was sufficient notice, too. Chancellor Chandler disagreed.
Tuesday, April 12, 2016
There are those I-need-to-pinch-myself moments in life that come along every once in a while. I was lucky enough to have one last week. I was invited to attend a conference and comment on two interesting draft papers written by two law faculty colleagues whose work I have long admired and who are lovely people. And the location was Miami Beach. Does it get any better than that for a law professor who likes the beach? I think not.
The event was the annual conference for the Institute for Law and Economic Policy (ILEP). The conference theme was "Vindicating Virtuous Claims." The papers will be published in the Duke Law Journal, which co-sponsored the program.
I will save details on the papers for later (when the papers are finalized). But I will briefly describe each here. The first paper on which I commented, written by Rutheford B ("Biff") Campbell (University of Kentucky College of Law), argues for federal preemption of state securities regulation governing the offer and sale of securities, since federal preemption would be more efficient. The second paper, written by James D. ("Jim") Cox (Duke University School of Law, who was honored at the event and received the most amazing tribute from his Dean, David Levi, at the closing dinner), argues for attaching more value to the normative effects of judicial decisions arising out of indeterminate doctrine (using materiality and the business judgment rule as core examples). I know that last part is a mouthful, but read it again, and I think you'll get it . . . .
Both papers were intellectually stimulating, and both scholars were quite engaging in their presentations. The other invited commentators were interesting and thought-provoking. And the day was filled overall with other interesting academic paper panels and a lively keynote lunch speaker. Together with the panel discussion on the evolution of Rule 23 and dinner the night before, it was an action-packed, invigorating conference!
. . . And then there was the time I spent after the conference recollecting myself (and writing student bar recommendation letters). The weather was cooperative (downright sunny and warm), and the surroundings at the hotel (food, accommodations, etc.) were fabulous. My Facebook friends got tired of my colorful photos and happy posts, especially since many of those folks were in locales further North and to the East in which it was cold and snowing on Saturday or Sunday.
So, I am taking this opportunity to note and celebrate my good fortune on, and to offer thanks for, being invited to the ILEP conference to comment on the forthcoming scholarly work of two great business law colleagues. I met some fascinating, pleasant new people among the conference constituents (from the bench, bar, and academy). And I enjoyed time on a chaise lounge. [sigh] But now, it's back to the reality of the final few weeks of the semester. I wish everyone the best in pushing through.
Tuesday, March 15, 2016
In my Energy Business: Law & Strategy course, I use Larry A. DiMatteo's article, Strategic Contracting: Contract Law as a Source of Competitive Advantage, 47 Am. Bus. L.J. 727 (2010). I have been using the article in the class since 2012 (this is the third time I have taught it), and I think it does a great job of providing a theoretical backdrop for practical application. I teach the article in combination with a one-sided proposed Memorandum of Understanding to help students think about the contracting process and and the long-term implications of what might seem like a small-scale negotiation. I highly recommend the piece.
In reading the article this time around, though, I was struck by how differently the piece treats limited liability companies (LLCs) and corporations and the way concerns about opportunistic behavior are raised in the context of the latter. In one portion of the article, DiMatteo notes:
Corporate strategy that fails to take account of the strategic use of law is likely to waste opportunities for competitive advantages. A corporate legal strategy can be used to gain competitive advantages both internally and externally.
I wholeheartedly agree, and this is part of the reason I teach my course. Although I don't think this is true of just "corporate" strategy, because the same applies to other entities, such as educational institutions, environmental organizations, LLCs, and even governments. Regular readers will not be surprised that I would choose to start the sentence "entity strategy" instead of "corporate strategy, " but his point is still well taken.
Later in the piece, Prof. DiMatteo takes the following position with regard to LLCs:
The freedom of contract paradigm that underlies LLCs allows for broad flexibility in strategically drafting the operating agreement. I will make a distinction here between proper and improper strategic drafting, because a distinction based on legality is insufficient. That is, improper terms may be perfectly legal under some states’ LLC statutes. The argument here is that the freedom of contract construct can lead to contractual abuse, albeit a legally sanctioned abuse. For example, a combination of clauses could be inserted into the operating agreement that strips nonmanager members of all power and protections, such as removal of fiduciary duties relating to the managing member, an indemnification clause to protect the managing member from liability for malfeasance, and a clause providing that the nonmember managers have no right to withdraw or to seek dissolution. These types of provisions may be legal under some statutory schemes, but strict enforcement of these clauses by the managing member would be abusive.
I fail to see why strategic use of law in this context is more problematic than the strategic use of law in other contexts. I do understand and validate concerns about on-going expectations of fiduciary protections related to entities, and that is why, as I have suggested previously, that the lack of fiduciary duties and post-formation changes to fiduciary duties (especially loyalty) should include disclosure and perhaps other structural protections. (I am less concerned about those forming the entity agreeing to limit or eliminate fiduciary duties because they are agreeing to the option at formation when they can object or walk away.) Still, I don't see any reason that freedom of contract in LLCs is fundamentally different from freedom of contract in any other setting, at least as along as you account for a potential knowledge gap about fiduciary duties. In contrast, I liked how Larry Ribstein framed the question of possible promoter liability for LLCs in New York, where he argued that one could make a complaint that "alleged a misrepresentation which would be actionable without implying a fiduciary duty."
I do agree with Prof. DiMatteo when he says, "In the end, contracts can be a strategic tool in obtaining a competitive advantage, or they can be a tool to support collaboration by minimizing the opportunities for advantage taking." Freedom of contract in LLC formation embraces both of these concepts, too. I just think that those forming the entity should be the ones to determine which path they will take.
Friday, February 19, 2016
I haven't seen his name on any of the short lists to replace Justice Scalia, but I would love to see the current Chief Justice of the Delaware Supreme Court, Leo Strine, get the nomination.
The benefits of nominating Chief Justice Strine include:
- Promise of an entertaining nomination process. With all that he has said and written, there would be a lot of fodder, but he would be sure to hold his own.
- A nominee whose wit and writing style could rival Justice Scalia's.
- Diversity. Chief Justice Strine went to Penn for law school, not Harvard or Yale. (Granted, he does teach at Harvard).
- Serious corporate law knowledge, and, at least on this blog, we know the Supreme Court of the United States needs help in this area.
- Extremely bright, curious, and widely read. He likely has knowledge of and an opinion on most areas of law, well outside of just corporate law.
Anyway, I am sure President Obama will go with a more conventional pick, but I do hope to see a Supreme Court justice with corporate law expertise on the court eventually.
Wednesday, February 10, 2016
New Scholarship on Hedge Fund Activism Urges Courts to Adopt Enhanced Scrutiny of Boards' Defensive Actions
Bernard Sharfman, in his new article on SSRN, The Tension Between hedge Fund Activism and Corporate Law, argues that hedge fund activism for control of a publicly traded corporation is a positive corrective measure in corporate governance. After asserting that hedge fund activism should be permitted, Sharfman, argues, controversially, that courts should depart from traditional deference to a corporate board's decision making authority under the business judgment rule. Alternatively, Sharfman urges courts to adopt a heightened standard of scrutiny when reviewing defensive board actions against hedge funds.
[Hedge Fund Activism] has a role to play as a corrective mechanism in corporate governance and it is up to the courts to find a way to make sure it continues to have a significant impact despite the courts’ inclination to yield to Board authority. In practice, this means that when the plaintiff is an activist hedge fund and the standard of review is the Unocal test because issues of control are present, a less permissive approach needs to be applied, requiring the courts to exercise restraint in interpreting the actions of activist hedge funds as an attempt to gain control.
If there are no issues of control, then Board independence and reasonable investigation still needs to be the focus. That is, before the business judgment rule can be applied, the courts need to utilize an enhanced level of scrutiny in determining whether the Board is truly independent of executive management or any other insider such as a fellow Board member. As previously discussed, Board independence is critical to maximizing the value of HFA. Moreover, reasonable investigation of the activist hedge fund’s recommendations should be required to justify Board action taken to mute the fund’s influence. Like the Unocal test, the burden of proof for establishing independence and reasonable investigation needs to be put on the Board. In sum, what is required in the court’s review of Board actions to mute the influence of an activist hedge fund is something similar to the first prong of the Unocal test except independence and reasonable investigation is now focused on the Board’s evaluation of the fund’s recommendations, not the threat to corporate policy and effectiveness.
Sharfman uses Third Point LLC v. Ruprecht, the 2014 Delaware case invovling Sotheby's poison pill, to illustrate how the traditional (deference) standard of review leads to boards being able to defeat hedge fund activists.
An interesting comment published in the Yale Law Journal by Yale Law Student Carmen X.W. Lu, Unpacking Wolf Packs, offers an alternative view of the Third Point case emphasizing the coalition of hedge funds acting in that case and the court's skepticism of wolf pack activist investors.
This week, Delaware Governor Jack Markell nominated Joseph R. Slights, III for the position held by retiring Vice Chancellor John Noble on the Delaware Court of Chancery.
Judge Slights previously served a 12-year term on the Delaware Superior Court. Immediately prior to his nomination, Judge Slights was a commercial litigation partner at the firm of Morris, James, Hitchens & Williams LLP.
Once Vice Chancellor Noble retires, Vice Chancellor Laster will become the judge with the most experience serving on the Delaware Court of Chancery. Vice Chancellor Laster was sworn into his position in October of 2009. It has been a quick 6+ years; it seems like that was just yesterday.
I outsource the details of Joseph Slights' nomination below:
Wednesday, January 20, 2016
Second Circuit Affirms High Misconduct Standard for Caremark Claims in Cent. Laborers’ Pension Fund v. Dimon
In early January, the Second Circuit Court of Appeals ruled in Cent. Laborers’ Pension Fund v. Dimon to affirm the dismissal of purported shareholder derivative claims alleging that directors of JP Morgan Chase--the primary bankers of Bernard L. Madoff Investment Securities LLC (“BMIS”) for over 20 years--failed to institute internal controls sufficient to detect Bernard Madoff’s Ponzi scheme. The suit was dismissed for failures of demand excuse. Plaintiffs contended that the District Court erred in requiring them to plead that defendants “utterly failed to implement any reporting or information system or controls,” and that instead, they should have been required to plead only defendants’ “utter failure to attempt to assure a reasonable information and reporting system exist[ed].” (emphasis added). The Second Circuit declined, citing to In re General Motors Co. Derivative Litig., No. CV 9627-VCG, 2015 WL 3958724, at *14–15 (Del. Ch. June 26, 2015), a Chancery Court opinion from earlier this year that dismissed a Caremark/oversight liability claim. In In re General Motors the Delaware Chancery Court, found that plaintiffs' allegations that:
[T]he Board did not receive specific types of information do not establish that the Board utterly failed to attempt to assure a reasonable information and reporting system exists, particularly in the case at hand where the Complaint not only fails to plead with particularity that [the defendant] lacked procedures to comply with its . . . reporting requirements, but actually concedes the existence of information and reporting systems. . . .
In other words, the Plaintiffs complain that [the defendant] could have, should have, had a better reporting system, but not that it had no such system.
The Second Circuit's opinion in Central Laborers' affirms that Caremark claims require allegations misconduct sufficient to satisfy a failure of good faith, and cannot rest solely on after-the-fact allegations of failed reasonableness of the corporate reporting system.
Wednesday, January 13, 2016
This post highlights SIGA Technologies, Inc. v. PharmAthene, Inc., Del. Supr., No. 20, 2015 (Dec. 23, 2015).
At the end of 2015, the Delaware Supreme Court issued an opinion affirming its earlier holding that where parties have agreed to negotiate in good faith, a failure to reach an agreement based upon the bad faith of one party entitles the other party to expectation damages so long as damages can be proven with "reasonable certainty."
Francis Pileggi, on his excellent Delaware Commercial and Business Litigation blog, provides a succinct summary of the case, available here. The parties to the suit entered into merger negotiations to develop a smallpox antiviral drug. Due to the uncertainty of the merger negotiations, the parties also entered into a non-binding license agreement, the terms of which would be finalized if the merger fell through for whatever reason. While nonbinding, the preliminary license agreement contained detailed financial terms and benchmarks. When the merger was terminated, SIGA proposed terms for a collaboration that departed from the preliminary license agreement. The Delaware Supreme Court affirmed the Court of Chancery finding that SIGA's acted in bad faith. The question of the case became what damages were due from the bad faith breach of a preliminary agreement to "negotiate in good faith,” when all essential terms have not been agreed to by the parties?
The first gem in the opinion, and something I'll be working into my damages lectures for first year contracts this spring, is that:
when a contract is breached, expectation damages can be established as long as the plaintiff can prove the fact of damages with reasonable certainty. The amount of damages can be an estimate.
What constitutes reasonable certainty changes whether the party is establishing damages are due versus the amount of the damages. And here is the second gem: the standard of proof can be lessened where willful wrongdoing contributed to the breach and the uncertainty about the amount of damages.
where the wrongdoer caused uncertainty about the final economics of the transaction by its failure to negotiate in good faith, willfulness is a relevant factor in deciding the quantum of proof required to establish the damages amount.
Wednesday, January 6, 2016
The AALS Annual meeting starts today in New York. The full program is available here, and listed below are two Section meeting announcements of particular interest to business law scholars:
Thursday, January 7th from 1:30 pm – 3:15 pm the SECTION ON AGENCY, PARTNERSHIP, LLC’S AND UNINCORPORATED ASSOCIATIONS, COSPONSORED BY TRANSACTIONAL LAW AND SKILLS will meet in the Murray Hill East, Second Floor, New York Hilton Midtown for a program titled:
"Contract is King, But Can It Govern Its Realm?"
The program will be moderated by Benjamin Means, University of South Carolina School of Law. Discussants include:
- Joan M. Heminway, University of Tennessee College of Law
- Lyman P.Q. Johnson, Washington and Lee University School of Law
- Mark J. Loewenstein, University of Colorado School of Law
- Mohsen Manesh, University of Oregon School of Law
- Sandra K. Miller, Professor, Widener University School of Business Administration, Chester, PA
BLPB hosted an online micro-symposium in advance of the Contract is King meeting. The wrap up from this robust discussion is available here.
Friday January 8th, from 1:30 pm – 3:15 pm join the SECTION ON BUSINESS ASSOCIATIONS AND LAW
AND ECONOMICS JOINT PROGRAM at the Sutton South, Second Floor, New York Hilton Midtown for a program titled:
"The Corporate Law and Economics Revolution Years Later: The Impact of Economics and Finance Scholarship on Modern Corporate Law".
The program will be moderated by Usha R. Rodrigues, University of Georgia School of Law, and feature the following speakers:
- Frank Easterbrook, Judge, U.S. Court of Appeals for the Seventh Circuit, Chicago, IL
- H. Kent Greenfield, Boston College Law School
- Roberta Romano, Yale Law School
- Tamara C. Belinfanti, New York Law School
- Kathryn Judge, Columbia University School of Law
- K. Sabeel Rahman, Brooklyn Law School
At the conclusion of the program, the officers of the Section on Business Associations would like to honor 13 faculty members
for their mentorship work throughout the year.
I hope to see many of you in New York soon!
January 6, 2016 in Anne Tucker, Conferences, Corporate Governance, Corporations, Delaware, Financial Markets, Joan Heminway, Law and Economics, Law School, Teaching, Unincorporated Entities | Permalink | Comments (0)
Kent Greenfield recently published a provocative article with Democracy on ending Delaware's dominance over corporate law. As is Greenfield's way, he makes a familiar story sound fresh and raises an interesting question. Is it democratic for a state with less than 1% of the country's population to have its laws control more than half of the Fortune 500 companies? Greenfield says no.
Power without accountability has no democratic legitimacy. If companies could choose which state’s environmental, employment, or anti-discrimination law applied to them, we’d be outraged. We should be similarly outraged about Delaware’s dominance in corporate law.
Greenfield suggests two alternative paths for ending Delaware's dominance. First: states could amend their business organization statutes so that the law of the state of incorporation (Delaware) doesn't govern the corporation, rather the law of the principal place of business would. Second, and perhaps more radically, nationalize corporate law.
The undemocratic critique is an astute observation. It takes the debate outside of the "race to the bottom" standard trope and into territory with perhaps more broad public appeal. Leaving aside the state competition for headquarters, tax base and jobs with solution one and potential political friction with solution two, both solutions address the undemocratic critique.
Tuesday, January 5, 2016
Some day, I may tire of calling out courts (and others) that refer to limited liability companies (LLCs) as "limited liability corporations, but today is not that day. Looking back on 2015, I thought I'd take a quick look to see who the worst offenders were, starting with the state courts. I figured I'd start with Delaware.
As a state that is proud of its status as a leader as a key forum of choice for corporations, and Delaware has done well for uncorporations, as well, it seemed logical. The book Why Corporations Choose Delaware, written by Lewis S. Black, Jr., and printed and distributed by the Delaware Department of State, Division of Corporation, explains:
Delaware continues to be the favored state of incorporation for U.S. businesses. Delaware has been preeminent as the place for businesses to incorporate since the early 1900s, and its incorporation business, supplemented by the growth in numbers of such “alternative entities” as limited liability companies, limited partnerships and statutory trusts, continues to grow smartly.
And Delaware does have a generally well-informed and skilled judiciary. Still, even Delaware is not above calling an LLC a "limited liability corporation." Better than many jurisdictions, Westlaw reports that the state had just three cases in 2015 making that error, and no such mistakes were noted after March 2015. Not ideal, but not bad.
Here are some other states I reviewed for 2015 (again, using Westlaw):
- Michigan: 0
- Pennsylvania: 3
- Ohio: 4
- Florida: 5
- Nevada: 6
- California: 7
- New York: 7
- Texas: 8
Overall, state courts called LLCs "corporations" 105 times in 2015. Federal courts did the same 280 times in 2015. As such, it works out to just over once a day that some U.S. court is making this mistake.
Big picture, given the number of cases courts see each year, it may seem that these are small numbers. Not really. A search of federal courts for the term "limited liability company" turns up 2949 cases from 2015, which suggests that around 10% of cases (9.49%) referring to LLCs in some substantive manner made a reference to a "limited liability corporation." NOTE: If one searches for "LLC," the number of cases exceeds 10,000 for 2015, but I decided that a court taking the time to spell out "limited liability company" suggested that the entity choice had a heightened relevance to the case.
At the state level, the numbers are a little better. State courts referred to "limited liability companies" 1691 times in 2015. With 105 cases calling an LLC a corporation, that works out to just over 6% of the time. Not great, but a substantial improvement.
I admit this is not a scientific review of the data and I am making some assumptions, but the sheers number do, I think, support the notion that all our courts can do better on this issue. And give state courts credit -- although federal courts are often viewed the more prestigious courts, state courts are holding their own on this issue. Perhaps state courts are a little more careful because entities are generally (though not always) creatures of state law.
This is not, I am sure, just the courts. I suspect a lot of these errors come from attorneys who call LLCs corporations, then the court just take their lead. Still not okay, but I can imagine that some courts just follow the lead of those arguing the cases before them on such issues.
So, for 2016, I issue a challenge to all U.S. courts and the lawyers who practice in them: let's cut these numbers in half! (I'd like them to go to zero, but one needs to be somewhat realistic, right?)
Wednesday, December 2, 2015
I so often find Keith Bishop's blog, California Corporate & Securities Law, both informative and entertaining. Monday's post in that forum is no exception. In that post, Keith describes three important principles of Delaware corporate law that are not codified in the General Corporation Law of the State of Delaware (commonly and fondly known as the Delaware General Corporation Law or DGCL). No surprise, but the three principles he identifies and describes are:
- the business judgment rule;
- derivative suit pleading requirements; and
- the intermediate standard of review applicable in certain limited fiduciary duty actions.
Great list. And I agree with what he says.
Of course, anyone who teaches corporate law has had to consider (and, to sone degree, call out) the areas of that body of law that derive from decisional, rather than statutory, law. I often have been heard to say, in the basic Business Associations course, that if students forget--or need to leave behind--one of the two required texts (a casebook and a statutory resource book) when they come to class, most days, they should forget/leave behind the casebook, since it is more important for them to have the statutory law in front of them to answer most Business Associations law questions. I note, however, that there are two large areas of exception: veil piercing and fiduciary duty. For those two doctrinal areas, I inform them that they won't need the statutory resource book as much as the casebook.
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.
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.
Daniel Kleinberger: Delineating Delaware’s Implied Covenant of Good Faith and Fair Dealing Part III (Contract Is King)
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. 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. 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.” 
The rejected notion arose from on an overbroad reading of Nemec v. Shrader  – 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.” Invoking Section 1101(d) of the Delaware Revised Uniform Limited Partnership Act, 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.’”
Some agreements contain express good faith provisions but omit to define the concept. Such omissions render the agreement ambiguous  and impose on the courts an interpretative task that involves looking not only to other, related provisions in the agreement  but also to the negotiations, if any, and other circumstances that led up to the agreement being made. A few Delaware cases have even resorted to the corporate fiduciary duty concept of good faith. 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.”
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).
 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.”)
 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)
 Id., at 420, n. 48.
 Nemec v. Shrader, 991 A.2d 1120 (Del. 2010).
 Gerber, 67 A.3d at 420, n. 48.
 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).
 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.
 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”).
 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”).
 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”).
 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).
 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.
 ULLCA (2013) § 105(c)(6).
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).