Wednesday, September 28, 2016
On Monday, Doug Moll posted a great question about RUPA 404(e), which also got some great comments. I started to write a reply comment, but it got so long, I though it worked better as a separate post. Doug asks the following (whole post here):
Under the “cabining in” language of RUPA (1997), the action has to fit within § 404(b) to be considered a breach of the duty of loyalty. Section 404(b)(1) prevents the “appropriation of a partnership opportunity.” When a partner attempts to block the partnership from taking an opportunity to protect the partner’s own related business, can it be argued that the partner is, at least indirectly, seeking to appropriate the opportunity for himself?
Alternatively, might the partner’s vote violate the § 404(b)(3) obligation to “refrain from competing with the partnership”?
Here's where I come out it:
As I think about it, I am with Frank Snyder's comment that "a partner is entitled to pursue her own interests in voting her partnership interest, unless there's some agreement to the contrary." I also think, though, that § 404(e) sanctions self-interested votes, subject to “the obligation of good faith and fair dealing” required under § 404(d).
So, I am not that troubled by the example from the comments that Doug cites, though I see where his concern comes from. To repeat the comment:
For example, a partner who, with consent, owns a shopping center may, under subsection (e), legitimately vote against a proposal by the partnership to open a competing shopping center.
First, because it’s clear that the partner first got consent to own the shopping center, the partner is not competing with the partnership, as I see it. Actually, the partnership wants to compete with the existing center, which one partner owns with consent of the partnership. As such, because of the consent, I don’t think § 404(b)(3) is a concern here. Section 404(e) says a self-interested vote is permissible, so the question is whether such a vote is consistent with the obligation of good faith and fair dealing from § 404(d).
Given that the partnership consented to ownership of the shopping center, it seems that the rest of the partnership would reasonably expect that the partner would not be excited to create a competitive shopping center. With this knowledge on both sides, it seems to me that casting a vote against a new shopping center can occur in good faith and mean the partner dealt fairly. The rest of the partnership can still proceed with the plan if they have enough votes under the partnership agreement, and if not (e.g., unanimous vote was needed), too bad.
Even without disclosure and consent, this might be permissible. Suppose existing partnership A owns a car dealership. The dealership was a Pontiac, Oldsmobile, and Saturn, dealer, and they are done and new use for the property will be needed. Suppose that one of the partners also owns a shopping center with another group of people, as part of partnership B. Should that partner be precluded from voting against converting the dealership in partnership A to a shopping center? I don’t think so.
In addition, Gottacker v. Monnier, 697 N.W.2d 436 (Wis. 2005) provides an interesting LLC parallel to this situation. Under the Wisconsin LLC act, the court says:
We determine that the WLLCL does not preclude members with a material conflict of interest from voting their ownership interest with respect to a given matter. Rather, it prohibits members with a material conflict of interest from acting in a manner that constitutes a willful failure to deal fairly with the LLC or its other members. We interpret this requirement to mean that members with a material conflict of interest may not willfully act or fail to act in a manner that will have the effect of injuring the LLC or its other members. This inquiry contemplates both the conduct along with the end result, which we view as intertwined. The inquiry also contemplates a determination of the purpose of the LLC and the justified expectations of the parties.
Id. ¶ 31. In that case, two members effectively transferred property from one entity to another, leaving a third member out. There was no question they were conflicted in their votes, but the test was not whether they could act vote in a conflicted manner (as they did). Instead, the question was whether they dealt fairly and in good faith, which had to be decided on remand (the court said they did). In assessing whether the entity or other members are injured, then, as long at the voting was done consistent with the organizing agreement, I think the test is whether the partner in question is getting something unfairly to the detriment of the other members.
Lastly, to Doug's example, in the comments to his post, he said: “[W]hen I vote to, for example, block the partnership from raising the rent on a property that I originally leased several years ago from the partnership (and with the partnership's permission), it is hard for me to understand why that vote should not be considered a breach of duty.” It seems to me that should not be a breach of fiduciary duty unless it violates some express agreement to the contrary.
There can be good faith and fair dealing under § 404(d) in such a case, and the partnership agreed to the terms up front. The question to me is simply, what kind of vote is needed to raise the rent? Again, if it requires unanimous consent, that’s the partnership’s problem. They could have changed that when they originally agree to the deal. If it’s majority vote, the other partners can change the rent despite the conflicted partner's no vote. I see no need to protect this kind of transaction with mandatory fiduciary duties. There’s not a disclosure or fair dealing problem to me, so I would sanction it, and I think that's the specific intent of § 404(e).
I admit, I am sometimes amazed at how much of a contractarian I have become.
Tuesday, September 20, 2016
Here’s a new one on the “LLC as corporation” front. A court in the Southern District of New York says the following:
[T]his Court has subject matter jurisdiction, since the parties are diverse and the amount in controversy exceeds $75,000. Hermes and Swain are “citizens” of different states; Hermes, a French limited liability corporation, has its headquarters in New York, while Swain is a New Jersey resident.
Hermés of Paris, Inc. v. Swain, 2016 WL 4990340, at *2 (S.D.N.Y., 2016)
In most such circumstances, when a court refers to a “limited liability corporation,” it meant to say “limited liability company.” See, e.g., Avarden Investments, LLC v. Deutsche Bank Nat'l Trust Co., No. 16-CV-014-LM, 2016 WL 4926155, at *2 (D.N.H. Sept. 15, 2016) (“Avarden is a limited liability company organized under the laws of New Hampshire. New Hampshire law permits a limited liability corporation to assign management responsibility of a limited liability company to a ‘manager.’ RSA 304-C:13.”). But not this time.
Bloomberg says Hermès of Paris, Inc. operates as a subsidiary of Hermes International SA. The French version of an LLC is not an SA, it often viewed as an SARL.
So, technically, a corporation is a “limited liability corporation” because corporations come with a grant of limited liability. The source of this language in this opinion is, in seems, the petition to compel arbitration, which states in paragraph 10: “Petitioner Hermés, an entity engaged in ‘commerce’ as defined in the FAA §1, is a limited liability corporation, with its United States headquarters in New York, New York.”
Another interesting (to me) note is that that court and the pleadings don’t ever say where Hermés is incorporated. They just say where it is headquartered. I see nothing that says its state of origin. I am not as up on my civil procedure (jurisdiction) as maybe I should be, but couldn’t that matter? That is, if Hermés of Paris, Inc., is a New Jersey corporation with headquarters in New York, might that not be a problem for diversity jurisdiction? (It looks like it’s not, though. I looked. But they do have a New Jersey warehouse. Still, the state of formation seems mildly important to note.)
Anyway, although I don’t like the use of the term at all, because it creates potential for confusion (is it an LLC or a corporation?), at least this time the words are correct, even if that’s not generally how we refer to the entity type. I’d still prefer the court to have just called it a corporation, though.
Tuesday, September 6, 2016
Private Ordering in the Uncorporation: Modified and Eliminated Fiduciary Duties Are Often the Same Thing
What does it mean to opt out of fiduciary duties? In follow-up to my co-blogger Joan Heminway's post, Limited Partnership Law: Should Tennessee Follow Delaware's Lead On Fiduciary Duty Private Ordering?, I will go a step further and say all states should follow Delaware's lead on private ordering for non-publicly traded unincorporated business associations.
Here's why: At formation, I think all duties between promoters of an unincorporated business association (i.e., not a corporation) are always, to some degree, defined at formation. This is different than the majority of other agency relationships where the expectations of the relationship are more ingrained and less negotiated (think employee-employer relationship).
As such, I'd make fiduciary duties a fundamental right by statute that can be dropped (expressly) by those forming the entity. I'd put an additional limit on the ability to drop fiduciary duties: the duties can only be dropped after formation if expressly stated in formation documents (or agreed unanimously later). That is, if you didn't opt out at formation, tell all those who could potentially join the entity how you can change fiduciary duties later. This helps limit some (though not all) freeze-out options, and I think it would encourage investors to check the entity documents closely (as they should).
At formation, the concerns we might have of, for example, an employee without fiduciary duties, are not the same as they are for co-venturers. Those starting an entity have long negotiated what is a breach of the duty of loyalty, for example. In contrast, I think fiduciary duties in most employer-employee (and similar) relationships reflect the majoritarian default and they facilitate the relationship existing at all. For LLCs and partnership entities, I think that's less clear. Entity formation is relatively rare compared to how often we enter other agency relationships, and they almost always involve significant negotiation (if not planning). And if they don't, the rules we expect traditionally should be the default. But where the parties talk about it, and they usually do, allowing a more robust sense of freedom of contract has value.
Even in Delaware, where one can negotiate out of fiduciary duties, there remains the duty of good faith and fair dealing. I think of that as meaning that the parties still have a right to the essence of the contract. That is, the contract has to mean something. It has to have had a purpose and potential value at formation, and no party can eliminate that. But, the parties only have a right to what was bargained for. As such, what we might traditionally consider a breach of the duty of loyalty could also breach the duty of good faith and fair dealing, but a traditional breach of the duty of loyalty might not be sufficient to find liability where there is expressly no duty of loyalty. Instead, the act must so contradict the purpose of the contract that it rises to the level of a breach the duty of good faith and fair dealing.
Part of the reason I support this option is that I think case law has already validated it, but in such an inartful manner that it confuses existing doctrine. See, e.g., McConnell v. Hunt Sports Enterprises, 132 Ohio App. 3d 657, 725 N.E.2d 1193 (Ct. App. 1999) (“An LLC, like a partnership, involves a fiduciary relationship. Normally, the presence of such a relationship would preclude direct competition between members of the company. However, here we have an operating agreement that by its very terms allows members to compete with the business of the company.”).
In closing, I will note that I am all for express provisions that require investors to pay attention at the outset. I don't believe in helping cheaters hide the ball. I just think law that encourages investors and others joining new ventures to pay attention is useful and will provide long-term value to entities. I don't think that eliminated fiduciary duties at formation raise any more of a risk than we already have with limited or modified fiduciary duties at formation. With the more limited protections described above, freedom of contract should reign.
Tuesday, August 30, 2016
Although we review claims of insufficiency de novo, United States v. Harvey, 746 F.3d 87, 89 (2d Cir. 2014), it is well recognized that “a defendant mounting such a challenge bears a heavy burden” because “in assessing whether the evidence was sufficient to sustain a conviction, we review the evidence in the light most favorable to the government, drawing all inferences in the government's favor and deferring to the jury's assessments of the witnesses' credibility.” . . .
[W]e reject Jasmin's challenge to her Hobbs Act conviction. The evidence presented at trial more than sufficiently describes the consideration received by Jasmin in exchange for her official actions as Mayor, including the $5,000 in cash from Stern, “advance” cash for their partnership, and shares in the limited liability corporation that would develop the community center.
Wednesday, July 27, 2016
Just in case you haven't gotten the message yet: Delaware law means fiduciary duty freedom of contract for alternative entities. In May 2016, the Delaware Chancery Court upheld a waiver of fiduciary duties in a master limited partnership. In Employees Retirement System of the City of St. Louis v. TC Pipelines GP, Inc., Vice Chancellor Glasscock upheld challenges to an interested transaction (sale of a pipeline asset to an affiliated entity) that was reviewed, according to the partnership agreement, by a special committee and found to be fair and reasonable. The waiver has been described as "ironclad" to give you a sense of how straight forward this decision was. No close call here.
Vice Chancellor Glasscock's letter opinion starts:
Delaware alternative entity law is explicitly contractual;1 it allows parties to eschew a corporate-style suite of fiduciary duties and rights, and instead to provide for modified versions of such duties and rights—or none at all—by contract. This custom approach can be value enhancing, but only if the parties are held to their bargain. Where equity holders in such entities have provided for such a custom menu of rights and duties by unambiguous contract language, that language must control judicial review of entity transactions, subject only to the cautious application of the implied covenant of good faith and fair dealing. Such is the case in the instant matter, which involves a master limited partnership (“MLP”) created with interested transactions involving the general partner as part of its business model.....
The Defendants point out that the [transaction] was approved by a special committee (the “Conflicts Committee”), which approval, in accordance with the partnership agreement, creates a conclusive presumption that the transaction is fair and reasonable to the Partnership. I find that the Conflicts Committee’s approval, in these circumstances, precludes judicial scrutiny of the substance of the transaction and grant the Defendants’ Motion.
Importantly, the contractual safe harbor for interested transactions established a process which, if followed, created a fair and reasonable transaction outside of judicial scrutiny and without recourse by the other partners. The court found that the partnership agreement precluded a good faith analysis of the Conflicts Committee's review and limited the court's review purely to matters of process.
The relevant portions of the Special Approval provision, importantly, are silent as to good faith.....According to the contractual language, the Special Approval of a duly constituted and fully informed Conflicts Committee is conclusive evidence that such transaction is fair and reasonable, and such approval is, therefore, preclusive of further judicial review. The Plaintiff does not allege that the Conflicts Committee was not duly constituted—that is, directors who are neither security holders nor employees or officers of the General Partner or its affiliates. Nor does the Plaintiff allege that the Conflicts Committee was not fully informed. Thus, the approval here is conclusive that the [transaction] is “fair and reasonable” to TCP. According to the explicit language of the LPA, when a conflicted transaction is deemed “fair and reasonable” by the terms of the agreement, such conflicted transaction is incapable of breaching the LPA.
Get the message? LOUD and CLEAR!
The opinion contains more analysis and excerpts of the relevant portions of partnership agreement. Look for an excerpt on this case in my ChartaCourse (electronic platform) Business Organizations casebook.
Tuesday, July 26, 2016
Anyone who reads this blog knows that I have issues with how people mess up the distinction between LLCs (limited liability companies) and corporations. In some instances, it is a subtle, likely careless, mistake. Other cases seem to be trolling me. Today, I present you such a case: Sky Cable, LLC v. Coley, 2016 WL 3926492 (W.D.Va., July 18, 2016). H/T: Jay D. Adkisson. The case describes the proceedings as follows:
DIRECTV asks the court to reverse-pierce the corporate veil and declare that Randy Coley is the alter ego of his three limited liability companies, such that the assets held by those LLCs are subject to the judgment in this case.
Okay, so claiming to pierce the "corporate veil" of an LLC is wrong (it doesn't have a "corporate" anything), but it's also exceedingly common for lawyers and courts to make such an assertion. This case takes the improper designation to the next level.
First, the court describes the LLCs in questios as "the Corporate Entities." It then goes on to discuss "Coley's limited liability companies." Ugh. The court further relates, "DIRECTV stated that in a forthcoming motion, it would ask the court to reverse-pierce the corporate veil given Coley's abuse of the corporate form." No such form, but perhaps we can now blame DIRECTV's counsel, in part, for this hot mess.
Here's the court's Legal Framework:
Generally, corporations are recognized as entities that are separate and distinct from their officers and stockholders. [Author's note: THERE ARE NO SHAREHOLDERS IN LLCS!] "But this concept of separate entity is merely a legal theory, 'introduced for purposes of convenience and to subserve the ends of justice,' and the courts 'decline to recognize [it] whenever recognition of the corporate form would extend the principle of incorporation "beyond its legitimate purposes and [would] produce injustices or inequitable consequences.' "" DeWitt Truck Brokers, Inc. v. W. Ray Flemming Fruit Co., 540 F.2d 681, 683 (4th Cir. 1976) (citations omitted). When appropriate, and " 'in furtherance of the ends of justice,' " a court may pierce the corporate veil and treat the corporation and its shareholders as one, id. (quoting 18 Am. Jur. 2d at 559), if it finds a corporation and its shareholders have misused or disregarded the corporate form, United States v. Kolon Indus., Inc., 926 F. Supp. 2d 794, 815 (E.D. Va. 2013). This is often referred to as an "alter ego theory."
The court continues: "Delaware courts take the corporate form and corporate formalities very seriously.... " Case Fin., Inc. v. Alden, No. CIV. A. 1184-VCP, 2009 WL 2581873, at *4 (Del. Ch. Aug. 21, 2009)." The opinion then states that veil piercing concepts"apply equally to limited liability companies which, like corporations, have a legal existence separate and distinct from its members." The concept may, but LLCs do not have to follow the same formalities as corporations to maintain separate existence. Even if veil piercing were appropriate here, the entire case continues to misstate the law of veil piercing LLCs. Note: Delaware courts do hold some blame here: Westmeyer v. Flynn, 382 Ill. App. 3d 952, 960, 889 N.E.2d 671, 678 (2008) ("[U]nder Delaware law, just as with a corporation, the corporate veil of an LLC may be pierced, where appropriate.").
Based on the opinion, it does seems as though the defendant here was being shady, at best, and perhaps outright fraudulent. I don't suggest that, based on the facts presented, the defendant shouldn't be held accountable for his debts. Still, in addition to the misstatements of the law, I am not sure veil piercing was necessary. As the court notes, "veil piercing is an equitable remedy and an extraordinary one, exercised only in exceptional circumstances "when 'necessary to promote justice.'" It seems to me, then, the court (and the plaintiff) should discuss other remedies first, relying only on veil piercing where "necessary."
As such, I'd like to see a discussion of fraudulent or improper transfer before veil piercing -- did the defendant improperly move assets that should have been available to the plaintiff into an entity? Before veil piercing three entities, it seems to me the court should determine what should have been available to the plaintiff -- if the answer is "nothing" then no amount of shady behavior should support veil piercing. If there should be assets, then the question should still be "which ones?" If the answer is all of the assets in all of then entities, then okay. But if the court is veil piercing three entities merely to ensure adequate recovery, that's an overreach, it seems to me. In addition, how about reviewing if there was actual fraud in how the defendant acted? That, too, could support recovery without the extraordinary veil piercing remedy.
Ultimately, it's possible the court got the outcome right here. But it clearly got the law wrong. A lot.
Tuesday, July 19, 2016
Today I will pose a simple question: Is Entity Type Material?
Of course, context matters, so here's where this is coming from: On July 1, 2016, Canterbury Park Holding Corporation filed an 8-K making the following announcement:
SHAKOPEE, Minnesota (July 1, 2016) - Canterbury Park Holding Corporation, a Minnesota corporation (Nasdaq Global Market: CPHC) (the “Company”), today announced that it has completed its previously announced reorganization of the Company’s business into a holding company structure (the “Reorganization”), pursuant to which a recently-formed Minnesota corporation with the same name, Canterbury Park Holding Company (“New Canterbury”), has replaced the Company as the publicly held corporation owned by the Company’s shareholders. At the market open today, July 1, 2016, the shares of common stock of New Canterbury will commence trading on the Nasdaq Global Market under the ticker symbol “CPHC,” the same ticker symbol previously used by the Company.
As a result of the Reorganization, the Company has been merged into a limited liability company subsidiary, Canterbury Park Entertainment LLC. In addition, the Company’s shareholders have automatically become shareholders of New Canterbury on a one-for-one basis, holding the same number of New Canterbury shares and the same ownership percentage after the Reorganization as they held immediately prior to the Reorganization. The business operations, directors and executive officers of the company will not change as a result of the Reorganization.
The exhibits list, though, provides:
Exhibit No. Description 2.1 Agreement and Plan of Merger, dated March 1, 2016, among Canterbury Park Holding Corporation, a Minnesota corporation, New Canterbury Park Holding Corporation, a Minnesota corporation, Canterbury Park Entertainment LLC, a Minnesota limited liability corporation. (Incorporated by reference to Exhibit 2.1 to the Registration Statement on Form S-4 (File No. 333-210877) filed with the SEC on April 22, 2016.)
A what? You probably guessed it: a "Minnesota limited liability corporation." No, it's a limited liability company, as properly noted in the press release.
Okay, so I suspect it's not really material to the SEC or most other investors in the sense that this is a mistake, as long as the filing and exhibit are otherwise accurate. I looked at the May 27, 2016, DEF 14A, which did list the LLC correctly. However, in searching that document I found this was part of the 14A:
GGCP Holdings is a Delaware limited liability corporation having its principal business office at 140 Greenwich Avenue, Greenwich, CT 06830.
Sigh. Well, it may not matter to the SEC, but it's material to me.
Wednesday, July 13, 2016
This is just me musing a bit, but in following up my post on how LLCs can choose to “be corporations” for federal tax purposes, meaning they get C corp tax treatment, I was thinking that maybe the IRS could just stop using state-law designations at all. That is, stop having “corporate” tax treatment at all.
My proposal is not abolishing corporate tax – that’s a much longer post and one I am not sure I’d agree with. Instead, the proposal is to have entities choose from options that are linked the Internal Revenue Code, and not to a particular entity. Thus, we would have (1) entity taxation, called C Tax, where an entity chooses to pay tax at the entity level, which would be typical C Corp taxation; (2) pass-through taxation, called K Tax, which is what we usually think of as partnership tax; and (3) we get rid of S corps, which can now be LLCs, anyway, which would allow an entity to choose S Tax.
This post deals with the tax code, which means I am in over my head, and because this is tax related, it means the solution is a lot more complicated than this proposal. But now that the code provisions are not really linked to the state law entity, I think we should try refer to state entities as state entities, and federal tax status with regard to federal tax status. Under such a code, it would be a little easier for people to understand the concept behind state entity status, and it would make more sense to people that a “C Corp” does mean “publicly traded corporation” (a far-too common misunderstanding). Thus, we could have C Tax corporations, S Tax LLCs, K Tax LLCs, for example. We'd know tax status and state-entity status quite simply and we'd separate the concepts.
A guy can dream, right?
Tuesday, July 5, 2016
So, readers of this blog know that I despise the misuse of the term "limited liability corporation" when the writer or speaker means "limited liability company," which is the correct term for an LLC. There is a time, though, when an LLC can be a corporation, and that is for federal tax purposes if the entity makes such a choice.
Entity choice is a state law decision, but and LLC can elect to be treated as a corporation under the Internal Revenue Code. The Internal Revenue Service recently issued Publication 3402, which explains:
Classification of an LLC Default classification.
An LLC with at least two members is classified as a partnership for federal income tax purposes. An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes). Also, an LLC's federal tax classification can subsequently change under certain default rules discussed later.
An LLC can elect to be classified as an association taxable as a corporation or as an S corporation. After an LLC has determined its federal tax classification, it can later elect to change that classification. For details, see Subsequent Elections, later. LLCs Classified as Partnerships If an LLC has at least two members and is classified as a partnership, it generally must file Form 1065, U.S. Return of Partnership Income. Generally, an LLC classified as a partnership is subject to the same filing and reporting requirements as partnerships. See the Instructions for Form 1065 for rep
Still, this should really be called an LLC that has elected federal tax status as a corporation or an "LLC FCorp." Or something like that. But at least in this situation, an LLC is something of a corporation.
Tuesday, June 21, 2016
Last week, a federal court determined that an insurance disclosure that asked about an "applicant's" criminal history did not apply to an LLC member's individual criminal past. In Jeb Stuart Auction Servs., LLC v. W. Am. Ins. Co., No. 4:14-CV-00047, 2016 WL 3365495, at *1 (W.D. Va. June 16, 2016), the court explained:
“Question Eight” on the [insurance] application asked, “DURING THE LAST FIVE YEARS (TEN IN RI), HAS ANY APPLICANT BEEN INDICTED FOR OR CONVICTED OF ANY DEGREE OF THE CRIME OF FRAUD, BRIBERY, ARSON OR ANY OTHER ARSON-RELATED CRIME IN CONNECTION WITH THIS OR ANY OTHER PROPERTY?” Hiatt, on behalf of Jeb Stuart (who [sic] was the sole [LLC] applicant for the insurance policy), answered, “No.” Hiatt signed the application and left.
As you might imagine, Hiatt had been convicted of "hiring individuals to wreck cars so that he could receive the proceeds from the applicable insurance policies," and, yep, about a month later, the building burned down. Id. at *2.
The insurance company cancelled the policy because it claimed Hiatt had lied on the application, and Hiatt sued for the improper cancellation of the policy because he did not lie (he prevailed) and for attorneys fees claiming “the insurer, not acting in good faith, has either denied coverage or failed or refused to make payment to the insured under the policy.” Id. at *3. Judge Kiser determined that not attorneys' fees were warranted:
Neither party was able to rely on a case on point regarding the issue of whether questions on an LLC's insurance application asking about criminal history applied to the members of the LLC, to the corporate entity, or to both. Although I believe the answer to that question is clear, I am not aware of any other court being called upon to answer it. Therefore, although it was unsuccessful in asserting its defense to Jeb Stuart's claim, West American's position did present a novel legal question. As such, the final Norman factor weighs in favor of a finding of good faith.
Monday, June 13, 2016
This past week, I completed the second leg of my June Scholarship and Teaching Tour. My time at "Method in the Madness: The Art and Science of Teaching Transactional Law and Skills" at Emory University School of Law last week was two days well spent. I had a great time talking to attendees about my bylaw drafting module for our transaction simulation course, Representing Enterprises, and listening to others talk about their transactional law and skills teaching. Great stuff.
This week's portion of my academic tour begins with a teaching whistle-stop at the Nashville School of Law on Friday, continues with attendance (with my husband) at a former student's wedding in Nashville on Saturday evening, and ends (my husband and I hope) with Sunday brunch out with our son (and his girlfriend if she is available). Specifically, on Friday, I teach BARBRI for four hours in a live lecture. The topics? Well, I drew a short straw on that. I teach agency, unincorporated business associations (including a bit about both extant limited liability statutes in Tennessee), and personal property--all in four hours. Ugh. Although I am paid for the lecture and my expenses are covered, I would not have taken (and would not continue to take) this gig if I didn't believe that I could be of some help to students. These topics--especially agency and partnership law, but also personal property--often are tested on the bar exam. So, on I press.
I also am completing work this week on the draft article that I will present in Chicago and Seattle on the last two stops of my tour. I will say more about that article in next week's post. In the mean time, let me know if you have any suggestions (or good jokes) on the law of agency, partnerships, LLCs, or personal property (e.g., tenancies, gifts, bailments, adverse possession, replevin) for my lecture on Friday . . . . It's so hard to make these speed-lectures somewhat engaging for the students. [sigh]
Wednesday, May 18, 2016
California is the back on my short list for the state's inability to successfully differentiate between corporations and limited liability companies (LLCs). Last week, an "unpublished/noncitable" decision that was published on Westlaw provided a good example.
The opinion states:
A corporation—including a limited liability corporation—may be served by effecting service on its agent for service of process. (Code Civ. Proc., § 416.10, subd. (a); see also Corp.Code, § 17701.16, subd. (a) [allowing service on limited liability corporations under Code Civ. Proc., § 413.10 et seq.].)7
*12 One of the ways a limited liability corporation can be served is by substituted service. (1 Weil & Brown, Cal. Practice Guide: Civil Procedure Before Trial (The Rutter Group 2015) ¶ 4:172, p. 4–26.) This requires that a copy of the summons and complaint be left at the office of the person to be served (or, in some cases, at the mailing address of the person to be served), in the presence of a person who is apparently in charge, “and by thereafter mailing a copy of the summons and complaint by first-class mail, postage prepaid to the person to be served at the place where a copy of the summons and complaint were left.” (Code Civ. Proc., § 415.20, subd. (a).)
No, no, no. First, even in California, an LLC is a "limited liability company." It says so right in the act. Cal. Corp. Code § 17701.01 (West) ("This title may be cited as the California Revised Uniform Limited Liability Company Act.").
And, yet, I have to admit, if you note the cite to the LLC act, California lawmakers have made this less clear than in other states. Yes, that's right. In California, the LLC Act is part of the California Corporations Code. Cal. Corp. Code §§ 17701.16 - 17713.13 (West). For that matter, so are partnerships, under Title 2. Sigh.
Would it be so terrible if the Corporations Code were called what it is: the Business Entities Code? As currently structured, LLCs and partnerships are arguably types of corporations under California law, as the above cases suggests. One could argue the headings don't change the meaning or intent of the laws. See Cal. Corp. Code § 6 (West) ("Title, division, part, chapter, article, and section headings contained herein do not in any manner affect the scope, meaning, or intent of the provisions of this code."). The problem with that is that the code text says otherwise: "This act shall be known as the Corporations Code." Cal. Corp. Code § 1 (West).
To reinforce that notion, the Code Commission notes from the 2014 main volume explain:
This code was listed in the appendices of Code Commission reports showing code classification as the “Corporations, Partnerships, and Associations Code.” The 14 syllables of that title appear to make it impractical, but no shorter phrase indicative of the full subject-scope has been found. Therefore, resort has been had to the rhetorical device of synecdoche, and the entire code designated by the name of longest part.
I admit I had to look up synecdoche to be sure I was on the right track, but the term supports, I think, my point that California is treating LLCs and partnerships as corporations (or some subset thereof). See, for example, this explanation:
Synecdoche is a literary device in which a part of something represents the whole or it may use a whole to represent a part.
Synecdoche may also use larger groups to refer to smaller groups or vice versa. It may also call a thing by the name of the material it is made of or it may refer to a thing in a container or packing by the name of that container or packing.
Still, even if it were accurate to says LLCs and partnerships are "types" of corporations under the California code, one thing is still clear: an LLC is a limited liability company, which is, at a minimum, a specific type of "limited liability corporation."
I supposed I can see how "14 syllables" might be deemed "impractical," but not at the cost of imprecision. The "Business Entities" -- or even just "Entities" or "Associations" -- Code would seem like a better, more accurate, option.
Oh well. At least the court cited the part of the California code for service of an LLC. That much, they got right.
Tuesday, May 10, 2016
I had a plan to write on something else today, but I got a note from Keith Bishop sharing his blog post, which he was right to think I would appreciated. In his post, Bishop discusses a California case:
The LLC May Well Be The Platypus Of Business Organizations
What happens to the attorney-client privilege when a corporation dissolves? Magistrate Judge Sallie Kim recently answered that question in Virtue Global Holdings Ltd. v. Rearden LLC, 2016 U.S. Dist. LEXIS 53076 (N.D. Cal. April 5, 2016):
When a corporation ceases to exist, “the corporate powers, rights and privileges of the corporation shall cease.” Cal. Corp. Code §1905(b). In that case, no entity holds the attorney-client privilege for Original MO2. City of Rialto, 492 F.Supp.2d at 1197 (“a dissolved corporation is not entitled to assert the attorney-client privilege”).
I am somewhat baffled by the ruling because the entity asserting the privilege in the case was not a corporation at all (Section 1905 is in the General Corporation Law). The entity attempting to claim the privilege was, according to the information provided in the opinion, indubitably a California limited liability company. Thus, the court should be citing the California Revised Uniform Limited Liability Company Act, not the General Corporation Law.
California, like many others states, seems to make the error relatively often.
Today, though, I will pick on the news. A Google News search of "limited liability corporation" for the past twenty-four hours provides a few such instances. (Note for new readers, an LLC is a "limited liability company," not corporation.)
I'll highlight two. According to one news outlet, the University of Illinois just extended a $2 million line of credit to an entity do research in Singapore.
To set up shop in another country, the university created a limited liability corporation, Singapore Research LLC. The LLC then established a private entity in Singapore which allows the center to compete legally for government grants.
Oops. Next, another news outlet reports:
A Nevada energy company said it wants to purchase an unfinished nuclear power plant from the Tennessee Valley Authority (TVA) and use the site in northeast Alabama to produce electricity with new technology.
Michael Dooley, managing partner of Phoenix Energy of Nevada, told the Associated Press his company wants to use the mothballed Bellefonte Nuclear Plant site as the base for a new, non-nuclear generation method.
. . .
Phoenix Energy of Nevada describes itself as a privately-held Nevada limited liability corporation, incorporated in October 2010, Kallanish Energy learns.
This time, though, the report is right. Phoenix Energy of Nevada, LLC (PENV) says on its web page it "is a Veteran owned closely and privately held viable early stage mid-market Nevada State Limited Liability Corporation (LLC) Small Business Company founded and incorporated in October 2010." Nope. It's an LLC.
I know I complain about this a lot, but there is value in getting it right. Reporters should get it right, and those who own the entity really should get it right. One of these days some court will find that an LLC didn't follow the corporate formalities required of a "limited liability corporation" and they won't even know to object.
I concede when one writes things like "company" and "corporation" a lot, a mistake may occur from time to time, especially when the distinction is not, on its face, crucial. My concern is less that people make mistakes. It's more that they don't know they are making one. That's where I come in.
On the plus side, I am about halfway through grading my Business Organizations exams, and not one person has called an LLC a corporation.
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, May 3, 2016
A recent Vanity Fair article discussing Citizens United is making the rounds. (I saw it on Facebook!) The article notes:
It had already been established, in Buckley v. Valeo (1976), that anyone has a First Amendment right to spend his or her own money advancing his or her own cause, including a candidacy for political office. Citizens United extended this right to legally created “persons” such as corporations and unions.
I have been giving some more thought to whole “personhood” discussion of late, and my thoughts have taken me back to both Hobby Lobby and Citizens United. What follows is a long blog post that pulls together my thoughts on these two cases in an admittedly not well developed way. But it's a start (though I really should be grading).
Tuesday, March 29, 2016
(c) for purposes of imposing liability on any member or manager of a limited liability company for the debts, obligations or other liabilities of the company, a court shall consider only the following factors no one (1) of which, except fraud, is sufficient to impose liability:(i) Fraud;(ii) Inadequate capitalization;(iii) Failure to observe company formalities as required by law; and(iv) Intermingling of assets, business operations and finances of the company and the members to such an extent that there is no distinction between them.
The veil of a limited liability company may be pierced under exceptional circumstances when: (1) the limited liability company is not only owned, influenced and governed by its members, but the required separateness has ceased to exist due to misuse of the limited liability company; and (2) the facts are such that an adherence to the fiction of its separate existence would, under the particular circumstances, lead to injustice, fundamental unfairness, or inequity.
(d) In any analysis conducted under subsection (c) of this section, a court shall not consider factors intrinsic to the character and operation of a limited liability company, whether a single or multiple member limited liability company. Factors intrinsic to the character and operation of a limited liability company include but are not limited to:(i) The ability to elect treatment as a disregarded or pass-through entity for tax purposes;(ii) Flexible operation or organization including the failure to observe any particular formality relating to the exercise of the company’s powers or management of its activities;(iii) The exercise of ownership, influence and governance by a member or manager;(iv) The protection of members’ and managers’ personal assets from the obligations and acts of the limited liability company.
Tuesday, March 22, 2016
March has provided a slate of mistakes as to entity form, focusing (as it almost always does) on limited liability companies (LLCs) and various outlets calling such entities "corporations." These are not in any particular order, but lists are neat. Enjoy!
(1 ) Politifact Checks Trump Facts, Forgets to Check Entity Law Facts
In an article on Politifact.com, Donald Trump incorrectly says Virginia winery is the largest on East Coast, which determines that Trump's claims about the size of a winery that his son runs to be false and notes some statements are incorrect. Ironically, the article also claims:
A legal disclaimer on the winery website says the GOP presidential candidate doesn’t own the winery. The venture is a limited liability corporation, and its owners are not a matter of public record.
Wrong. The winery site says, "Trump Winery is a registered trade name of Eric Trump Wine Manufacturing LLC, which is not owned, managed or affiliated with Donald J. Trump, The Trump Organization or any of their affiliates." An LLC is still not a corporation.
(2) Big Bang Theory: Big Brains Don't Know Entity Law
I don't watch the Big Bang Theory, but my colleague at Valparaiso University, Professor Rebecca J. Huss, is a reader of this blog who also cares about precise language with regard to LLCs alerted me to this one. The story line of the March 10 show (the show can be found here) related to a the creation of a partnership agreement for some of the characters. One thing that is realistic is that the folks think it's a good idea to form an entity and draft contract language without a lawyer. One character says he has some concerns about the partnership, and another replies with this "joke": "Are you suggesting a limited liability corporation, because I did not LLC that coming." (The offending segment is roughly 14 minutes into the show.) (This was also covered at Kentucky Business Entity Law Blog, here, which noted, "Ughhhh. LLC ≠ limited liability corporation. Rather, LLC = limited liability company.")
(3) Ghost LLCs Masquerading as Corporations
The Washington Post last week ran a story, How ‘ghost corporations’ are funding the 2016 election. The article discusses how entities can be used to shield those backing political candidates. The article states:
Advocates for stronger campaign-finance enforcement fear there will be even more pop-up limited liability corporations (LLCs) funneling money into independent groups, making it difficult to discern the identities of wealthy players seeking to influence this year’s presidential and congressional contests.
. . . .
Many corporate givers this cycle are well-established hedge funds, energy companies and real estate firms. But a significant share of the money is coming from newly formed LLCs with cryptic names that offer few clues about their backers.
(4) Pass-Through Tax Law Isn't Really About Corporations (mostly)
The Topeka Capital-Journal Editorial Board wrote on March 20: LLC loophole needs plugging: Even some small business owners think the tax exemption should be eliminated. The editorial is related to a 2012 Kansas law, HB 2117, which eliminated taxes on pass-though entities like LLCs, S corps, partnerships, farms, and sole proprietorships. (So, I admit, S corps are corporation, but they are essentially partnerships for federal tax purposes.) Even though I agree with some their concerns, the board makes a couple mistakes here when they assert that the bill "was simply an unconditional gift from the state for anyone who has created an entity called a limited liability corporation (LLC)."
First, it assumes that just LLCs get the benefit, which is not true. All pass-though entities benefit. Second, of course, the "limited liability corporation" is a corporation, not an LLC, and the corporation (other than one chosen to be an S corp) does not get the benefit of the law.
(5) Court Gets Entity Right, Regulations Not Quite
I'm not one to leave the courts out of this. Judge Robert M. Dow, Jr., of the United States District Court, Northern Illinois has an incredible resume. A member of Phi Beta Kappa and a Rhodes Scholar, his credentials are impressive. In a recent decision, though, his opinion refers to a defendant LLC correctly, but then goes on to say that Treasury Regulations are silent on treatment of "limited liability corporations." Alas, that's not accurate. Here's the passage:
It is undisputed that, as of the date of Anderson Bros.' withdrawal from the fund, Anderson Bros. (an Illinois corporation) was 100% owned by Anderson. Anderson therefore had a “controlling interest” in Anderson Bros. 29 U.S.C. § 1.414(c)-2(b)(2)(A). At the same time, Defendant (an Illinois limited liability company) was also solely owned by Anderson. Section 1.414(c)-2 of the Treasury Regulations does not address specifically the treatment of limited liability corporations, and the Board does not address this issue in its brief. According to the Internal Revenue Service (“IRS”), “an LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes * * *, unless it files Form 8832 and affirmatively elects to be treated as a corporation.” IRS, Single Member Limited Liability Companies, https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Single-Member-Limited-Liability-Companies (last visited Mar. 16, 2016).
Bd. of Trustees of the Auto. Mechanics' Local No. 701 Union & Inustry Pension Fund v. 6516 Ogden Ave., LLC, No. 14-CV-3531, 2016 WL 1043422, at *4 (N.D. Ill. Mar. 16, 2016) (emphasis added).
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.
Wednesday, February 17, 2016
Justice Scalia’s sudden passing has generated a tidal wave of media and academic attention on the future of the Supreme Court. As a corporate law scholar, I have to admit to a tinge of jealousy to be seemingly outside of this controversy, the hand wringing, and the political equivalent of Dungeons and Dragons that has ensued as people examine the various maneuverers available to our elected politicians and those vying-to be elected.
My solution? I searched for pending corporate cases hanging in the balance of the new, and indeterminate, vacancy on the Supreme Court. I wanted to know if there were any cases pending that would likely be decided differently in a post-Scalia court, or at least hang in a 4-4 split and thus uphold the lower court ruling. There isn’t a big juicy corporate law case pending, or at least one that I readily identified.
Not to be deterred, however, there is a case worth highlighting. Americold Realty Trust v. ConAgra Foods, Inc., was argued on January 19th before the Supreme Court (transcript available here). The issue before the Supreme Court in Americold was how to establish the citizenship of a real estate trust for purposes of diversity citizenship. Is the trust's citizenship dependent upon the citizenship of the controlling trustees (as argued by Americold)? Or is it dependent upon the citizenship of the trust beneficiaries (argued by ConAgra Foods), or some combination? Locating citizenship with trustees narrows the potential states and ensures diversity citizenship whereas citizenship with the beneficiaries, of which there are thousands, implicates most states and thus frustrates federal jurisdiction.
At the heart of the oral argument was the 1990 ruling Carden v. Arkoma Associates, which established a bright line between the citizenship of corporations (located in the state of incorporation) and the citizenship of all other artificial business entities (located in the states of the beneficial owners of the business).
In Carden, the Supreme Court wrote:
In 1958 it revised the rule established in Letson, providing that a corporation shall be deemed a citizen not only of its State of incorporation but also "of the State where it has its principal place of business." 28 U.S.C. 1332(c). No provision was made for the treatment of artificial entities other than corporations, although the existence of many new, post-Letson forms of commercial enterprises, including at least the sort of joint stock company ..., the sort of limited partnership association ..., and the sort of Massachusetts business trust ... We have long since decided that, having established special treatment for corporations, we will leave the rest to Congress; we adhere to that decision.
Drawing on the Carden precedent, the question became whether the REIT as issue in Americold was organized as a traditional corporation or not.
Ronald Mann writing for the SCOTUS Blog summarized Justice Scalia’s role in oral argument on this issue with the following:
Justice Antonin Scalia early on asked, “[w]ho owns these assets under Maryland law? Is it . . . this new corporation-type entity? That’s the entity that can sue.” That conclusion led him to dismiss out of hand Americold’s contention that the citizenship of the trust managers should be decisive: “[T]he trustees are sort of in the position of managers, just as though you hired a CEO.”
Scalia's skepticism about the REIT functioning like a corporation was shared by the other Justices despite the fact that modern REITs, in many ways, resemble corporations more so than other unincorporated business entities. REITs have dispersed and diffused shareholders, often with shares traded on public exchanges. This position was articulated by an amicus brief filed by National Association of Real Estate Investment Trusts (NAREIT). The Justices however signaled a truly formalistic approach asking if the entity was indeed formed as a corporation (not did it function as one or was it capitalized as one). Only if so would the state of incorporation rule prevail.
A Justice Scalia-influenced Supreme Court's last word on corporate jurisprudence may very likely be one of pure form over substance. Merely asking which entity form was used without looking at the distinguishing features of a corporation and the justifications for why corporations were treated differently beginning in 1958 produces a corporate law legacy of flimsy jurisprudence. Failing to take into account the market realities and relying upon strict categorical distinctions without reference to function would create a bright line, but not necessarily a bright result.
Tuesday, February 2, 2016
Embracing Freedom of Contract in the LLC: Linking the Lack of Duty of Loyalty to a Duty of Disclosure
I have been giving a lot of thought to the idea of waiving the duty of loyalty in LLCs in Delaware. The more I think about it, the more I am okay with the concept of allowing members of an LLC to decide to do away with the duty of loyalty when they form the entity. Delaware, of course, retains the implied covenant of good faith and fair dealing in any contract, and I think parties to a contract should be able to decide the terms of their deal.
Still, I am sympathetic to those who are concerned about eliminating the duty of loyalty because it does seem rather awful, and yet, I am also a proponent of freedom of contract. How to reconcile these things? Well, I am now of the mind that perhaps we need to bring a partnership principle to LLCs to help. In partnerships, the default rule is that changes to the partnership agreement or acts outside the ordinary course of business require a unanimous vote. See UPA § 18(h) & RUPA § 401(j). I think changes to the duty of loyalty should have the same requirement, and perhaps that even the rule should be mandatory, not just default.
At formation, then, those creating an LLC would be allowed to do whatever they want to set their fiduciary duties, up to and including eliminating the consequences for breaches of the duty of loyalty. This is part of the bargain, and any member who does not agree to the terms need not become a member. Any member who joins the LLC after formation is then on notice (perhaps even with an affirmative disclosure requirement) that the duty of loyalty has been modified or eliminated. This is not especially concerning to me.
What would concern me more is a change in the duty of loyalty after one becomes a member. That is, if the majority of LLC members could later change the loyalty provision, then that seems problematic to me, as fiduciary duties are not just to protect the majority. As such, it seems to me more proper that changes to the duty of loyalty, when a member does not have any say in that change, is what should be restricted. Like in changing a partnership agreement, if everyone agrees, then there is not a problem. And if you accept the provision when you join, it is not a problem. But you shouldn't have a fiduciary duty removed or modified after the fact without your consent.
Because the duty of loyalty is a fixture that most people expect, I do see value in requiring (at least for some time) that there be clear disclosure of the applicable to duties to potential LLC members. But at least for the moment, I am feeling the freedom of contract option on the duty of loyalty is quite reasonable.