Wednesday, December 23, 2015
Still grading, and (in the process) reflecting on the line in Marcia Narine's post from last week on the references to “creepy tender offers” and “limited liability corporations” in her students' final exam submissions . . . . I thought I might share today a few of my own favorite outtakes from my students' Business Associations exams. I know that the time crunch and the nature of the exam software contribute mightily to the typing errors in student submissions, but on the reading end, some of the answers submitted are just . . . well . . . funny. As you'll no doubt note, today's post focuses mostly on closely held corporations (with one typo relating to limited partnerships).
First , there are, of course, the transposed letters. Most of these don't warrant more than a brief mention. The limited partnership act references to UPLA and RUPLA, instead of ULPA and RULPA fit into this category. Similar are the inevitable variants of case names (Donahue becoming Danahue, Donahur, and Donaue, etc.).
Then, there are the many misspelling of fiduciary(ies)--which I have come to believe may just be a hard word to type. (Or maybe no one actually knows how to spell it.) Uncommon misspellings of this often misspelled exam word include three versions that I found in one exam, in the same paragraph: foiducaries, fidurcairy, and fiducaiys. (I should note that all of these correct to "fiduciary" or "fiduciaries" in the spellcheck, which I had to override to make this post. Hmm. Maybe they were not as far off as I thought.)
Perhaps my favorite submission from the closely held corporation parts of the exam, however, was the one from the student who (repeating at the outset of his/her answer a short-form version of the prompt from my exam question) simply wrote: "What is the f duty?" There was a bit of blank space after the letter "f" in that submission, so, given the possible existence of some exam period frustration . . . . I think you can see where my mind went as I read that. (Or maybe that would be--with words transposed--"What the f is duty?") :>) Please forgive the irreverance!
Anyway, more on exams next week, when I am done. Can't wait. To be finished with grading, that is. Look for my holiday post for you all on my state of mind in that regard tomorrow morning. Ho, ho, ho.
Tuesday, December 15, 2015
As I continue my mission to solidify the limited liability company (LLC) as its own entity, and not a corporation or corporate derivative, I have come to realize that U.S.-based distinctions are usually easier than international ones. One challenge we have is that we often try to find direct entity analogies from country to country, when none may exist.
Case in point: Over at Lexology.com lat week, an article titled Is litigation funding in peril? appeared. The article states, "In its ruling (KKO 2015:17), the Finnish Supreme Court found that under certain criteria it is possible to hold the shareholders of a limited liability company liable for the company's liabilities." So, if this were a U.S. LLC, we'd know there are no "shareholders" of an LLC. We have members (or should). But, I am no expert in Finnish law, but it is different than U.S. law. According to Wikipedia (that all-knowing source), Osakeyhtiö, abbreviated Oy, means "stock company," thought others sources says it means "limited company" or limited stock company." Nonetheless, the shareholder characterization appears acceptable for a Finnish (but not a U.S.) entity.
Finnish entities do not break down the same way as U.S. entities (this is not surprising). Thus, in Finland, there are limited partnerships, limited companies, and public limited companies. My suspicion is that the Osakeyhtiö is actually more like a corporation, as "the management is provided by the management board," but general parlance is that it is an LLC because of how it translates.
The Lexology article discusses limited liability companies, but then repeatedly discusses piercing the "corporate" veil and the "corporate structure" of the entities in questions. To draw a direct analogy to U.S. entities, and to try to hold my overseas colleagues to U.S. language, would be unfair. It may be that in a non-U.S. jurisdiction, "limited liability companies" in such an instance means the more general "limited liability entities," and is not intended as a term of art for the LLC. However, there is language that can be employed globally to help make entity distinctions more clear, particularly when talking about general concepts for a more general audience. Avoiding terms of art where specificity is not intended would be helpful.
For example, if we talk about a "limited liability veil," we can use that to apply to all limited liability entities. This is particularly apt when discussing situations where multiple entities are in play, and perhaps we're discussing veil piercing of a partner corporation and its subsidiary LLC.
Similarly, we can talk about "entity structure," instead of "corporate structure," to ensure we're not assigning specific rules and obligations to the wrong entity type.
Cross-border entity issues are inherently complex, and understanding how foreign courts will view various business arrangements is always a challenge. Foreign courts often have to grapple with foreign entities, and must decide how to reconcile the entity choice with domestic law. I appreciate the challenge, and recognize that there are rarely easy answers. I do think, though, that avoiding specific entity language when more general language will suffice, it's a good idea, because we can avoid inadvertently attaching domestic rules to a foreign entity.
We use analogies as anchors to help us understand concepts. That can be good, and it can be helpful. But we must be careful not to overdo it. Despite some similarities, LLCs are distinct from corporations and LLPs. And the Oy is different than the GmbH or the S.A. or the NV. Comparisons are inevitable, and often helpful. But, if we get more specific than we need to, before we need to, we run the risk of framing the question incorrectly and prematurely.
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
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).
Sandra Miller: Un-Sophisticated Parties Require Mandatory Duties at least in Publicly-Traded Entities if Not in all Entities (Contract Is King Micro-symposium)
Guest post by Sandra Miller:
The ratio of LLC filings to corporate filings in Delaware from 2010 to 2014 was over 3 to 1. Alternative business entities are no longer the province of a relatively small number of sophisticated investors. Increasingly, corporations are becoming the “alternative” and LLCs and other unincorporated entities the norm. Mom and Pop business as well as sophisticated real estate syndicators use alternative business entities. Additionally, as discussed below, publicly-traded limited partnerships and LLCs are now being aggressively marketed.
Accordingly, the assumptions that might once have justified greater reliance on private ordering in LLCs and alternative business entities should be revisited. Not all investors are highly sophisticated parties and a relentlessly contractual approach to business entity governance is not appropriate for unsophisticated parties. Nor is it appropriate for those without sophisticated legal counsel. In backhanded fashion, this point was recognized by Larry E. Ribstein who advocated the removal of restrictions on waivers of fiduciary duties in limited partnerships when these entities were used by sophisticated firms that were unlikely to be publicly traded. Ribstein expressly stated that limited partnership interests may be less vulnerable than corporate shareholders and are unlikely to be publicly traded. (See Fiduciary Duties and Limited Partnerships)
Master limited partnerships (e.g. publicly-traded limited partnerships and publicly-traded LLCs) provide an important example of how capital from unsophisticated investors now flows readily into alternative investments. According to the National Association of Publicly-Traded Partnerships (NAPTP) most MLP investors are individuals, the vast majority of whom are over age 50. Many investors are individuals, estates, and retirement plans – unsophisticated economic players. Thus, there are asymmetries in the marketplace that make it unlikely that the marketplace will efficiently discount the effects of waivers. Given the investor profile, at a very minimum, the duty of loyalty should be non-waivable for publicly-traded entities. (See Toward Consistent Fiduciary Duties)
There are even strong arguments in favor of reinstating mandatory minimum fiduciary duties for all business entities, public or private. Contractarians pre-suppose a level contractual playing field. Yet, repeat players who structure similar transactions repeatedly are at a distinct advantage. Moreover, there may not be equal legal representation of majority and minority investors. (See A New Direction for LLC Research in a Contractarian Legal Environment) Moreover, it is total madness to think that a contractual approach to business entity governance reduces costs. If anything, costs are increased by the lack of standard terms under a contractual regime.
In short, we have empirical data and years of experience with waivers that expose serious inefficiencies and injustices in a system that permits the waiver of all fiduciary duties. It is time to reconsider the benefits of a mandatory duty of loyalty for all entities, public or private.
Monday, November 16, 2015
Daniel Kleinberger: Delineating Delaware’s Implied Covenant of Good Faith & Fair Dealing (Contract Is King Micro-sympsium)
Guest post by Daniel Kleinberger:
Part I - Introduction
My postings this week will seek to delineate Delaware’s implied contractual covenant of good faith and fair dealing and the covenant’s role in Delaware entity law
An obligation of good faith and fair dealing is implied in every common law contract and is codified in the Uniform Commercial Code (“U.C.C”). The terminology differs: Some jurisdictions refer to an “implied covenant;” others to an “implied contractual obligation;” still others to an “implied duty.” But whatever the label, the concept is understood by the vast majority of U.S. lawyers as a matter of commercial rather than entity law. And, to the vast majority of corporate lawyers, “good faith” does not mean contract law but rather conjures up an important aspect of a corporate director’s duty of loyalty.
Nonetheless, Delaware’s “implied contractual covenant of good faith and fair dealing” has an increasingly clear and important role in Delaware “entity law” – i.e., the law of unincorporated business organizations (primarily limited liability companies and limited partnerships) as well as the law of corporations.
Because to the uninitiated “good faith” can be frustratingly polysemous, this first blog “clears away the underbrush” by explaining what Delaware’s implied covenant’s “good faith” is not.
Part II – A Couple of Major “Nots”
- Not the Looser Approach of the Uniform Commercial Code
The Uniform Commercial Code codifies the common law obligation of good faith and fair dealing for matters governed by the Code: “Every contract or duty within [the Uniform Commercial Code] imposes an obligation of good faith in its performance and enforcement.” The Code defines “good faith” as “mean[ing] [except for letter of credit matters] honesty in fact and the observance of reasonable commercial standards of fair dealing.” An official comment elaborates: “Although ‘fair dealing’ is a broad term that must be defined in context, it is clear that it is concerned with the fairness of conduct rather than the care with which an act is performed.”
The UCC standard thus incorporates facts far beyond the words of the contract at issue and furthers a value (fairness) which in the entity context is usually the province of fiduciary duty. The UCC definition provides some constraint by referring to “reasonable commercial standards,” but “[d]etermining . . . unreasonableness inter se owners of an organization is a different task than doing so in a commercial context, where concepts like ‘usages of trade’ are available to inform the analysis.” ULLCA (2013) § 105(e), cmt.
The Delaware Supreme Court has flatly rejected the U.C.C. approach for Delaware unincorporated businesses.
- Not the Corporate Good Faith of Disney, Stone v. Ritter, and Caremark
An obligation to act in good faith has long been part of a corporate director’s duty under Delaware law, but the concept became ever more important following the landmark case of Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). In Van Gorkom, the Delaware Supreme Court held directors liable for gross negligence in approving a merger transaction, a holding that “shocked the corporate world.”
Spurred by the Delaware corporate bar, the Delaware legislature promptly amended Delaware’s corporate statute. The amendment permits Delaware corporations to essentially opt out of the Van Gorkom rule. The now famous Section 102(b)(7) authorizes a Delaware certificate of incorporation to:
eliminat[e] or limit the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty …, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; [or] (ii) for acts or omissions not in good faith….
In effect, the provision authorizes exculpation from damages arising from claims of director negligence, but for some time the exception “for acts or omissions not in good faith” was controversial. Where plaintiffs could not allege breach of the duty of loyalty, they sought to equate “not in good faith” with extreme negligence.
Notably, the meaning of “not in good faith” was pivotal in the lengthy and costly litigation arising from the Disney corporation’s termination of Michael Ovitz. However, the Supreme Court’s decision in In re Walt Disney Co. Derivative Litig. left the issue murky. Eventually, in Stone v. Ritter, the court made clear that in this context “good faith” is an aspect of the duty of loyalty. The Court then equated a lack of this type of good faith with a director’s utter failure to attend to his or her oversight obligations (the so-called Caremark I duties).
Thus, a Delaware director’s fiduciary duty of good faith has nothing to do with the “good faith” of the Delaware implied covenant of good faith and fair dealing.
This posting is derived from Daniel S. Kleinberger, “Delaware’s Implied Contractual Covenant of Good Faith and “Sibling Rivalry” Among Equity Holders,” a paper presented at the 21st Century Commercial Law Forum: 15th International Symposium in Beijing, at Tsinghua University’s School of Law, November 1, 2015 (all footnotes and most citations omitted).
Mohsen Manesh: Strine & Laster’s “Modest” Proposal to Limit Contract’s Realm (Contract Is King Micro-Symposium)
Guest post by Mohsen Manesh:
First, I want to give a big thanks to Anne and the rest of the Business Law Professor Bloggers for graciously hosting this mirco-symposium! As a longtime BLPB reader, it is a privilege to now contribute to the online conversation.
In this post, I want to explore the boundaries of the proposal recently made by Delaware Chief Justice Strine and Vice Chancellor Laster to address the problem, as they see it, that has been created by the unbound freedom of contract in the alternative entity context. In their provocative “Siren Song” book chapter, the judicial pair advocate limits on the freedom of contract by making the fiduciary duty of loyalty mandatory. But, importantly, they limit their proposal to publicly traded LLCs and LPs. 
This limitation is striking because it makes their proposal, in one respect at least, so very modest. There exists literally hundreds of thousands of Delaware LLCs and LPs. (121,592 LLCs were formed in Delaware in 2014 alone!) Only around 150 are publicly traded.  Thus, the Strine and Laster proposal for curtailing the freedom of contract affects only a tiny fraction of the alternative entity universe.
But in another respect, the Strine and Laster proposal is quite audacious and radical. Imposing mandatory fiduciary duties fundamentally cuts at their state’s famously strong statutory commitment to freedom of contract and the reputation that that has fostered in legal and business circles. After all, there is a reason why our symposium and AALS program are titled “Contract is King.” As a pragmatic matter, it is hard to see how Delaware could back away from its commitment to the freedom of contract.
Certainly, there is reason to single out publicly traded entities for special treatment. The agreements governing publicly traded alternative entities bear all of the hallmarks of contracts of adhesion: prolix and confusing, often unread and unnegotiated, offered on a take-it-or-leave it basis, and arguably stuffed full of terms that favor the drafting party (the firm’s managers and sponsors) at the expense of often unsophisticated, public investors. Indeed, my own research has shown that these agreements commonly contain clauses that eliminate the default fiduciary duty of loyalty or exculpate for damages arising therefrom, replacing the default duty with less rigorous contractual obligations.
And anyone who closely follows Delaware case law knows how these agreements have played out in practice. In recent years, the Delaware Supreme Court and Court of Chancery have dismissed case after case in which the public investors of alternative entities have alleged self-dealing on the part of the managers or controllers of the entity. And it’s clear that oftentimes the courts are dismissing these cases begrudgingly, despite their own feelings of fairness. 
So, there might well be reason to change the rules for publicly traded entities to limit the freedom of contract by imposing a mandatory fiduciary duty of loyalty. But on the other hand, as I suspect others in this micro-symposium will argue, many of critiques that Strine and Laster levy at publicly traded alternative entities– unsophisticated investors, the absence of true bargaining, and confusing contract terms that often unduly favor the managers—could be levied at many private entities as well. If so, then why should Strine & Laster’s proposal be limited to public entities?
Moreover, even if public investors do not read or understand the terms that they are agreeing to by investing, and even if those terms are unduly favorable to the managers of the entity, the units purchased by investors in a publicly traded alternative entity have been priced by a liquid market that is—to at least some degree—efficient, meaning that those management-friendly terms have been already priced into the units. So, to some extent, public investors are getting exactly what they pay for.  In contrast, the investors in private entities do not benefit from this kind of built-in market wisdom. So, don’t they deserve the judicial protection of a mandatory fiduciary duty even more so than their public investor counterparts?
Given all of this, even if one accepts Strine and Laster’s account of the problems created by the freedom of contract, does it makes sense to limit their solution to the narrow sliver of publicly held entities? Or is their proposed solution simply a pragmatic recognition that for better or worse “Contract is King” and that any reform to that bedrock principle must be modest and incremental.
As I’ll explain in my next post, from my perspective, it is hard to see Delaware stepping back wholesale from its commitment to the freedom of contract in the alternative entity context. But for publicly traded firms at least, I do see reasons why we might see a curtailment of the unlimited freedom of contracting.
 The Siren Song of Unlimited Contractual Freedom, in Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations 13 (Robert W. Hillman & Mark J. Loewenstein eds., 2015) (“In light of these problems, it seems to us that a sensible set of standard fiduciary defaults might benefit all constituents of alternative entities…. For publicly traded entities, the duty of loyalty would be nonwaivable.”)
 See, e.g., In re Encore Energy Partners LP Unitholder Litig., 2012 WL 3792997 (Del. Ch. Aug. 31, 2012) aff’d 72 A.3d 93 (Del. 2013); Gerber v. EPE Holdings, LLC, 2013 WL 209658 (Del. Ch. Jan. 18, 2013); Brinckerhoff v. Enbridge Energy Co., Inc., 2011 WL 4599654 (Del. Ch. Sept. 30, 2011) aff’d 67 A.3d 369 (Del. 2013); In re K-Sea Transp. Partners L.P. Unitholders Litig. 2012 WL 1142351 (Del. Ch. Apr. 4, 2012) aff’d, 67 A.3d 354, 360-61 (Del. 2013). But see In re El Paso Pipeline Partners, 2015 WL 1815846 (Del. Ch. Apr. 20, 2015) (judgment for damages against general partner for breach of contractual duty).
 See, e.g., Encore Energy Partners, 2012 WL 3792997, *13 (Parsons, V.C.) (acknowledging the “near absence under the [LP agreement] of any duties whatsoever [owed] to the public equity holders,” and advising “[i]nvestors apprehensive about the risks inherent in waiving the fiduciary duties of those with whom they entrust their investments may be well advised to avoid master limited partnerships.”); Gerber v. Enterprise Prods. Holdings, LLC, 2012 WL 34442, *13 (Del. Ch. Jan. 6, 2012) (Noble, V.C.) (“The facts of this case take the reader and the writer to the outer reaches of conduct allowable under [Delaware law]. It is easy to be troubled by the allegations.”); Gerber v. EPE Holdings, 2013 WL 209658, *10 (Noble, V.C.) (“It is not difficult to understand [the plaintiff-investor’s] skepticism and frustration, but his real problem is the contract that binds him and his fellow limited partners.”).
 See Gerber v. Enterprise Prods. Holdings, LLC, 2012 WL 34442, *10 n.42 (Del. Ch. Jan. 6, 2012) (Noble, V.C.) (“This [case] raises the issue of just what protection Delaware law affords the public investors of limited partnerships that take full advantage of [the freedom of contract]. If the protection provided by Delaware law is scant, then the LP units of these partnerships might trade at a discount….”).
Jeffrey Lipshaw: Regarding Uncorporations, Is Contract a King or Mere Pretender to the Throne? (Micro-symposium)
Guest post by Jeffrey Lipshaw:
I’m honored to be asked to participate in this micro-symposium, and will (sort of) address the first two questions as I have restated them here.
- Does contract play a greater role in “uncorporate” structures than in otherwise comparable corporations and, more importantly, do I care?
Yes, as I’ll get to in #2, but indeed I probably don’t care. My friend and casebook co-author, the late great Larry Ribstein, was more than a scholar-analyst of the non- or “un-” corporate form; he was an enthusiastic advocate. It’s pretty clear that had to do with his faith in the long-term rationality of markets and their constituent actors and a concomitant distrust of regulatory intervention. Indeed, he argued the uncorporate form, based in contract, was more amenable than the regulatory-based corporate form to the creation of that most decidedly immeasurable quality, trust, and therefore the reduction of transaction costs. I confess I never quite understood the argument and tried to explain why, but only after Larry passed away, so I never got an answer.
Unlike Larry (and a number of my fellow AALS Agency, Partnership, & LLC section members), I was never able to generate a lot of normative fervor about the ultimate superiority of the non-corporate form. I view all organizational and transactional structures, including corporations, LLCs, and contracts, as models or maps. The contractual, corporate, and uncorporate models are always reductions in the bits and bytes of information from the complex reality, and that’s what makes them useful, just as a map of Cambridge, Massachusetts that was as complex as the real Cambridge would be useless.
The difference between city maps and word maps is that the latter are artifacts we lawyers create to chart or control a reality that, in all its damnable uncooperativeness, insists upon moving forward through time and not necessarily respecting all that hard work we did trying to map its possible twists and turns. City maps may also become obsolete over time, but streets and buildings tend not to evolve and adapt quite as quickly or fluidly as human desires and relationships. So we have fewer issues with the gaps between physical maps and physical reality (notwithstanding the desire of my car’s GPS to sell me annual updates) than with the gaps between what we want now and what we wrote down some time ago (whether by way of bylaws, operating agreement, or supply contract) to see that we got it.
Hence, if uncorporations differ from corporations, it’s more a matter of degree than of any real difference. Both are textual artifacts. We have created or assumed obligations pursuant to the text at certain points in time, and we use the artifacts and their associated legal baggage opportunistically when we can. I am not convinced that organizing in the form or corporations or uncorporations makes much difference on that score.
- Is the unfettered ordering in LLCs and limited partnerships – like being able to eliminate wholly all fiduciary duties among the members or partners, as Delaware permits – a good thing? Or should there be some standardized (and I presume therefore mandatory) fiduciary obligations for uncorporations, as Chief Justice Strine and Vice-Chancellor Laster suggest?
Having now gotten my general curmudgeonly-ness out of the way about the whole subject, and believing that a foolish consistency is the hobgoblin of little minds, I want to point out an area where the corporate model and its baggage indeed don’t match up to what normal human beings would expect as reasonable. I confess it’s something that has been a bug up my backside for a number of years, in that I personally had to counsel on the dilemma, and would have loved it if we had organized this particular company as a Delaware limited partnership with only limited and specified fiduciary obligations.
Here’s the circumstance. ABC Corporation spins off one of its businesses into a majority-owned subsidiary, DEF Corporation, possibly as the first step in a complete divestiture. (There’s possibly a tax benefit doing it this way, but let’s not go there right now.) DEF is now publicly traded, with a substantial minority, but ABC controls it both as to ownership (a majority share percentage) and management (posit that ABC appoints a majority of the board of the subsidiary). Assume that DEF’s common stock is now trading at, say, $15 per share on the NASDAQ. A third party, XYZ Corporation, contacts ABC’s CEO, and says the following: “We are prepared to pay $32 per share for all of DEF, both yours and the public minority, but we view this as pre-emptive, and if you shop the bid, we will walk away.” ABC’s CEO’s visceral reaction is to tell XYZ that if it will send over the check, she will deliver the share certificate this afternoon. Indeed, were DEF still wholly owned, that’s probably what would happen soon, if not that afternoon.
But Delaware corporate law doesn’t like that at all when there’s a public minority. See McMullin v. Beran, 765 A.2d 910 (Del. 2000) and Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (Del. 2009). DEF’s board is going to have to create a special committee of the independent (i.e. public) directors to undertake diligence satisfying the duty of care obligation. That committee will feel obliged to hire independent counsel and its own investment banker. It may believe that its duty requires a shopping of the bid, which could cause the pre-emptive offer to go away. But how do we know that there isn’t a $35 per share offer just waiting out there? (I commented on this in connection with Lyondell back in 2008.) As any transactional lawyer knows, time means deal risk.
I’m not suggesting that the duty of care obligations imposed by the corporate law are wrong in change of control cases, but their imposition in Smith v. Van Gorkom (where the essence of the decision was that, regardless of the attractiveness of the offer, the board went too fast and wasn’t careful enough) provoked the adoption of §102(b)(7), exculpating the directors from monetary liability on account of any breach of the duty of care largely because they were held liable in a “devil if you do – devil if you don’t” circumstance. That is to say, §102(b)(7) is an implicit acknowledgment that broad and standardized fiduciary obligations are sometimes overbroad. But there’s really no way, at least logically, to tell a board when a bid is sufficiently pre-emptive as to trump the ordinary procedural precautions.
The great benefit of Delaware LLC and LP law, in providing that the usual fiduciary duties apply as a default matter, but permitting the parties to eliminate or modify them, as one cannot under the corporate law, is precisely the customization that would have been useful here. Assuming no penalty in the market for having organized as a public limited partnership or LLC (see Blackstone Group LP), that form would have allowed the governing organizational document to waive any fiduciary obligation of the board or the majority owner in connection with the consideration of a seemingly pre-emptive offer, and avoided delay and the associated risk to the deal.
With all due respect to Chief Justice Strine and Chancellor Laster, I still don’t believe this has anything to do with the magic of private ordering in contract. As I’ve written extensively, I think there’s significant illusion among lawyers and law professors about the extent to which any text capable of colorable competing interpretations actually reflects any mutual intention even if it was the subject of arm’s-length negotiation. That’s because I tend to believe that even sophisticated parties to sophisticated contracts put in a lot of boilerplate they hope maps accurately the twists and turns of future events or, more importantly, clearly favors them if there’s ever a dispute. And when there is a later dispute, they turn to the text and hope to hell there’s something helpful in it. So I’ve never been under the misapprehension that the operating agreement or partnership agreement of a publicly held LLC or LP reflects real intentions about the resolution of later disputes any more than corporate bylaws or the rights and preferences of a class of stock.
The LLC or LP form is just an alternative map or model, with alternative rights and obligations. In the case that bugged me, it would have been a way to avoid a problem the corporate model really couldn’t quite get right. Whether that’s “contract” or something else, reinstating standardized or mandatory fiduciary obligations strikes me as eliminating the very choice the different forms were meant to offer.
Thursday, November 12, 2015
Next week, the BLPB is hosting a micro-symposium organized by the AALS section on Agency, Partnership, LLCs, and Unincorporated Associations. Confirmed participants include Joan MacLeod Heminway (BLPB editor), Dan Kleinberger, Jeff Lipshaw, Mohsen Manesh, and Sandra Miller.
The micro-symposium will explore the role of private ordering in LLCs and other alternative business entities, a broad topic that encompasses many interesting questions:
(1) To what extent, and in what ways, does contract play a greater role in LLCs and LPs than in otherwise comparable corporations? Is it helpful to conceptualize private ordering in this context as contractual?
(2) Does unfettered private ordering reliably advance the interests of even the most sophisticated parties? Does it waste judicial resources? In their book chapter, The Siren Song of Unlimited Contractual Freedom, two distinguished Delaware jurists, Chief Justice Leo Strine and Vice Chancellor J. Travis Laster, raise these concerns and argue in favor of more standardized fiduciary default rules.
(3) Should the law impose fiduciary duties of loyalty and care as safeguards against abuse of the unobservable discretion managers enjoy because those duties reflect widely held social norms that most investors would expect to govern the conduct of managers?
(4) If the parties themselves would choose to waive their fiduciary obligations, is there nevertheless a continuing role for mandatory terms and judicial monitoring of the parties' relationship?
(5) Does it matter whether an LLC or alternative business entity is closely held or publicly traded?
We look forward to an engaging discussion next week via blog, and we invite everyone who will be at AALS to attend our section meeting on January 7 at 1:30pm. Joined by panelists Lyman Johnson and Mark Loewenstein, we will continue the conversation in person.
Friday, October 9, 2015
Christine Hurt has written an interesting article on limited liability partnerships in bankruptcy. It's available here.
Here's the abstract:
Brobeck. Dewey. Howrey. Heller. Thelen. Coudert Brothers. These brand-name law firms had many things in common at one time, but today have one: bankruptcy. Individually, these firms expanded through hiring and mergers, took on expensive lease commitments, borrowed large sums of money, and then could not meet financial obligations once markets took a downturn and practice groups scattered to other firms. The firms also had an organizational structure in common: the limited liability partnership.
In business organizations classes, professors teach that if an LLP becomes insolvent, and has no assets to pay its obligations, the creditors of the LLP will not be able to enforce those obligations against the individual partners. In other words, partners in LLPs will not have to write a check from personal funds to make up a shortfall. Creditors doing business with an LLP, just as with a corporation, take this risk and have no expectation of satisfaction of claims by individual partners, absent an express guaranty. In bankruptcy terms, creditors look solely to the capital of the entity to satisfy claims. While bankruptcy proceedings involving general partnerships may have been uncommon, at least in theory, bankruptcy proceedings involving limited liability partnerships have recently become front-page news.
The disintegration of large, complex LLPs, such as law firms, does not fit within the Restatement examples of small general partnerships that dissolve fairly swiftly and easily for at least two reasons. First, firm creditors, who have no recourse to individual partners’ wealth, wish to be satisfied in a bankruptcy proceeding. In this circumstance, federal bankruptcy law, not partnership law, will determine whether LLP partners will have to write a check from personal funds to satisfy obligations. Second, these mega-partnerships have numerous clients who require ongoing representation that can only be competently handled by the full attention of a solvent law firm. In these cases, the dissolved law firm has neither the staff nor the financial resources to handle sophisticated, long-term client needs such as complex litigation, acquisitions, or financings. These prolonged, and lucrative, client matters cannot be simply “wound up” in the time frame that partnership law anticipates. The ongoing client relationship begins to look less like an obligation to be fulfilled and more like a valuable asset of the firm.
Partnership law would scrutinize the taking of firm business by former partners under duty of loyalty doctrines against usurping business opportunities and competing with one’s own partnership, both duties that terminate upon the dissolution of the general partnership or the dissociation of the partner. However, bankruptcy law is not as forgiving as the LLP statutes, and bankruptcy trustees view the situation very differently under the “unfinished business” doctrine. The bankruptcy trustee, representing the assets of the entity and attempting to salvage value for creditors, instead seeks to make sure that assets, including current client matters, remain in partnership solution unless exchanged for adequate consideration, even if the partners agree to let client matters stay with the exiting partners.
This Article argues that the high-profile bankruptcies of Heller Ehrman LLP, Howrey LLP, Dewey & LeBeouf, LLP, and others show in stark relief the conflict between general partnership law and bankruptcy law. The emergence of the hybrid LLP creates an entity with general partnership characteristics, such as the right to co-manage and the imposition of fiduciary duties, but with limited liability for owner-partners. These characteristics co-exist peacefully until they do not, which seems to be at the point of dissolution. Then, the availability of limited liability changes partners’ incentives upon dissolution. Though bankruptcy law attempts to resolve this, it conflicts with partnership law to create more uncertainty.
Tuesday, September 22, 2015
This post is related to another great post from Tom Rutledge at the Kentucky Business Entity Law Blog, Diversity Jurisdiction and Jurisdictional Discovery: The Third Circuit Holds That “Hiding The Ball” Will Not Work. Tom's post is about Lincoln Benefit Life Company v. AEI Life, LLC, No. 14-2660, 2015 WL 5131423, ___ F.2d__ (3rd Cir. Sept. 2, 2015), which is available here.
Lincoln Benefit allows a plaintiff, after a reasonable inquiry into the resources available (like court records and public documents), to allege complete diversity in good faith, if there is no reason to believe any LLC members share the same state of citizenship. Thus, the diversity claim can be made on "information and belief." Tom explains that
While it may do nothing to address the fact that diversity jurisdiction may be unavailable consequent to de minimis indirect ownership . . . it does limit the ability of a defendant to “hide the ball” as to its citizenship while objecting that the other side has not adequately pled citizenship and therefore diversity.
This concern arises out of the fact that LLCs, as unincorporated associations, are treated like partnerships for purposes of federal diversity jurisdiction, meaning that an LLC is a citizen of every state in which it has a member. Thus, if an LLC has members that are partnerships or other LLCs, then a plaintiff would need to drill down all the way until they find get to natural people or corporations to know all the states in which the LLC is a citizen. (As a reminder, under 28 U.S.C. § 1332, federal diversity jurisdiction requires that the dispute both involve more than $75,000 and that there be complete diversity between all plaintiffs and all defendants.)
For corporations, the statute provides: "a corporation shall be deemed to be a citizen of every State and foreign state by which it has been incorporated and of the State or foreign state where it has its principal place of business . . . ."
Some may argue that LLCs, with the limited liability shield for all members, are just like corporations and should be treated as such for diversity purposes. I think there is instant appeal to treating LLCs as corporations in that setting, but after further thought, I don't think it's as simple as it looks (at least, not for me). As one who continues to argue that LLCs and corporations are distinct entities, I think there is a real (and valid) difference between "incorporated" as required under § 1332 and the more general term, "formed."
I would agree that one can make a reasonable argument (though I think contrary to § 1332, and not my choice) that where limited liability applies to all unit holders (or members), then the corporation rule for diversity should apply to all entities that are formed (not just incorporated). If so, though, then that would likely include LPs and LLLPs, too, because any entity that requires filing, (i.e., all limited liability entities) could then reasonably be views as "formed" under state law. That is okay, if that's the desired policy, but it's not limited to LLCs in that case.
Still, there are those who would argue that one can interpret "incorporated" in § 1332 to mean "formed," but I think that's wrong. "Formed" has its origins in partnership law. See, e.g., Uniform Partnership Act § 202 (1997) ("Formation of partnership."). Id.§ 202(c) ("In determining whether a partnership is formed, the following rules apply . . . ."). A legislature could make such a change, but it should be a legislative change.
Despite the best efforts of thousands of courts, LLCs are formed, not "incorporated." See Uniform LLC Act § 202(d): "(1) A limited liability company is formed when the [Secretary of State] has filed the certificate of organization and the company has at least one member, unless the certificate states a delayed effective date pursuant to Section 205(c)." As such, under current law for federal diversity, "incorporated" applies to corporations only.
Beyond that, as to LLCs specifically, I think there is a difference between member-managed LLCs and manager-managed LLCs in carrying out the corporate analogy. That is, a manager-managed LLC is (usually) quite comparable to a corporation and a member-managed LLC is more easily compared to a partnership. That raises the question: should there be a control test, if that's really the question, as to how diversity applies? There is no control test for close corporations, either, I would note, and instead a bright line is applied by entity, not control or risk of liability.
Furthermore, if it's just the concept of complete limited liability, I would argue that an LP with a corporate GP (that only operates for the purposes of that LP) is functionally similar to an LLC in terms of liability, yet there seems to be less of a question how we analyze the LP for diversity purposes.
It seems to me Lincoln Benefit got the test right, under current law. Let's see how that goes before we start conflating LLCs and corporations in yet another area.
Tuesday, September 8, 2015
Limited liability companies (LLCs) are often viewed as some sort of a modified corporation. This is wrong, as LLCs are unique entities (as are, for example, limited partnerships), but that has not stopped lawyers and courts, including this nation's highest court, from conflating LLCs and corporations.
About four and a half years ago, in a short Harvard Business Law Review Online article, I focused on this oddity, noting that many courts
seem to view LLCs as close cousins to corporations, and many even appear to view LLCs as subset or specialized types of corporations. A May 2011 search of Westlaw’s “ALLCASES” database provides 2,773 documents with the phrase “limited liability corporation,” yet most (if not all) such cases were actually referring to LLCs—limited liability companies. As such, it is not surprising that courts have often failed to treat LLCs as alternative entities unto themselves. It may be that some courts didn’t even appreciate that fact. (footnotes omitted).
I have been writing about this subject again recently, so I decided to revisit the question of just how many courts call LLCs “limited liability corporations” instead of “limited liability companies.” I returned to Westlaw, though this time it's WestlawNext, to do the search of cases for the term "limited liability corp!". (Exclamation point is to include corp., corporation, and corporations in my search, not to show excitement at the prospect.)
The result: 4575 cases use the phrase at least once.
That means that, since May 2011, 1802 additional cases have incorrectly identified the definition of an LLC. (I concede that some cases may have used the term to note it was wrong, but I didn't find any in a brief look.)
Even the United States Supreme Court published one case using the incorrect phrase, and it was decided around three years after my article was published. See Daimler AG v. Bauman, 134 S. Ct. 746, 752, 187 L. Ed. 2d 624 (2014) ("MBUSA, an indirect subsidiary of Daimler, is a Delaware limited liability corporation."). (Author's note: ARRRRGH!) The court also stated, "Jurisdiction over the lawsuit was predicated on the California contacts of Mercedes–Benz USA, LLC (MBUSA), a subsidiary of Daimler incorporated in Delaware with its principal place of business in New Jersey." Id. (emphasis added). (Author's Note: Really?)
This opinion was written by Justice Ginsberg, and joined by Chief Justice Roberts, and Justices Scalia, Kennedy, Thomas, Breyer, Alito, and Kagan. Justice Sotomayor filed a concurring opinion that did not, unfortunately, concur in judgment but disagree with the characterization of the LLC. The entire court at least acquiesced in the incorrect characterization of the LLC!
It appears things have to get worse before they can get better, but I will remain vigilant. I’m working on an article that builds on this, and it will hopefully help courts and practitioners keep LLCs and corporations distinct.
In the meantime, I humbly submit to Chief Justice Roberts, and the rest of the Court, that there are already some useful things in law reviews.
September 8, 2015 in Business Associations, Case Law, Corporations, Joshua P. Fershee, Law Reviews, Lawyering, LLCs, Partnership, Research/Scholarhip, Unincorporated Entities | Permalink | Comments (2)
Tuesday, August 18, 2015
Over at the Kentucky Business Entity law blog, Thomas Rutledge discusses a recent decision from the United States District Court for the Southern District of Indiana, affirming a Bankruptcy Court decision that finding that when a member of an LLC with voting control personally files bankruptcy, that right to control the LLC became a vested in the trustee because the right was part of the bankruptcy estate. The case is In re Lester L. Lee, No. 4-15-cv-00009-RLY-WGH, Adv. Proc. No. 14-59011 (S.D. Ind. August 10, 2015) (PDF here).
A key issue was that the bankruptcy filer (Lester Lee) had 51% of the vote, but no shares. The court then explains:
7. . . . [t]he Operating Agreement states . . .
(D) Each member shall have the voting power and a share of the Principal and income and profits and losses of the company as follows:
Member’s Name (Share) (Votes)
Debra Jo Brown (20%) (10)
Brenda R. Lee (40%) (20)
Larry L. Lee (20%) (10)
Melinda Gabbard (20%) (10)
Lester L. Lee (0%) (51)
. . . .
8. . . . Trustee’s counsel became aware of the Debtor’s 51% voting rights as a member, and that pursuant to applicable law, “this noneconomic interest became property of the estate subject to control of the Trustee on the filing of the petition pursuant to 11 U.S.C. § 541.”
Here's Rutledge's take:
On appeal, the Court’s primary focus was upon whether the right to vote in an LLC constitutes “property of the estate,” defined by section 541(a)(1) of the Bankruptcy Code as “all legal or equitable interest of the Debtor in property as of the commencement of the case. After finding that Lee could be a “member” of the LLC notwithstanding the absence of any share in the company’s profits and losses or the distributions it should make, the Court was able to determine that Lee was a member. In a belt and suspenders analysis, the Court determined also that the voting rights themselves could constitute “economic rights in the company” affording him the opportunity to, for example, “ensure his continued employment as manager” thereof.
In a response to Rutledge's blog, Prof. Carter Bishop notes,
The court did not state the trustee could exercise those voting rights. The next step is crucial. If the operating agreement is an executory contract of a multi-member LLC, BRC 365 will normally respect LLC state law restrictions as “applicable law” and deny the trustee the right to exercise the debtor’s voting rights (similar outcome to a non-delegable personal service contract).This was a managing member of a multi-member LLC, so I assume BRC 365 blocks the trustee’s exercise.
Rutledge notes that could be the case, but it's also possible the Lee court was saying we already decided that -- voting rights are part of the estate.
I find all of this interesting and important to think about, especially given my limited bankruptcy knowledge. My main interest, though, is how might we plan around such a situation? Many LLC statutes provide some options.
For example, some states allow those forming an LLC to adopt a provision in the Operating Agreement that makes bankruptcy an event that triggers "an event of dissociation,” which would make the filer (or his or her successor in interest) no longer a member. See, e.g., Indiana Code sec. 23-18-6-5(b) ("A written operating agreement may provide for other events that result in a person ceasing to be a member of the limited liability company, including insolvency, bankruptcy, and adjudicated incompetency."). This raises the question, then, of whether the bankruptcy code trumps this LLC code such that the bankruptcy filing creates an estate that makes it so the state LLC law cannot operate to eliminate the filer as a member.
The answer is no, the state law doesn't trump the bankruptcy code, but the state provision can still have effect. A recent Washington state decision (petition for review granted), relying on Virginia law, determined that where state law dissociates a member upon a bankruptcy filing, the trustee cannot be a member, and thus the trustee cannot exercise membership rights:
[I]nstead of dissociating the debtor, Virginia law operated to dissociate the bankruptcy estate itself. The court concluded, “Consequently, unless precluded by § 365(c) or (e), his bankruptcy estate has only the rights of an assignee.
Given the similarities between Virginia's and Washington's treatment of LLC members who file for bankruptcy, we adopt the reasoning of Garrison–Ashburn [253 B.R. 700 (Bankr. E.D. Va. 2000)]. By applying Washington law, we conclude that RCW 25.15.130 dissociates a bankruptcy estate such that it retained the rights of an assignee under RCW 25.15.250(2), but not membership or management rights, despite the provisions of 11 U.S.C. § 541(c)(1).
The court then needed to decided whether § 365 allows a member to retain his or her membership. Under Washington partnership law, as applied to the bankruptcy code, the court explained:
under § 365, the other partners are not obligated to accept an assumption of the partnership agreement. Partnerships are voluntary associations, and partners are not obligated to accept a substitution for their choice of partner. The restraint on assumability also makes the deemed rejection provision of § 365 inapplicable to the partnership agreement. Therefore, § 365(e)'s invalidation of ipso facto provisions does not apply, and state partnership law is not superseded. The debtor-partner's economic interest is protected by other sections of the bankruptcy code, but he no longer is entitled to membership.
Tuesday, January 6, 2015
Over at The Conglomerate, Usha Rodrigues says, "Larry Ribstein was wrong." Usha argues that she's right to teach LLCs at the end of the course, and Larry was of the mind that LLCs should play a more prominent role in the business entities course.
For my teaching, I'm with Larry on this, though I am also of the mind that Usha (and other teachers) may have different goals, so taking another tack is not wrong. I'm pretty sure we're all better teachers when we are true to ourselves and our thinking. For me, anyway, I am, without a doubt, at my worst in the classroom (and probably out) when I try to mimic someone else.
So here's how Usha explains her thinking:
I don't leave LLCs til the end of the semester because I think they're unimportant. It's because the cases are so damn thin. It's still such a new form, I just don't see much there there. Most of them wind up being trial courts who read the statute in completely stupid ways. Blech.
So I teach corporations and partnerships emphasizing fiduciary duty, default vs. mandatory rules, and the importance of the code. In fact, one semester I confess that I would ask a question and then intone, "Look to the code!" so often I felt like a Tolkien refugee. By the time I get to the LLCs cases, which are pretty basic, the class is ready for my message: the LLC is a new form. When dealing with something new, judges look both to the organizational statutes and to the organizational forms they know as they shape the law. Plus the LLC is such an interesting mix between the corporate and partnership form, it just makes sense to get through them both before diving in.
It's hard to argue with Usha's rationale. Like Larry, she's smart, and this is a reasonable take. For me, though, it doesn't work toward my goals, so I have a different point of view. I think it's more in line with where Larry was coming from, though I admit I don't know.
Here's why: I want students (and lawyers and courts) to treat LLCs as unique entities. Leaving them to the end of the course reinforces the idea that LLCs are hybrid entities the combine partnerships and corporations. I just don't think that's the right way to think about LLCs.
Certainly, it is true that LLCs share characteristics of partnerships and corporations. But partnerships and corporations can have similarities, too. We can, for example, refer back to the partnership case of Meinhard v. Salmon when discussing corporate fiduciary duties and corporate opportunity.
In my experience, teaching LLCs at the end of the course seemed to frame the LLC as an entity that is just pulling from partnership or corporate law. As such, it seemed the students were thinking that the real challenge for LLCs was figuring out whether to pull from partnership law or corporate law for an analogy. Part of the reason for that, I think, is that so many of the LLCs cases seem to think so, too. See, e.g., Flahive. As Usha would say, "Blech."
The LLC is prominent enough in today's world that I think it warrants a more prominent role in the introductory business organizations course. If we don't bring the LLCs more to the fore, we allow courts to continue to misconstrue the entity form, in part because we aren't giving students the tools they need to ensure courts understand the unique nature of the LLC.
I figure Usha can get students where she needs to on this regardless of how she teaches business associations. She is a lot smarter than I am. Given my goals and how I think about the LLC, though, I'll keep starting my class with an introduction to LLC formation, and I'll keep teaching LLC cases and issues throughout the semester.
Thursday, November 13, 2014
1) Difference between LLCs, corporations and partnerships
2) Del. and ULLCA coverage of fiduciary duties, and especially the issue of contractual waiver and default
19) No right to distributions, and no right to vote for distributions if manager-managed
20) No right to salary or employment
21) Taxable liability for LLC membership
22) Exit rights—voluntary withdrawals vs. restricted withdrawals, and whether or not that comes with the ability to force the return of an investment or a new status as a creditor of the LLC
23) Liability for improper distributions
24) Veil piercing, particularly given the lack of corporate formalities
I would love some feedback from practitioners as well. What do law students and practicing lawyers need to know about LLCs? What's missing from this list? What should I get rid of? Please feel free to comment below or to email your thoughts to email@example.com.
November 13, 2014 in Business Associations, C. Steven Bradford, Corporate Personality, Corporations, Delaware, Law School, LLCs, Marcia Narine, Partnership, Teaching, Unincorporated Entities | Permalink | Comments (1)
Friday, September 12, 2014
In 2007, J. W. Verret (George Mason) and then Chief Justice Myron Steele authored an article entitled Delaware's Guidance: Ensuring Equity for the Modern Witenagemot, which discussed "some of the extrajudicial activities in which members of the Delaware judiciary engage to minimize the systemic indeterminacy resulting from the resolution of economic disputes by a court of equity."
One of these extrajudicial activities is authoring or co-authoring law review articles. In this post, I am not going to weigh in on whether Delaware judges should be authoring law review articles, but rather, I simply note that there are two recent law review articles and one recent book chapter by Delaware judges that warrant our attention.
John Maynard Keynes is said to have observed, "When the facts change, I change my mind. What do you do, sir?" In Delaware's Choice, Professor Subramanian argues that the facts underlying the constitutionality of Section 203 have changed. Assuming his facts are correct, and the Professor says that no one has challenged his account to date, then they have implications for more than Section 203. They potentially extend to Delaware's jurisprudence regarding a board's ability to maintain a stockholder rights plan, which becomes a preclusive defense if a bidder cannot wage a proxy contest for control of the target board with a realistic possibility of success. Professor Subramanian's facts may call for rethinking not only the constitutionality of Section 203, but also the extent of a board's ability to maintain a rights plan.
One important aspect of Citizens United has been overlooked: the tension between the conservative majority’s view of for-profit corporations, and the theory of for-profit corporations embraced by conservative thinkers. This article explores the tension between these conservative schools of thought and shows that Citizens United may unwittingly strengthen the arguments of conservative corporate theory’s principal rival.
Citizens United posits that stockholders of for-profit corporations can constrain corporate political spending and that corporations can legitimately engage in political spending. Conservative corporate theory is premised on the contrary assumptions that stockholders are poorly-positioned to monitor corporate managers for even their fidelity to a profit maximization principle, and that corporate managers have no legitimate ability to reconcile stockholders’ diverse political views. Because stockholders invest in for-profit corporations for financial gain, and not to express political or moral values, conservative corporate theory argues that corporate managers should focus solely on stockholder wealth maximization and non-stockholder constituencies and society should rely upon government regulation to protect against corporate overreaching. Conservative corporate theory’s recognition that corporations lack legitimacy in this area has been strengthened by market developments that Citizens United slighted: that most humans invest in the equity markets through mutual funds under section 401(k) plans, cannot exit these investments as a practical matter, and lack any rational ability to influence how corporations spend in the political process.
Because Citizens United unleashes corporate wealth to influence who gets elected to regulate corporate conduct and because conservative corporate theory holds that such spending may only be motivated by a desire to increase corporate profits, the result is that corporations are likely to engage in political spending solely to elect or defeat candidates who favor industry-friendly regulatory policies, even though human investors have far broader concerns, including a desire to be protected from externalities generated by corporate profit-seeking. Citizens United thus undercuts conservative corporate theory’s reliance upon regulation as an answer to corporate externality risk, and strengthens the argument of its rival theory that corporate managers must consider the best interests of employees, consumers, communities, the environment, and society — and not just stockholders — when making business decisions.
One frequently cited distinction between alternative entities — such as limited liability companies and limited partnerships — and their corporate counterparts is the greater contractual freedom accorded alternative entities. Consistent with this vision, discussions of alternative entities tend to conjure up images of arms-length bargaining similar to what occurs between sophisticated parties negotiating a commercial agreement, such as a joint venture, with the parties successfully tailoring the contract to the unique features of their relationship.
As judges who collectively have over 20 years of experience deciding disputes involving alternative entities, we use this chapter to surface some questions regarding the extent to which this common understanding of alternative entities is sound. Based on the cases we have decided and our reading of many other cases decided by our judicial colleagues, we do not discern evidence of arms-length bargaining between sponsors and investors in the governing instruments of alternative entities. Furthermore, it seems that when investors try to evaluate contract terms, the expansive contractual freedom authorized by the alternative entity statutes hampers rather than helps. A lack of standardization prevails in the alternative entity arena, imposing material transaction costs on investors with corresponding effects for the cost of capital borne by sponsors, without generating offsetting benefits. Because contractual drafting is a difficult task, it is also not clear that even alternative entity managers are always well served by situational deviations from predictable defaults.
In light of these problems, it seems to us that a sensible set of standard fiduciary defaults might benefit all constituents of alternative entities. In this chapter, we propose a framework that would not threaten the two key benefits that motivated the rise of LPs and LLCs as alternatives to corporations: (i) the elimination of double taxation at the entity level and (ii) the ability to contract out of the corporate opportunity doctrine. For managers, this framework would provide more predictable rules of governance and a more reliable roadmap to fulfilling their duties in conflict-of-interest situations. The result arguably would be both fairer and more efficient than the current patchwork yielded by the unilateral drafting efforts of entity sponsors.
Tuesday, August 19, 2014
At West Virginia University College of Law, we started classes yesterday, and I taught my first classes of the year: Energy Law in the morning and Business Organizations in the afternoon. As I do with a new year coming, I updated and revised my Business Organizations course for the fall. Last year, I moved over to using Unicorporated Business Entities, of which I am a co-author. I have my own corporations materials that I use to supplement the book so that I cover the full scope of agency, partnerships, LLCs, and corporations. So far, it's worked pretty well. I spent several years with Klein, Ramseyer and Bainbridge's Business Associations, Cases and Materials on Agency, Partnerships, and Corporations (KRB), which is a great casebook, in its own right.
I did not make the change merely (or even mostly) because I am a co-author. I made the change because I like the structure we use in our book. I had been trying to work with KRB in my structure, but this book is designed to teach in with the organization I prefer, which is more topical than entity by entity. I'll note that a little while ago, my co-blogger Steve Bradford asked, "Are We Teaching Business Associations Backwards?" Steve Bainbridge said, "No." He explained,
I've tried that approach twice. Once, when I was very young, using photocopied materials I cut and pasted from casebook drafts the authors kindly allowed me to use. Once by jumping around Klein, Ramseyer, and Bainbridge. Both times it was a disaster. Students found it very confusing (and boy did my evaluations show it!). It actually took more time than the entity by entity approach, because I ended up having to do a lot of review (e.g., "you'll remember from 2 weeks ago when we discussed LLCs most recently that ...."). There actually isn't all that much topic overlap. Among corporations, for example, you've got the business judgment rule, derivative suits, "duty" of good faith, executive compensation, the special rules for close corporations, proxies, and so on, most of which either don't apply to LLCs etc.... or don't deserve duplicative treatment.
I have great respect for Prof. Bainbridge, and his writing has influenced me greatly, but (not surprisingly), I come out more closely aligned with my perception of Larry Ribstein on such issues, and with Jeff Lipshaw, who commented,
I disagree about the lack of topic overlap, and suspect Larry Ribstein is raging about this in BA Heaven right now. . . .
This may reflect differences among student populations, but the traditional corporate law course, focusing primarily on public corporations, is less pertinent in many schools where students are unlikely to be doing that kind of work when they graduate. It's far more likely that they'll need to be able to explain to a client why the appropriate business form is a corporation or an LLC, and what the topical differences between them are.
I completely agree, and I would go another step to say that I find the duplication to be a valuable reinforcement mechanism that is worth (what I have seen as limited) extra time. I am teaching a 4-credit course, though, which gives me time I never had in my prior institution's 3-credit version.
One thing I am doing differently this year is my first assignment, which seeks to build on what I see as a need for students here. That is, I think many of them will need to be able to explain entity differences and help clients select the right option.
I had my students fill out the form for a West Virginia Limited Liability Company (PDF here). I had a few goals. First, I don't like to have students leave any of my classes without handling at least some of the forms or other documents they are likely to encounter in practice. Second, I did it without any instruction this time (I have used similar forms later in the course) because I thought it would help me tee up an introduction to all this issues I want them thinking about with regard to entity choice. (It did.) Finally, I like getting students to see the connection between the form and the statute. We can link though and see why the form requires certain issues, discuss waivable and nonwaivable provisions, and talk about things like entity purpose, freedom of contract, and the limits of limited liability.
If nothing else, the change kept things fresh for me. I welcome any comments and suggestions on any of this, and I wish everyone a great new academic year.