Monday, November 16, 2015

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.[1] But, importantly, they limit their proposal to publicly traded LLCs and LPs. [2]

This limitation is striking because it makes their proposal, in one respect at least, so very modest. There exists literally hundreds of thousands of Delaware LLCs and LPs. (121,592 LLCs were formed in Delaware in 2014 alone!) Only around 150 are publicly traded. [3] Thus, the Strine and Laster proposal for curtailing the freedom of contract affects only a tiny fraction of the alternative entity universe.

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

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

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

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

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

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

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

-Mohsen Manesh

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

[2]  Id.

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

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

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

Conferences, Corporate Governance, Corporations, Delaware, LLCs, Partnership, Unincorporated Entities | Permalink


I wonder whether the Strine/Laster view represents the somewhat jaundiced view of judges who only see the failures. I use the Blackstone Group LP as my example of a publicly traded LP with the full extent of the permissible Delaware disclaimer on fiduciary remedies. If I am reading the stock price chart correctly, BX went out at $31 per share in the IPO, sank to about $3.90 in February 2009 at the nadir of the financial crisis, rose back up to about $41 in May of this year, and is now back around $31. I doubt that anybody who invested for the long term is complaining - I certainly wouldn't bitch if my portfolio were now at the same level it was in June 2007. Of the 150 or so publicly traded alternative entities in Delaware, how are they doing compared to the market as a whole? Blackstone seems to be just fine, notwithstanding the disclaimers!!!

Posted by: Jeff Lipshaw | Nov 16, 2015 1:19:44 PM

Perhaps the better perspective on this issue is the public/private distinction rather than the corporate/contract distinction. Entities whose interests are publicly traded are “creatures of contract” only in the same way in which you have willingly assented to the terms in your agreement with the credit card company.

So, I ask – why should the formality of form determine whether investors can rely on fiduciary duty to protect them from those who manage “Other People’s Money”?

Posted by: Daniel S. Kleinberger | Nov 17, 2015 7:35:15 AM

@Jeff Lipshaw: I think you’re certainly right that the Strine/Laster proposal reflects their frustrations adjudicating cases in which they feel powerless to wring justice from the management-friendly terms of a given LLC or LP agreements. But I’m not sure how far focusing on stock price gets you. It’s true that BX has been relatively successful since its IPO. (Of course, for every BX there are other publicly traded alternative entities, like FIG or OZM, both of which IPO’ed around the same time as BX and have lost substantial value since.) But what we can’t know is how much more investor value would have been realized if the managers of a publicly traded alternative entity had a fiduciary duty of loyalty to make decisions in the best interests of the entity and its owners. On the other hand, we can’t know how much marginal investor value has been achieved in fact (this in particularly true in the energy MLP context) by enabling the entity’s managers to engage in conflict-of-interest transactions with the entity.

Posted by: Mohsen Manesh | Nov 17, 2015 10:50:18 AM

@Dan Kleinberger: Thanks for your comment. I agree that the governing agreements of publicly traded LLCs and LPs are prototypical contracts of adhesion. Likewise, I agree that it is odd that though two entities might both be publicly traded, the formality of each entity’s legal form should dictate whether the public investors can rely on fiduciary duty to protect them from those who manage their equity investment. This was the central thesis of one my earliest articles:

But, note, that there are two potential responses to this formalism. One is your response: that fiduciary duties should be made mandatory in all public entities, regardless of legal form. The other response goes in the opposite direction: to allow public corporations to do what is already permitted for their LLC and LP brethren—namely the elimination of fiduciary duties. For better or worse, the latter seems to describe the inexorable path of Delaware corporate law, with DGCL 102(b)(7) and then DGCL 122(17). More recently, in the Revlon context, which is analogous to the McMullin v. Beran situation that so bothers Jeff, cases like C&J Energy Services and Corwin v. KKR have made clear that the fiduciary duty to get the best price is not one that courts are eager to enforce with any rigor.

Posted by: Mohsen Manesh | Nov 17, 2015 10:51:25 AM

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