Tuesday, November 17, 2015

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. 

-Sandra Miller



Business Associations, Corporate Governance, Corporations, Delaware, LLCs, Partnership, Unincorporated Entities | Permalink


Sandy - I follow you on public-traded entities, but not necessarily w/r/t to closely-held ones. One of the problems with fiduciary duties among owners in closely held businesses is that often mere breach of contract claims turn into fiduciary claims. Not surprisingly, I think that the uniform acts (LLC, LP, GP – 2013 versions) have it right. Following is part of the comment to ULLCA (2013) § 105(d)(2)

[begin quotation]
Under this act, a properly drafted operating agreement may substantially alter and even eliminate fiduciary duties. However, two important limitations exist.

First, arrangements subject to this subsection may not be “manifestly unreasonable.” See Subsection (e) (delineating this standard).

Second, the operating agreement may not transform the relationship inter se members, managers, and the LLC into an entirely arm’s length arrangement. For example, displacement of fiduciary duties is effective only to the extent that the displacement is stated clearly and with particularity. This rule is fundamental in the jurisprudence of fiduciary duty. See, e.g., Paige Capital Mgmt, L.L.C. v. Lerner Master Fund, L.L.C., Civ. A. No. 5502-CS, 2011 WL 3505355, at *31 (Del. Ch. Aug. 8, 2011) (Del. Ch. 2011) (stating that, even under a statute that “permits the waiver of fiduciary duties . . . such waivers must be set forth clearly”); Kelly v. Blum, Civ. A. No. 4516-VCP, 2010 WL 629850, at *10, n.70 (Del. Ch. Feb. 24, 2010) (“Having been granted great contractual freedom by the LLC Act, drafters of or parties to an LLC agreement should be expected to provide . . . clear and unambiguous provisions when they desire to expand, restrict or eliminate the operation of traditional fiduciary duties”). It would therefore be manifestly unreasonable for an operating agreement to negate this rule.
[end quotation]


Posted by: Daniel S. Kleinberger | Nov 17, 2015 7:53:01 AM

Sandy, I have always appreciated your outspoken stance on the pitfalls of freedom of contract in alternative entities. I’m curious: It sounds like you’re willing to concede freedom of contract permitting fiduciary waivers for sophisticated parties at least. If so, then who is sufficiently sophisticated? How should the law distinguish between sophisticated parties and unsophisticated parties? Could we even devise a legal test that is accurate, administrable and determinate?

Posted by: Mohsen Manesh | Nov 17, 2015 10:52:10 AM

I'm not sure what a "mandatory duty of loyalty for all entities, public or private" means. Let's say I'm a venture capitalist. My firm is Early Ventures, LLC. It is the general partner in Early Venture Partners I, L.P. and Early Venture Partners II, L.P. I write in each limited partnership agreement either the full fiduciary waiver permissible in Delaware, or the more limited waiver of the duty of loyalty available under RULPA to deal with this problem. Fund I and Fund II may compete with each other for investment opportunities, and I want it to be clear than there's no cause of action if that occurs. Modifying or eliminating the duty of loyalty in that circumstance hardly strikes me as madness.

Posted by: Jeff Lipshaw | Nov 18, 2015 5:16:36 AM

Jeff, I entirely agree. I don't think business opportunities is the problem. It's self-dealing, as in Kinder Morgan. BTW, at the LLC Institute last week I learn to my great surprise that, although VC Laster's decision has been appealed, the appeal does not challenge his reading of the agreement.

Posted by: Daniel S. Kleinberger | Nov 18, 2015 8:00:41 PM

Great article and very well explained.

Posted by: Moses and Moses P.C | Oct 31, 2017 12:53:20 AM

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