Tuesday, March 15, 2016

Why Not Have Freedom of Strategic Contracting in LLC Formation?

In my Energy Business: Law & Strategy course, I use Larry A. DiMatteo's article, Strategic Contracting: Contract Law as a Source of Competitive Advantage, 47 Am. Bus. L.J. 727 (2010).  I have been using the article in the class since 2012 (this is the third time I have taught it), and I think it does a great job of providing a theoretical backdrop for practical application.  I teach the article in combination with a one-sided proposed Memorandum of Understanding to help students think about the contracting process and and the long-term implications of what might seem like a small-scale negotiation. I highly recommend the piece.  

In reading the article this time around, though, I was struck by how differently the piece treats limited liability companies (LLCs) and corporations and the way concerns about opportunistic behavior are raised in the context of the latter.   In one portion of the article, DiMatteo notes: 

Corporate strategy that fails to take account of the strategic use of law is likely to waste opportunities for competitive advantages. A corporate legal strategy can be used to gain competitive advantages both internally and externally.

I wholeheartedly agree, and this is part of the reason I teach my course.  Although I don't think this is true of just "corporate" strategy, because the same applies to other entities, such as educational institutions, environmental organizations, LLCs, and even governments.  Regular readers will not be surprised that I would choose to start the sentence "entity strategy" instead of "corporate strategy, " but his point is still well taken.  

Later in the piece, Prof. DiMatteo takes the following position with regard to LLCs: 

The freedom of contract paradigm that underlies LLCs allows for broad flexibility in strategically drafting the operating agreement. I will make a distinction here between proper and improper strategic drafting, because a distinction based on legality is insufficient. That is, improper terms may be perfectly legal under some states’ LLC statutes. The argument here is that the freedom of contract construct can lead to contractual abuse, albeit a legally sanctioned abuse. For example, a combination of clauses could be inserted into the operating agreement that strips nonmanager members of all power and protections, such as removal of fiduciary duties relating to the managing member, an indemnification clause to protect the managing member from liability for malfeasance, and a clause providing that the nonmember managers have no right to withdraw or to seek dissolution. These types of provisions may be legal under some statutory schemes, but strict enforcement of these clauses by the managing member would be abusive.

I fail to see why strategic use of law in this context is more problematic than the strategic use of law in other contexts. I do understand and validate concerns about on-going expectations of fiduciary protections related to entities, and that is why, as I have suggested previously, that the lack of fiduciary duties and post-formation changes to fiduciary duties (especially loyalty) should include disclosure and perhaps other structural protections.  (I am less concerned about those forming the entity agreeing to limit or eliminate fiduciary duties because they are agreeing to the option at formation when they can object or walk away.) Still, I don't see any reason that freedom of contract in LLCs is fundamentally different from freedom of contract in any other setting, at least as along as you account for a potential knowledge gap about fiduciary duties. In contrast, I liked how Larry Ribstein framed the question of possible promoter liability for LLCs in New York, where he argued that one could make a complaint that "alleged a misrepresentation which would be actionable without implying a fiduciary duty."

I do agree with Prof. DiMatteo when he says, "In the end, contracts can be a strategic tool in obtaining a competitive advantage, or they can be a tool to support collaboration by minimizing the opportunities for advantage taking." Freedom of contract in LLC formation embraces both of these concepts, too.  I just think that those forming the entity should be the ones to determine which path they will take.  

https://lawprofessors.typepad.com/business_law/2016/03/why-not-have-freedom-of-strategic-contracting-in-llc-formation.html

Corporations, Delaware, Joshua P. Fershee, LLCs, Partnership, Unincorporated Entities | Permalink

Comments

Great post. I think DiMatteo used the LLC example to highlight the extreme version of freedom of contracting within organizations, and used that as a foil to illustrate the ethical limits of strategic legal contracting. That excellent article was part of a special issue in vol. 47 of the American Business Law Journal, including works from multiple authors who discuss law and strategy from multiple perspectives. Highly recommended in case you haven't taken a look at those articles as well.

Posted by: David Orozco | Mar 26, 2016 4:26:15 PM

Thanks for the comment, I think your point about DiMatteo's purposes is well taken. And you are right that is a great issue. I use several of those articles in my Energy Business: Law & Strategy Course.

Posted by: Joshua Fershee | Mar 28, 2016 11:48:46 AM

Great post, as it gives me a lot to think about. I especially like the broad concept of "entity strategy." I would just like to add another dimension to this discussion: what remedies would be available for breach of an LLC's operating agreement and how costly would it be for the promisee to enforce it? A concrete example would be very helpful too ...

Posted by: Enrique Guerra-Pujol | Apr 9, 2016 8:30:39 AM

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