Tuesday, September 6, 2016
Private Ordering in the Uncorporation: Modified and Eliminated Fiduciary Duties Are Often the Same Thing
What does it mean to opt out of fiduciary duties? In follow-up to my co-blogger Joan Heminway's post, Limited Partnership Law: Should Tennessee Follow Delaware's Lead On Fiduciary Duty Private Ordering?, I will go a step further and say all states should follow Delaware's lead on private ordering for non-publicly traded unincorporated business associations.
Here's why: At formation, I think all duties between promoters of an unincorporated business association (i.e., not a corporation) are always, to some degree, defined at formation. This is different than the majority of other agency relationships where the expectations of the relationship are more ingrained and less negotiated (think employee-employer relationship).
As such, I'd make fiduciary duties a fundamental right by statute that can be dropped (expressly) by those forming the entity. I'd put an additional limit on the ability to drop fiduciary duties: the duties can only be dropped after formation if expressly stated in formation documents (or agreed unanimously later). That is, if you didn't opt out at formation, tell all those who could potentially join the entity how you can change fiduciary duties later. This helps limit some (though not all) freeze-out options, and I think it would encourage investors to check the entity documents closely (as they should).
At formation, the concerns we might have of, for example, an employee without fiduciary duties, are not the same as they are for co-venturers. Those starting an entity have long negotiated what is a breach of the duty of loyalty, for example. In contrast, I think fiduciary duties in most employer-employee (and similar) relationships reflect the majoritarian default and they facilitate the relationship existing at all. For LLCs and partnership entities, I think that's less clear. Entity formation is relatively rare compared to how often we enter other agency relationships, and they almost always involve significant negotiation (if not planning). And if they don't, the rules we expect traditionally should be the default. But where the parties talk about it, and they usually do, allowing a more robust sense of freedom of contract has value.
Even in Delaware, where one can negotiate out of fiduciary duties, there remains the duty of good faith and fair dealing. I think of that as meaning that the parties still have a right to the essence of the contract. That is, the contract has to mean something. It has to have had a purpose and potential value at formation, and no party can eliminate that. But, the parties only have a right to what was bargained for. As such, what we might traditionally consider a breach of the duty of loyalty could also breach the duty of good faith and fair dealing, but a traditional breach of the duty of loyalty might not be sufficient to find liability where there is expressly no duty of loyalty. Instead, the act must so contradict the purpose of the contract that it rises to the level of a breach the duty of good faith and fair dealing.
Part of the reason I support this option is that I think case law has already validated it, but in such an inartful manner that it confuses existing doctrine. See, e.g., McConnell v. Hunt Sports Enterprises, 132 Ohio App. 3d 657, 725 N.E.2d 1193 (Ct. App. 1999) (“An LLC, like a partnership, involves a fiduciary relationship. Normally, the presence of such a relationship would preclude direct competition between members of the company. However, here we have an operating agreement that by its very terms allows members to compete with the business of the company.”).
In closing, I will note that I am all for express provisions that require investors to pay attention at the outset. I don't believe in helping cheaters hide the ball. I just think law that encourages investors and others joining new ventures to pay attention is useful and will provide long-term value to entities. I don't think that eliminated fiduciary duties at formation raise any more of a risk than we already have with limited or modified fiduciary duties at formation. With the more limited protections described above, freedom of contract should reign.
https://lawprofessors.typepad.com/business_law/2016/09/private-ordering-in-the-uncorporation-modified-and-eliminated-fiduciary-duties-are-often-the-same-th.html
Hey, Josh. Sorry for the delayed and lengthy response. Busy week.
You make some great points here. Like you, I most often favor approaches to planning and drafting that encourage transaction participants to go in with their eyes and ears open and their brains engaged. Everyone should read and understand the terms of agreements they enter into. That’s especially true when it comes to entity formation. But you and I both probably know many limited liability investors who are sophisticated and able to bear financial risk who do not read the limited partnership or LLC documents that they are sent on a deal when they know the players (repeat players in a smaller market for deals) or just can’t be bothered. But let’s leave that aside for the moment.
I also agree that modified fiduciary duties often are virtually the same in application as eliminated fiduciary duties are. But I would say that there is more room for the equities to come into play in judicial review when a business entity statute says that fiduciary duties cannot be eliminated through private ordering than when it says they can. It’s this very fact that concerns planners and drafters who argue for the contractual elimination of fiduciary duties. The intervention of the judiciary ex post adds too much uncertainty and unpredictability to the equation. I simply believe that some (limited) uncertainty and unpredictability is better for the form of entity in the long haul because it allows the judiciary to punish truly bad actors who use entity law statutes to attract co-owners or investors and use a bargaining advantage or leverage to dominate and control those co-owners or investors in unanticipated ways that may not be cognizable under current law as breaches of the obligation of good faith or fair dealing. I see good faith and fair dealing as a very narrow doctrine, as currently applied.
For example, folks vary on their legal and practical views about a case like Anderson v. Wilder (https://scholar.google.com/scholar_case?case=7204186694868661394&hl=en&as_sdt=6&as_vis=1&oi=scholarr). Granted, this is a case involving a closely held member-managed LLC. But classic fiduciary duty adherents and contractarians disagree wildly on whether that decision, and others like it that apply fiduciary duty analysis in adjudicating questions about the lawful exercise of rights under governance agreements (i.e., partnership, operating, and limited liability company agreements). I admit, however, that I am not as convinced as you are that “all duties between promoters of an unincorporated business association (i.e., not a corporation) are always, to some degree, defined at formation.” (Although I am unsure how much you intend to take away from the general behavior you seem to be observing when you use the words “to some degree.”) That’s the nub, isn’t it? For whom, and in what circumstances, are we convinced that their bargaining is both fair and complete when they come to terms on the formation or amendment of the governance rules for a business entity such that a court should not be permitted to intervene to prevent one constituent of the business entity from taking advantage of another because it violates the reasonable expectations of the business venturers—the fundamental governance principles on which the business association among those folks was/is built?
I do not have a great answer to this question, but I think you and I are both wrestling with it, and reasonable minds can differ as to how we cut the balance. I just like the intermediate turf and believe that parties acting fairly, in good faith, and with good lawyers can draft adequately and surely for the future without having to contractually eliminate fiduciary duties—which always have been the backstop of trust in entity law governance. The contractual elimination of fiduciary duties in unincorporated business entities turns them into mere contractual relationships for internal governance purposes, and I believe that ultra-contractarian approach detracts from the value of entity law overall. I like freedom of contract in the unincorporated forms of business association, but I also believe that fiduciary duty law provides an important gloss.
Posted by: joanheminway | Sep 9, 2016 7:45:36 AM