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.
Wednesday, July 27, 2016
Just in case you haven't gotten the message yet: Delaware law means fiduciary duty freedom of contract for alternative entities. In May 2016, the Delaware Chancery Court upheld a waiver of fiduciary duties in a master limited partnership. In Employees Retirement System of the City of St. Louis v. TC Pipelines GP, Inc., Vice Chancellor Glasscock upheld challenges to an interested transaction (sale of a pipeline asset to an affiliated entity) that was reviewed, according to the partnership agreement, by a special committee and found to be fair and reasonable. The waiver has been described as "ironclad" to give you a sense of how straight forward this decision was. No close call here.
Vice Chancellor Glasscock's letter opinion starts:
Delaware alternative entity law is explicitly contractual;1 it allows parties to eschew a corporate-style suite of fiduciary duties and rights, and instead to provide for modified versions of such duties and rights—or none at all—by contract. This custom approach can be value enhancing, but only if the parties are held to their bargain. Where equity holders in such entities have provided for such a custom menu of rights and duties by unambiguous contract language, that language must control judicial review of entity transactions, subject only to the cautious application of the implied covenant of good faith and fair dealing. Such is the case in the instant matter, which involves a master limited partnership (“MLP”) created with interested transactions involving the general partner as part of its business model.....
The Defendants point out that the [transaction] was approved by a special committee (the “Conflicts Committee”), which approval, in accordance with the partnership agreement, creates a conclusive presumption that the transaction is fair and reasonable to the Partnership. I find that the Conflicts Committee’s approval, in these circumstances, precludes judicial scrutiny of the substance of the transaction and grant the Defendants’ Motion.
Importantly, the contractual safe harbor for interested transactions established a process which, if followed, created a fair and reasonable transaction outside of judicial scrutiny and without recourse by the other partners. The court found that the partnership agreement precluded a good faith analysis of the Conflicts Committee's review and limited the court's review purely to matters of process.
The relevant portions of the Special Approval provision, importantly, are silent as to good faith.....According to the contractual language, the Special Approval of a duly constituted and fully informed Conflicts Committee is conclusive evidence that such transaction is fair and reasonable, and such approval is, therefore, preclusive of further judicial review. The Plaintiff does not allege that the Conflicts Committee was not duly constituted—that is, directors who are neither security holders nor employees or officers of the General Partner or its affiliates. Nor does the Plaintiff allege that the Conflicts Committee was not fully informed. Thus, the approval here is conclusive that the [transaction] is “fair and reasonable” to TCP. According to the explicit language of the LPA, when a conflicted transaction is deemed “fair and reasonable” by the terms of the agreement, such conflicted transaction is incapable of breaching the LPA.
Get the message? LOUD and CLEAR!
The opinion contains more analysis and excerpts of the relevant portions of partnership agreement. Look for an excerpt on this case in my ChartaCourse (electronic platform) Business Organizations casebook.
Wednesday, July 13, 2016
This is just me musing a bit, but in following up my post on how LLCs can choose to “be corporations” for federal tax purposes, meaning they get C corp tax treatment, I was thinking that maybe the IRS could just stop using state-law designations at all. That is, stop having “corporate” tax treatment at all.
My proposal is not abolishing corporate tax – that’s a much longer post and one I am not sure I’d agree with. Instead, the proposal is to have entities choose from options that are linked the Internal Revenue Code, and not to a particular entity. Thus, we would have (1) entity taxation, called C Tax, where an entity chooses to pay tax at the entity level, which would be typical C Corp taxation; (2) pass-through taxation, called K Tax, which is what we usually think of as partnership tax; and (3) we get rid of S corps, which can now be LLCs, anyway, which would allow an entity to choose S Tax.
This post deals with the tax code, which means I am in over my head, and because this is tax related, it means the solution is a lot more complicated than this proposal. But now that the code provisions are not really linked to the state law entity, I think we should try refer to state entities as state entities, and federal tax status with regard to federal tax status. Under such a code, it would be a little easier for people to understand the concept behind state entity status, and it would make more sense to people that a “C Corp” does mean “publicly traded corporation” (a far-too common misunderstanding). Thus, we could have C Tax corporations, S Tax LLCs, K Tax LLCs, for example. We'd know tax status and state-entity status quite simply and we'd separate the concepts.
A guy can dream, right?
Tuesday, June 21, 2016
Last week, a federal court determined that an insurance disclosure that asked about an "applicant's" criminal history did not apply to an LLC member's individual criminal past. In Jeb Stuart Auction Servs., LLC v. W. Am. Ins. Co., No. 4:14-CV-00047, 2016 WL 3365495, at *1 (W.D. Va. June 16, 2016), the court explained:
“Question Eight” on the [insurance] application asked, “DURING THE LAST FIVE YEARS (TEN IN RI), HAS ANY APPLICANT BEEN INDICTED FOR OR CONVICTED OF ANY DEGREE OF THE CRIME OF FRAUD, BRIBERY, ARSON OR ANY OTHER ARSON-RELATED CRIME IN CONNECTION WITH THIS OR ANY OTHER PROPERTY?” Hiatt, on behalf of Jeb Stuart (who [sic] was the sole [LLC] applicant for the insurance policy), answered, “No.” Hiatt signed the application and left.
As you might imagine, Hiatt had been convicted of "hiring individuals to wreck cars so that he could receive the proceeds from the applicable insurance policies," and, yep, about a month later, the building burned down. Id. at *2.
The insurance company cancelled the policy because it claimed Hiatt had lied on the application, and Hiatt sued for the improper cancellation of the policy because he did not lie (he prevailed) and for attorneys fees claiming “the insurer, not acting in good faith, has either denied coverage or failed or refused to make payment to the insured under the policy.” Id. at *3. Judge Kiser determined that not attorneys' fees were warranted:
Neither party was able to rely on a case on point regarding the issue of whether questions on an LLC's insurance application asking about criminal history applied to the members of the LLC, to the corporate entity, or to both. Although I believe the answer to that question is clear, I am not aware of any other court being called upon to answer it. Therefore, although it was unsuccessful in asserting its defense to Jeb Stuart's claim, West American's position did present a novel legal question. As such, the final Norman factor weighs in favor of a finding of good faith.
Monday, June 13, 2016
This past week, I completed the second leg of my June Scholarship and Teaching Tour. My time at "Method in the Madness: The Art and Science of Teaching Transactional Law and Skills" at Emory University School of Law last week was two days well spent. I had a great time talking to attendees about my bylaw drafting module for our transaction simulation course, Representing Enterprises, and listening to others talk about their transactional law and skills teaching. Great stuff.
This week's portion of my academic tour begins with a teaching whistle-stop at the Nashville School of Law on Friday, continues with attendance (with my husband) at a former student's wedding in Nashville on Saturday evening, and ends (my husband and I hope) with Sunday brunch out with our son (and his girlfriend if she is available). Specifically, on Friday, I teach BARBRI for four hours in a live lecture. The topics? Well, I drew a short straw on that. I teach agency, unincorporated business associations (including a bit about both extant limited liability statutes in Tennessee), and personal property--all in four hours. Ugh. Although I am paid for the lecture and my expenses are covered, I would not have taken (and would not continue to take) this gig if I didn't believe that I could be of some help to students. These topics--especially agency and partnership law, but also personal property--often are tested on the bar exam. So, on I press.
I also am completing work this week on the draft article that I will present in Chicago and Seattle on the last two stops of my tour. I will say more about that article in next week's post. In the mean time, let me know if you have any suggestions (or good jokes) on the law of agency, partnerships, LLCs, or personal property (e.g., tenancies, gifts, bailments, adverse possession, replevin) for my lecture on Friday . . . . It's so hard to make these speed-lectures somewhat engaging for the students. [sigh]
Wednesday, May 18, 2016
California is the back on my short list for the state's inability to successfully differentiate between corporations and limited liability companies (LLCs). Last week, an "unpublished/noncitable" decision that was published on Westlaw provided a good example.
The opinion states:
A corporation—including a limited liability corporation—may be served by effecting service on its agent for service of process. (Code Civ. Proc., § 416.10, subd. (a); see also Corp.Code, § 17701.16, subd. (a) [allowing service on limited liability corporations under Code Civ. Proc., § 413.10 et seq.].)7
*12 One of the ways a limited liability corporation can be served is by substituted service. (1 Weil & Brown, Cal. Practice Guide: Civil Procedure Before Trial (The Rutter Group 2015) ¶ 4:172, p. 4–26.) This requires that a copy of the summons and complaint be left at the office of the person to be served (or, in some cases, at the mailing address of the person to be served), in the presence of a person who is apparently in charge, “and by thereafter mailing a copy of the summons and complaint by first-class mail, postage prepaid to the person to be served at the place where a copy of the summons and complaint were left.” (Code Civ. Proc., § 415.20, subd. (a).)
No, no, no. First, even in California, an LLC is a "limited liability company." It says so right in the act. Cal. Corp. Code § 17701.01 (West) ("This title may be cited as the California Revised Uniform Limited Liability Company Act.").
And, yet, I have to admit, if you note the cite to the LLC act, California lawmakers have made this less clear than in other states. Yes, that's right. In California, the LLC Act is part of the California Corporations Code. Cal. Corp. Code §§ 17701.16 - 17713.13 (West). For that matter, so are partnerships, under Title 2. Sigh.
Would it be so terrible if the Corporations Code were called what it is: the Business Entities Code? As currently structured, LLCs and partnerships are arguably types of corporations under California law, as the above cases suggests. One could argue the headings don't change the meaning or intent of the laws. See Cal. Corp. Code § 6 (West) ("Title, division, part, chapter, article, and section headings contained herein do not in any manner affect the scope, meaning, or intent of the provisions of this code."). The problem with that is that the code text says otherwise: "This act shall be known as the Corporations Code." Cal. Corp. Code § 1 (West).
To reinforce that notion, the Code Commission notes from the 2014 main volume explain:
This code was listed in the appendices of Code Commission reports showing code classification as the “Corporations, Partnerships, and Associations Code.” The 14 syllables of that title appear to make it impractical, but no shorter phrase indicative of the full subject-scope has been found. Therefore, resort has been had to the rhetorical device of synecdoche, and the entire code designated by the name of longest part.
I admit I had to look up synecdoche to be sure I was on the right track, but the term supports, I think, my point that California is treating LLCs and partnerships as corporations (or some subset thereof). See, for example, this explanation:
Synecdoche is a literary device in which a part of something represents the whole or it may use a whole to represent a part.
Synecdoche may also use larger groups to refer to smaller groups or vice versa. It may also call a thing by the name of the material it is made of or it may refer to a thing in a container or packing by the name of that container or packing.
Still, even if it were accurate to says LLCs and partnerships are "types" of corporations under the California code, one thing is still clear: an LLC is a limited liability company, which is, at a minimum, a specific type of "limited liability corporation."
I suppose I can see how "14 syllables" might be deemed "impractical," but not at the cost of imprecision. The "Business Entities" -- or even just "Entities" or "Associations" -- Code would seem like a better, more accurate, option.
Oh well. At least the court cited the part of the California code for service of an LLC. That much, they got right.
Tuesday, May 10, 2016
This is just to give everyone a "heads up" on a symposium being held this fall (Friday, October 21 and Saturday, October 22) to honor Lyman Johnson and David Millon. The symposium is being sponsored by the Washington & Lee Law Review (which will publish the papers presented), and I am thrilled to be among the invited speakers. I will have more news on the symposium and my paper for it as the date draws nearer. But I wanted everyone to know about this event so that folks could plan accordingly if they want to attend. I understand Lexington, Virginia is lovely in late October . . . . Actually, it's always been lovely when I have been up there! And the honorees and contributors are a stellar group (present company notwithstanding). I hope to see some of you there.
At the 2017 AALS annual meeting, January 3-7 in San Francisco, the AALS Sections on Agency, Partnerships LLCs, and Unincorporated Associations & Nonprofit and Philanthropy Law will hold a joint session on LLCs, New Charitable Forms, and the Rise of Philanthrocapitalism.
In December 2015, Facebook founder Mark Zuckerberg and his wife, Dr. Priscilla Chan, pledged their personal fortune—then valued at $45 billion—to the Chan-Zuckerberg Initiative (CZI), a philanthropic effort aimed at “advancing human potential and promoting equality.” But instead of organizing CZI using a traditional charitable structure, the couple organized CZI as a for-profit Delaware LLC. CZI is perhaps the most notable example, but not the only example, of Silicon Valley billionaires exploiting the LLC form to advance philanthropic efforts. But are LLCs and other for-profit business structures compatible with philanthropy? What are the tax, governance, and other policy implications of this new tool of philanthrocapitalism? What happens when LLCs, rather than traditional charitable forms, are used for “philanthropic” purposes?
From the heart of Silicon Valley, the AALS Section on Agency, Partnerships LLCs, and Unincorporated Associations and Section on Nonprofit and Philanthropy Law will host a joint program tackling these timely issues. In addition to featuring invited speakers, we seek speakers (and papers) selected from this call.
Any full-time faculty of an AALS member or fee-paid school who has written an unpublished paper, is working on a paper, or who is interested in writing a paper in this area is invited to submit a 1- or 2-page proposal by June 1, 2016. The Executive Committees of the Sections will review all submissions and select two papers by July 1, 2016. If selected, a very polished draft must be submitted by November 30, 2016. All submissions and inquiries should be directed to the Chairs of the Sections at the email addresses below:
University of Oregon School of Law
Garry W. Jenkins
Associate Dean for Academic Affairs
John C. Elam/Vorys Sater Professor of Law
Moritz College of Law,State University
Tuesday, May 3, 2016
A recent Vanity Fair article discussing Citizens United is making the rounds. (I saw it on Facebook!) The article notes:
It had already been established, in Buckley v. Valeo (1976), that anyone has a First Amendment right to spend his or her own money advancing his or her own cause, including a candidacy for political office. Citizens United extended this right to legally created “persons” such as corporations and unions.
I have been giving some more thought to whole “personhood” discussion of late, and my thoughts have taken me back to both Hobby Lobby and Citizens United. What follows is a long blog post that pulls together my thoughts on these two cases in an admittedly not well developed way. But it's a start (though I really should be grading).
Tuesday, March 22, 2016
March has provided a slate of mistakes as to entity form, focusing (as it almost always does) on limited liability companies (LLCs) and various outlets calling such entities "corporations." These are not in any particular order, but lists are neat. Enjoy!
(1 ) Politifact Checks Trump Facts, Forgets to Check Entity Law Facts
In an article on Politifact.com, Donald Trump incorrectly says Virginia winery is the largest on East Coast, which determines that Trump's claims about the size of a winery that his son runs to be false and notes some statements are incorrect. Ironically, the article also claims:
A legal disclaimer on the winery website says the GOP presidential candidate doesn’t own the winery. The venture is a limited liability corporation, and its owners are not a matter of public record.
Wrong. The winery site says, "Trump Winery is a registered trade name of Eric Trump Wine Manufacturing LLC, which is not owned, managed or affiliated with Donald J. Trump, The Trump Organization or any of their affiliates." An LLC is still not a corporation.
(2) Big Bang Theory: Big Brains Don't Know Entity Law
I don't watch the Big Bang Theory, but my colleague at Valparaiso University, Professor Rebecca J. Huss, is a reader of this blog who also cares about precise language with regard to LLCs alerted me to this one. The story line of the March 10 show (the show can be found here) related to a the creation of a partnership agreement for some of the characters. One thing that is realistic is that the folks think it's a good idea to form an entity and draft contract language without a lawyer. One character says he has some concerns about the partnership, and another replies with this "joke": "Are you suggesting a limited liability corporation, because I did not LLC that coming." (The offending segment is roughly 14 minutes into the show.) (This was also covered at Kentucky Business Entity Law Blog, here, which noted, "Ughhhh. LLC ≠ limited liability corporation. Rather, LLC = limited liability company.")
(3) Ghost LLCs Masquerading as Corporations
The Washington Post last week ran a story, How ‘ghost corporations’ are funding the 2016 election. The article discusses how entities can be used to shield those backing political candidates. The article states:
Advocates for stronger campaign-finance enforcement fear there will be even more pop-up limited liability corporations (LLCs) funneling money into independent groups, making it difficult to discern the identities of wealthy players seeking to influence this year’s presidential and congressional contests.
. . . .
Many corporate givers this cycle are well-established hedge funds, energy companies and real estate firms. But a significant share of the money is coming from newly formed LLCs with cryptic names that offer few clues about their backers.
(4) Pass-Through Tax Law Isn't Really About Corporations (mostly)
The Topeka Capital-Journal Editorial Board wrote on March 20: LLC loophole needs plugging: Even some small business owners think the tax exemption should be eliminated. The editorial is related to a 2012 Kansas law, HB 2117, which eliminated taxes on pass-though entities like LLCs, S corps, partnerships, farms, and sole proprietorships. (So, I admit, S corps are corporation, but they are essentially partnerships for federal tax purposes.) Even though I agree with some their concerns, the board makes a couple mistakes here when they assert that the bill "was simply an unconditional gift from the state for anyone who has created an entity called a limited liability corporation (LLC)."
First, it assumes that just LLCs get the benefit, which is not true. All pass-though entities benefit. Second, of course, the "limited liability corporation" is a corporation, not an LLC, and the corporation (other than one chosen to be an S corp) does not get the benefit of the law.
(5) Court Gets Entity Right, Regulations Not Quite
I'm not one to leave the courts out of this. Judge Robert M. Dow, Jr., of the United States District Court, Northern Illinois has an incredible resume. A member of Phi Beta Kappa and a Rhodes Scholar, his credentials are impressive. In a recent decision, though, his opinion refers to a defendant LLC correctly, but then goes on to say that Treasury Regulations are silent on treatment of "limited liability corporations." Alas, that's not accurate. Here's the passage:
It is undisputed that, as of the date of Anderson Bros.' withdrawal from the fund, Anderson Bros. (an Illinois corporation) was 100% owned by Anderson. Anderson therefore had a “controlling interest” in Anderson Bros. 29 U.S.C. § 1.414(c)-2(b)(2)(A). At the same time, Defendant (an Illinois limited liability company) was also solely owned by Anderson. Section 1.414(c)-2 of the Treasury Regulations does not address specifically the treatment of limited liability corporations, and the Board does not address this issue in its brief. According to the Internal Revenue Service (“IRS”), “an LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes * * *, unless it files Form 8832 and affirmatively elects to be treated as a corporation.” IRS, Single Member Limited Liability Companies, https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Single-Member-Limited-Liability-Companies (last visited Mar. 16, 2016).
Bd. of Trustees of the Auto. Mechanics' Local No. 701 Union & Inustry Pension Fund v. 6516 Ogden Ave., LLC, No. 14-CV-3531, 2016 WL 1043422, at *4 (N.D. Ill. Mar. 16, 2016) (emphasis added).
Tuesday, March 15, 2016
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.
Tuesday, January 26, 2016
At the request of Tom Rutledge, chair of the American Bar Association Section of Business Law's Committee on LLCs, Partnerships and Unincorporated Entities (that sure is a mouthful!), I am passing on the following:
While the dates are still being resolved, this October, 2016, the Committee of LLCs, Partnerships and Unincorporated Entities will again be sponsoring a two-day LLC Institute in Arlington, Virginia. This program brings together more than 100 high-level practitioners and academics to review a variety of issues involving the law of unincorporated business organizations. In recent years presentations have been made by Joan Heminway, Carter Bishop, Dan Kleinberger, Colin Marks, Michelle Harner and Benjamin Means. I think each will vouch for the quality of the program.
We are actively soliciting proposals for panels. If you are working on something, or if there is something you would like to discuss before an audience that I can guarantee will be “hot”, please let me know.
Indeed, I can vouch for the program, at which I have presented twice. There typically is an opportunity presented to write a short piece for Business Law Today, if you are interested. My contribution from the 2015 LLC Institute (a real page-turner--not) can be found here.
Wednesday, January 6, 2016
Tomorrow afternoon (as Anne promoted earlier today), I will participate in the annual Association of American Law Schools ("AALS") panel discussion for the Section on Agency, Partnerships, LLCs and Unincorporated Associations. The panel discussion this year is entitled "Contract is King, But Can It Govern Its Realm?" and focuses on the contractarian aspects of LLC law. Here's the panel description from the AALS annual meeting program:
This program will explore the role of contract in unincorporated associations, with particular emphasis on the LLC and limited partnership forms. In most jurisdictions, the sparse prescriptions in the default rules imply that the parties will draft an operating agreement that reflects the material points of their bargain. For example, Delaware emphasizes that its policy for LLCs and LPs is to give “maximum effect to the principle of freedom of contract.” Modern contract theory, however, raises significant questions about the extent to which any documentation of a transaction can be “complete,” even if sophisticated parties negotiate at arm’s length and attempt to fully reduce their expectations to writing. If complete contracts are indeed an ideal rather than the reality, can legislatures impose default rules (fiduciary or otherwise) to fill the gaps without undermining the benefits of private ordering? To what extent should judges look outside the operating agreement to determine the parties’ intent? Our format will be a lively moderated discussion, and we will invite significantly more audience participation from the outset than attendees may have come to expect from AALS section meetings.
As you may recall (and as Anne reminded us in her earlier post on the AALS conference sessions), we hosted a weblog micro-symposium on issues relating to this topic in anticipation of this annual meeting program back in November, for which the concluding post is here, and my contributions are here and here.
I expect that we will explore through the conference panel (which, as the program description indicates, will engage the audience for much of the time) the nature and status of LLC agreements as contracts and the coexistence of contract with fiduciary duties and the implied covenant of good faith and fair dealing. I hope that we can cover points of theory, policy, doctrine, and practice. I will be adding some non-Delaware flavor in some areas of the discussion and encouraging folks to contemplate whether LLC operating agreements are contracts or merely treated like contracts for certain LLC law purposes. Please come join in on the fun if you are attending the conference this year! I may have more to say after the discussion has concluded . . . .
The AALS Annual meeting starts today in New York. The full program is available here, and listed below are two Section meeting announcements of particular interest to business law scholars:
Thursday, January 7th from 1:30 pm – 3:15 pm the SECTION ON AGENCY, PARTNERSHIP, LLC’S AND UNINCORPORATED ASSOCIATIONS, COSPONSORED BY TRANSACTIONAL LAW AND SKILLS will meet in the Murray Hill East, Second Floor, New York Hilton Midtown for a program titled:
"Contract is King, But Can It Govern Its Realm?"
The program will be moderated by Benjamin Means, University of South Carolina School of Law. Discussants include:
- Joan M. Heminway, University of Tennessee College of Law
- Lyman P.Q. Johnson, Washington and Lee University School of Law
- Mark J. Loewenstein, University of Colorado School of Law
- Mohsen Manesh, University of Oregon School of Law
- Sandra K. Miller, Professor, Widener University School of Business Administration, Chester, PA
BLPB hosted an online micro-symposium in advance of the Contract is King meeting. The wrap up from this robust discussion is available here.
Friday January 8th, from 1:30 pm – 3:15 pm join the SECTION ON BUSINESS ASSOCIATIONS AND LAW
AND ECONOMICS JOINT PROGRAM at the Sutton South, Second Floor, New York Hilton Midtown for a program titled:
"The Corporate Law and Economics Revolution Years Later: The Impact of Economics and Finance Scholarship on Modern Corporate Law".
The program will be moderated by Usha R. Rodrigues, University of Georgia School of Law, and feature the following speakers:
- Frank Easterbrook, Judge, U.S. Court of Appeals for the Seventh Circuit, Chicago, IL
- H. Kent Greenfield, Boston College Law School
- Roberta Romano, Yale Law School
- Tamara C. Belinfanti, New York Law School
- Kathryn Judge, Columbia University School of Law
- K. Sabeel Rahman, Brooklyn Law School
At the conclusion of the program, the officers of the Section on Business Associations would like to honor 13 faculty members
for their mentorship work throughout the year.
I hope to see many of you in New York soon!
January 6, 2016 in Anne Tucker, Conferences, Corporate Governance, Corporations, Delaware, Financial Markets, Joan Heminway, Law and Economics, Law School, Teaching, Unincorporated Entities | Permalink | Comments (0)
Tuesday, January 5, 2016
Some day, I may tire of calling out courts (and others) that refer to limited liability companies (LLCs) as "limited liability corporations, but today is not that day. Looking back on 2015, I thought I'd take a quick look to see who the worst offenders were, starting with the state courts. I figured I'd start with Delaware.
As a state that is proud of its status as a leader as a key forum of choice for corporations, and Delaware has done well for uncorporations, as well, it seemed logical. The book Why Corporations Choose Delaware, written by Lewis S. Black, Jr., and printed and distributed by the Delaware Department of State, Division of Corporation, explains:
Delaware continues to be the favored state of incorporation for U.S. businesses. Delaware has been preeminent as the place for businesses to incorporate since the early 1900s, and its incorporation business, supplemented by the growth in numbers of such “alternative entities” as limited liability companies, limited partnerships and statutory trusts, continues to grow smartly.
And Delaware does have a generally well-informed and skilled judiciary. Still, even Delaware is not above calling an LLC a "limited liability corporation." Better than many jurisdictions, Westlaw reports that the state had just three cases in 2015 making that error, and no such mistakes were noted after March 2015. Not ideal, but not bad.
Here are some other states I reviewed for 2015 (again, using Westlaw):
- Michigan: 0
- Pennsylvania: 3
- Ohio: 4
- Florida: 5
- Nevada: 6
- California: 7
- New York: 7
- Texas: 8
Overall, state courts called LLCs "corporations" 105 times in 2015. Federal courts did the same 280 times in 2015. As such, it works out to just over once a day that some U.S. court is making this mistake.
Big picture, given the number of cases courts see each year, it may seem that these are small numbers. Not really. A search of federal courts for the term "limited liability company" turns up 2949 cases from 2015, which suggests that around 10% of cases (9.49%) referring to LLCs in some substantive manner made a reference to a "limited liability corporation." NOTE: If one searches for "LLC," the number of cases exceeds 10,000 for 2015, but I decided that a court taking the time to spell out "limited liability company" suggested that the entity choice had a heightened relevance to the case.
At the state level, the numbers are a little better. State courts referred to "limited liability companies" 1691 times in 2015. With 105 cases calling an LLC a corporation, that works out to just over 6% of the time. Not great, but a substantial improvement.
I admit this is not a scientific review of the data and I am making some assumptions, but the sheers number do, I think, support the notion that all our courts can do better on this issue. And give state courts credit -- although federal courts are often viewed the more prestigious courts, state courts are holding their own on this issue. Perhaps state courts are a little more careful because entities are generally (though not always) creatures of state law.
This is not, I am sure, just the courts. I suspect a lot of these errors come from attorneys who call LLCs corporations, then the court just take their lead. Still not okay, but I can imagine that some courts just follow the lead of those arguing the cases before them on such issues.
So, for 2016, I issue a challenge to all U.S. courts and the lawyers who practice in them: let's cut these numbers in half! (I'd like them to go to zero, but one needs to be somewhat realistic, right?)
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.
Thursday, December 3, 2015
Facebook (not surprisingly) and other social media blew up when Facebook CEO, Mark Zuckerberg, and his wife, Dr. Priscilla Chan, released an open letter to their new baby daughter, Max. (Congratulations to all, by the way.) The Chan Zuckerberg family announced that they would be giving a ton of money to support important causes, which caused people to get excited, get skeptical, and get mad.
One big complaint has been that the family chose a limited liability company (LLC), which is not a corporation (more on that later), rather than a not-for-profit entity to do the work. Some say this makes it a scam. I say hooey. Even if it were a scam, it’s not because they chose an LLC.
- First, without knowing the LLCs members or structure, there’s no reason to say the LLC cannot be a 501(c)(3). But, more important, the Letter to Max never says they will give money to charity. Never.
The letter says:
As you begin the next generation of the Chan Zuckerberg family, we also begin the Chan Zuckerberg Initiative to join people across the world to advance human potential and promote equality for all children in the next generation. Our initial areas of focus will be personalized learning, curing disease, connecting people and building strong communities.
We will give 99% of our Facebook shares -- currently about $45 billion -- during our lives to advance this mission.
How the Chan Zuckerberg’s choose to advance that mission can easily be through an LLC, whether it is tax-exempt or not. They may have chosen the for-profit (or benefit) LLC as the entity so that they could seek profit in certain ways, with the thought that the profit seeking supports the mission. Or maybe they want to be able to give to for-profit entities to build and grow business in areas that further their mission, but lacks status that would satisfy IRS nonprofit requirements.
Regardless, the choice of LLC may be a good one. I am thinking these folks have good counsel and financial advisors, so the entity choice probably serves their purposes, or at least their best estimate of those future purposes. And I am all for them putting that kind of money behind what seems to me like an excellent mission. So, like them or hate, but back off their choice of entity. (Leave the LLC alone!)
And, since this would not be a post of mine without noting the utter media failure in referring to the LLC, again, it’s a limited liability company, not corporation, as several news outlets have reported. PBS tends to be my favorite news source, which makes it all the more painful that they may be the source of this limited liability corporation nonsense.
The apparent source of the limited liability “corporation” nonsense is the PBS Newshour, link here. I know the U.S. Supreme Court has gotten this wrong, too, but I had hope for better from PBS. Oh well. I'll still be listening to PBS for quality news, and I'll still be happy to hear when someone commits to putting billions of dollars behind good causes. If either one doesn't follow through, I'll be disappointed, but I am not ready to give up hope on either one, just yet.
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)).
Friday, November 20, 2015
The micro-symposium has generated interest in a broad range of topics, so we are adding the following post by Peter Molk & Verity Winship discussing their recent scholarship on dispute resolution in LLC operating agreements and its intersection with the "contract is king" discussion this week.
This post highlights a particular area of private ordering within the LLC and other alternative entities: contractual provisions within the operating agreement that set the rules for resolving internal disputes. These terms determine how disputes are resolved, such as by specifying when claims must be submitted to arbitration, where disputes can be heard, and whether parties waive the jury right or impose fee-shifting of litigation costs. They apply to internal disputes, meaning they govern the dispute process among the LLCs’ members, managers, and the LLC itself.
How do these provisions fit with the debate over whether contract should be king? The broadest connection is straightforward. Dispute resolution provisions allocate rights and duties within LLCs, so the debate about the proper bounds of freedom of contract in the LLC space has implications for them as well. But how firms set the rules for internal disputes is also relevant to the particular debate about the imposition of fiduciary duties. Suppose that fiduciary duties were to become mandatory in publicly traded LLCs and LPs, as Delaware Chief Justice Strine and Vice Chancellor Laster have proposed and as Sandra Miller and Mohsen Manesh discuss in their posts in this micro-symposium. Imposing fiduciary duties, by expanding the actions that disgruntled members can bring, in turn puts particular pressure on the dispute resolution clauses.
To see the connection, look no further than the debate in the corporate context about private ordering of shareholder litigation in corporate charters and bylaws. Contract is not king in the corporate context – a host of mandatory rules, including fiduciary duties, are imposed to protect investor rights. Since corporations cannot respond by waiving fiduciary duties, some have instead taken the step of nevertheless effectively eliminating these protections by contracting out of enforcement mechanisms. Recent efforts at imposing fee shifting can be characterized as indirectly weakening mandatory protections by reducing the probability of enforcing them.
For corporations, the Delaware legislature eventually stepped in to ban fee-shifting provisions in the organizational documents of Delaware stock corporations. The legislative response is telling. It targets only stock corporations, using the business form as a proxy for characteristics that trigger a need for additional protections. This takes us back to the question of whether contract should be king, and whether business form is a good rough indicator of characteristics (sophistication, consent) that we care about.
In an empirical study we are conducting, we identified dispute resolution provisions in a sample of operating agreements of privately owned Delaware LLCs. 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.
We can think of these practices as altering the calculus parties engage in when deciding whether to enforce their rights that exist under the agreement. While looking at dispute resolution provides a more accurate picture for LLCs’ governance regimes, it also complicates the contract-as-king debate. Strengthening LLC members’ mandatory protections beyond the duty of good faith and fair dealing, as several earlier posts propose, does little good if LLCs respond by cutting back parties’ ability to enforce these protections.