Archives For limited liability companies

With thanks to Geoff and everyone else, it’s great to join the cast here at TOTM. Geoff gave a nice introduction, so I won’t use this first post to further that purpose – especially when I have substance to discuss. The only prefatory words I’ll offer are that my work lies at the intersection of law and technology, with a focus on telecommunications and the regulation of technology. Most of my posts here will likely relate to those subjects. But I may occasionally use this forum to write briefly on topics further afield of my research agenda (and to which I therefore cannot dedicate more than blog-post-length musings to develop).

But one paragraph of navel-grazing is enough; on to substance:

The WSJ had a nice piece the other day about the Consumer Product Safety Commission’s (CPSC) ongoing persecution of Craig Zucker. Several years ago, Zucker founded a company that sold small, strong, rare-earth magnets that are a ton of fun to play with. He called them BuckyBalls. In 2011, the CPSC determined that BuckBalls are inherently unsafe because children may swallow them, which can result in serious injury. The CPSC effectively forced the company to shut down in 2012. Unsatisfied with forcing a profitable small firm out of the market, the CPSC is now going after Zucker individually to, at his own expense, recall and refund the purchase price of all BuckyBalls the company sold.

BuckyBalls(Full disclosure: I own a bunch of BuckyBalls. In fact, they’re all over my office. To date, they have not harmed anyone. The photo to the left is of the “BuckyBall decapode” that I have behind my chair. Note: the CPSC is not concerned about BuckyBall decapodes, which could pose a legitimate danger if they became sentient, but about the individual magnets.)

The CPSC’s action is a case study in bad judgment, arguably abusive and vindictive government conduct, and a basic lack of common sense. But I don’t want to focus on common sense here – I want to focus on the common law. My question is why in the world do we need the CPSC protecting consumers from these magnets when the common law clearly offers sufficient protection?

These cases almost always follow a similar pattern. Adults buy BuckyBalls. Adults either give children BuckyBalls or leave BuckyBalls where children can get them. Children, acting as children are wont to act, somehow swallow BuckyBalls.

The CPSC’s complaint identifies 5 specific cases of children ingesting BuckyBalls and notes that “over one dozen” reports have been received. The complaint doesn’t discuss in detail any injuries that resulted, beyond noting that in some cases surgery was required (and in one case, treatment included “monitoring for infection and internal damage”). It doesn’t say whether any of these cases resulted in permanent injury or disability (presumably not, or that would surely be mentioned). There have been no reported deaths or, that I have seen reported, debilitating injuries.

On the flipside, over the few years that Zucker was in business (roughly 2009, when the product became popular, through 2012, when the company closed down), he sold about $75 million worth of BuckyBalls (per the WSJ piece, “’Two and a half million adults spent $30’”). This product wasn’t a mere novelty, but something created substantial economic value for consumers.

So, what do we have? A relatively small number of injuries, with very few disputable facts, and readily identifiable harm. These would be some of the easiest possible cases to bring to court, and would occur in small enough numbers that they wouldn’t burden the court system. After the first of these cases was decided, most of the others – given the similarity of facts – would likely settle. If the harms caused by BuckyBalls were sufficient to outweigh the economic value created by this product, Zucker could have responded by altering the product, seeking insurance, or shutting down. This is exactly the sort of case we have the courts for!

That penultimate sentence should be dwelt upon: the incremental approach of the common law would allow the firm to alter and improve its product, to avoid or reduce future harm. In this way, the law develops along with new products and technologies, supporting a dynamic market. Compare this to the CPSC approach, which was to demand that Zucker comply with the agency’s demands in a short period of time (which he did), and then, the very next day, to bring the administrative suit that forced Zucker to shut the company down. The CPSC could not have reviewed his response to its demands in that timeframe; even if it did and found the response lacking, its next step should have been to engage him to address any problems, with the twain objectives of both remedying any problems but also preserving the business. Rather, the CPSC’s purpose seems to have been from the outset to shut Zucker down. It seems that in its fervor to protect the children from negligent adults, it is willing to harm the consumers who enjoy these products — perhaps we should rechristen it the Children’s Product Safety Commission.

Others have written about the CPSC’s lack of common sense in this matter. My contribution to that discussion would be to say that the CPSC has become the FTC’s successor as the “National Nanny” (not to say the FTC does not deserve the title, as demonstrated by the POM Wonderful case – but today CPSC may be even more deserving of the title).

But the BuckyBalls case raises a more fundamental concern. The CPSC surely should be lambasted for its decision to pursue this matter at all; and even more for persecuting Mr. Zucker. But beyond that, this case raises fundamental questions about the need for, and the basic legitimacy of, the CPSC.

About a month ago I discussed a case in which I had written an amicus brief:

Last year I wrote here about Roni LLC v Arfa, which I cited as an example of the ”troubling lawlessness of NY LLC law.” In brief, the court sustained a non-disclosure claim based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them” despite holding that the parties’ arms-length pre-formation business relationship did not support a fiduciary relationship.  I argued that this new pre-formation duty to disclose

promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.

I later noted that my blog post was cited in the appellants’ brief on appeal, which triggered a response in the respondents’ brief (see n. 25) and then my amicus brief in connection with the appeal, which the NY Court of Appeals accepted for filing.

Now the NY Court of Appeals has decided the case.  In its brief opinion the Court said “we conclude that plaintiffs’ allegations of a fiduciary relationship survive the dismissal motion.” The Court added (footnote 2):

2 Based on the foregoing analysis, we need not decide the question of whether the promoter defendants’ status as organizers of the limited liability companies, standing alone, was sufficient to allege a fiduciary relationship.

In other words, the Court of Appeals, without saying so directly, effectively rejected the lower court’s determination that the complaint had not alleged a fiduciary relationship.  The Court did so in order to avoid a holding in favor of promoter liability that would, I argued, “make a mess out of NY LLC law.”

The Court elsewhere in its brief opinion alluded to another aspect of my amicus brief.  My brief pointed out (p. 6) that there was no authority for a pre-formation disclosure duty in LLCs, and that analogies from other business entities

should be drawn carefully because * * * the LLC has evolved as a unique entity, sharing some features of but ultimately distinct from all other business entities. See generally, Larry E. Ribstein, Rise of the Uncorporation ch. 6 (2010). 

In its opinion, the Court recognized (n. 1) that “[c]ertainly, there are differences between limited liability companies and traditional corporations, but the distinctions are not relevant to the allegations in this case.”  They were not relevant because the Court strained to accept the alternative basis for a fiduciary duty the lower court had rejected.

In short, I invited the Court not to wreck NY LLC law by imposing open-ended pre-formation promoter liability.  The Court accepted my invitation although this forced it to weave a circuitous course around the lower court’s opinion.

Now, I must avoid taking too much credit for the result in the case.  The NY court might have reached the same conclusion without my brief.  The case was very well argued by the defendant-appellant’s lawyer, David Katz, who raised all the relevant issues. 

All I can say for sure is that my brief made it harder for the Court of Appeals to accept the lower court’s promoter liability theory, and the Court did, in fact, reject that theory.   I think it’s plausible my brief affected some of the language in the opinion, and thereby the course of NY LLC law.

I make these points not solely out of pure ego (not that I’m totally devoid of same) but because they relate to the many words that have been spilled over the uselessness of legal academics.  You see, we academics do have some credibility because we devote ourselves to the study of underlying theory and policy rather than to achieving particular results in cases.  This is a quality that could be lost if legal academic is restructured so as to reduce the time and resources available for such work.

TOTM goes to court

Larry Ribstein —  15 November 2011

Last year I wrote here about Roni LLC v Arfa, which I cited as an example of the ”troubling lawlessness of NY LLC law.” In brief, the court sustained a non-disclosure claim based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them” despite holding that the parties’ arms-length pre-formation business relationship did not support a fiduciary relationship.  I argued that this new pre-formation duty to disclose

promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.

I later noted that my blog post was cited in the appellants’ brief on appeal, which triggered a response in the respondents’ brief (see n. 25) and then my amicus brief in connection with the appeal, which the NY Court of Appeals accepted for filing.  

The case is being argued today at about 1:30 EST. Tune in (click the blue “oral arguments webcast” link on the right in the middle) for this latest chapter in the saga of the blog post that went to court.

Update:  Peter Mahler provides a very helpful and complete summary of the oral argument.

A recent NY App. Div case, Pappas v. Tzolis, presents a tangled web that illustrates the current state of the LLC contracting architecture in the U.S. I previously discussed the lower court opinion in this case, concluding that ” any appeal of this judgment should be interesting.” (See also Peter Mahler.) I was right about that.

The complaint alleges that Tzolis and plaintiffs formed an LLC (Vrahos) for the sole purpose of entering into a long-term lease.  Tzolis got a sublease on the property in exchange for advancing the LLC’s $1.2 million security deposit and additional payments. Tzolis later took over the lease so he could extinguish the sublease.  The plaintiff members assigned him their interests, receiving a payment that was 20 times what they invested about a year earlier.  Six months thereafter Tzolis assigned the lease to a third party for $17.5 million.  The complaint alleges he was negotiating this sale at the time of buying out the plaintiffs.  Plaintiffs sue on various theories essentially based Tzolis’s breach of fiduciary duty in failing to disclose these negotiations.

At this point the case gets complicated.

To begin with, the LLC operating agreement, in a section titled “Other Activities of Members,” provided that “[a]ny Member may engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members.” The title of this section was “other activities.”

Given the title and the reference to “competition with the LLC, this section seems to refer only to dealings outside the LLC rather than a buyout of co-members’ interest without disclosing negotiations to sell the LLC’s only property. The title’s reference to “other activities” clarifies this intent.  Except that the agreement elsewhere says that “headings. . . shall be given no effect in the interpretation of this Agreement.” If the heading has no effect, should the section be limited to outside dealings as it implies, or extended to “investments of any nature whatsoever,” including an “investment” in another member’s interest, as it says?

Confused yet?  Ok, let’s add another layer.  At the time of the assignment the parties signed a handwritten “certificate,” which included the following language:

[E]ach of the undersigned Sellers, in connection with their respective assignments to Steve Tzolis of their membership interests in Vrahos LLC, has performed their own due diligence in connection with such assignments. Each of the undersigned Sellers has engaged its own legal counsel, and is not relying on any representation by Steve Tzolis or any of his agents or representatives, except as set forth in the assignments & other documents delivered to the undersigned Sellers today. Further, each of the undersigned Sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned Sellers in connection with such assignments.

Still not confused?  The LLC was formed in Delaware, which normally means Delaware law applies.  But the operating agreement provided that it was governed by NY law.

How should a court untangle this mess?  Let’s start with what law applies.  As I discussed regarding the lower court opinion in this case, referring to the choice-of-law analysis in The Law Market, incorporating in Delaware indicates the parties’ intent to apply Delaware law notwithstanding a contrary choice of law clause.  This intent is supported by Kobayashi and my paper presenting data indicating that LLCs choose Delaware in order to get the advantages of Delaware’s legal infrastructure.  On the other hand, the parties arguably were focusing on choice of law more in the choice of law clause (NY) than in the state of organization (Delaware).

Both courts in this case concluded that a choice between the two states was unnecessary because both states reached the same result.  The problem is that that same result was different in the two opinions — dismissal of the complaint below, reversed above.

The lower court relied on Delaware’s freedom-of-contract provision, and said that “under New York law, parties are free to contract as they wish, so long as the terms of their contract are neither unlawful, nor in violation of public policy.” But as I noted in my post on the lower court opinion, NY has no equivalent to Delaware’s freedom of contract provision.

If the only relevant contract provision here were the operating agreement, the defendant should lose.  As discussed in my earlier post, even Delaware requires fiduciary opt-outs to be clear, which this was not.  The Appellate Division appropriately cited Kelly v. Blum on that point (which I discussed here).

But does the handwritten certificate have the requisite clarity? There the plaintiffs explicitly disclaimed they were owed any fiduciary duty in connection with the specific transaction at issue.  The lower court didn’t make much of this, saying that the defendant didn’t claim it was a waiver, but that it just evidenced and certified the non-existence of any fiduciary duties defendant might have owed.  This strategy may have been intended to head off the argument that any release of duties in the certificate was invalid because of defendant’s preexisting fiduciary duty.

The Appellate Division didn’t buy this strategy.  Having held that Tzolis owed a duty under the agreement, the court held that the certificate couldn’t override it.

The court relied on Blue Chip Emerald v Allied Partners 299 A.D.2d 278, 750 N.Y.S.2d 291 (1st Dep’t 2002). This is part of a line of cases discussed in Ribstein & Keatinge, §9:5, n.51 involving non-enforcement of seemingly clear fraud waivers. For other cases along the same lines see Kronenberg v. Katz, 872 A.2d 568 (Del. Ch. 2004); Salm v. Feldstein, 20 A.D.3d 469, 799 N.Y.S.2d 104, 106 (2d Dep’t 2005). Also, a non-LLC case, Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006) (criticized here) refused to insulate a seller from liability for intentional misrepresentations despite a clear and comprehensive contract that covered precisely these claims because “the public policy of this State will not permit” a contract that would insulate a seller who deliberately lied or knew that the company had made false representations.

But there are cases upholding fraud waivers.  See DIRECTV Group, Inc. v. Darlene Investments, LLC, 2006 WL 2773024 (S.D. N.Y. 2006), applying Delaware law, and two recent NY Court of Appeals cases: Centro Empresarial Cempresa S.A. v. America Movil and Arfa v. Zamir. Centro emphasized that the release was broad, the fiduciary relationship was “no longer one of unquestioning trust,” and the plaintiff understood that the fiduciary was acting in its own interest. Arfa relied on the facts that plaintiffs were sophisticated and there was distrust between the parties. In these circumstances the courts held that plaintiff could not simply rely on defendant, but had a duty to investigate further. See Peter Mahler’s excellent discussion of these NY cases.

A vigorous dissent in Pappas by Justice Freedman, joined by Justice Friedman, relied on Centros.  The dissent acknowledged that while the operating agreement did not eliminate Tzolis’s fiduciary duties, the certificate notified plaintiffs that they shouldn’t place “unquestioning trust” in Tzolis, and therefore “was tantamount to a release” of fiduciary duty claims.  Moreover,

Tzolis’s substantial offer to plaintiffs should have alerted them to the fact that some deal was in the offing. Pappas and Ifantapoulos did not ask Tzolis why he was offering them 20 times more than what they had invested in Vrahos one year earlier; their lack of due diligence is unreasonable as a matter of law and fatal to plaintiffs’ claim.

Obviously this tangled mess in a substantial deal where the parties clearly could afford sophisticated advice suggests that something is amiss somewhere in the system.

Does the problem lie in the statute?  The parties easily could have taken advantage of Delaware’s broad freedom of contract provision and entered into a clear fiduciary opt-out, which would seem appropriate in the sort of limited joint venture involved in this case.  Instead they deliberately complicated their choice of law to use NY law which lacks such a provision.

But Abry indicates that Delaware law is no panacea.  Is NY clearer, given Centros?  The problem is that it is one thing to say that the parties’ relationship has broken down into clear distrust, as in Centros, and another to derive that distrust from the certificate alone, which is itself subject to the incomplete waiver of fiduciary duties in the initial agreements.

Abry suggests that once the parties agree to fiduciary duties because they failed to opt out, these duties may preclude them from ever opting out.  At that point the best they can hope for is a judicial determination that the fiduciary duty did not result in liability for particular conduct.  That could be based on actual distrust (Centros) or other circumstantial evidence (the high buyout price in a rapidly rising market).

Which raises a final question:  was there even a breach of fiduciary duty in this case?  What difference should it make whether defendant had an offer in hand?  The plaintiffs had reason to know the lease value was rising rapidly.

The basic problem is that this case has been decided on a motion to dismiss, and therefore on the complaint’s allegations.  Issues about what plaintiffs knew, when did they know it, and what did defendant have to tell them are for trial.

The answer here is to let the parties, via a clear agreement, opt out of liability for intentional nondisclosures.  A clear opt out should prevent the need for a trial.  Why can’t at least sophisticated parties agree to fend for themselves in determining what price they should get for their property? Under such a rule it would be up to the lawyers to help the parties clarify their intentions, as the lawyers arguably did here.  But given the incomplete statutory protection in NY and the unclear cases in both NY and Delaware there was an inadequate legal framework for such an agreement.

Update: Read Peter Mahler’s through analysis of the case.

Last year I wrote here about Roni LLC v Arfa, which I cited as an example of the “troubling lawlessness of NY LLC law.”

As discussed in my blog post, the court in that case, after holding that the parties’ arms-length pre-formation business relationship did not support a fiduciary relationship, nevertheless denied defendants’ motion to dismiss based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them.” The court applied old corporate cases holding that “both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders.”

I criticized the court’s holding as misapplying NY LLC law, concluding:

[T]he court’s reasoning using hoary old corporate promoter cases to create a pre-formation fiduciary duty to disclose in LLC cases promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.

It seems the only way NY business people involved in business formation can avoid this problem is simply to avoid New York.

My blog post ended up being cited in the appellants’ brief on appeal, which prompted a response in the respondents’ brief (see n. 25).

I was then moved to write an amicus brief in connection with the appeal, which the NY Court of Appeals has now accepted for filing. To complete the picture, here’s the appellants’ reply.

I understand the case will be heard in November and decided a couple of months thereafter.  It will be interesting to see what the Court of Appeals makes of all this.

I wrote last year about how the Florida Supreme Court had messed with the LLC “charging order” remedy to give the creditors of the sole member of an LLC access not just to the members’ financial rights, as the statute allows, but also to the member’s governance rights, which the statute arguably forecloses. The dissenters cited academic opposition (including from me) to the majority’s approach, its usurpation of the legislature’s role, and potential application beyond single-member LLCs.  I pointed out that

Now it’s back in the legislature’s court – and not just Florida, since this opinion is likely to be cited under any of the many statutes that resemble Florida’s. One possible fix is to change the statute to provide that creditors are not restricted to charging orders in smllcs. That might not work completely because it invites using nominal members with very small governance interests. More drastically, legislatures also might remove the temptation for asset protection by reinstating the business purpose requirement for LLCs, or at least qualifying the use of the charging order for LLCs used primarily for protecting assets from creditors.

I also discuss the law on this in Ribstein & Keatinge, §7:8, n. 17.

Now the legislative shoe has dropped in at least a couple of states:

  • Florida Stat. §608.433(6)-(8) tries to cabin the damage from Olmstead by providing special provisions for foreclosure on an interest in one-member LLCs.
  • Nevada Rev. St. §86.401 (2) clarifies that the charging order is the exclusive remedy for members’ creditors in all LLCs (thus cutting off the attachment or other route to taking over governance rights) and that foreclosure is unavailable even in one-member LLCs.

This swift legislative action indicates how state law can adjust rapidly to changes in a competitive legal environment.  Of course one might quarrel with these particular adjustments on policy grounds.  For a deeper discussion of the issues involved, see my article Reverse Liability and the Design of Business Associations.

The legislative response in these particular states highlight the bifurcated market in LLC law — the national market for formations of large LLCs dominated by Delaware, and the market for very small LLCs dominated by Florida and Nevada. See Kobayashi and Ribstein.  I suspect that these latter states may be competing for asset protection business, which is consistent with their actions here in quickly shoring up LLC members’ protection from creditors.

On Friday the Delaware Supreme Court decided the important case of CML V, LLC v. Bax (see Francis Pileggi’s helpful summary).

The court, per CJ Steele, held that a creditor lacks standing to sue an insolvent LLC derivatively.  The court reasoned that when the Delaware LLC Act says in §18-1002 that a plaintiff in an LLC derivative suit “must be a member or an assignee of a limited liability company,” it really and unambiguously means that he “must be a member or an assignee of a limited liability company.” Not a creditor.

Plaintiff argued that the Delaware statute refers only to member/assignee suits authorized by §18-1001 and does not preclude all creditor derivative suits.  This argument, draws force from N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007), which said that creditors of an insolvent corporation could sue derivatively under similarly phrased §327 of the DGCL. Plaintiff also insisted that it would be absurd to distinguish between LLCs and corporations.

CJ Steele responded that while the DGCL is limited to a shareholder-instituted derivative suit, Delaware §18-1002 refers to “a derivative suit.”  Also, while §18-1001 says that a a member or assignee “may” bring a derivative suit, §18-1001 says the plaintiff “must” be a member or an assignee, thereby calling attention to mandatory nature of §18-1002.

As to the plaintiff’s absurdity argument, here’s the opinion gets interesting (footnotes omitted):

[T]he General Assembly is free to elect a statutory limitation on derivative standing for LLCs that is different than that for corporations, and thereby preclude creditors from attaining standing. The General Assembly is well suited to make that policy choice and we must honor that choice. In this respect, it is hardly absurd for the General Assembly to design a system promoting maximum business entity diversity. Ultimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.

Moreover, in the LLC context specifically, the General Assembly has espoused its clear intent to allow interested parties to define the contours of their relationships with each other to the maximum extent possible. It is, therefore, logical for the General Assembly to limit LLC derivative standing and exclude creditors because the structure of LLCs affords creditors significant contractual flexibility to protect their unique, distinct interests. because there’s no difference in this respect between LLCs and corporations.

So this opinion reinforces developing Delaware law highlighting the LLC’s nature as a contractual entity, in contrast to the regulatory nature of the corporation.  Indeed, as I point out in my Rise of the Uncorporation (p. 6):

Uncorporations are characterized by their reliance on contracts. This is an aspect of uncorporations’ partnership heritage, as partnerships are contracts among the owners. * * * In contrast, corporate law is mainly couched in mandatory terms. * * * [T]he corporation’s special regulatory nature emerged from its historical roots. The corporation initially was a vehicle for government enterprises, monopolies, or franchises.

The CML opinion also carefully responded to plaintiff’s argument that this holding strips the Chancery Court of equitable jurisdiction to deal with injustice, in violation of the Delaware constitution. The court reasoned that the constitution freezes equity’s jurisdiction as of 1792, a time when LLCs didn’t exist.  The court went on to explain (footnotes omitted):

[T]he General Assembly passed the LLC Act as a broad enactment in derogation of the common law, and it acknowledged as much. Consequently, when adjudicating the rights, remedies, and obligations associated with Delaware LLCs, courts must look to the LLC Act because it is only the statute that creates those rights, remedies, and obligations.

Although the LLC statute provides that equity supplements its express provision, this refers only to rights and remedies the statute doesn’t address. On the other hand,

if the General Assembly has defined a right, remedy, or obligation with respect to an LLC, courts cannot interpret the common law to override the express provisions the General Assembly adopted.

The court points out that the creditor plaintiff’s exclusive redress in this situation is to contract for protection, and notes a variety of contractual terms that could have addressed the problem in this case.

This is a significant opinion because of its bluntness.  The basic point is that the legislature has decreed that LLCs are about contracts, so LLCs, unlike corporations, are freed from the sort of mandatory interference by Chancery that the constitution provides for corporations. In short, LLCs can opt out of litigation; corporations can’t.

This is wholly consistent with the central point of my Uncorporation and Delaware Indeterminacy, which surveys in detail Delaware uncorporation law and contrasts it with Delaware corporate law.

It’s also consistent with CJ Steele’s 2007 article, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies.  There he criticized his predecessor’s opinion in the Gotham case, which suggested that fiduciary duties are unwaivable, noting:

The supreme court apparently found it difficult to abandon the view that judicial oversight of disputes within the governance structure of limited liability unincorporated entities must invariably be from the perspective of a set of freestanding non-waivable equitable principles, drawn from the common law of corporate governance.

The Delaware legislature later fixed the Gotham court’s mistake, and CJ Steele has made clear ever since that the legislature meant what it said.  In this case he settles the potential constitutional impediment.

Interestingly, the Supreme Court’s reasoning in this case eschewed the more elaborate reasoning of VC Laster in this case, analyzed here. Although the Vice Chancellor reached the same result, he included an extensive analysis of how the LLC act differs from the corporate act in protecting creditors, thereby making the creditor derivative suit unnecessary. CJ Steele implies that it doesn’t matter whether the LLC Act includes effective substitute remedies.  It’s enough that the legislature has spoken and left creditors to their contracts.

Finally, it’s worth concluding the same way I did in my earlier post on this case by contrasting the clear and predictable approach in the Delaware courts with the

chaotic and unprincipled case law on LLCs in the supposedly commercially sophisticated New York, which I’ve discussed in several posts, as noted here. Among other sins, New York courts constructed an LLC derivative remedy out of nothing, and then had to make up the rest of LLC derivative suit law out of a whole cloth. In CML, VC Laster combined scholarly analysis and business sophistication in an opinion that gives contracting parties and later courts plenty of guidance.”

CJ Steele makes it even clearer:  There is no derivative remedy for LLCs in Delaware other than that provided for in the statute. Moreover, the parties to LLCs must look to their contracts.  If they want a court to fill in the blanks for them, they should have been a corporation, or an LLC in some other state.

We got our first LLC opinion from Chancellor Strine in his new position atop the Delaware Chancery Court.  It’s worth close attention in its own right as a case of first impression, and as an indication of the new Chancellor’s general approach to these cases.

The case is Achaian, Inc. v. Leemon Family LLC. Francis Pileggi does his usual good job on the basic analysis, so I’ll be brief on that.

The LLC was owned 50% by Leemon, 30% by Holland and 20% by plaintiff Achaian, a passive investor.  The Holland trust and Leemon managed the LLC together until Leemon took control over the other members’ objection.   The Holland trust purported to transfer its interest to Achaian.  Then Achaian sued for dissolution under Del. §18-802 claiming deadlock.  Leemon claims that Achaian only got an additional economic interest since Leemon didn’t consent to the assignment of ownership rights.

The Delaware statute, section 18-702(a), says an assignee of an LLC interest has no management rights except as provided in an LLC agreement. 18-704(a) says that an assignee is admitted as a member in compliance with the LLC agreement.

The agreement defines a member’s interest as “the entire ownership interest of the member.” Section 7.1 provides that “a member may transfer all or any portion of its interest in [the LLC] to any Person at any time. If at any time such transfer shall cause [the LLC] to have more than one Member, then this [LLC] Agreement shall be appropriately amended to reflect the fact that [the LLC] will then be treated as a partnership for purposes of the [Internal Revenue] Code. . .” Section 7.2 provides that “no person shall be admitted as a member of [the LLC] after the date of this [LLC] Agreement without the written consent of the Member . . . ”  The parties agree that “the Member” in 7.2 must be read as “Members,” so that all have a right to object to the admission of a new Member.

The Chancellor held that “entire” in the definition of “interest” refers to voting as well economic rights. The Chancellor reasoned that 7.1’s reference to a transfer adding a member suggests that a transfer includes ownership rights and section 7.2 deosn’t require a vote to confer additional voting rights on somebody who’s also a member.  Rather, he said, 7.2 is designed only “as a manifestation of the unremarkable idea that one gets to choose one’s own business partners.”  Requiring a vote for additional voting rights, said the Chancellor, “is a strained extension of the traditional idea underlying partnerships and limited liability companies, and is not supported rationally by the LLC Agreement’s text or by the context.”

Having decided that Achaian got additional ownership rights from Holland without Leemon’s consent, the Chancellor applied Delaware §18-802 as if this were a 50-50 joint venture, making applicable by analogy the reasoning under Delaware GCL §273: dissolution is justified where 50-50 holders can’t agree on continuation and the LLC agreement doesn’t provide a way to resolve the matter.  Hence he denied dismissal of the dissolution claim.

There is a lot to love in this case.  First, Chancellor Strine gives the matter the kind of close and sophisticated analysis he was renowned for as Vice Chancellor.  Second, he cited and quoted my LLC treatise.  Third, he continued Chancellor Chandler’s tradition of citing songs as authority — in this case the Commodores’ “Three Times a Lady” in n. 54, for the proposition that once somebody’s admitted as a member he doesn’t have to be admitted each time a member gets more shares.  Fourth, and best yet, the Chancellor says Leemon’s argument that the agreement contemplated a “serial admission scheme” lacks the critical support of “learned commentaries and treatises on alternative entities.” I very much like a requirement that parties’ positions in LLC cases require support from my or other treatises.

The only problem with the case is that it reaches the wrong result.

The big problem is that, as the Chancellor himself notes, the default rule in LLC statutes, including Delaware’s, is restricted transferability of management rights “given the closely held nature of most LLCs” (quoting §7:4 of Ribstein & Keatinge). The question here is whether the agreement varies the default rule.  It does not, because “entire” modifies “interest,” which, as already noted, the Act defines as including only economic rights.  No matter what modifier you put there, the basic thing being modified is economic rights.  To be sure, I can’t tell why “entire” is in there and the interpretation should try to make sense of every word.  But that’s not enough to reverse the statutory default.

Sections 7.1 and 7.2 of the agreement don’t expressly deal with the situation in which an existing member acquires additional voting rights.  That doesn’t render the agreement ambiguous.  Rather, the statute fills the gap by providing that a member can get shares with voting rights only by member consent.  Contrary to the Chancellor’s reading, the second sentence of §7.1 doesn’t assume that a transfer of a membership interest includes voting rights, but rather refers to the situation when the members create voting rights by consent under the statute.

Alas, the Chancellor’s reason is also not supported by the song he cites in support.  The Chancellor was implying that “one time a lady” was enough — three times would be redundant, just as you don’t need multiple membership votes for a member.  But Lionel Ritchie was saying in that song that he was a lost soul without purpose or direction until his lady came along and rescued him with “heart, soul and stone inspiration.”  The guy in the song needed all three — just love or soul wouldn’t have been enough without inspiration.  So, too, a member needs another vote to get additional membership interests.

Note that in addition to the quote from my treatise in the case, my treatise also says that “[r]estrictions on transfer of management authority may be appropriate for LLCs that are closely held firms” because, among other things, “transfers introduce potential new conflicts of interest.” Thus, contrary to the Chancellor’s reasoning, a veto on new ownership rights of an existing member does make sense in a very closely held firm.

That reasoning is particularly applicable to this case.  Holland’s transfer to Achaian completely changed the voting configuration in the LLC.  It stands to reason that any ambiguity in the agreement in this situation should be resolved against waiving the default rule requiring consent to the transfer.

So under my approach, Achaian would not get Holland’s 30%, there would not be a 50-50 split, and the §273 reasoning shouldn’t apply.  Leemon would still be in control. There would be no deadlock to resolve, and no dissolution, at least absent misconduct by Leemon.

Having said all this I don’t want to be too critical.  This was a case of first impression where there was at least an argument for the Chancellor’s result.  Moreover, the central problem was with the agreement, which failed to deal explicitly with an important situation and threw in an extra word (“entire”) as a spanner in the works.  But I would deal with such situations the way Chancellor Chandler did — with a tight reading of the agreement that forces the parties to be explicit when they vary the statute.  In this case, a tight reading would let stand the statutory default.

So the opinion was erudite (it cited and quoted my treatise) and funny (you don’t expect to see a Commodores’ song quoted in an LLC opinion, even if it didn’t support the holding).  Alas, it was not right.

But as another song said, “two out of three ain’t bad.”

The paper, with Kobayashi, is Law As A Byproduct: Theories Of Private Law Production.  Here’s the abstract:

Public lawmakers lack incentives to engage in a socially optimal amount of legal innovation. Private lawmaking is a potential solution to this problem. However, private lawmaking faces a dilemma: In order to be effective privately produced laws need to be publicly enacted, but under current law enactment eliminates the intellectual property rights that are essential to motivate private lawmakers. Because of this dilemma, much private lawmaking is done as a byproduct of other activities. The mixed incentives entailed in this “byproduct” approach make it a second-best response to the problems of public lawmaking. Potential solutions involve finding a better balance between public access and private rights.

The paper treats the creation of law as a form of intellectual property.  The central problem the paper identifies is the weakness of intellectual property protection of law.  This forces private lawmaking into the second-best world of “byproduct” lawmaking, where private lawmaking is essentially a form of lobbying.  This particularly includes the practicing bar’s significant role in lawmaking, and uniform laws.  The paper draws illustrations of byproduct laws from the development of the limited liability company, including the “L3C” spinoff.  We conclude with suggestions of how to fix intellectual property law to bring private lawmaking closer to a first-best world.

This paper is a natural outgrowth of several strands of my work alone and with others, including on LLCs and uncorporations, jurisdictional competition, lawyers as lawmakers, uniform laws, the “information revolution’s” effect on the law industry, and law teaching.

The literature on the state “market” for LLC law is growing.  Bruce Kobayashi and I published what I would modestly call the leading study (K & R) on jurisdictional competition for LLCs.  There is also an unpublished study to which our article is in part a response by Dammann & Schündeln (D & S). Now there’s a third study, Hausermann, For a Few Dollars Less: Explaining State to State Variation in Limited Liability Company Popularity.  Here’s the abstract:

The limited liability company (LLC) is a much more popular business entity in some U.S. states than in others. This empirical study provides the first detailed analysis of this phenomenon, using a partly original set of cross-sectional state-level data. I find that formation fees, rather than taxes or substantive rules or anything else, explain the variation in LLC popularity best. Differentials between the fees for organizing an LLC and the fees for organizing a corporation explain 17% to 28% of the state-to-state variation in LLC popularity. These formation fee differentials are not very big, but they are highly visible at the moment the business entity is formed. In contrast, the data show no relationship between LLC popularity and differentials in annual fees and state entity-level taxes. I find only weak evidence that the popularity of the LLC is associated with different substantive rules contained in state LLC statutes. However, LLCs are more popular in those states whose LLC statutes expressly uphold the principle of contractual freedom and thus reassure LLC members that courts will not rewrite their contract in the event of a lawsuit. Finally, I found no evidence that LLC popularity is related to different levels of uniformity of LLC statutes, the age of LLC statutes, and other factors.

Note that while K & R and D & S focus on state competition for out-of-state formations, Hausermann looks at the “popularity” of the LLC vs. the corporate form within each state.  Kobayashi and I found that Delaware has won the national competition, the most likely explanation being the quality of its courts.  This contrasts with D & S’s findings “that substantive law matters to the formation state choices of closely held limited liability companies” and that LLCs “appear to be migrating away from states that offer lax norms on minority investor protection.”

Hausermann mostly confirms K & R’s conclusion that the substance of the statutes is not determining parties’ formation choices.  His corporation/LLC comparison finds that the important variable is the difference in each state between the fees for forming an LLC and those for forming a corporation.

A few points to note about Hausermann’s study:

  • Although the author emphasizes K & R and D & S re state competition for LLCs, the closer comparison is with Kobayashi and my study of the state-by-state relative popularity of LLCs and LLPs, which Hausermann also discusses. We found that LLCs beat LLPs despite the expectation from the “network externalities” literature that the LLP’s connection to the “network” of partnership cases and forms would give it an advantage over the LLC.  Similar to Hausermann, we found that the costs of forming the two types of business associations (specifically, entity-level taxes) affected state-to-state differences in their relative popularity.
  • Hausermann finds that even tiny fee differences between corporations and LLCs make a difference in popularity of the two forms and that the parties ignore continuing fees and focus on upfront fees.  This rightly puzzles the author and calls for more theory and data.  I speculate that this reflects incomplete information on the part of many people who are forming LLCs.  This is clearly the case for ignoring continuing fees.  Moreover, since the vast majority of small firms should be LLCs rather than corporations (for more on this, see my Rise of the Uncorporation), making the choice based on tiny differences in upfront fees and ignoring continuing fees likely reflects bad advice and poor information.  In other words, Hausermann’s study arguably suggests the legal services industry is failing small firms.  Perhaps law’s information revolution will fix this.
  • Hausermann shows that freedom of contract regarding fiduciary duties matters to the corporation/LLC choice. This, coupled with the fact that the sheer number of mandatory rules in a statute doesn’t matter, indicates the importance to small firms of certainty that their contract will be enforced by its terms (see Hausermann at p. 36).  The importance of legal certainty is discussed in my and Kobayashi’s recently posted draft on private lawmaking (to be discussed here shortly).

Note what Hausermann finds doesn’t matter to parties’ choice between corporation and LLC:

  • Protection of third-party creditors.  This suggests creditors think they can protect themselves, and that the rise in LLCs vs. corporations is not about avoiding debts.
  • Default rules that members can easily vary by contract.  This is not surprising.  But perhaps default rules would matter if parties had a better and more varied menu of private forms from which to choose. This also relates to Kobayashi and my work on the potential role of private lawmaking.
  • Uniformity in general, and adoption of NCCUSL-promulgated uniform laws in particular.  This casts more doubt on the value of NCCUSL.  My most recent uniform laws article with Kobayashi helps explain why parties aren’t attracted to NCCUSL-drafted laws.

Hausermann rightly suggests the need for further research, including on the effect of overall formation costs, and the role of lawyers in guiding parties to particular forms.

More generally, I would suggest the need not only for more data but also more theory to guide both what kinds of data to get and how to interpret the data that is gotten.  In other words, Rise of the Uncorporation should be required reading for scholars seeking to mine the potentially rich data produced by the leading business law phenomenon of our time — the rapid rise and evolution of the LLC.