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Wilkes v. Springside and the Rise of the Uncorporation

Posted by Larry Ribstein on October 16, 2010

As I noted last week I participated with several corporate law luminaries in a conference at Western New England College in Springfield, Massachusetts on the famous case of Wilkes v. Springside Nursing Home, 370 Mass. 842, 353 N.E.2d 657 (1976). Springfield is near Pittsfield, where Springside was located and this case originated.

As most law students and corporate scholars know, Wilkes importantly qualified the same court’s case of the year before, Donahue v. Rodd Electrotype Co. of New England, Inc., 328 N.E.2d 505 (1975).  Donahue held that “stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another.”

The Wilkes court was

concerned that untempered application of the strict good faith standard enunciated in Donahue to cases such as the one before us will result in the imposition of limitations on legitimate action by the controlling group in a close corporation which will unduly hamper its effectiveness in managing the corporation in the best interests of all concerned. The majority, concededly, have certain rights to what has been termed ‘selfish ownership’ in the corporation which should be balanced against the concept of their fiduciary obligation to the minority. * * *

Therefore, when minority stockholders in a close corporation bring suit against the majority alleging a breach of the strict good faith duty owed to them by the majority, we must carefully analyze the action taken by the controlling stockholders in the individual case. It must be asked whether the controlling group can demonstrate a legitimate business purpose for its action. * * * In asking this question, we acknowedge the fact that the controlling group in a close corporation must have some room to maneuver in establishing the business policy of the corporation. It must have a large measure of discretion, for example, in declaring or withholding dividends, deciding whether to merge or consolidate, establishing the salaries of corporate officers, dismissing directors with or without cause, and hiring and firing corporate employees.

When an asserted business purpose for their action is advanced by the majority, however, we think it is open to minority stockholders to demonstrate that the same legitimate objective could have been achieved through an alternativecourse of action less harmful to the minority’s interest. * * *

The court held that the defendants had not shown a legitimate business purpose for firing plaintiff and minority shareholder Wilkes, and therefore that the action was an illegitimate freeze-out, entitling Wilkes to a remedy.

The conference featured an interesting discussion between the lawyers who represented Wilkes and Springside.   We learned from Wilkes’s lawyer (and nephew) David Martel how his senior lawyer on the case, James Egan, fashioned a case for breach of a partnership agreement despite the fact that the parties had incorporated because Egan knew about case law where shareholders were treated as partners.

The master and probate court rejected the partnership theory below because the parties had incorporated. The highest court took the case on direct appeal. That court had just decided Donahue and evidently was looking for an opportunity to refine the rule in Donahue. (Yet based on my inquiries at the conference, it’s not clear Mr. Egan even knew about Donahue when he fashioned his partnership argument.)

Retired Judge William Simons, Springside’s lawyer, described the parties deal as one to buy and sell property.  Simons says the facts didn’t support the theory that the parties were “truly a partnership” and thought the Supreme Judicial Court should have ordered another hearing rather than taking this as an established fact.

I find the following quotes from the Wilkes opinion particularly significant:

Wilkes consulted his attorney, who advised him that if the four men were to operate the contemplated nursing home as planned, they would be partners and would be liable for any debts incurred by the partnership and by each other. On the attorney’s suggestion, and after consultation among themselves, ownership of the property was vested in Springside, a corporation organized under Massachusetts law. * * *

In light of the theory underlying this claim, we do not consider it vital to our approach to this case whether the claim is governed by partnership law or the law applicable to business corporations. This is so because, as all the parties agree, Springside was at all times relevant to this action, a close corporation as we have recently defined such an entity in Donahue v. Rodd Electrotype Co. of New England, Inc. * * *

This quote encapsulates the problem in the case:  At the time of Wilkes, the parties had to force what was essentially a partnership into corporate form in order to get the limited liability that would be essential for a venture like a nursing home.  There was no way in 1976 for the parties to have a true partnership with limited liability.  If it had been a partnership, Wilkes could have gotten the firm dissolved for having been denied the participation in governance he was entitled to under partnership law (see Bromberg & Ribstein on Partnership, §7.06(c)).  Without an applicable standard form, and given the costs and difficulties of small firms contracting over exit, the court had to essentially make up a deal for the party ex post. 

My paper for the conference describes how the modern contracting technology enabled by the advent of the LLC (see also The Rise of the Uncorporation) enables a solution of this problem, and therefore assists entrepreneurs like the men involved in Springside Nursing. 

Wilkes and the interesting background we learned in Springfield, Massachusetts provided a glimpse into the past and insight into the future of business associations.

My paper will appear shortly on SSRN and then in the conference issue of the Western New England Law Review. I highly recommend the other papers in the conference, which presented other perspectives on the case.  I may write about some of those papers when they go public.

Posted in corporate law, LLCs, uncorporations, Unincorporated business entities | Comments Off

Is Delaware uncorporate law unconstitutional?

Posted by Larry Ribstein on October 10, 2010

It is well known that Delaware unincorporated entity statutes (e.g., 6 Del. Code Section 18-1101) permit the waiver of all fiduciary duties, not only of care, but also of loyalty.  Now along comes Lyman Johnson, a respected corporate scholar, to argue, in Delaware’s Non-Waivable Duties that those statutes violate the Delaware constitution (HT Pileggi). 

Johnson argues, in a nutshell, that whatever the statute says, the Delaware Chancery Court has inherent constitutionally-conferred equitable jurisdiction to decide the issue of enforceability of fiduciary waivers for itself, de novo, which neither a contract nor the legislature can remove.  Chancery judges cannot avoid their responsibility by “blithely” referring to an agreement or statute. 

I’m not persuaded.  It would take a long article to detail my objections.  Luckily I’ve written several on point.  Johnson cites two of my articles, from 1993 and 1997.  But I’ve written a lot since then, particularly on the issues Johnson covers.   See, e.g., The Uncorporation and Corporate Indeterminacy, The Rise of the Uncorporation (particularly Chapter 7) and many blog posts. 

The bottom line is that the courts have made their own analysis, taking the legislature’s judgment into account.  Johnson doesn’t like the tool the courts have used in many of these cases – that is, the implied good faith covenant, which he characterizes as an “untried concept” the courts have attempted to “clumsily retool.”  But he cites only a corporate case (Nemec v. Shrader, 991 A.2d 1120 (Del. 2010)), ignoring the sophisticated application of this doctrine in unincorporated cases (see, e.g., the article and book cited above and this recent blog post).

Johnson doesn’t seem to argue with the proposition that the courts could decide to accept the legislature’s judgment as to the enforceability of fiduciary waivers, which is what they’ve done.  His problem is that he doesn’t agree with their decision. He’d like them to make a “context-specific inquiry” as to “the degree of moral and commercial repugnance of the managerial behavior, the experience and sophistication of the Members, and the financial and strategic significance of the challenged dealings for the overall welfare of the LLC.”  He wants courts to consider not only on the parties’ interests, but also “the ramifications for business dealings more generally, the overall state of business morality being an important and legitimate societal concern.”

What about freedom of contract?  Johnson doesn’t say that no contract is safe — just those in firms, because they’re “creatures of statute”  and privileged legal “persons” with constitutional protections (citing, of course, Citizens United v. Federal Election Com’n., 130 S. Ct. 876 (2010)).  But now we’ve obviously come a long way from a constitutional argument based on equity jurisdiction.  And statutory-creation and “legal person” arguments, questionable in general for corporations, are particularly dubious for unincorporated firms, as I’ve discussed at length, most recently throughout my Rise of the Uncorporation.  [And, as I'm arguing in a forthcoming article, those arguments have little to do with Citizens United.]  There’s no way around the fact that corporations and uncorporations are fundamentally contracts.  Merely because they can be regulated does not make them not contracts – many relationships that are clearly contractual are also highly regulated.   See, e.g., Butler & Ribstein, Opting Out of Fiduciary Duties:  A Response to the Anti-Contractarians, 65 Washington Law Review 1 (1990).

Even Johnson recognizes the appropriateness of courts’ taking into account “the desirability of greater certainty and determinacy in intra-firm relations, and on allowing passive investors to exchange the possibility of greater risk from broad waivers for other perceived benefits.”  He qualifies this by saying “[i]nvestors customarily do not bargain for betrayal; at least not all of them do all of the time.”  But this is a judgment about what investors actually are contracting for – a judgment that courts, in fact, make repeatedly in construing uncorporate contracts under Delaware’s freedom of contract provision, as discussed in the sources cited above.

Johnson is concerned that “[t]here are well-recognized shortcomings with much ex ante bargaining,” including lack of sophistication, foresight and completeness.  Yes, contracts are imperfect.  But the parties, courts and legislatures do take this into account.  Again, this is policy, not constitutional law. 

Nor is it fiduciary law.  As I discuss extensively in Are Partners Fiduciaries, the fiduciary relationship depends on the nature of the duty undertaken, not on the parties’ relative bargaining positions. Perhaps courts should take the parties’ bargaining positions into account when enforcing waivers, but that’s just because it’s a contract, not because it’s a fiduciary relationship.

Johnson is concerned that Delaware’s uncorporate freedom of contract doesn’t take account of some types of fiduciary relationships.  The problem is that the examples he gives are not fiduciary relationships (see, again, Are Partners Fiduciaries?).  For example, he’s concerned about whether a waiver would cover a breach of fiduciary duty by a promoter in connection with formation.  But as I wrote last summer, this isn’t properly a fiduciary duty.  He’s concerned about duties to creditors.  Again, not fiduciary.  See also Ribstein & Keatinge on LLCs, §9:1, n. 1.

Obviously this is a provocative and interesting article.  I’m glad Lyman wrote it.  I’m particularly happy to see somebody reflecting deeply on fundamental issues of uncorporate law.  I don’t expect Delaware to suddenly forfeit its strong advantage in uncorporate law based on this article.   I elaborate on the paper because it reflects a dying gasp of anti-contractarian thought.  Fortunately we have moved beyond these arguments.  The result is far from a catastrophe of helplessly skinned investors, but a productive movement toward expert judging and more careful and sophisticated ex ante contracting.  The biggest failing of this article is that it is firmly anchored in the past – to some extent a distant past.  Time to move on.

Posted in limited liability companies, LLCs, uncorporations, Unincorporated business entities | 3 Comments »

Terrorism Finance Meets Business Associations

Posted by J.W. Verret on August 17, 2010

Now that TOTM blog traffic is hitting all-time highs, I thought it would be a good time to share a link to my most recently published paper, Terrorism Finance, Business Associations, and the “Incorporation Transparency Act.” It is highly critical of Senator Levin’s “Incorporation Transparency and Law Enforcement Assistance Act,” over which Senator Levin, Senator Lieberman, and the Obama Treasury Department are currently haggling.

I got the idea to write an article about this Act from reading posts from colleague Ribstein and blog neighbor Bainbridge some time ago.  Senator Carl Levin has been pushing to mandate that states keep open registeries listing the names of all owners of business entities they form.  There are a number of problems with this proposal.  First, it is sold as an anti-terrorism measure.  During the first two rounds of hearings on the bill, officials from the various law enforcement agencies made vague references to the war on terror, which…don’t get me wrong, I support wholeheartedly.

They did not, however, provide any meaningful analysis for why alternative entities stand at the heart of terrorism finance.  To the extent that terrorism has involved intricate finance in the past, it has been through the Hawala system of underground Asian and Middle Eastern bankers.  But hawaladars don’t form alternative entities…they have no reason to.  Why would they need the protection of limited liability when the very nature of their business is, in both the United States and abroad, centrally an illicit enterprise?

Moreover, hawaladars function within a system of cultural and family bonds, with reputational costs as paramount, allowing them to transfer money outside of a sophisticated wire transfer system.  To a hawaladar, protection from personal liability for entity obligations is entirely useless.  But more importantly, the 9/11 Report describes how most international terrorists have been self-financing their activity, both from legal employment and illicit credit card fraud and drug distribution.  Also remember that the 9/11 hijackers did not use LLCs or LLPs in their activities either, and to the extent terrorists continue to use the banking system the Patriot Act already provides an extensive surveillance mechanism that the Levin Bill does precious little to supplement.  Even more ridiculously, the Levin Bill anticipates owners filing their identification with the relevant state of formation, thus we would rely on terrorists to accurately report their ownership information!

The Levin Bill fails to achieve its stated objective.  The truly pernicious part of the bill is the cost that would accompany its implementation.  Business privacy is an important element of business entity use.  Imagine if, instead of acquiring tracts of land in Florida through acquiring shell entities, Roy Disney had to acquire tracts through the Disney company directly?  Making beneficial ownership information public can potentially result in reapportionment of bargaining leverage because it potentially reveals insight about one party’s walk-away point.

The Levin Bill reporting obligations are triggered by ownership.  But what is an owner?  If I am the only creditor of an LLC, and I have all of the LLC’s assets secured as collateral, and the debt covenants provide me with veto power over all LLC decisions, am I an owner?  This part could get very tricky.  The Levin Bill ties in the definition of “ownership” to “control.”  That will get even trickier.  Furthermore, the Bill harms the entire enabling purpose of alternative entities.  One important advantage of using alternative entities is the freedom to design governance structures appropriate for a particular venture.  But where governance structures are arranged to avoid Levin Reporting obligations, rather than to create governance structures appropriate for a particular venture, that benefit of the alternative entity form is lost.

All in all, a very bad bill.  TOTM readers, be sure to write your Congressman.

UPDATE: One reader comments “If you’ve ever done due diligence for fraud, you would support this bill.”  Not true.  I agree completely that due diligence is a vital element of business relationships, so important in fact that I think its a bad idea for due diligence to be managed by the federal government in this context.

Posted in close corporations, corporate governance, LLCs | Comments Off

Microsoft LLC

Posted by Larry Ribstein on July 28, 2010

Holman Jenkins, writing in today’s WSJ, criticizes Steve Ballmer’s management failures that have left its investors with a decade of “dead money.”

At bottom, this is a corporate governance problem. Manifestly, the solution is not to let management keep stepping up to the plate with shareholder money and promising home runs that never materialize. Nor is the solution another big, one-time dividend like the massive, $3-a-share payout in 2004. That $32 billion attempt to placate investors, in retrospect, may have been the seminal blunder of the Ballmer era. It didn’t go far enough. What the company should have done, and should do now, is sharply lift its regular dividend and then promise to keep lifting it, so management will have to strain and push to reinvest in its core business while still meeting its dividend commitment to shareholders. Mr. Ballmer or whoever succeeds him needs to be placed under relentless daily pressure to distinguish between necessary spending on the business and pursuit of me-too products that don’t serve shareholder interests.

Even better, Microsoft should become an LLC. Like a traditional highly leveraged private equity target, it should become a cash cow regularly producing milk rather than trying to stay a virile bull siring calves. Only it shouldn’t wait for a private equity buyout that probably won’t come in the current environment. Instead, it should adopt an uncorporate governance structure that enables it to commit to regular distributions to its owners. Think Sears Brands, LLC and Chrysler Group LLC. For details, see my Rise of the Uncorporation, Chapter 8.

This raises the question of where the innovations will be coming from if not from Microsoft.

Posted in LLCs, uncorporations | Comments Off

AALS Agency, Partnerships and LLCs Section Call for Papers

Posted by Josh Wright on August 31, 2008

Larry Ribstein is organizing the upcoming AALS session of agency, partnerships and LLCs and has posted the following call for papers:

The Section on Agency, Partnerships and Limited Liability Companies is calling for papers for the 2009 AALS Annual Meeting in San Diego. We are interested in presentations on the application of modern theories and empirical methods of business associations to agency and unincorporated firms. The program has two goals: First, to show how these theories can be enriched by taking them outside the “box” of corporate law; and second, to show the relevance of agency and unincorporated firms to the mainstream of corporate theory and empirics. A non-exhaustive list of possible topics includes the nature and function of fiduciary duties, agency theory, the role and enforcement of contracts, jurisdictional competition and choice of form, the relationship of federal and state law, jurisprudence, international and institutional comparisons, and legal and economic history. Please email either a draft paper if available, or if not an abstract and outline, to Larry E. Ribstein, University of Illinois College of Law, ribstein [at] law.uiuc.edu by no later than September 1, 2008.

If you’ve got a paper that falls into this category, and want to head to San Diego for the 2009 AALS meeting, send the paper, abstract or outline to Larry at the email address in the post.

Posted in business, corporate governance, corporate law, economics, federalism, legal scholarship, LLCs, mergers & acquisitions | Comments Off

Delaware is winning the LLC race.

Posted by Bill Sjostrom on May 1, 2008

Dammann and Schundeln have a new paper up on SSRN entitled “Where are Limited Liability Companies Formed? An Empirical Analysis” (see here) that examines the state of formation choice of 64,000+ LLCs. Here’s the abstract:

We empirically study the incorporation choices or, more accurately: formation choice, of limited liability companies. Most of the firms in our large sample of more than 64,000 limited liability companies are formed in the state where their principal place of business is located (the PPB state). As their size increases, however, firms become more likely to be formed outside that state, with Delaware emerging as the primary destination for those that are not formed in the PPB state. In particular, of those firms that have 1,000 or more employees, roughly half are formed outside their home state, and of the latter, more than 80% are formed in Delaware.

We show that substantive law matters to the formation choices of closely held limited liability companies. More specifically, limited liability companies appear to be migrating away from those states that offer lower levels of protection for minority investors: We find statistically significant evidence that firms are less likely to be formed in their PPB state if the latter offers relatively lenient rules on managerial liability or if it allows companies to be dissolved via a less than unanimous resolution of the members.

Posted in federalism, LLCs | Comments Off

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