Is Delaware uncorporate law unconstitutional?

Larry Ribstein —  10 October 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.

Larry Ribstein

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Professor of Law, University of Illinois College of Law

3 responses to Is Delaware uncorporate law unconstitutional?

  1. 

    Larry,

    Thanks for highlighting the recent posting of my piece. I, like you, could respond at length to your comments but will note just three, very briefly.

    First, even though the larger focus of the piece is a constitional argument, I do address policy issues at the end of my article because my constitutional argument leads there, ineluctably. The policy issues are back on the table for the Delaware judiciary, whether they like it or not. I stated explicitly that they could, as a judiciary, dispense with duties categorically in the noncorporate area but that, of course, is sharply at odds with a customary case by case adjudicative approach in the fiduciary duty area, is at complete odds with corporate law(where the judges are utterly unconstrained to apply fiduciary duties notwithstanding a corporate “contract” exists, thereby making the supposed “contractual” distinction between LLCs and corporations unpersuasive), and most importantly, such judicial decisions on this subject would not and could not be because the General Assembly mandated it(which the GA cannot do, the key point of the piece)and therefore the judges should stop saying so. Second, I don’t say duties run to creditors but that upon insolvency creditors are the residual claimants of duties to the company, yet creditors do not waive duties contractually. Third, you can’t make fiduciary duties disappear by willing them away in your writing, however persuaded you are(naturally)of the correctness of your policy position. They have been around for centuries, still are around in many subject areas and states, and can still be applied in Delaware LLC and partnership law whatever the General Assembly might say. The GA waiver statute is enaabling legislation that is necessary, but not sufficient, to effectuate a waiver.

  2. 

    Not having an extra-contractual fiduciary duty is very different from having no duties at all.

  3. 

    If I say “I am selling you these shoes but I am not obliged to hand it to you and no liability will ensue” Am I binding myself? If someone signs a partnership agreement and says he has no loyalty duty whatsoever Is he willing to be bound by the agreement?
    In Civil Law countries, you can not waive the duty of acting in good faith towards your partners since this would amount to not to be bound at all