Steve Bainbridge invites my opinion of Delaware lawyer Edward McNally’s view that alternative entities “may not protect investors.” By “alternative entities” he is referring to limited liability companies and limited partnerships, despite his own recognition that they “have become the preferred form of entity for new businesses” (so why aren’t corporations “alternative entities”)? He uses as the text for his sermon VC Noble’s recent opinion in Brinckerhoff v. Enbridge Energy Co. involving the interpretation of a broad fiduciary duty waiver.
McNally says that “the lack of a uniform governance structure in these alternative entities may cause problems” when there are outside investors. He argues that broad fiduciary waivers may result in investors not being adequately paid for the risks they’re taking because “it seems doubtful that those risks can ever be adequately anticipated.” By contrast
corporate entities with much more standardized governance norms with greater investor protection have long flourished and raised capital. The corporate governance form benefits from its predictability and presumably raised capital effectively without the added risk of unpredictable governance provisions. Thus, the theoretical justification for letting alternative entities be governed loosely [that investors are paid for the risks they take] may not be valid.
Moreover, he says, the parties may not know for sure whether the waiver is effective. He cites the following example:
Years ago, we had a case where a master limited partnership’s 60-page operating agreement attempted in great detail to spell out how to handle conflict of interest transactions involving its general partner. After consulting a national legal expert on limited partnerships, the general partner bought limited partnership interests following what it thought was the correct process. It was promptly sued, lost and paid millions of dollars in damages. The court held it followed the wrong process, and in doing so had breached its duty to the partnership. Complexity has its own risks.
He concludes that this is why “few alternative entities have been used as a vehicle to issue publicly traded securities, such as limited partnerships or membership interests.”
McNally repeatedly refers to the entity involved in Brinckerhoff as an “LLP.” These are the initials for a “limited liability partnership,” which is a form of general partnership. However, the entity in the case is a limited partnership, or “LP.” He also confuses the “good faith” duty, a fiduciary duty which the agreement in Brinckerhoff added, with the “implied contractual covenant of good faith and fair dealing,” a non-waivable rule of contractual interpretation under Delaware law.
Apart from these technical glitches, I question McNally’s reasoning. As to his claim of unpredictability, as I have discussed at some length, Delaware alternative entities are actually a way to avoid the more serious indeterminacy problem in corporate law. McNally’s illustration of uncorporate unpredictability is unpersuasive. Maybe the general partner’s legal advisor was wrong, or the court erred. Both can also happen in corporate practice. Anyway, he says this happened “years ago.” Delaware uncorporate jurisprudence has developed rapidly in recent years, as the Brinckerhoff case itself illustrates.
Now let’s examine the case. A pipeline partnership found itself mid-project at the nadir of the finaical crisis. Its controller offered to invest. A special committee negotiated a deal and hired legal and financial advisors to evaluate it. They determined that it met the agreement’s “arms length” value standard for deals with affiliates. The court held this was not bad faith. The court noted (n. 39):
Although on some level the [agreement] may appear problematic for the simple reason that the controller of a limited partnership’s general partner is engaging in a transaction with the limited partnership, the LPA anticipates such transactions. Moreover, if the Court were to determine that [plaintiff] could state a claim that Enbridge [the defendant controlling party] acted in bad faith even though Enbridge negotiated the JVA with an independent special committee, then what would Enbridge have to do to be able to dispose of bad faith claims on a motion to dismiss? Would Enbridge be required, in analogy to In re John Q. Hammons Hotels Inc. S’holder Litig., 2009 WL 3165613 (Del. Ch. Oct. 2, 2009), to negotiate a transaction with an independent committee and have the transaction approved by a majority of the public unit holders? Requiring Enbridge to put in place those “robust procedural protections,” in order to be able to dispose of a bad faith claim on a motion to dismiss, would seem to rewrite the LPA when the Delaware General Assembly has explicitly stated that “[i]t is the policy of [Delaware’s Limited Partnership Act] … to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements.” 6 Del. C. § 17–1101(c).
The court interestingly compares the determinacy of the partnership agreement with the indeterminacy the parties avoided by not being a corporation.
As I have discussed elsewhere (e.g., here and here) the parties to uncorporations may quite reasonably trade off exit and managerial incentives for control and fiduciary duties. The courts should enforce these contracts and the Delaware courts do. It follows that McNally’s broader point that uncorporate entities are generally unsuitable for outside investors is flat wrong.
McNally raises the separate question of why there are only a relative few publicly held alternative entities. One reason may be that the exit tradeoff I referred to may not work in publicly held firms. Most such firms need the corporate feature of “capital lock in” which precludes buyout and dissolution provisions.
Bottom line: Lawyers need to understand that “alternative” entities are an important transactional tool for clients. Protestations that uncorporate law is too new or unpredictable, which were common 20 years ago, simply don’t wash today.