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.
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Corporate governance matters also for these alternative entities. Although these entities (e.g. limited liability companies and partnerships) often benefit from a more flexible legal framework impregnated with default rules and opt-out mechanisms created by the legislator, the reality (especially for corporate lawyers like me dealing with private limited companies in Europe) at times may be less straightforward. The fact that these entities are often “governed loosely” puts to the test lawyers’ creativity and expertise as well as courts’ ability to deal with governance problems in these entities (yes, these problems exist!). I am particularly referring to bargaining problems that determine coordination flaws inside these companies. Yes, these problems exist, and no, these entities are not too small for that. Why do they exist? That is another story. Anyway, lawyers, legislators and courts should enable outside investment and back up these entities and their partners’ business objects and goals by monitoring and providing mechanisms of coordination. For instance, in Europe we are currently discussing the European Commission Proposal for a Regulation of the European Parliament and of the Council on a Common European Sales Law. Article 1(2) of the Proposal states that “This Regulation enables traders to rely on a common set of rules and use the same contract terms for all their cross-border transactions thereby reducing unnecessary costs while providing a high degree of legal certainty” (see http://ec.europa.eu/justice/contract/files/common_sales_law/regulation_sales_law_en.pdf.). The main goal of this proposal is to improve the establishing and the functioning of the internal market by facilitating cross-border transactions for business (SMEs) and cross-border purchases for consumers. I wonder if SMEs and business people really see in this instrument something for them…I hope so. At least the intentions are good. Moreover, considering the nature of these entities, will this instrument be efficiently enforced? Is it appealing? Perhaps it is. The bottom line is that corporations are not “alternative entities”, because they do not reflect bluntly what I label the paradox of private autonomy and freedom of contract. In other words, although it is true that private autonomy, reflected in the freedom of contract, forms the basis of the legal framework of these entities (that is why they are so appealing: often one can opt-out from the rules provided by the legislator), in fact, the exercise of private autonomy by the parties can limit, divide, direct or institutionalize their power and consequently become an obstacle to the efficient functioning of the market itself. The coordination problems I mentioned above are the result of this (maybe not the only one). When that is the case, courts, lawyers, as well as the legislator should be ready to create mechanisms capable of enforcing these contracts and make transactions work. Are courts, lawyers and legislators ready for that? And what would make parties go for that? Again, this is another story.
Lécia Vicente
Florence, Italy
Thanks, Lecia, for the extensive comment. I would only respond by saying that “alternative entities” give parties an opportunity to choose the level of autonomy they prefer. I think the post that I was replying to unduly minimizes the value of that opportunity.