A recently published on-line symposium calls needed attention to Delaware Chief Justice Myron Steele’s remarkable article, Freedom of Contract and Default Contractual Duties in the Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221 (2009) (no free link available).
The Chief Justice makes an argument that is guaranteed to shock traditional business association scholars: that there should be no default fiduciary duty in Delaware LLCs or limited partnerships. According to the CJ, this would effectuate “Delaware’s strong policy favoring freedom of contract.”
CJ Steele notes that there are no fiduciary duties currently in the LLC statute, providing no basis for implying duties from the standard form. This argument is less clear for limited partnerships, which link to the general partnership act’s duty of loyalty in §15-404. The Chief Justice argues that the freedom of contract provision in §17-1101 effectively negates this duty. Although default duties arguably are preserved by reference in this provision, freedom of contract may trumps a nebulous default.
The ambiguity about default duties calls for application of policy considerations. The Chief Justice relies significantly on my writing, particularly Are Partners Fiduciaries? (for a more recent version of my theory see Fencing Fiduciary Duties). I argue for narrowly construing default fiduciary duties because of the extra transaction and other costs associated with broad duties. In other articles [see, e.g., Larry E. Ribstein, Fiduciary Duty Contracts in Unincorporated Firms, 54 WASH. & LEE L. REV. 537 (1997) also cited by the Chief Justice] I have argued that the parties ought to be able to narrow default duties by contract.
The Chief Justice builds on these policies to take the extra step of leaving it to the parties to contractually define fiduciary duties from scratch. Here’s his reasoning in a nutshell (46 Am. Bus. L. J. 239-40) (footnotes omitted):
Professor Larry Ribstein has written extensively on the economic costs and benefits of fiduciary duties. Professor Ribstein explains that “the existence of default fiduciary duties depends solely on the structure of the parties’ relationship that is, on the terms of their express or implied contract — and not on any vulnerability arising other than from this structure.” Specifically, for LLCs, Ribstein sets forth three economic rationales to narrowly define fiduciary duties.
First, according to Ribstein, even where fiduciary duties have some benefits, those benefits are outweighed by costs such as “effect on the purported fiduciary’s incentives and the reduction of trust or reciprocity from substituting legal duties for extralegal constraints.” In particular, Ribstein notes, “courts often ignore the costs of fiduciary duties perhaps because these costs matter most in the cases that do not get to court, and therefore seem insignificant compared to the unfairness in the case being litigated.” Second, Ribstein argues that “there are benefits to clearly delineating the situations in which fiduciary duties apply, including minimizing litigation and contracting costs and effecting extralegal conduct norms.” Third, and finally, Ribstein concludes that “a narrow approach to fiduciary duties inheres in the contractual nature of such duties.” Ribstein warns that “[a]pplying fiduciary duties broadly threatens to undermine parties’ contracts by imposing obligations the parties do not want or expect.”
Professor Ribstein’s thoughtful analysis also applies to default fiduciary duties. In particular, the cost of applying any default fiduciary duty is outweighed by its benefit. First, default fiduciary duties add unnecessary costs to contracting. Second, default fiduciary duties also add unexpected litigation costs. Finally, any benefit to default fiduciary duties is limited because the LLC, by its nature, is designed to be a highly customized vehicle, determined primarily by contract. A critic to my cost-benefit analysis will invariably argue: (1) there is no cost to default fiduciary duties because the LLC statute provides that parties may eliminate any default duties and (2) parties benefit from fiduciary duties because they expect them and need not contract for them. However, I will demonstrate why those criticisms are misplaced.
First, default fiduciary duties add unnecessary contracting costs. The nebulous nature of default fiduciary duties makes it difficult for parties to eliminate some, but not all, potential fiduciary duties. * * * If we assume no default fiduciary duties, the parties need only explicitly provide for a self-dealing proscription. The contract is much easier to draft, and the parties have more confidence that they adequately provided for that ban without also introducing other unwanted fiduciary duties.
A question remains: how often will parties want to remove the default fiduciary duties? If, for the most part, parties simply intend to keep the default fiduciary duties, then it would be less costly for parties to contract. However, if we proceed from the baseline of no default fiduciary duty, adding in a wholesale provision adopting Delaware’s fiduciary duty principles could also be easily achieved — without much cost. As I described in the last paragraph, this will benefit the parties who intend to adopt a discrete number of those duties because it will be less costly to contract for those limited duties. Moreover, by adopting an LLC, the parties have consciously chosen to use a highly customizable vehicle–in so choosing, we naturally infer that the parties intend customization.
Second, default fiduciary duties introduce unexpected litigation expenses. Without default fiduciary duties, the parties’ litigation will focus solely on the agreement between them–and not on fiduciary duty principles outside of the contract. * * *
In light of those potential costs, the courts must also weigh them against any benefits to applying default fiduciary duties. Professor Ribstein explains that “[i]n general, this is a matter of articulating standard form terms to minimize contracting costs. It is difficult and expensive for parties to enter into customized contracts covering all of the details of a long-term agency-type relationship.” However, it is important to remember that in the context of an LLC that the parties have specifically chosen to use an LLC agreement, which provides contractual flexibility, and have bargained for the relevant provisions in this agreement. Thus, it does not necessarily follow that default fiduciary duty principles will more accurately reflect the parties’ intent rather than principles of contract interpretation. Instead, because the parties chose a Delaware LLC and because the Delaware judiciary is skilled in resolving difficult issues of contract interpretation, the opposite conclusion is likely true, that is, parties would prefer Delaware courts to determine their rights and duties in accordance with the terms of the contract and not an unbargained-for default fiduciary principle. Moreover, if the parties intended to apply traditional fiduciary duties to their relationship, they could easily add a provision stating precisely that in the agreement.
The Chief Justice has a point. I grappled with the problem of contracting around default duties in my Uncorporation and Corporate Indeterminacy (at 165, footnotes omitted):
Vice Chancellor Strine’s admonition to lawyers not to address fiduciary duties “coyly” could require such careful and costly drafting that it makes fiduciary duties in effect mandatory. Even a moderate insistence on careful drafting could put fiduciary duty waivers out of the reach of smaller firms. In other words, by making very skilled drafting the price of avoiding indeterminacy, Delaware’s uncorporate law may be trading lower litigation costs for higher fees to transactional lawyers. This may reserve the benefits of the uncorporate approach only for the largest and most sophisticated uncorporations.
In other words, the current Delaware approach achieves free contracting at significant cost. Chief Justice Steele’s approach may be the best way to deal with that problem.
The important question is whether there will be many parties who (1) fail to contract fully regarding fiduciary duties; and (2) expect a certain level of fiduciary duties to apply. If both apply, then eliminating default fiduciary duties could defeat expectations and increase litigation by frustrated LLC members. The Chief Justice’s response is that parties to Delaware LLCs know they’re getting a contractual regime and therefore are getting what they expect. In other words, the market for LLC law offers a potential opportunity to contract not only out of default duties, but also away from the existence of default rules.
The brief articles in the symposium by Ann Conaway, Bill Callison & Allan Vestal, Carter Bishop, Dan Kleinberger, and Louis Hering take both sides of the issue, but do not, in my opinion, fully grapple with CJ Steele’s (and my) policy arguments. Unfortunately I didn’t have an opportunity to participate in this symposium (not sure why, since after all the Chief Justice does rely on me!) so I haven’t had a chance to insert a full-fledged version of my thinking into the debate. I plan to write at more length on this, but wanted to take this opportunity to opine on the important issues raised by the Chief Justice while the iron was hot.