Archives For limited liability companies

Chancellor Chandler has announced his retirement as Delaware’s leading corporate trial judge (Pileggi and the WSJ).

News reports likely will focus on the Chancellor’s work on high-visibility corporate cases.  But I think he made his most lasting mark in helping create a modern jurisprudence for sophisticated LLCs and limited partnerships. 

Delaware statutory law laid the foundation in giving “maximum effect to the principle of freedom of contract and to the enforceability of” agreements in LLCs and limited partnerships.  But it was left to the Delaware courts, and most notably Chancellor Chandler, to figure out how to give life to this principle of freedom of contract in the context of open-ended long-term agreements, unexpected situations and uncertain application of express contract terms.

The Chancellor responded to this challenge by eschewing a constrained corporate-type approach which gave primacy to statutory defaults, and taking the parties’ contract seriously.  For a couple of examples that I’ve discussed in recent years, see here and here.

Here’s hoping the new Chancellor (rumored to be Strine) continues this tradition.


AALS Section on Agency, Partnerships, LLCs and Unincorporated Associations

2012 AALS Annual Meeting Washington, D.C.

The AALS Section on Agency, Partnerships, LLCs and Unincorporated Associations will hold a program during the AALS 2012 Annual Meeting in Washington, D.C. on the subject of Using Unincorporated Business Entities for Non-Business or Non-Profit Purposes. 

Business entities may be created for purposes that do not include, or at least are not limited to, the pursuit of business or profit activities.  In such instances, unincorporated business entities may offer advantages over incorporated entities.  At the same time, unincorporated entities may create complex issues for the entities’ stakeholders and managers.

We are soliciting papers on a broad range of issues dealing with the use of unincorporated business entities for non-business or non-profit purposes.  Among the topics that might be addressed are:  

The extent to which states compete to be the jurisdiction of organization for such non-business entities and whether this competition is socially efficient.

  • The respective roles of federal and state law in these developments.
  • The comparative advantages (or disadvantages) of unincorporated entities over incorporated entities when used for non-business purposes.
  • The emergence of the L3C or similar ‘social benefit’ entities and their utility (or lack thereof).
  • The implications for management, structural and legal concepts (e.g., limited liability, agency principles, fiduciary duties, and the duty of good faith) when an unincorporated business entity is operated for non-business purposes.

Submission Procedure:   A draft paper or proposal may be submitted via email to:  Professor Rutheford B Campbell, Jr. at the following e-mail address: (Please note that in the e-mail address there is only one “l” in “rcampbel”). 

Deadline Date for Submission:   June 1, 2011.

Form and Length of Paper; Submission Eligibility:  There is no requirement as to the form or length of proposals.  Faculty members of AALS member and fee-paid law schools are eligible to submit papers. Foreign, visiting and adjunct faculty members, graduate students, and fellows are not eligible to submit.

Registration Fee and Expenses:  Program participants will be responsible for paying their annual meeting registration fee and expenses.

How will papers be reviewed?  Papers will be selected after review by the section’s Executive Committee.

Will program be published in journal?   The section does not plan to publish the papers in a journal.

Contact for submission and inquiries:    Professor Rutheford B Campbell, Jr. University of Kentucky College of Law     Phone: (859)257-4050     FAX: (859)323-1061

In my recent paper, Close Corporation Remedies and the Evolution of the Closely Held Firm, written for a symposium on the famous Massachusetts close corporation case Wilkes v. Springside Nursing, I focused on the LLC alternative to close corporations.  I observed that  

by providing a clearly non-corporate structure of default rules and a variety of state statutes, LLCs make it easier than close corporations for parties to reach agreements that approximate their ex ante expectations.  Courts can then fill in the gaps using the contract and statute as general guidelines rather than having to construct a contract from a whole cloth as in Wilkes. 

Judicial opinions in close corporations tend to proceed from a generalized notion of what the minority shareholder expected from the deal – that is, the ability to get distributions or salary – without regard to the express and implied contract terms.  By contrast, courts in LLC cases increasingly have focused on what parties actually put in their contracts, interpreted in light of the statutory standard form they used as a basis for their business agreement.  Instead of asking what reasonable parties would want if they could contract cheaply, courts now tend to ask what the specific parties actually wanted given what they contracted for.

I noted that Delaware and New York are leading the way in creating a distinct LLC contractual approach to judicial dissolution of closely held firms.  A leading example is New York’s Matter of 1545 Ocean Avenue, LLC v. Crown Royal Ventures, LLC, which I discussed here. My blog post noted four important elements of the 1545 Ocean test:

  • The LLC statute clarifies that the test for dissolving an LLC is distinct from that for a close corporation.
  • The statutory test emphasizes the operating agreement — specifically, whether it is “reasonably practicable” to operate “in conformity with the operating agreement.”  This is consistent with the Delaware judicial dissolution standard I have discussed, e.g., here, here and here, and in my Rise of the Uncorporation, 180-82.
  • The court might dissolve an LLC even when it can continue operating under the agreement, but when it “cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created.” I noted that the parties therefore “may need to be careful about specifying the purpose of the LLC in the operating agreement.”
  • The LLC generally cannot be dissolved merely because of managerial self-dealing unless the above standard is met.  The remedy for self-dealing is usually a derivative claim. Although my article Litigating in LLCs suggests that dissolution sometimes works better than wasteful litigation, this choice may be a matter for the operating agreement.

Now the ever-helpful Peter Mahler provides an analysis of recent NY cases applying the 1545 Ocean standard. He summarizes three cases reaching three results: 

 that the petitioners failed to show that the LLC “can no longer meet its business purpose regarding the intake of consumer database,” and also fail to make any “showing that the company is financially unfeasible.”  A petitioner “must plead facts reflecting the inability of the entity to carry on its business in accordance with the articles of organization” and may not merely “parrot” the language of LLCL 702.  The “palpable” animosity between the parties, Justice Strauss adds, “alone will not support a petition for dissolution.”

  • Matter of RBR Equities, LLC, Short Form Order, Index No. 40736/10 (Sup Ct Suffolk County Jan. 18, 2011). In a case similar to Mehraban involving a real estate development that had financial difficulties and couldn’t get site plan approval, the court held there were factual issues precluding dissolution. The respondent claimed petitioners approved modified site plans and failed to respond to cash calls. The respondent also argued that the operating agreement’s broad purpose “to engage in any lawful act or activity” “is being achieved and that the development plan for the LLC’s property is extremely close to approval and fruition.” The court reasoned that despite unexpected difficulties:

The records both in support and in opposition to the dissolution present numerous issues of fact as to the operations and purpose of The LLC as well as whether or not, it is reasonably practicable to carry on The LLC.  In addition, attached to the opposition papers, the Respondent has provided copies of letters from 3rd parties, expressing interest in the Subject Property, which may weigh in on the issue of financial feasibility. Therefore, the Court cannot determine as a matter of law, that it is no longer reasonably practicable to carry out the purpose of The LLC and judicial dissolution at this time, is not warranted.

As Mr. Mahler points out, “it’s hard to say whether the result in any of these three cases would have been different in the free-wheeling, pre-1545 Ocean era.   But it does seem clear that the courts are approaching the issue in a uniform fashion guided by the appellate decision’s contract-based analysis.”

The real test will come when the court is faced with a case that is very strong for dissolution on traditional close corporation equitable grounds but where it can find no plausible basis in the operating agreement.

It is interesting to ask whether this New York development is an example of jurisdictional competition with Delaware, which originated this approach as discussed above.

One thing is clear:  the LLC, at least in its NY/Delaware manifestation, now represents a superior technology compared with close corporations in dealing with the dissolution of any firm that has an operating agreement.  If one assumes that contracts should be the basis of closely held firms, then the LLC approach is superior, period.  In any event, the close corporation approach should be regarded as reserved primarily for very informal firms that want limited liability.  The question is whether that should be a null set.  After all, creditors as well as shareholders gain from the predictability and stability that an enforceable agreement provides.

Packers, LLC?

Larry Ribstein —  1 February 2011

Just in time for the Super Bowl the New Yorker writes about the non-profit Packers — the only NFL team organized in this form.  The argument for the NFL rule barring anymore non-profits is that it takes a lot of money to run an NFL franchise.  But the article says

Green Bay stands as a living, breathing, and, for the owners, frightening example, that pro sports can aid our cities in tough economic times, not drain them of scarce public resources. Fans in San Diego and Minnesota, in particular, where local N.F.L. owners are threatening to uproot the home teams and move them to Los Angeles, might look toward Green Bay and wonder whether they could do a better job than the men in the owner’s box. And if N.F.L. owners go ahead and lock the players out next season, more than a few long suffering fans might look at their long suffering franchises and ask, “Maybe we don’t need owners at all.” It has worked in Green Bay—all the way to the Super Bowl.

This called to mind Usha Rodrigues’s recent Entity and Identity, which discusses non-profits’ benefits of creating (per the abstract) “a special ‘warm-glow’ identity that cannot be replicated by the for-profit form.” Usha discusses, among other examples, the Packers and the Cubs.

The Cubs were the subject of Shlenksy v. Wrigley, 95 Ill. App. 2d 173, 237 N.E.2d 776 (1968), in which an owner challenged the majority shareholder’s refusal to put lights in Wrigley field.  As Usha says (footnotes omitted):

The case illustrates the power of the business judgment rule: directors’ actions cannot be questioned absent fraud, illegality, or conflict of interest. For our purposes, what is interesting is that it appears that Wrigley, who owned 80% of the firm’s shares, may have been interested in running the corporation in a way that “protect[ed] values such as tradition and concern for neighbors, even at the expense of short term profit.” While the business judgment rule provides a shield, nevertheless majority owners in a for-profit organization such goals and motives are vulnerable to attack by minority shareholders. In contrast, the nonprofit structure of the Packers ensures that a Shlenksy-style suit could never even be brought against the management.

George Will has written (in Pursuit of Happiness and Other Sobering Thoughts 311 (1978)) that when, back in the pre-Tribune days, he sought to buy stock in the Cubs a substantial Cub shareholder told him to ignore “price-earnings ratios, return on capital, and a bunch of other hogwash which has no place in a transaction between two true sportsmen.”  Usha is suggesting that it that’s so, the team should make it official and use the non-profit form.

But do you really need a non-profit corporation to ensure the preservations of lofty ideas?  In my Accountability and Responsibility in Corporate Governance I stress the capaciousness of the business judgment rule in accommodating this objective.  After all, Wrigley’s emphasis on traditionalism and no lights helped build a powerful franchise and cement Chicagoans to the team despite the use of the for-profit form.

Usha may have a point that the non-profit form does it better by better signaling the firm’s objectives.  But, as with everything, there are tradeoffs.  Agency costs might be higher in non-profits, which have no owners in the sense of residual claimants to discipline managers. 

It might be better to have a hybrid form, which locks “warm glow” into the for-profit form.  You might do that in a conventional for-profit corporation, and Wrigley did succeed in fighting off the challenge in Shlensky.  But you never know when the rigid precepts of the corporation, including fiduciary duties, will rear up in court and defeat the parties’ idiosyncratic objectives.

That’s where LLCs come in.  As I argue at length in my Rise of the Uncorporation, the flexibility of the LLC form allows the owners to tailor it to their needs without worrying they will be bit by centuries of corporate law.  Even here, uncertainty may arise when the for-profit nature of the firm clashes with “warm glow” objectives.  For example, unless the LLC operating agreement locks the issue down tight, and unless the firm is organized under the clear pro-contract principles of Delaware law, the managers of a “Packers, LLC” turn down a very lucrative bid to leave Green Bay?

A variation on the LLC, the “low profit LLC,” or “L3C,” addresses this problem by providing for a firm that has owners but that commits not to make profits a significant objective of the firm.  I’m skeptical, however, that these firms solve more problems than they create.  See the above book at p. 161 and an earlier blog post.

The bottom line is a “warm glow” is one of the many things that uncorporations do better than corporations. Even so, I’m not suggesting that we need to tinker with the Packers.

It’s been interesting to watch uncorporations (particularly LLCs and limited partnerships) evolve over the last twenty years or so.  Perhaps the most interesting aspect of this evolution is what’s been happening in Delaware regarding contracting over fiduciary duties.  This is particularly intriguing because it concerns a key area of difference between corporations and uncorporations — that is, the role of private ordering.  See generally my Rise of the Uncorporation, particularly Chapters 7 and 8.

The story begins with Delaware’s adoption of Section 1101 of its LP and LLC acts, which gave firms the power to opt out of fiduciary duties. 

Firms initially used this provision somewhat gingerly, and the courts responded with ginger applications, as discussed in my Uncorporation and Corporate Indeterminacy and Fiduciary Duties and Limited Partnership Agreements, 37 SUFFOLK U. L. REV . 927 (2004) (SSRN) . 

For example, in Miller v. American Real Estate Partners, 2001 WL 1045643, at *10–11 (Del. Ch. Sept. 6, 2001), VC Strine held that an agreement giving a general partner complete discretion to manage and control the business didn’t authorize him to invest partnership funds in aid of his own venture.  The court emphasized the importance of the agreement, noting that Delaware limited partnership law “reflects the doctrine of caveat emptor, as is fitting given that investors in limited partnerships have countless other investment opportunities available to them that involve less risk and/or more legal protection.” However, the court added:

[J]ust as investors must use due care, so must the drafter of a partnership agreement who wishes to supplant the operation of traditional fiduciary duties.  In view of the great freedom afforded to such drafters and the reality that most publicly traded limited partnerships are governed by agreements drafted exclusively by the original general partner, it is fair to expect that restrictions on fiduciary duties be set forth clearly and unambiguously.  A topic as important as this should not be addressed coyly. * * *

The Delaware Supreme Court in Gotham Partners, L.P. v. Hallwood Realty Partners, L.P. , 817 A.2d 160, 167–68 (Del. 2002) sounded a caveat on freedom of contract by stating in dictum that Delaware law didn’t allow elimination of fiduciary duties.  The court echoed VC Strine in noting “the historic cautionary approach of the courts of Delaware that efforts by a fiduciary to escape a fiduciary duty, whether by a corporate director or officer or other type of trustee, should be scrutinized searchingly.”

Interestingly for present purposes, the court was unwilling to leave a gap-filling role to the implied contractual covenant of good faith and fair dealing.

However, the Delaware legislature responded to Gotham by amending the above statute to explicitly provide that fiduciary duties may be “eliminated” by the partnership agreement. Then Delaware Chief Justice Steele followed up with an article urging his fellow Delaware judges to enforce agreements in Delaware noncorporate cases. See Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies , 32 DEL. J. C. L . 1 (2007).

In general, as Rise of the Uncorporation notes in Chapter 8, limited partnerships (and LLCs) get more contractual freedom than corporations (which can only opt out of the duty of care) because they “almost always are the product of detailed bargaining. * * * [T]he limited partnership substitutes other constraints on managers for fiduciary duties, particularly high-powered owner-like incentives  of managers and the owners’ greater access to the firm’s cash.”

Wood v. Baum, 953 A.2d 136 (Del. 2008) explicitly extended this contractual freedom to a publicly traded LLC, dismissing a complaint containing a strong allegation of a breach of monitoring that might have gotten attention in a corporate case under Stone v. Ritter, 911 A. 2d 362 (Del. 2006).

This leaves open what the Delaware courts might do post-financial crisis/Dodd-Frank in a case involving the near elimination of all fiduciary duties in a Blackstone-type entity fraught with conflicts of interest (here’s an earlier post on this situation). 

We have a response, if not definitive answer, in VC Laster’s decision in Lonergan v. EPE Holdings, LLC, 5 A.3d 1008 Del.Ch.,2010. This was a publicly traded LP in which a general partner’s board sought a merger of two related entities.  Here are the important provisions of the agreement (footnotes omitted): 

Except as expressly set forth in this Agreement, neither [Holdings GP] nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Partnership or any Limited Partner and the provisions of this Agreement, to the extent that they restrict or otherwise modify the duties and liabilities, including fiduciary duties, of [Holdings GP] or any other Indemnitee otherwise existing at law or in equity, are agreed by the Partners to replace such other duties and liabilities of [Holdings GP] or such other Indemnitee.

* * *

Any standard of care and duty imposed by this Agreement or under the Delaware Act or any applicable law, rule or regulation shall be modified, waived or limited, to the extent permitted by law, as required to permit [Holdings GP] to act under this Agreement and to make any decision pursuant to the authority prescribed in this Agreement, so long as such action is reasonably believed by [Holdings GP] to be in, or not inconsistent with, the best interests of [Holdings].

The court summarized:

In light of these provisions, the only duties owed by Holdings GP flow from (i) contractual standards set forth in the Holdings LP Agreement and (ii) the implied covenant of good faith and fair dealing. The complaint does not identify any provision of the Holdings LP Agreement that the Proposed Transaction might violate. It relies solely on the implied covenant.

The court might have filled in in protection for the limited partners via narrow interpretation of the agreement and the implied contractual covenant of good faith and fair dealing. This would be consistent with the approach used in earlier cases like Miller, discussed above.  Indeed, the plaintiff argued in Lonergan for application of a Revlon analysis and for broad disclosure duties.  The court theoretically could hold that the agreement could preclude these duties only by explicit provisions and not by a blanket waiver of duties.  However, the court declined the invitation (footnotes omitted):

When parties exercise the authority provided by the LP Act to eliminate fiduciary duties, they take away the most powerful of a court’s remedial and gap-filling powers. As a result, parties must draft an LP agreement as completely as possible, and they bear the risk of incompleteness. If the parties have agreed how to proceed under a future state of the world, then their bargain naturally controls. But when parties fail to address a future state of the world-and they necessarily will because contracting is costly and human knowledge imperfect-then the elimination of fiduciary duties implies an agreement that losses should remain where they fall. After all, if the parties wanted courts to be in the business of shifting losses after the fact, then they would not have eliminated the most powerful tool for doing so.

Respecting the elimination of fiduciary duties requires that courts not bend an alternative and less powerful tool into a fiduciary substitute. * * *To the extent the complaint seeks to re-introduce fiduciary review through the backdoor of the implied covenant, it fails to state a colorable claim.

The bottom line is that, as Congress and the SEC seek increase regulation of corporate governance through Dodd-Frank, Delaware is going in the opposite direction through uncorporations.  There was a recent glimmer that Delaware might be up for a direct fight: in Parkcentral Global, L.P. v. Brown Inv. Management, L.P., 1 A.3d 291 (Del., 2010) the Delaware Supreme Court held that limited partners’ right of access to partnership books under Delaware law was not preempted by federal financial privacy regulations. 

These cases potentially make the uncorporation an escape hatch for firms seeking a way out of Dodd-Frank. If they choose to use it, we might see a rather interesting confrontation between Delaware and the federal government.

My article with Bruce Kobayashi, previously available as a working paper, has just been published in 2011 University of Illinois Law Review 91 with the above new title .  The published version has been posted on SSRN. Here’s the revised abstract:

Most of the work on jurisdictional competition for business associations has focused on publicly held corporations and the factors that have led to Delaware’s dominant position in attracting out of state firms. Is there an analogous jurisdictional competition to attract formations by closely held firms? Limited liability companies (LLCs) offer a good opportunity to examine this question. Most LLC statutes have been adopted and changed rapidly during the past 20 years. Unlike general and limited partnerships, which have been shaped by uniform laws, LLC statutes vary significantly, and states have devoted a lot of effort to drafting their individual statues. This variation provides an opportunity to test the statutory provisions and other factors that influence LLC’s choice of where to organize. We find little evidence that firms choose to form outside their home state in order to take advantage of variations in statutory provisions. Instead, we find evidence that large LLCs, like large corporations, tend to form in Delaware, and that they do so for the many of the same reasons – that is, for the quality of Delaware’s legal system.

As previously discussed,  I attended and presented a paper at an interesting symposium on the famous close corporation case, Wilkes v. Springside.  Now the paper is available.  Here’s the abstract:

Close Corporation Remedies and the Evolution of the Closely Held Firm

This paper examines the law of closely held firms from an evolutionary perspective. The corporate tax and constraints on the availability of limited liability forced closely held firms to compromise their planning objectives and choose standard forms that did not fully reflect their needs. This forced courts to construct duties and remedies that did not relate to the parties’ contracts. The famous close corporation case of Wilkes v. Springside Nursing Home, Inc. classically illustrates this problem. The advent and spread of the limited liability company significantly increased the availability of suitable standard forms for closely held firms. As a result, courts now can focus on fully effectuating the parties’ contracts rather than creating remedies the parties may not have wanted. This analysis has implications for potential improvements in contracting for closely held firms.

On Friday I’m joining Eric Gouvin, Lyman Johnson, Mark Loewenstein, Bob Thompson, Dan Kleinberger, Benjamin Means, Doug Moll, Deborah DeMott and Massachusetts Justice Francis X. Spina at a Western New England College conference on “Fiduciary Duties in the Closely Held Firm 35 Years after Wilkes v. Springside Nursing.”  Not surprisingly, I’ll be talking about the impact of LLCs on this old law.  Believe it or not, I conclude that LLCs are a better approach.  The article will be online soon.  In the meantime, you can get a feel for my approach by reading the book.

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.

The ever helpful Francis Pileggi brings us news of the Delaware Chancery Court’s recent decision in Lola Cars International Ltd. v. Krohn Racing, LLC, which refused after trial to dissolve an LLC under Delaware §18-802.

As I discussed last December, the court previously denied a motion to dismiss the dissolution complaint. I then noted that the statutory language allowing judicial dissolution when it is “not reasonably practicable to carry on the business in conformity with” the operating agreement required the court to analyze the parties’ expectations under their agreement. See my discussion of these issues in my book, Rise of the Uncorporation (180-82). This contrasts with the courts’ generalized expectations analysis, often disconnected from the parties’ agreement, in close corporation dissolution cases. [I will have more to say about the close corporation/LLC contrast in a forthcoming article.]

The problem in Lola is that the agreement also included termination provisions. Did the parties want these to be exclusive, or did they contemplate that judicial dissolution also would apply? They could have clarified this in the agreement, and Delaware Chancellor Chandler held two years ago that such agreements are enforceable. But what should the court do in the absence of an explicit waiver?

In the earlier Lola Cars opinion, the court held that

the Operating Agreement nowhere requires that a member terminate the Operating Agreement solely in accord with its stipulated termination provisions. Thus, the Court cannot conclude that these terms are exclusive. It simply cannot be true that a number of nonexclusive, permissive termination clauses in the Operating Agreement can preclude judicial dissolution as provided for in the Act.

However, in the most recent opinion the court denied dissolution after trial. The court again relied on the operating agreement:

The Court concludes by emphasizing that a party to a limited liability company agreement may not seek judicial dissolution simply as a means of freeing Lola itself from what it considers a bad deal. This is so even if the Member Parties’ relationship has—as here, due largely to pressure applied by Lola both within and without the litigation context—been badly damaged. Endorsing such a rule would allow for one party—unfairly—to defeat the reasonable expectations of its counterparty. Moreover, the Member Parties in their private ordering effort embraced a provision within the Operating Agreement that allows for disentanglement. * * * [I]t is not for the Court to terminate, or rewrite, the Operating Agreement.

The court explained its apparent change of heart from the earlier opinion by noting that the level of managerial misconduct proved at trial fell short of the complaint’s allegations. Id. n. 275.

I’m not completely comfortable with these opinions, for several reasons:

  • Although the court could read the agreement either to permit or not to permit dissolution, I don’t see how it could read the agreement both ways in the same case.
  • I don’t like the court’s use of “moreover” in the quote immediately above, which suggests that “reasonable expectations” might come from something other than the operating agreement.
  • The court’s footnote explanation that the remedy depends on the level of party misconduct is unsatisfying. If the agreement’s termination provisions were intended to preclude judicial dissolution, then damages, and not judicial dissolution, should be the exclusive remedy for any breach of duty the court might have found at trial.

In the final analysis, however, the real problem lies in the agreement. As I said in my previous post on Lola:

The bottom line is that this case indicates that the legal drafting “technology” in LLCs still has not been perfected. This leaves the courts to struggle through the relationship between the agreement and the default provisions of the statute.

Or as Chancellor Chandler said, when holding that non-dissolution agreements are enforceable (quoting the Bard): “our remedies oft in ourselves do lie.”

Over at the Glom’s Junior Scholar Workshop Bob Lawless, Gordon Smith and I discuss Mahsen Manesh’s Delaware and the Market for LLC Law: A Theory of Contractibility and Legal Indeterminacy. This paper argues that Delaware’s lower, flatter charges for LLCs than for corporations indicate its lack of market power in the market for LLCs. Then he explains why Delaware has lower market power for LLCs: LLC law is more determinate than corporate law, so there’s less room for Delaware’s courts to work their distinctive magic for LLCs than for corporations.

As I discuss at the Glom, Manesh has it backward. Delaware does succeed in the market for LLCs (see my article with Kobayashi, Jurisdictional Competition for LLCs) because its law in the latter area is more determinate (see my Uncorporation and Corporate Indeterminacy), which fits the contractual nature of LLCs. LLCs flock to Delaware because of its unique contract-enforcement technology that other states cannot, or at least do not, replicate. My blog posts over the years (e.g.) illustrate this technology in action. Different competitive strategies can work for uncorporations than for corporations because the two types of business forms fundamentally differ regarding their reliance on contract (see my book, Rise of the Uncorporation).

So it’s great that Manesh sees the advantages of bringing LLCs into the previously corporate-dominated jurisdictional competition literature. I hope that he and others continue along this path. But as they embark on their journey they should bring some reading material along with them. Above are a few examples.

I have frequently discussed the ongoing jurisprudential drama in Delaware on how firms can avoid fiduciary duties.

The basic setup here is that Delaware allows LLCs and other unincorporated firms to completely eliminate fiduciary duties. But they have to do it carefully.

Here’s my most recent discussion of the state of play on what that means:

As I discussed recently, Delaware law * * * imposes an obligation of clear drafting of fiduciary waivers in order to take advantage of the statutory license to contract freely. See Ribstein & Keatinge §9:4, The Uncorporation and Corporate Indeterminacy, DirecTV Latin America, LLC v. Park 610, LLC, 2010 WL 305201 at *27 (S.D.N.Y., January 26, 2010) (Del. law), Kelly v. Blum, 2010 WL 629850 at *10, n. 70 (Del.Ch., February 24, 2010), and Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del.Ch., April 20, 2009).

One big question is whether the parties have to explicitly negate fiduciary duties, or whether it is enough to include language that clearly defines a non-fiduciary duty, without negating the default fiduciary duty.

A recent opinion by VC Strine is illuminating on that subject. Francis Pileggi gives his usual good analysis of Related Westpac LLC v. JER Snowmass LLC, C.A. No. 5001-VCS (Del. Ch. July 23, 2010). The case involved the frequent situation of active operating and passive financing members who disagree about the future of the business – the operator wants to push ahead, the investor wants to stop funding the venture. The court held that the investor did not breach contractual, good faith or fiduciary duties by declining to continue to contribute capital and by exercising his voting power. Mr. Pileggi cites the relevant language in the opinion, which I’ll repeat here (footnotes omitted):

The Operating Agreements represent an example of the contractual freedom parties can use under our law to craft an approach to operating an entity that fits their own needs. When, as the parties here did, they cover a particular subject in an express manner, their contractual choice governs and cannot be supplanted by the application of inconsistent fiduciary duty principles that might otherwise apply as a default.

Now some factual background on the agreements, from the opinion, again footnotes omitted:

The Operating Agreements make plain that JER Snowmass’s right to refuse to consent to a Major Decision that constitutes a Material Action was unqualified by any reasonableness condition. They do so by plainly stating that the approval of plans submitted by the Operations Manager was not to be “unreasonably withheld or delayed, except with respect to JER Snowmass, to the extent the modification constitutes a Material Action.” Material Actions are defined as anything that would “require additional Capital Contributions” or “involve any material change in the budget … or any line item therein.” Thus, as to Material Actions, JER Snowmass was clearly free to give or withhold its consent in its commercial interest. By contrast, the Operating Agreements make clear that JER Snowmass could not “unreasonably with[o]ld” consent on a range of other matters including taxes, terms of a “co-list” arrangement, and the removal of Westpac Investments LLC as the “Operations Manager” of Related.

The Operating Agreements also provide that the Operations Manager may issue capital calls to members. Under the Operating Agreements, “if any Member is required … to provide Additional Funds to the LLC[s] and shall fail to do so, such Failing Member’s sole liability, and the Contributing Member’s sole remedy, shall be expressly set forth in [the Operating Agreements] … [and][n]o Member … shall have any personal liability to provide such Additional Funds.” That remedy provides that the issuing member can choose to “either notify the other members that such Contributing Member is withdrawing such contribution from the LLC[s] … or … agree to contribute an amount equal to the Failing Member’s Default Amount.”

The relevant issue involved a material action as to which the agreement made clear that the member was free to withhold consent even in its own commercial interests.

All of this sounds unremarkable, except for the fact that there was no explicit fiduciary waiver. To see why that matters, let’s go back to my Indeterminacy article, linked above (footnotes omitted):

In Miller v. American Real Estate Partners, Vice Chancellor Strine refused to hold that the agreement authorized the general partner to invest partnership funds to protect his own venture instead of pursuing investments that would be less risky and more profitable for the partnership. No. Civ. A. 16788, 2001 WL 1045643, at *10–11 (Del. Ch. Sept. 6, 2001). The agreement gave the general partner full, exclusive and complete discretion to manage and control the business and affairs of the Partnership, to make all decisions affecting the business and affairs of the Partnership, and to take all such actions as it deems necessary or appropriate to accomplish the purposes of the Partnership as set forth herein. The agreement also provided:

Whenever in this Agreement the General Partner is permitted or required to make a decision (i) in its “sole discretion” or “discretion”, with “absolute discretion” or under a grant of similar authority or latitude, the General Partner shall be entitled to consider only such interests and factors as it desires and shall have no duty or obligation to give any consideration to any interest of or factors affecting the Partnership, the Operating Partnership or the Record Holders, or (ii) in its “good faith” or under another express standard, the General Partner shall act under such express standard and shall not be subject to any other or different standards imposed by this Agreement or any other agreement contemplated herein.

Vice Chancellor Strine held that the agreement not only failed explicitly to preclude the application of default fiduciary duties, but affirmatively revealed an intention to include such duties because the parties used a popular form but deleted language explicitly preempting default duties. The court also noted references to default fiduciary duties in the registration statement used to sell the partnership interests. Preemption of fiduciary duties therefore was not “plain” enough under Sonet, and so default substantive fairness and the duty of loyalty applied.

So VC Strine may have at least slightly shifted his position in the last decade to no longer require an explicit negation of fiduciary duties. Language inconsistent with the parties’ intent to impose fiduciary duties will be enough.

The cases, however, differ in a few respects. The most important difference is that Miller involved a general partner of a limited partnership – that is, a party that clearly had default fiduciary duties. Related Westpac involved a mere non-managing member. In my theory of fiduciary duties, fiduciary duties necessarily accompany open-ended management power. Therefore, while there were fiduciary duties that needed clearly to be negated in Miller, there was arguably no such duty to negate in Related Westpac. Could this explain VC Strine’s willingness in the later case to hold the duty negated without an explicit disclaimer?

The bottom line is that there’s still confusion in the Delaware cases not only about how to negate duties, but what must be negated. I’m awaiting further developments.

Meanwhile, I wonder when the drafting technology in Delaware will rise to the level of taking care of these problems. Why can’t the parties to sophisticated LLCs take the seemingly small extra step of explicitly defining and negating their duties?