Archives For LLCs

TOTM goes to court

Larry Ribstein —  15 November 2011

Last year I wrote here about Roni LLC v Arfa, which I cited as an example of the ”troubling lawlessness of NY LLC law.” In brief, the court sustained a non-disclosure claim based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them” despite holding that the parties’ arms-length pre-formation business relationship did not support a fiduciary relationship.  I argued that this new pre-formation duty to disclose

promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.

I later noted that my blog post was cited in the appellants’ brief on appeal, which triggered a response in the respondents’ brief (see n. 25) and then my amicus brief in connection with the appeal, which the NY Court of Appeals accepted for filing.  

The case is being argued today at about 1:30 EST. Tune in (click the blue “oral arguments webcast” link on the right in the middle) for this latest chapter in the saga of the blog post that went to court.

Update:  Peter Mahler provides a very helpful and complete summary of the oral argument.

A recent NY App. Div case, Pappas v. Tzolis, presents a tangled web that illustrates the current state of the LLC contracting architecture in the U.S. I previously discussed the lower court opinion in this case, concluding that ” any appeal of this judgment should be interesting.” (See also Peter Mahler.) I was right about that.

The complaint alleges that Tzolis and plaintiffs formed an LLC (Vrahos) for the sole purpose of entering into a long-term lease.  Tzolis got a sublease on the property in exchange for advancing the LLC’s $1.2 million security deposit and additional payments. Tzolis later took over the lease so he could extinguish the sublease.  The plaintiff members assigned him their interests, receiving a payment that was 20 times what they invested about a year earlier.  Six months thereafter Tzolis assigned the lease to a third party for $17.5 million.  The complaint alleges he was negotiating this sale at the time of buying out the plaintiffs.  Plaintiffs sue on various theories essentially based Tzolis’s breach of fiduciary duty in failing to disclose these negotiations.

At this point the case gets complicated.

To begin with, the LLC operating agreement, in a section titled “Other Activities of Members,” provided that “[a]ny Member may engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members.” The title of this section was “other activities.”

Given the title and the reference to “competition with the LLC, this section seems to refer only to dealings outside the LLC rather than a buyout of co-members’ interest without disclosing negotiations to sell the LLC’s only property. The title’s reference to “other activities” clarifies this intent.  Except that the agreement elsewhere says that “headings. . . shall be given no effect in the interpretation of this Agreement.” If the heading has no effect, should the section be limited to outside dealings as it implies, or extended to “investments of any nature whatsoever,” including an “investment” in another member’s interest, as it says?

Confused yet?  Ok, let’s add another layer.  At the time of the assignment the parties signed a handwritten “certificate,” which included the following language:

[E]ach of the undersigned Sellers, in connection with their respective assignments to Steve Tzolis of their membership interests in Vrahos LLC, has performed their own due diligence in connection with such assignments. Each of the undersigned Sellers has engaged its own legal counsel, and is not relying on any representation by Steve Tzolis or any of his agents or representatives, except as set forth in the assignments & other documents delivered to the undersigned Sellers today. Further, each of the undersigned Sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned Sellers in connection with such assignments.

Still not confused?  The LLC was formed in Delaware, which normally means Delaware law applies.  But the operating agreement provided that it was governed by NY law.

How should a court untangle this mess?  Let’s start with what law applies.  As I discussed regarding the lower court opinion in this case, referring to the choice-of-law analysis in The Law Market, incorporating in Delaware indicates the parties’ intent to apply Delaware law notwithstanding a contrary choice of law clause.  This intent is supported by Kobayashi and my paper presenting data indicating that LLCs choose Delaware in order to get the advantages of Delaware’s legal infrastructure.  On the other hand, the parties arguably were focusing on choice of law more in the choice of law clause (NY) than in the state of organization (Delaware).

Both courts in this case concluded that a choice between the two states was unnecessary because both states reached the same result.  The problem is that that same result was different in the two opinions — dismissal of the complaint below, reversed above.

The lower court relied on Delaware’s freedom-of-contract provision, and said that “under New York law, parties are free to contract as they wish, so long as the terms of their contract are neither unlawful, nor in violation of public policy.” But as I noted in my post on the lower court opinion, NY has no equivalent to Delaware’s freedom of contract provision.

If the only relevant contract provision here were the operating agreement, the defendant should lose.  As discussed in my earlier post, even Delaware requires fiduciary opt-outs to be clear, which this was not.  The Appellate Division appropriately cited Kelly v. Blum on that point (which I discussed here).

But does the handwritten certificate have the requisite clarity? There the plaintiffs explicitly disclaimed they were owed any fiduciary duty in connection with the specific transaction at issue.  The lower court didn’t make much of this, saying that the defendant didn’t claim it was a waiver, but that it just evidenced and certified the non-existence of any fiduciary duties defendant might have owed.  This strategy may have been intended to head off the argument that any release of duties in the certificate was invalid because of defendant’s preexisting fiduciary duty.

The Appellate Division didn’t buy this strategy.  Having held that Tzolis owed a duty under the agreement, the court held that the certificate couldn’t override it.

The court relied on Blue Chip Emerald v Allied Partners 299 A.D.2d 278, 750 N.Y.S.2d 291 (1st Dep’t 2002). This is part of a line of cases discussed in Ribstein & Keatinge, §9:5, n.51 involving non-enforcement of seemingly clear fraud waivers. For other cases along the same lines see Kronenberg v. Katz, 872 A.2d 568 (Del. Ch. 2004); Salm v. Feldstein, 20 A.D.3d 469, 799 N.Y.S.2d 104, 106 (2d Dep’t 2005). Also, a non-LLC case, Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006) (criticized here) refused to insulate a seller from liability for intentional misrepresentations despite a clear and comprehensive contract that covered precisely these claims because “the public policy of this State will not permit” a contract that would insulate a seller who deliberately lied or knew that the company had made false representations.

But there are cases upholding fraud waivers.  See DIRECTV Group, Inc. v. Darlene Investments, LLC, 2006 WL 2773024 (S.D. N.Y. 2006), applying Delaware law, and two recent NY Court of Appeals cases: Centro Empresarial Cempresa S.A. v. America Movil and Arfa v. Zamir. Centro emphasized that the release was broad, the fiduciary relationship was “no longer one of unquestioning trust,” and the plaintiff understood that the fiduciary was acting in its own interest. Arfa relied on the facts that plaintiffs were sophisticated and there was distrust between the parties. In these circumstances the courts held that plaintiff could not simply rely on defendant, but had a duty to investigate further. See Peter Mahler’s excellent discussion of these NY cases.

A vigorous dissent in Pappas by Justice Freedman, joined by Justice Friedman, relied on Centros.  The dissent acknowledged that while the operating agreement did not eliminate Tzolis’s fiduciary duties, the certificate notified plaintiffs that they shouldn’t place “unquestioning trust” in Tzolis, and therefore “was tantamount to a release” of fiduciary duty claims.  Moreover,

Tzolis’s substantial offer to plaintiffs should have alerted them to the fact that some deal was in the offing. Pappas and Ifantapoulos did not ask Tzolis why he was offering them 20 times more than what they had invested in Vrahos one year earlier; their lack of due diligence is unreasonable as a matter of law and fatal to plaintiffs’ claim.

Obviously this tangled mess in a substantial deal where the parties clearly could afford sophisticated advice suggests that something is amiss somewhere in the system.

Does the problem lie in the statute?  The parties easily could have taken advantage of Delaware’s broad freedom of contract provision and entered into a clear fiduciary opt-out, which would seem appropriate in the sort of limited joint venture involved in this case.  Instead they deliberately complicated their choice of law to use NY law which lacks such a provision.

But Abry indicates that Delaware law is no panacea.  Is NY clearer, given Centros?  The problem is that it is one thing to say that the parties’ relationship has broken down into clear distrust, as in Centros, and another to derive that distrust from the certificate alone, which is itself subject to the incomplete waiver of fiduciary duties in the initial agreements.

Abry suggests that once the parties agree to fiduciary duties because they failed to opt out, these duties may preclude them from ever opting out.  At that point the best they can hope for is a judicial determination that the fiduciary duty did not result in liability for particular conduct.  That could be based on actual distrust (Centros) or other circumstantial evidence (the high buyout price in a rapidly rising market).

Which raises a final question:  was there even a breach of fiduciary duty in this case?  What difference should it make whether defendant had an offer in hand?  The plaintiffs had reason to know the lease value was rising rapidly.

The basic problem is that this case has been decided on a motion to dismiss, and therefore on the complaint’s allegations.  Issues about what plaintiffs knew, when did they know it, and what did defendant have to tell them are for trial.

The answer here is to let the parties, via a clear agreement, opt out of liability for intentional nondisclosures.  A clear opt out should prevent the need for a trial.  Why can’t at least sophisticated parties agree to fend for themselves in determining what price they should get for their property? Under such a rule it would be up to the lawyers to help the parties clarify their intentions, as the lawyers arguably did here.  But given the incomplete statutory protection in NY and the unclear cases in both NY and Delaware there was an inadequate legal framework for such an agreement.

Update: Read Peter Mahler’s through analysis of the case.

Last year I wrote here about Roni LLC v Arfa, which I cited as an example of the “troubling lawlessness of NY LLC law.”

As discussed in my blog post, the court in that case, after holding that the parties’ arms-length pre-formation business relationship did not support a fiduciary relationship, nevertheless denied defendants’ motion to dismiss based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them.” The court applied old corporate cases holding that “both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders.”

I criticized the court’s holding as misapplying NY LLC law, concluding:

[T]he court’s reasoning using hoary old corporate promoter cases to create a pre-formation fiduciary duty to disclose in LLC cases promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.

It seems the only way NY business people involved in business formation can avoid this problem is simply to avoid New York.

My blog post ended up being cited in the appellants’ brief on appeal, which prompted a response in the respondents’ brief (see n. 25).

I was then moved to write an amicus brief in connection with the appeal, which the NY Court of Appeals has now accepted for filing. To complete the picture, here’s the appellants’ reply.

I understand the case will be heard in November and decided a couple of months thereafter.  It will be interesting to see what the Court of Appeals makes of all this.

On Friday the Delaware Supreme Court decided the important case of CML V, LLC v. Bax (see Francis Pileggi’s helpful summary).

The court, per CJ Steele, held that a creditor lacks standing to sue an insolvent LLC derivatively.  The court reasoned that when the Delaware LLC Act says in §18-1002 that a plaintiff in an LLC derivative suit “must be a member or an assignee of a limited liability company,” it really and unambiguously means that he “must be a member or an assignee of a limited liability company.” Not a creditor.

Plaintiff argued that the Delaware statute refers only to member/assignee suits authorized by §18-1001 and does not preclude all creditor derivative suits.  This argument, draws force from N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007), which said that creditors of an insolvent corporation could sue derivatively under similarly phrased §327 of the DGCL. Plaintiff also insisted that it would be absurd to distinguish between LLCs and corporations.

CJ Steele responded that while the DGCL is limited to a shareholder-instituted derivative suit, Delaware §18-1002 refers to “a derivative suit.”  Also, while §18-1001 says that a a member or assignee “may” bring a derivative suit, §18-1001 says the plaintiff “must” be a member or an assignee, thereby calling attention to mandatory nature of §18-1002.

As to the plaintiff’s absurdity argument, here’s the opinion gets interesting (footnotes omitted):

[T]he General Assembly is free to elect a statutory limitation on derivative standing for LLCs that is different than that for corporations, and thereby preclude creditors from attaining standing. The General Assembly is well suited to make that policy choice and we must honor that choice. In this respect, it is hardly absurd for the General Assembly to design a system promoting maximum business entity diversity. Ultimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.

Moreover, in the LLC context specifically, the General Assembly has espoused its clear intent to allow interested parties to define the contours of their relationships with each other to the maximum extent possible. It is, therefore, logical for the General Assembly to limit LLC derivative standing and exclude creditors because the structure of LLCs affords creditors significant contractual flexibility to protect their unique, distinct interests. because there’s no difference in this respect between LLCs and corporations.

So this opinion reinforces developing Delaware law highlighting the LLC’s nature as a contractual entity, in contrast to the regulatory nature of the corporation.  Indeed, as I point out in my Rise of the Uncorporation (p. 6):

Uncorporations are characterized by their reliance on contracts. This is an aspect of uncorporations’ partnership heritage, as partnerships are contracts among the owners. * * * In contrast, corporate law is mainly couched in mandatory terms. * * * [T]he corporation’s special regulatory nature emerged from its historical roots. The corporation initially was a vehicle for government enterprises, monopolies, or franchises.

The CML opinion also carefully responded to plaintiff’s argument that this holding strips the Chancery Court of equitable jurisdiction to deal with injustice, in violation of the Delaware constitution. The court reasoned that the constitution freezes equity’s jurisdiction as of 1792, a time when LLCs didn’t exist.  The court went on to explain (footnotes omitted):

[T]he General Assembly passed the LLC Act as a broad enactment in derogation of the common law, and it acknowledged as much. Consequently, when adjudicating the rights, remedies, and obligations associated with Delaware LLCs, courts must look to the LLC Act because it is only the statute that creates those rights, remedies, and obligations.

Although the LLC statute provides that equity supplements its express provision, this refers only to rights and remedies the statute doesn’t address. On the other hand,

if the General Assembly has defined a right, remedy, or obligation with respect to an LLC, courts cannot interpret the common law to override the express provisions the General Assembly adopted.

The court points out that the creditor plaintiff’s exclusive redress in this situation is to contract for protection, and notes a variety of contractual terms that could have addressed the problem in this case.

This is a significant opinion because of its bluntness.  The basic point is that the legislature has decreed that LLCs are about contracts, so LLCs, unlike corporations, are freed from the sort of mandatory interference by Chancery that the constitution provides for corporations. In short, LLCs can opt out of litigation; corporations can’t.

This is wholly consistent with the central point of my Uncorporation and Delaware Indeterminacy, which surveys in detail Delaware uncorporation law and contrasts it with Delaware corporate law.

It’s also consistent with CJ Steele’s 2007 article, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies.  There he criticized his predecessor’s opinion in the Gotham case, which suggested that fiduciary duties are unwaivable, noting:

The supreme court apparently found it difficult to abandon the view that judicial oversight of disputes within the governance structure of limited liability unincorporated entities must invariably be from the perspective of a set of freestanding non-waivable equitable principles, drawn from the common law of corporate governance.

The Delaware legislature later fixed the Gotham court’s mistake, and CJ Steele has made clear ever since that the legislature meant what it said.  In this case he settles the potential constitutional impediment.

Interestingly, the Supreme Court’s reasoning in this case eschewed the more elaborate reasoning of VC Laster in this case, analyzed here. Although the Vice Chancellor reached the same result, he included an extensive analysis of how the LLC act differs from the corporate act in protecting creditors, thereby making the creditor derivative suit unnecessary. CJ Steele implies that it doesn’t matter whether the LLC Act includes effective substitute remedies.  It’s enough that the legislature has spoken and left creditors to their contracts.

Finally, it’s worth concluding the same way I did in my earlier post on this case by contrasting the clear and predictable approach in the Delaware courts with the

chaotic and unprincipled case law on LLCs in the supposedly commercially sophisticated New York, which I’ve discussed in several posts, as noted here. Among other sins, New York courts constructed an LLC derivative remedy out of nothing, and then had to make up the rest of LLC derivative suit law out of a whole cloth. In CML, VC Laster combined scholarly analysis and business sophistication in an opinion that gives contracting parties and later courts plenty of guidance.”

CJ Steele makes it even clearer:  There is no derivative remedy for LLCs in Delaware other than that provided for in the statute. Moreover, the parties to LLCs must look to their contracts.  If they want a court to fill in the blanks for them, they should have been a corporation, or an LLC in some other state.

We got our first LLC opinion from Chancellor Strine in his new position atop the Delaware Chancery Court.  It’s worth close attention in its own right as a case of first impression, and as an indication of the new Chancellor’s general approach to these cases.

The case is Achaian, Inc. v. Leemon Family LLC. Francis Pileggi does his usual good job on the basic analysis, so I’ll be brief on that.

The LLC was owned 50% by Leemon, 30% by Holland and 20% by plaintiff Achaian, a passive investor.  The Holland trust and Leemon managed the LLC together until Leemon took control over the other members’ objection.   The Holland trust purported to transfer its interest to Achaian.  Then Achaian sued for dissolution under Del. §18-802 claiming deadlock.  Leemon claims that Achaian only got an additional economic interest since Leemon didn’t consent to the assignment of ownership rights.

The Delaware statute, section 18-702(a), says an assignee of an LLC interest has no management rights except as provided in an LLC agreement. 18-704(a) says that an assignee is admitted as a member in compliance with the LLC agreement.

The agreement defines a member’s interest as “the entire ownership interest of the member.” Section 7.1 provides that “a member may transfer all or any portion of its interest in [the LLC] to any Person at any time. If at any time such transfer shall cause [the LLC] to have more than one Member, then this [LLC] Agreement shall be appropriately amended to reflect the fact that [the LLC] will then be treated as a partnership for purposes of the [Internal Revenue] Code. . .” Section 7.2 provides that “no person shall be admitted as a member of [the LLC] after the date of this [LLC] Agreement without the written consent of the Member . . . ”  The parties agree that “the Member” in 7.2 must be read as “Members,” so that all have a right to object to the admission of a new Member.

The Chancellor held that “entire” in the definition of “interest” refers to voting as well economic rights. The Chancellor reasoned that 7.1’s reference to a transfer adding a member suggests that a transfer includes ownership rights and section 7.2 deosn’t require a vote to confer additional voting rights on somebody who’s also a member.  Rather, he said, 7.2 is designed only “as a manifestation of the unremarkable idea that one gets to choose one’s own business partners.”  Requiring a vote for additional voting rights, said the Chancellor, “is a strained extension of the traditional idea underlying partnerships and limited liability companies, and is not supported rationally by the LLC Agreement’s text or by the context.”

Having decided that Achaian got additional ownership rights from Holland without Leemon’s consent, the Chancellor applied Delaware §18-802 as if this were a 50-50 joint venture, making applicable by analogy the reasoning under Delaware GCL §273: dissolution is justified where 50-50 holders can’t agree on continuation and the LLC agreement doesn’t provide a way to resolve the matter.  Hence he denied dismissal of the dissolution claim.

There is a lot to love in this case.  First, Chancellor Strine gives the matter the kind of close and sophisticated analysis he was renowned for as Vice Chancellor.  Second, he cited and quoted my LLC treatise.  Third, he continued Chancellor Chandler’s tradition of citing songs as authority — in this case the Commodores’ “Three Times a Lady” in n. 54, for the proposition that once somebody’s admitted as a member he doesn’t have to be admitted each time a member gets more shares.  Fourth, and best yet, the Chancellor says Leemon’s argument that the agreement contemplated a “serial admission scheme” lacks the critical support of “learned commentaries and treatises on alternative entities.” I very much like a requirement that parties’ positions in LLC cases require support from my or other treatises.

The only problem with the case is that it reaches the wrong result.

The big problem is that, as the Chancellor himself notes, the default rule in LLC statutes, including Delaware’s, is restricted transferability of management rights “given the closely held nature of most LLCs” (quoting §7:4 of Ribstein & Keatinge). The question here is whether the agreement varies the default rule.  It does not, because “entire” modifies “interest,” which, as already noted, the Act defines as including only economic rights.  No matter what modifier you put there, the basic thing being modified is economic rights.  To be sure, I can’t tell why “entire” is in there and the interpretation should try to make sense of every word.  But that’s not enough to reverse the statutory default.

Sections 7.1 and 7.2 of the agreement don’t expressly deal with the situation in which an existing member acquires additional voting rights.  That doesn’t render the agreement ambiguous.  Rather, the statute fills the gap by providing that a member can get shares with voting rights only by member consent.  Contrary to the Chancellor’s reading, the second sentence of §7.1 doesn’t assume that a transfer of a membership interest includes voting rights, but rather refers to the situation when the members create voting rights by consent under the statute.

Alas, the Chancellor’s reason is also not supported by the song he cites in support.  The Chancellor was implying that “one time a lady” was enough — three times would be redundant, just as you don’t need multiple membership votes for a member.  But Lionel Ritchie was saying in that song that he was a lost soul without purpose or direction until his lady came along and rescued him with “heart, soul and stone inspiration.”  The guy in the song needed all three — just love or soul wouldn’t have been enough without inspiration.  So, too, a member needs another vote to get additional membership interests.

Note that in addition to the quote from my treatise in the case, my treatise also says that “[r]estrictions on transfer of management authority may be appropriate for LLCs that are closely held firms” because, among other things, “transfers introduce potential new conflicts of interest.” Thus, contrary to the Chancellor’s reasoning, a veto on new ownership rights of an existing member does make sense in a very closely held firm.

That reasoning is particularly applicable to this case.  Holland’s transfer to Achaian completely changed the voting configuration in the LLC.  It stands to reason that any ambiguity in the agreement in this situation should be resolved against waiving the default rule requiring consent to the transfer.

So under my approach, Achaian would not get Holland’s 30%, there would not be a 50-50 split, and the §273 reasoning shouldn’t apply.  Leemon would still be in control. There would be no deadlock to resolve, and no dissolution, at least absent misconduct by Leemon.

Having said all this I don’t want to be too critical.  This was a case of first impression where there was at least an argument for the Chancellor’s result.  Moreover, the central problem was with the agreement, which failed to deal explicitly with an important situation and threw in an extra word (“entire”) as a spanner in the works.  But I would deal with such situations the way Chancellor Chandler did — with a tight reading of the agreement that forces the parties to be explicit when they vary the statute.  In this case, a tight reading would let stand the statutory default.

So the opinion was erudite (it cited and quoted my treatise) and funny (you don’t expect to see a Commodores’ song quoted in an LLC opinion, even if it didn’t support the holding).  Alas, it was not right.

But as another song said, “two out of three ain’t bad.”

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.

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.

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.

This Friday, January 7, I’ll be presenting a paper on this topic at the AALS Section on Agency, Partnership, LLC’s and Unincorporated Associations, 8:30-10:15, Hilton, Franciscan A, Ballroom Level, Hilton San Francisco Union Square.  [Yes, at the Hilton.  That’s a long story in itself with many plot lines and themes, which I will get into here if provoked.]

Other speakers will be Jens C. Dammann (Texas), Franklin Gevurtz (McGeorge), Mohsen Manesh (Oregon).

My paper considers the relationship between choice of adjudicator or forum and choice of law in business associations, focusing on LLCs.  The bottom line is that jurisdictional choice concerns both issues, and that there are significant differences between LLCs and corporations.  So my tentative title is “Choosing Form and Forum.”

My prior writings relating to this talk include:

Choice of Forum and corporate governance, and Litigating Delaware Governance Law in an Alien Land (discussing forum and law choice for business association litigation).

Jurisdictional Competition for Limited Liability Companies (with Kobayashi, forthcoming Illinois Law Review) (which shows data indicating that large LLCs end up in Delaware, and do so for the courts rather than for the law, and includes a discussion of Professor Dammann’s work).

The Uncorporation and Corporate Indeterminacy (discussing the differences between LLC and corporate law and the ramifications of this difference).

Manesh on the market for LLC law (discussing Manesh’s paper).

So, if you’re in SF, hope to see you Friday.

The ever-helpful Francis Pileggi thoroughly discusses an interesting and important recent Delaware opinion by VC Laster, CML V, LLC v. Bax, C.A. No. 5373-VCL (Del.Ch. Nov. 3, 2010) which holds a creditor lacks standing under the Delaware LLC act to sue an insolvent LLC derivatively.  The following builds on Mr. Pileggi’s excellent analysis.

The court interpreted Section 18-1002 of the Delaware LLC Act, which provides:

In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and: (1) At the time of the transaction of which the plaintiff complains; or (2) The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction.

Seems simple doesn’t it?  The section says “the plaintiff must be a member or an assignee. . . ”

But almost nothing’s simple in the world of litigation. Plaintiff creditor, neither a member nor an assignee, argued that the court should borrow principles from Delaware corporate law.  That law lets creditors sue derivatively (see N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007)) under statutory language (Section 327 of the DGCL) which applies to a “derivative suit instituted by a stockholder. . . ” This language technically leaves open whether a derivative suit may be brought other than by a stockholder subject to different rules.

The court noted that the Delaware LLC statute borrowed wording from the LP statute and that a “leading treatise” interpreted that statute as giving exclusive standing to limited partners, citing, of course, Bromberg & Ribstein.  

The plaintiff mainly argued the court should ignore the plain language because it “generates an absurd distinction between insolvent corporations, where creditors can sue derivatively, and insolvent LLCs, where they cannot.”  But the court wisely responded:

“Because the conceptual underpinnings of the corporation law and Delaware’s [alternative entity] law are different, courts should be wary of uncritically importing requirements from the DGCL into the [alternative entity] context.” Twin Bridges Ltd. P’ship v. Draper, 2007 WL 2744609, at *19 (Del. Ch. Sept. 14, 2007). 

More importantly, the court went on to show why the LLC act should be interpreted differently: because of its policy of leaving parties to the protection of their contracts.  As Kelli Alces and I have noted, this policy is particularly applicable to creditors, who

The most defensible distinction between debt and equity interests is that, given the open-endedness of the residual claim, it is inherently more difficult for equity holders to contractually specify duties than for debt holders. Although shareholders have contracting options, such as terms that specify the firm’s obligations to pay dividends, standard-form credit and equity contracts differ regarding specificity of duties. This matters for fiduciary duties because a strong duty of loyalty is appropriate only when the agent delegates open-ended discretion to the principal. The creditors are better left to flexible enforcement of specific contract terms than broad fiduciary remedies.

Ribstein & Alces, Directors’ Duties in Failing Firms, 1 J. Bus. & Tech. L. 529, 536 (2007) (SSRN).

VC Laster pointed out various ways the LLC act facilitates contractual protection of creditors, including by a provision in the operating agreement and by using the series LLC provisions to supplement security interests in specific assets.  He also observed that Section 502(b) of the LLC act lets an LLC creditor enforce a member’s contribution obligation.  The court said this creditor right gave rise to the trust fund doctrine, and in turn to the creditor derivative action.  Thus, says the court, “[b]y addressing the germ from which the analogous corporate creditor derivative action grew, the LLC Act removes the impetus for a similar experiment with LLCs.” 

The most striking thing about this scholarly opinion is its clear contrast with the chaotic and unprincipled case law on LLCs in the supposedly commercially sophisticated New York, which I’ve discussed in several posts, as noted here.  Among other sins, New York courts constructed an LLC derivative remedy out of nothing, and then had to make up the rest of LLC derivative suit law out of a whole cloth.  In CML, VC Laster combined scholarly analysis and business sophistication in an opinion that gives contracting parties and later courts plenty of guidance.

As I noted last week I participated with several corporate law luminaries in a conference at Western New England College in Springfield, Massachusetts on the famous case of Wilkes v. Springside Nursing Home, 370 Mass. 842, 353 N.E.2d 657 (1976). Springfield is near Pittsfield, where Springside was located and this case originated.

As most law students and corporate scholars know, Wilkes importantly qualified the same court’s case of the year before, Donahue v. Rodd Electrotype Co. of New England, Inc., 328 N.E.2d 505 (1975).  Donahue held that “stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another.”

The Wilkes court was

concerned that untempered application of the strict good faith standard enunciated in Donahue to cases such as the one before us will result in the imposition of limitations on legitimate action by the controlling group in a close corporation which will unduly hamper its effectiveness in managing the corporation in the best interests of all concerned. The majority, concededly, have certain rights to what has been termed ‘selfish ownership’ in the corporation which should be balanced against the concept of their fiduciary obligation to the minority. * * *

Therefore, when minority stockholders in a close corporation bring suit against the majority alleging a breach of the strict good faith duty owed to them by the majority, we must carefully analyze the action taken by the controlling stockholders in the individual case. It must be asked whether the controlling group can demonstrate a legitimate business purpose for its action. * * * In asking this question, we acknowedge the fact that the controlling group in a close corporation must have some room to maneuver in establishing the business policy of the corporation. It must have a large measure of discretion, for example, in declaring or withholding dividends, deciding whether to merge or consolidate, establishing the salaries of corporate officers, dismissing directors with or without cause, and hiring and firing corporate employees.

When an asserted business purpose for their action is advanced by the majority, however, we think it is open to minority stockholders to demonstrate that the same legitimate objective could have been achieved through an alternativecourse of action less harmful to the minority’s interest. * * *

The court held that the defendants had not shown a legitimate business purpose for firing plaintiff and minority shareholder Wilkes, and therefore that the action was an illegitimate freeze-out, entitling Wilkes to a remedy.

The conference featured an interesting discussion between the lawyers who represented Wilkes and Springside.   We learned from Wilkes’s lawyer (and nephew) David Martel how his senior lawyer on the case, James Egan, fashioned a case for breach of a partnership agreement despite the fact that the parties had incorporated because Egan knew about case law where shareholders were treated as partners.

The master and probate court rejected the partnership theory below because the parties had incorporated. The highest court took the case on direct appeal. That court had just decided Donahue and evidently was looking for an opportunity to refine the rule in Donahue. (Yet based on my inquiries at the conference, it’s not clear Mr. Egan even knew about Donahue when he fashioned his partnership argument.)

Retired Judge William Simons, Springside’s lawyer, described the parties deal as one to buy and sell property.  Simons says the facts didn’t support the theory that the parties were “truly a partnership” and thought the Supreme Judicial Court should have ordered another hearing rather than taking this as an established fact.

I find the following quotes from the Wilkes opinion particularly significant:

Wilkes consulted his attorney, who advised him that if the four men were to operate the contemplated nursing home as planned, they would be partners and would be liable for any debts incurred by the partnership and by each other. On the attorney’s suggestion, and after consultation among themselves, ownership of the property was vested in Springside, a corporation organized under Massachusetts law. * * *

In light of the theory underlying this claim, we do not consider it vital to our approach to this case whether the claim is governed by partnership law or the law applicable to business corporations. This is so because, as all the parties agree, Springside was at all times relevant to this action, a close corporation as we have recently defined such an entity in Donahue v. Rodd Electrotype Co. of New England, Inc. * * *

This quote encapsulates the problem in the case:  At the time of Wilkes, the parties had to force what was essentially a partnership into corporate form in order to get the limited liability that would be essential for a venture like a nursing home.  There was no way in 1976 for the parties to have a true partnership with limited liability.  If it had been a partnership, Wilkes could have gotten the firm dissolved for having been denied the participation in governance he was entitled to under partnership law (see Bromberg & Ribstein on Partnership, §7.06(c)).  Without an applicable standard form, and given the costs and difficulties of small firms contracting over exit, the court had to essentially make up a deal for the party ex post. 

My paper for the conference describes how the modern contracting technology enabled by the advent of the LLC (see also The Rise of the Uncorporation) enables a solution of this problem, and therefore assists entrepreneurs like the men involved in Springside Nursing. 

Wilkes and the interesting background we learned in Springfield, Massachusetts provided a glimpse into the past and insight into the future of business associations.

My paper will appear shortly on SSRN and then in the conference issue of the Western New England Law Review. I highly recommend the other papers in the conference, which presented other perspectives on the case.  I may write about some of those papers when they go public.

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.