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A recently published on-line symposium calls needed attention to Delaware Chief Justice Myron Steele’s remarkable article, Freedom of Contract and Default Contractual Duties in the Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221 (2009) (no free link available).

The Chief Justice makes an argument that is guaranteed to shock traditional business association scholars:  that there should be no default fiduciary duty in Delaware LLCs or limited partnerships.  According to the CJ, this would effectuate “Delaware’s strong policy favoring freedom of contract.”

CJ Steele notes that there are no fiduciary duties currently in the LLC statute, providing no basis for implying duties from the standard form.  This argument is less clear for limited partnerships, which link to the general partnership act’s duty of loyalty in §15-404. The Chief Justice argues that the freedom of contract provision in §17-1101 effectively negates this duty.  Although default duties arguably are preserved by reference in this provision, freedom of contract may trumps a nebulous default.

The ambiguity about default duties calls for application of policy considerations. The Chief Justice relies significantly on my writing, particularly Are Partners Fiduciaries? (for a more recent version of my theory see Fencing Fiduciary Duties).  I argue for narrowly construing default fiduciary duties because of the extra transaction and other costs associated with broad duties. In other articles [see, e.g., Larry E. Ribstein, Fiduciary Duty Contracts in Unincorporated Firms, 54 WASH. & LEE L. REV. 537 (1997) also cited by the Chief Justice] I have argued that the parties ought to be able to narrow default duties by contract.

The Chief Justice builds on these policies to take the extra step of leaving it to the parties to contractually define fiduciary duties from scratch. Here’s his reasoning in a nutshell (46 Am. Bus. L. J. 239-40) (footnotes omitted):

Professor Larry Ribstein has written extensively on the economic costs and benefits of fiduciary duties. Professor Ribstein explains that “the existence of default fiduciary duties depends solely on the structure of the parties’ relationship that is, on the terms of their express or implied contract — and not on any vulnerability arising other than from this structure.” Specifically, for LLCs, Ribstein sets forth three economic rationales to narrowly define fiduciary duties.

First, according to Ribstein, even where fiduciary duties have some benefits, those benefits are outweighed by costs such as “effect on the purported fiduciary’s incentives and the reduction of trust or reciprocity from substituting legal duties for extralegal constraints.” In particular, Ribstein notes, “courts often ignore the costs of fiduciary duties perhaps because these costs matter most in the cases that do not get to court, and therefore seem insignificant compared to the unfairness in the case being litigated.” Second, Ribstein argues that “there are benefits to clearly delineating the situations in which fiduciary duties apply, including minimizing litigation and contracting costs and effecting extralegal conduct norms.” Third, and finally, Ribstein concludes that “a narrow approach to fiduciary duties inheres in the contractual nature of such duties.” Ribstein warns that “[a]pplying fiduciary duties broadly threatens to undermine parties’ contracts by imposing obligations the parties do not want or expect.”

Professor Ribstein’s thoughtful analysis also applies to default fiduciary duties. In particular, the cost of applying any default fiduciary duty is outweighed by its benefit. First, default fiduciary duties add unnecessary costs to contracting. Second, default fiduciary duties also add unexpected litigation costs. Finally, any benefit to default fiduciary duties is limited because the LLC, by its nature, is designed to be a highly customized vehicle, determined primarily by contract. A critic to my cost-benefit analysis will invariably argue: (1) there is no cost to default fiduciary duties because the LLC statute provides that parties may eliminate any default duties and (2) parties benefit from fiduciary duties because they expect them and need not contract for them. However, I will demonstrate why those criticisms are misplaced.

First, default fiduciary duties add unnecessary contracting costs. The nebulous nature of default fiduciary duties makes it difficult for parties to eliminate some, but not all, potential fiduciary duties. * * * If we assume no default fiduciary duties, the parties need only explicitly provide for a self-dealing proscription. The contract is much easier to draft, and the parties have more confidence that they adequately provided for that ban without also introducing other unwanted fiduciary duties.

A question remains: how often will parties want to remove the default fiduciary duties? If, for the most part, parties simply intend to keep the default fiduciary duties, then it would be less costly for parties to contract. However, if we proceed from the baseline of no default fiduciary duty, adding in a wholesale provision adopting Delaware’s fiduciary duty principles could also be easily achieved — without much cost. As I described in the last paragraph, this will benefit the parties who intend to adopt a discrete number of those duties because it will be less costly to contract for those limited duties. Moreover, by adopting an LLC, the parties have consciously chosen to use a highly customizable vehicle–in so choosing, we naturally infer that the parties intend customization.

Second, default fiduciary duties introduce unexpected litigation expenses. Without default fiduciary duties, the parties’ litigation will focus solely on the agreement between them–and not on fiduciary duty principles outside of the contract. * * *

In light of those potential costs, the courts must also weigh them against any benefits to applying default fiduciary duties. Professor Ribstein explains that “[i]n general, this is a matter of articulating standard form terms to minimize contracting costs. It is difficult and expensive for parties to enter into customized contracts covering all of the details of a long-term agency-type relationship.” However, it is important to remember that in the context of an LLC that the parties have specifically chosen to use an LLC agreement, which provides contractual flexibility, and have bargained for the relevant provisions in this agreement. Thus, it does not necessarily follow that default fiduciary duty principles will more accurately reflect the parties’ intent rather than principles of contract interpretation. Instead, because the parties chose a Delaware LLC and because the Delaware judiciary is skilled in resolving difficult issues of contract interpretation, the opposite conclusion is likely true, that is, parties would prefer Delaware courts to determine their rights and duties in accordance with the terms of the contract and not an unbargained-for default fiduciary principle. Moreover, if the parties intended to apply traditional fiduciary duties to their relationship, they could easily add a provision stating precisely that in the agreement.

The Chief Justice has a point.  I grappled with the problem of contracting around default duties in my Uncorporation and Corporate Indeterminacy (at 165, footnotes omitted):

Vice Chancellor Strine’s admonition to lawyers not to address fiduciary duties “coyly” could require such careful and costly drafting that it makes fiduciary duties in effect mandatory. Even a moderate  insistence on careful drafting could put fiduciary duty waivers out of the reach of smaller firms. In other words, by making very skilled drafting the price of avoiding indeterminacy, Delaware’s uncorporate law may be trading lower litigation costs for higher fees to transactional lawyers. This may reserve the benefits of the uncorporate approach only for the largest and most sophisticated uncorporations.

In other words, the current Delaware approach achieves free contracting at significant cost.  Chief Justice Steele’s approach may be the best way to deal with that problem. 

The important question is whether there will be many parties who (1) fail to contract fully regarding fiduciary duties; and (2) expect a certain level of fiduciary duties to apply.  If both apply, then eliminating default fiduciary duties could defeat expectations and increase litigation by frustrated LLC members. The Chief Justice’s response  is that parties to Delaware LLCs know they’re getting a contractual regime and therefore are getting what they expect.  In other words, the market for LLC law offers a potential opportunity to contract not only out of default duties, but also away from the existence of default rules.

The brief articles in the symposium by Ann Conaway, Bill Callison & Allan Vestal, Carter Bishop, Dan Kleinberger, and Louis Hering take both sides of the issue, but do not, in my opinion, fully grapple with CJ Steele’s (and my) policy arguments.  Unfortunately I didn’t have an opportunity to participate in this symposium (not sure why, since after all the Chief Justice does rely on me!) so I haven’t had a chance to insert a full-fledged version of my thinking into the debate. I plan to write at more length on this, but wanted to take this opportunity to opine on the important issues raised by the Chief Justice while the iron was hot.

Steve Bainbridge invites my opinion of Delaware lawyer Edward McNally’s view that alternative entities “may not protect investors.” By “alternative entities” he is referring to limited liability companies and limited partnerships, despite his own recognition that they “have become the preferred form of entity for new businesses” (so why aren’t corporations “alternative entities”)? He uses as the text for his sermon VC Noble’s recent opinion in Brinckerhoff v. Enbridge Energy Co. involving the interpretation of a broad fiduciary duty waiver.

McNally says that “the lack of a uniform governance structure in these alternative entities may cause problems” when there are outside investors. He argues that broad fiduciary waivers may result in investors not being adequately paid for the risks they’re taking because “it seems doubtful that those risks can ever be adequately anticipated.” By contrast

corporate entities with much more standardized governance norms with greater investor protection have long flourished and raised capital. The corporate governance form benefits from its predictability and presumably raised capital effectively without the added risk of unpredictable governance provisions. Thus, the theoretical justification for letting alternative entities be governed loosely [that investors are paid for the risks they take] may not be valid.

Moreover, he says, the parties may not know for sure whether the waiver is effective.  He cites the following example:

Years ago, we had a case where a master limited partnership’s 60-page operating agreement attempted in great detail to spell out how to handle conflict of interest transactions involving its general partner. After consulting a national legal expert on limited partnerships, the general partner bought limited partnership interests following what it thought was the correct process. It was promptly sued, lost and paid millions of dollars in damages. The court held it followed the wrong process, and in doing so had breached its duty to the partnership. Complexity has its own risks.

He concludes that this is why “few alternative entities have been used as a vehicle to issue publicly traded securities, such as limited partnerships or membership interests.”

McNally repeatedly refers to the entity involved in Brinckerhoff as an “LLP.”  These are the initials for a “limited liability partnership,” which is a form of general partnership.  However, the entity in the case is a limited partnership, or “LP.”   He also confuses the “good faith” duty, a fiduciary duty which the agreement in Brinckerhoff added, with the “implied contractual covenant of good faith and fair dealing,” a non-waivable rule of contractual interpretation under Delaware law.

Apart from these technical glitches, I question McNally’s reasoning.  As to his claim of unpredictability, as I have discussed at some length, Delaware alternative entities are actually a way to avoid the more serious indeterminacy problem in corporate law. McNally’s illustration of uncorporate unpredictability is unpersuasive.  Maybe the general partner’s legal advisor was wrong, or the court erred.  Both can also happen in corporate practice. Anyway, he says this happened “years ago.”  Delaware uncorporate jurisprudence has developed rapidly in recent years, as the Brinckerhoff case itself illustrates.

Now let’s examine the case.  A pipeline partnership found itself mid-project at the nadir of the finaical crisis.  Its controller offered to invest.  A special committee negotiated a deal and hired legal and financial advisors to evaluate it.  They determined that it met the agreement’s “arms length” value standard for deals with affiliates. The court held this was not bad faith. The court noted (n. 39):

Although on some level the [agreement] may appear problematic for the simple reason that the controller of a limited partnership’s general partner is engaging in a transaction with the limited partnership, the LPA anticipates such transactions. Moreover, if the Court were to determine that [plaintiff] could state a claim that Enbridge [the defendant controlling party] acted in bad faith even though Enbridge negotiated the JVA with an independent special committee, then what would Enbridge have to do to be able to dispose of bad faith claims on a motion to dismiss? Would Enbridge be required, in analogy to In re John Q. Hammons Hotels Inc. S’holder Litig., 2009 WL 3165613 (Del. Ch. Oct. 2, 2009), to negotiate a transaction with an independent committee and have the transaction approved by a majority of the public unit holders? Requiring Enbridge to put in place those “robust procedural protections,” in order to be able to dispose of a bad faith claim on a motion to dismiss, would seem to rewrite the LPA when the Delaware General Assembly has explicitly stated that “[i]t is the policy of [Delaware’s Limited Partnership Act] … to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements.” 6 Del. C. § 17–1101(c).

The court interestingly compares the determinacy of the partnership agreement with the indeterminacy the parties avoided by not being a corporation.

As I have discussed elsewhere (e.g., here and here) the parties to uncorporations may quite reasonably trade off exit and managerial incentives for control and fiduciary duties.  The courts should enforce these contracts and the Delaware courts do.  It follows that McNally’s broader point that uncorporate entities are generally unsuitable for outside investors is flat wrong.

McNally raises the separate question of why there are only a relative few publicly held alternative entities.  One reason may be that the exit tradeoff I referred to may not work in publicly held firms.  Most such firms need the corporate feature of “capital lock in” which precludes buyout and dissolution provisions.

Bottom line:  Lawyers need to understand that “alternative” entities are an important transactional tool for clients.  Protestations that uncorporate law is too new or unpredictable, which were common 20 years ago, simply don’t wash today.

As I discussed last May, corporations are hoarding cash.  According to today’s WSJ, they’re still hoarding cash.

Mira Ganor writes, in Agency Costs in the Era of Economic Crisis, that it could be about CEO compensation. Here’s the abstract:

This Article reports results of an empirical study that suggests that the current economic crisis has changed managerial behavior in the US in a way that may impede economic recovery. The study finds a strong, statistically significant and economically meaningful, positive correlation between the CEO total annual compensation and corporate cash holdings during the economic crisis, in the years 2008-2010. This correlation did not exist in comparable magnitudes in prior years. The finding supports the criticism against current managerial compensation practices and suggests that high CEO compensation increases managerial risk aversion in times of crisis and contributes to the growing money hoarding practices that worsen an economic slowdown. One possible explanation for the empirical findings is that during the last economic crisis, managerial risk seeking transformed into risk aversion that stalls economic recovery. The study has implications for the discussion on managerial pay arrangements and the implementation of the Dodd-Frank Act concerning say-on-pay

Whatever the cause, as I wrote last May there is a possible solution for cash hoarding (and possibly a better way to deal with agency costs generally), at least for some types of firms:

As I’ve pointed out in numerous articles (e.g.) and in my Rise of the Uncorporation, the uncorporation replaces often-ineffective corporate-type disciplines like fiduciary duties and shareholder voting with financial discipline centered on debt and distributions, which restricts the amount of cash managers have to play with.

And the underuse of the uncorporate form itself comes down to another problem:  the corporate tax.

My paper, Energy Infrastructure Investment and the Rise of the Uncorporation has been published in the current issue of the Journal of Applied Corporate Finance.  It includes a useful summary of my views of uncorporations applied to larger firms.  As of now it’s behind a pay wall.  Here’s the abstract:

While most large U.S. businesses have long been organized as corporations, a significant portion of our economy, including major parts of our energy infrastructure, are organized as other types of legal entities. These “uncorporations” include such business forms as Master Limited Partnerships (MLPs) and Limited Liability Companies (LLCs). Many practitioners have dismissed these alternative entities as merely tax devices and only peripherally important to mainstream business. But this view misses important features of the uncorporation that make it an important alternative in dealing with the “agency” costs that arise in public companies from separating managerial control from equity ownership. Corporate governance relies heavily on agents such as auditors, class action lawyers, judges, and independent directors to protect shareholders from managerial self‐interest. The obvious costs and defects of relying on these governance mechanisms have generally been seen as a reasonable price to pay for the benefits of the corporate form. But this conclusion depends on the availability and effectiveness of the alternative mechanisms for addressing agency costs. Uncorporations provide such an alternative by tying managers’ economic well‐being so closely to that of their firms that corporate monitoring devices become less necessary. Uncorporate governance mechanisms include managerial compensation that is based largely (if not entirely) on the firm’s profits or cash distributions, and restrictions on managers’ control of corporate cash through liquidation rights and requirements for cash distributions. Business people and policy makers should evaluate the potential benefits of uncorporations before concluding that the costs of corporate governance are an inevitable price of separating ownership and control in modern firms

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.

One is not a partnership

Larry Ribstein —  6 September 2011

Bob Hillman and Don Weidner have a nice little paper in the form of a dialog about what you have when a partner withdraws leaving only one “partner”: Partners Without Partners: The Legal Status of Single Person Partnerships.  Here’s part of the abstract:

Although we have differing views on whether a single person partnership is possible under RUPA, we conclude on common ground that the buyout is appropriate. We also unite in a call for statutory clarification.

Gary Rosin, commenting on the paper, states his position more succinctly, quoting Springsteen: “When you’re alone you’re alone.  When you’re alone you ain’t nothing but alone.”

The basic problem is that the partnership statutes define a partnership as two or more persons, but don’t specify whether withdrawal of the penultimate partner triggers dissolution of the entity or, instead, a buyout plus continuation by the sole remaining partner.

In my view the answer is clear.

In a two-member partnership, the firm necessarily dissolves and is not continued on dissociation of one of the members because the remaining firm would not have the requisite two members to be a partnership.

Bromberg & Ribstein, §7.03(c), n. 13a. Although you can’t get that from the statute, it is a necessary implication of the definition of partnership.

If you insist that the fact that the statute doesn’t define this as a dissolution event, or that the partnership “entity” still exists notwithstanding withdrawal, then here’s some policy for you.  The function of the partnership statute is to serve as a standard form for a particular type of relationship — i.e, among two or more members.  As I point out in my Rise of the Uncorporation (p. 158, fn omitted),

The idea of multiple owners is inherent in the partnership standard form and coherent with partnership’s other provisions. Among other things, partnerships are based on contracts, which seemingly require two or more people: they are associations involving sharing of financial and management rights among the members, and the important partnership concepts of dissociation   and dissolution necessarily imply a relationship from which to dissociate. Moreover, multiple owners distinguish partnership from another standard form—that of agency, which is based on a single party (the principal) getting all of the benefit (i.e., profit) and having all of the control.

I go on to discuss whether people should be permitted to contract for one-member partnerships, which I view as a more complex issue.  But the cases discussed by Hillman and Weidner don’t involve contracts.

H & W are concerned about whether this approach would frustrate buyout rights that would otherwise exist.  Maybe, but this is just a default rule.  The parties can contract for any kind of buyout they want, as long as they don’t end up with a sole proprietorship.  If they don’t contract, they can’t back into a buyout by trying to define a partnership as something it isn’t.

Anyway, the uncertainty costs of the H & W approach exceed the benefits.  Allowing a buyout and survival of the partnership leads to a host of problems, some of which they discuss.  For example, what if the partnership is an LLP — would the liability protection continue for events after the penultimate partner’s dissociation even if it’s a one-member entity and therefore not a partnership (and so technically ineligible to be an LLP)?

This issue and the H & W article raise two broader concerns. First, the problem here is a symptom of uniform lawmaking, which I’ve discussed elsewhere (e.g.). H & W point out (p. 8) that problems with partnership dissolution persist despite “more than a century” of partnership law drafting dominated by the uniform lawmaking process.  This is no wonder given the perversity of the process discussed in my article with Kobayashi linked immediately above.  Weidner’s recollections as RUPA reporter (see p. 9) only confirm the twists and turns of the process and the ad hoc way decisions are sometimes made.  Moreover, even a perfect process necessarily will have glitches or develop problems over time.  Yet uniform lawmaking is designed to lock in a single solution and to eschew the interstate competition that has helped develop LLC and corporate law.

Second, do we really need all of this complexity?  As noted above and in Gary Rosin’s post, part of the problem is the continuing pall cast by the vague and uncertain “entity” concept.  Simply viewing a partnership as a contract subject to a various rules, some of which are default rules provided for in the standard form, provides simpler and more direct answers.  The “entity” concept turns the contract into a mess of a legal construct.  Since the parties can’t be sure how a court will analyze the situation, they may not even be able to settle the issue by contract. The two-member partnership becomes another victim of lawyer-driven over-complexity.

Anyway, all we need to know for now is in Bromberg & Ribstein:  when a partner withdraws from a two member partnership he leaves one owner.  One owner is not a partnership, and can’t become one via a buyout. Hence the partnership dissolves.  If you don’t like that solution, contract around it.

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.

The literature on the state “market” for LLC law is growing.  Bruce Kobayashi and I published what I would modestly call the leading study (K & R) on jurisdictional competition for LLCs.  There is also an unpublished study to which our article is in part a response by Dammann & Schündeln (D & S). Now there’s a third study, Hausermann, For a Few Dollars Less: Explaining State to State Variation in Limited Liability Company Popularity.  Here’s the abstract:

The limited liability company (LLC) is a much more popular business entity in some U.S. states than in others. This empirical study provides the first detailed analysis of this phenomenon, using a partly original set of cross-sectional state-level data. I find that formation fees, rather than taxes or substantive rules or anything else, explain the variation in LLC popularity best. Differentials between the fees for organizing an LLC and the fees for organizing a corporation explain 17% to 28% of the state-to-state variation in LLC popularity. These formation fee differentials are not very big, but they are highly visible at the moment the business entity is formed. In contrast, the data show no relationship between LLC popularity and differentials in annual fees and state entity-level taxes. I find only weak evidence that the popularity of the LLC is associated with different substantive rules contained in state LLC statutes. However, LLCs are more popular in those states whose LLC statutes expressly uphold the principle of contractual freedom and thus reassure LLC members that courts will not rewrite their contract in the event of a lawsuit. Finally, I found no evidence that LLC popularity is related to different levels of uniformity of LLC statutes, the age of LLC statutes, and other factors.

Note that while K & R and D & S focus on state competition for out-of-state formations, Hausermann looks at the “popularity” of the LLC vs. the corporate form within each state.  Kobayashi and I found that Delaware has won the national competition, the most likely explanation being the quality of its courts.  This contrasts with D & S’s findings “that substantive law matters to the formation state choices of closely held limited liability companies” and that LLCs “appear to be migrating away from states that offer lax norms on minority investor protection.”

Hausermann mostly confirms K & R’s conclusion that the substance of the statutes is not determining parties’ formation choices.  His corporation/LLC comparison finds that the important variable is the difference in each state between the fees for forming an LLC and those for forming a corporation.

A few points to note about Hausermann’s study:

  • Although the author emphasizes K & R and D & S re state competition for LLCs, the closer comparison is with Kobayashi and my study of the state-by-state relative popularity of LLCs and LLPs, which Hausermann also discusses. We found that LLCs beat LLPs despite the expectation from the “network externalities” literature that the LLP’s connection to the “network” of partnership cases and forms would give it an advantage over the LLC.  Similar to Hausermann, we found that the costs of forming the two types of business associations (specifically, entity-level taxes) affected state-to-state differences in their relative popularity.
  • Hausermann finds that even tiny fee differences between corporations and LLCs make a difference in popularity of the two forms and that the parties ignore continuing fees and focus on upfront fees.  This rightly puzzles the author and calls for more theory and data.  I speculate that this reflects incomplete information on the part of many people who are forming LLCs.  This is clearly the case for ignoring continuing fees.  Moreover, since the vast majority of small firms should be LLCs rather than corporations (for more on this, see my Rise of the Uncorporation), making the choice based on tiny differences in upfront fees and ignoring continuing fees likely reflects bad advice and poor information.  In other words, Hausermann’s study arguably suggests the legal services industry is failing small firms.  Perhaps law’s information revolution will fix this.
  • Hausermann shows that freedom of contract regarding fiduciary duties matters to the corporation/LLC choice. This, coupled with the fact that the sheer number of mandatory rules in a statute doesn’t matter, indicates the importance to small firms of certainty that their contract will be enforced by its terms (see Hausermann at p. 36).  The importance of legal certainty is discussed in my and Kobayashi’s recently posted draft on private lawmaking (to be discussed here shortly).

Note what Hausermann finds doesn’t matter to parties’ choice between corporation and LLC:

  • Protection of third-party creditors.  This suggests creditors think they can protect themselves, and that the rise in LLCs vs. corporations is not about avoiding debts.
  • Default rules that members can easily vary by contract.  This is not surprising.  But perhaps default rules would matter if parties had a better and more varied menu of private forms from which to choose. This also relates to Kobayashi and my work on the potential role of private lawmaking.
  • Uniformity in general, and adoption of NCCUSL-promulgated uniform laws in particular.  This casts more doubt on the value of NCCUSL.  My most recent uniform laws article with Kobayashi helps explain why parties aren’t attracted to NCCUSL-drafted laws.

Hausermann rightly suggests the need for further research, including on the effect of overall formation costs, and the role of lawyers in guiding parties to particular forms.

More generally, I would suggest the need not only for more data but also more theory to guide both what kinds of data to get and how to interpret the data that is gotten.  In other words, Rise of the Uncorporation should be required reading for scholars seeking to mine the potentially rich data produced by the leading business law phenomenon of our time — the rapid rise and evolution of the LLC.

The 2011 Supplement to Ribstein & Lipshaw, Unincorporated Business Entities (4th Edition) is now available in Word and Pdf. It will be posted on the Lexis website in the next couple of weeks.

If you want to teach the law of business associations as many of your students will actually be practicing it — the cutting edge world where contracts and transactional planning matter — and if you want a deep approach to this subject matter rather than just a couple-week add-on to the same old corporations course, then this book is for you.

On the other hand, if you want the latest version of the 19th century “agency and partnership” course, or to continue teaching your grandparents’ corporate law course, with the same old soporific cases (or, maybe, “hip” new cases containing the same old soporific law), then of course you can do that, too, but not with this book.

A few days ago Paul Caron summarized moves toward corporate taxation of pass-through entities with more than $50 million gross receipts, adding links to prior posts on this subject.

Today’s WSJ echoes this story, quoting Sen. Max Baucus, Senate Finance Chair: “We’re talking about business income here. Why not have the large pass-throughs … pay a corporate rate?”

Well, here’s “why not”:  Changing the tax on pass-throughs could significantly reduce governance efficiency and may not produce that much more revenue.

As detailed in my Rise of the Uncorporation, an important uncorporate feature is their emphasis on owner “exit,” in the form of distributions and buyouts, over corporate-type monitoring such as boards of directors, shareholder voting and fiduciary duties.  Recent financial crises have shown the problems with corporate-type management, even after decades of reform.  This should encourage openness to alternatives, including uncorporate management. But corporate taxation, by taxing income both when earned by the corporation and when distributed to owners, effectively penalizes the distributions and buyouts that are so important to uncorporate governance. 

Instead of increasing the application of the corporate tax we should be asking how expanding the domain of tax pass-throughs could increase efficient uncorporate governance.   As discussed in Rise of the Uncorporation (243-44, footnotes omitted):

Taxing distributions burdens an important aspect of the uncorporate approach to governance. Yet the only way large firms can be publicly held is to fit into a small exception from the rule treating publicly traded firms as corporations. Large firms that want the discipline provided by owner access to the cash need to end-run the tax on distributions by using tax-deductible debt, thereby increasing the risk of costly bankruptcy. This encourages firms to continue to use the corporate form even as the costs of this form increase. * * *

The factors discussed above in this chapter pointing to more use of the uncorporation for publicly held firms eventually might encourage a change in tax policy. As discussed above, the current exception from the corporate tax on publicly traded firms is limited essentially to passive rent collectors such as natural resource and real estate firms. This is probably narrower than the class of firms that could benefit from flow-through partnership taxation and that would seek this taxation under a more flexible rule. For example, mature, slowgrowth firms that get fairly predictable earnings from established brands might derive comparable benefits from a tax rule that encouraged regular distributions to owners.

Congress might accommodate this need for flexibility by drawing the corporate-partnership tax border with a view to encouraging governance structures that mitigate agency costs. Firms arguably should be able to balance the costs and benefits of the tax as they do with other governance devices. In other words, firms’ governance choices should determine the application of the tax rather than vice versa. At the same time, as long as the corporate tax remains, Congress has to restrict firms’ ability to opt out of it. Lawmakers could let firms choose to be taxed as partnerships on the condition that they have substantially adopted partnership-type governance, including committing to making distributions. This would be analogous to the tax code’s approach to REITs in which the application of partnership-type tax turns to some extent on the firms’ distribution of earnings. It also would be consistent with the goal of making statutory standard forms coherent because it would enable firms to mesh tax consequences with their choice of business association.

A full analysis of proposals to tax pass-throughs should look closely at claims about potential revenue gains given likely increased reliance on debt, as well as the efficiency costs of undermining the uncorporate form and increasing bankruptcy costs.

Jets and LBOs

Larry Ribstein —  1 May 2011

I have written about the disciplinary effect of the uncorporate form, particularly in LBOs.  See, e.g., here and Chapter 8 of my Rise of the Uncorporation.

Now here’s more evidence:  Edgerton, Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts.  Here’s the abstract:

This paper uses rich, new data to examine the fleets of corporate jets operated by both publicly traded and privately held firms. In the cross-section, firms owned by private equity funds average jet fleets at least 40% smaller than observably similar publicly-traded firms. Similar fleet reductions are observed within firms that go private in leveraged buyouts. I discuss assumptions under which comparisons across and within firms provide estimates of lower and upper bounds on the average treatment effect of taking a firm from public to private in a leveraged buyout. Both censored and standard quantile regressions suggest that results at the mean are driven by firms in the upper 30% of the conditional jet distribution. Results thus suggest that executives in a substantial minority of public firms enjoy more generous perquisites than they would if subject to the pressures of private equity ownership.

The study controls for the factors that cause firms to select into PE-ownership. 

Note that the study finds that “jet fleets in [non-PE private] firms look more like those in publicly-traded firms than those in PE-owned firms.”  The author suggests that these are founder-owned firms.  Buyouts cause reductions in agency costs in these firms that are similar to those in publicly owned firms.  In other words, as I’ve written, following Jensen, this is a story about PE-type governance, not closely vs. publicly held.

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.