The big news from the Federal Trade Commission (FTC) is all about noncompetes. From what were once the realms of labor and contract law, noncompetes are terms in employment contracts that limit in various ways the ability of an employee to work at a competing firm after separation from the signatory firm. They’ve been a matter of increasing interest to economists, policymakers, and enforcers for several reasons. For one, there have been prominent news reports of noncompetes used in dubious places; the traditional justifications for noncompetes seem strained when applied to low-wage workers, so why are we reading about noncompetes binding sandwich-makers at Jimmy John’s?
Common-law cases involving one or another form of noncompete go back several hundred years. So, what’s new? First, on Jan. 4, the FTC announced settlements with three firms regarding their use of noncompetes, which the FTC had alleged to violate Section 5. These are consent orders, not precedential decisions. The complaints were, presumably, based on rule-of-reason analyses of facts, circumstances, and effects. On the other hand, the Commission’s recent Section 5 policy statement seemed to disavow the time-honored (and Supreme-Court-affirmed) application of the rule of reason. I wrote about it here, and with Gus Hurwitz here. My ICLE colleagues Dirk Auer, Brian Albrecht, and Jonathan Barnett did too, among others.
Noncompete restrictions harm both workers and competing businesses. For workers, noncompete restrictions lead to lower wages and salaries, reduced benefits, and less favorable working conditions. For businesses, these restrictions block competitors from entering and expanding their businesses.
Always?Distinct facts and circumstances? Commissioner Christine Wilson noted the brevity of the statement in her dissent:
…each Complaint runs three pages, with a large percentage of the text devoted to boilerplate language. Given how brief they are, it is not surprising that the complaints are woefully devoid of details that would support the Commission’s allegations. In short, I have seen no evidence of anticompetitive effects that would give me reason to believe that respondents have violated Section 5 of the FTC Act.
She did not say that the noncompetes were fine. In a separate statement regarding one of the matters, she noted that various aspects of noncompetes imposed on security guards (running two years from termination of employment, with $10,000 liquidated damages for breach) had been found unreasonable by a state court, and therefore unenforceable under Michigan law. That seemed to her “reasonable.” I’m no expert on Michigan state law, but those terms seem to me suspect under general standards of reasonability. Whether there was a federal antitrust violation is far less clear.
One more clue–and even bigger news–came the very next day: the Commission published a notice of proposed rulemaking (NPRM) proposing to ban the use of noncompetes in general. Subject to a limited exception for the sale of a business, noncompetes would be deemed violative of Section 5 across occupations, income levels, and industries. That is, the FTC proposed to regulate the terms of employment agreements for nearly the whole of the U.S. labor force. Step aside federal and state labor law (and the U.S. Labor Department and Congress); and step aside ongoing and active statutory experimentation on noncompete enforcement in the states.
So many questions.There are reasons to wonder about many noncompetes. They do have the potential to solve holdup problems for firms that might otherwise underinvest in employee training and might undershare trade secrets or other proprietary information. But that’s not much of an explanation for restrictions on a counter person at a sub shop, and I’m pretty suspicious of the liquidated damages provision in the security-guards matter. Credible economic studies raise concerns, as well.
Still, this is an emerging area of study, and many positive contributions to it (like the one linked just now, and this) illustrate research challenges that remain. An FTC Bureau of Economics working paper (oddly not cited in the 215-page NPRM) reviews the body of literature, observing that results are mixed, and that many of the extant studies have shortcomings.
So here are a few more questions that cannot possibly be resolved in a single blog post:
Does the FTC have the authority to issue substantive (“legislative”) competition regulations?
Would a regulation restricting a common contracting practice across all occupations, industries, and income levels raise the major questions doctrine? (Ok, skipping ahead: Yes.)
Does it matter, for the major questions doctrine or otherwise, that there’s a substantial body of federal statutory law regarding labor and employment and a federal agency (a good deal larger than the FTC) charged to enforce the law?
Does it matter that the FTC simply doesn’t have the personnel (or congressionally appropriated budget) to enforce such a sweeping regulation?
Is the number of experienced labor lawyers currently employed as staff in the FTC’s Bureau of Competition nonzero? If so, what is it?
Does it matter that this is an active area of state-level legislation and enforcement?
Do the effects of noncompetes vary as the terms of noncompetes vary, as suggested in the ABA comments linked above? And if so, on what dimensions?
Do the effects vary according to the market power of the employer in local (or other geographically relevant) labor markets and, if so, should that matter to an antitrust enforcer?
If the effects vary significantly, is a one-size-fits-all regulation the best path forward?
Many published studies seem to report average effects of policy changes on, e.g., wages or worker mobility for some class of workers. Should we know more about the distribution of those effects before the FTC (or anyone else) adopts uniform federal regulations?
How well do we know the answer to the myriad questions raised by noncompetes? As the FTC working paper observes, many published studies seem to rely heavily on survey evidence on the incidence of noncompetes. Prior to adopting a sweeping competition regulation, should the FTC use its 6b subpoena authority to gather direct evidence? Why hasn’t it?
The FTC’s Bureau of Economics employs a large expert staff of research economists. Given the questions raised by the FTC Working Paper, how else might the FTC contribute to the state of knowledge of noncompete usage and effects before adopting a sweeping, nationwide prohibition? Are there lacunae in the literature that the FTC could fill? For example, there seem to be very few papers regarding the downstream effects on consumers, which might matter to consumers. And while we’re in labor markets, what about the relationship between noncompetes and employment?
I didn’t even get to the once-again dismal ratings of FTC’s senior agency leadership in the 2022 OPM Federal Employee Viewpoint Survey. Last year’s results were terrible—a precipitous drop from 2020. This year’s results were worse. Worse yet, they show that last year’s results were not mere transient deflation in morale. But a discussion will have to wait for another blog post.
Policy discussions about the use of personal data often have “less is more” as a background assumption; that data is overconsumed relative to some hypothetical optimal baseline. This overriding skepticism has been the backdrop for sweeping new privacy regulations, such as the California Consumer Privacy Act (CCPA) and the EU’s General Data Protection Regulation (GDPR).
More recently, as part of the broad pushback against data collection by online firms, some have begun to call for creating property rights in consumers’ personal data or for data to be treated as labor. Prominent backers of the idea include New York City mayoral candidate Andrew Yang and computer scientist Jaron Lanier.
The discussion has escaped the halls of academia and made its way into popular media. During a recent discussion with Tesla founder Elon Musk, comedian and podcast host Joe Rogan argued that Facebook is “one gigantic information-gathering business that’s decided to take all of the data that people didn’t know was valuable and sell it and make f***ing billions of dollars.” Musk appeared to agree.
The animosity exhibited toward data collection might come as a surprise to anyone who has taken Econ 101. Goods ideally end up with those who value them most. A firm finding profitable ways to repurpose unwanted scraps is just the efficient reallocation of resources. This applies as much to personal data as to literal trash.
Unfortunately, in the policy sphere, few are willing to recognize the inherent trade-off between the value of privacy, on the one hand, and the value of various goods and services that rely on consumer data, on the other. Ideally, policymakers would look to markets to find the right balance, which they often can. When the transfer of data is hardwired into an underlying transaction, parties have ample room to bargain.
But this is not always possible. In some cases, transaction costs will prevent parties from bargaining over the use of data. The question is whether such situations are so widespread as to justify the creation of data property rights, with all of the allocative inefficiencies they entail. Critics wrongly assume the solution is both to create data property rights and to allocate them to consumers. But there is no evidence to suggest that, at the margin, heightened user privacy necessarily outweighs the social benefits that new data-reliant goods and services would generate. Recent experience in the worlds of personalized medicine and the fight against COVID-19 help to illustrate this point.
Data Property Rights and Personalized Medicine
The world is on the cusp of a revolution in personalized medicine. Advances such as the improved identification of biomarkers, CRISPR genome editing, and machine learning, could usher a new wave of treatments to markedly improve health outcomes.
Personalized medicine uses information about a person’s own genes or proteins to prevent, diagnose, or treat disease. Genetic-testing companies like 23andMe or Family Tree DNA, with the large troves of genetic information they collect, could play a significant role in helping the scientific community to further medical progress in this area.
However, despite the obvious potential of personalized medicine, many of its real-world applications are still very much hypothetical. While governments could act in any number of ways to accelerate the movement’s progress, recent policy debates have instead focused more on whether to create a system of property rights covering personal genetic data.
Some raise concerns that it is pharmaceutical companies, not consumers, who will reap the monetary benefits of the personalized medicine revolution, and that advances are achieved at the expense of consumers’ and patients’ privacy. They contend that data property rights would ensure that patients earn their “fair” share of personalized medicine’s future profits.
But it’s worth examining the other side of the coin. There are few things people value more than their health. U.S. governmental agencies place the value of a single life at somewhere between $1 million and $10 million. The commonly used quality-adjusted life year metric offers valuations that range from $50,000 to upward of $300,000 per incremental year of life.
It therefore follows that the trivial sums users of genetic-testing kits might derive from a system of data property rights would likely be dwarfed by the value they would enjoy from improved medical treatments. A strong case can be made that policymakers should prioritize advancing the emergence of new treatments, rather than attempting to ensure that consumers share in the profits generated by those potential advances.
These debates drew increased attention last year, when 23andMe signed a strategic agreement with the pharmaceutical company Almirall to license the rights related to an antibody Almirall had developed. Critics pointed out that 23andMe’s customers, whose data had presumably been used to discover the potential treatment, received no monetary benefits from the deal. Journalist Laura Spinney wrote in The Guardian newspaper:
23andMe, for example, asks its customers to waive all claims to a share of the profits arising from such research. But given those profits could be substantial—as evidenced by the interest of big pharma—shouldn’t the company be paying us for our data, rather than charging us to be tested?
In the deal’s wake, some argued that personal health data should be covered by property rights. A cardiologist quoted in Fortune magazine opined: “I strongly believe that everyone should own their medical data—and they have a right to that.” But this strong belief, however widely shared, ignores important lessons that law and economics has to teach about property rights and the role of contractual freedom.
Why Do We Have Property Rights?
Among the many important features of property rights is that they create “excludability,” the ability of economic agents to prevent third parties from using a given item. In the words of law professor Richard Epstein:
[P]roperty is not an individual conception, but is at root a social conception. The social conception is fairly and accurately portrayed, not by what it is I can do with the thing in question, but by who it is that I am entitled to exclude by virtue of my right. Possession becomes exclusive possession against the rest of the world…
Excludability helps to facilitate the trade of goods, offers incentives to create those goods in the first place, and promotes specialization throughout the economy. In short, property rights create a system of exclusion that supports creating and maintaining valuable goods, services, and ideas.
But property rights are not without drawbacks. Physical or intellectual property can lead to a suboptimal allocation of resources, namely market power (though this effect is often outweighed by increased ex ante incentives to create and innovate). Similarly, property rights can give rise to thickets that significantly increase the cost of amassing complementary pieces of property. Often cited are the historic (but contested) examples of tolling on the Rhine River or the airplane patent thicket of the early 20th century. Finally, strong property rights might also lead to holdout behavior, which can be addressed through top-down tools, like eminent domain, or private mechanisms, like contingent contracts.
In short, though property rights—whether they cover physical or information goods—can offer vast benefits, there are cases where they might be counterproductive. This is probably why, throughout history, property laws have evolved to achieve a reasonable balance between incentives to create goods and to ensure their efficient allocation and use.
Personal Health Data: What Are We Trying to Incentivize?
There are at least three critical questions we should ask about proposals to create property rights over personal health data.
What goods or behaviors would these rights incentivize or disincentivize that are currently over- or undersupplied by the market?
Are goods over- or undersupplied because of insufficient excludability?
Could these rights undermine the efficient use of personal health data?
Much of the current debate centers on data obtained from direct-to-consumer genetic-testing kits. In this context, almost by definition, firms only obtain consumers’ genetic data with their consent. In western democracies, the rights to bodily integrity and to privacy generally make it illegal to administer genetic tests against a consumer or patient’s will. This makes genetic information naturally excludable, so consumers already benefit from what is effectively a property right.
When consumers decide to use a genetic-testing kit, the terms set by the testing firm generally stipulate how their personal data will be used. 23andMe has a detailed policy to this effect, as does Family Tree DNA. In the case of 23andMe, consumers can decide whether their personal information can be used for the purpose of scientific research:
You have the choice to participate in 23andMe Research by providing your consent. … 23andMe Research may study a specific group or population, identify potential areas or targets for therapeutics development, conduct or support the development of drugs, diagnostics or devices to diagnose, predict or treat medical or other health conditions, work with public, private and/or nonprofit entities on genetic research initiatives, or otherwise create, commercialize, and apply this new knowledge to improve health care.
Because this transfer of personal information is hardwired into the provision of genetic-testing services, there is space for contractual bargaining over the allocation of this information. The right to use personal health data will go toward the party that values it most, especially if information asymmetries are weeded out by existing regulations or business practices.
Regardless of data property rights, consumers have a choice: they can purchase genetic-testing services and agree to the provider’s data policy, or they can forgo the services. The service provider cannot obtain the data without entering into an agreement with the consumer. While competition between providers will affect parties’ bargaining positions, and thus the price and terms on which these services are provided, data property rights likely will not.
So, why do consumers transfer control over their genetic data? The main reason is that genetic information is inaccessible and worthless without the addition of genetic-testing services. Consumers must pass through the bottleneck of genetic testing for their genetic data to be revealed and transformed into usable information. It therefore makes sense to transfer the information to the service provider, who is in a much stronger position to draw insights from it. From the consumer’s perspective, the data is not even truly “transferred,” as the consumer had no access to it before the genetic-testing service revealed it. The value of this genetic information is then netted out in the price consumers pay for testing kits.
If personal health data were undersupplied by consumers and patients, testing firms could sweeten the deal and offer them more in return for their data. U.S. copyright law covers original compilations of data, while EU law gives 15 years of exclusive protection to the creators of original databases. Legal protections for trade secrets could also play some role. Thus, firms have some incentives to amass valuable health datasets.
But some critics argue that health data is, in fact, oversupplied. Generally, such arguments assert that agents do not account for the negative privacy externalities suffered by third-parties, such as adverse-selection problems in insurance markets. For example, Jay Pil Choi, Doh Shin Jeon, and Byung Cheol Kim argue:
Genetic tests are another example of privacy concerns due to informational externalities. Researchers have found that some subjects’ genetic information can be used to make predictions of others’ genetic disposition among the same racial or ethnic category. … Because of practical concerns about privacy and/or invidious discrimination based on genetic information, the U.S. federal government has prohibited insurance companies and employers from any misuse of information from genetic tests under the Genetic Information Nondiscrimination Act (GINA).
But if these externalities exist (most of the examples cited by scholars are hypothetical), they are likely dwarfed by the tremendous benefits that could flow from the use of personal health data. Put differently, the assertion that “excessive” data collection may create privacy harms should be weighed against the possibility that the same collection may also lead to socially valuable goods and services that produce positive externalities.
In any case, data property rights would do little to limit these potential negative externalities. Consumers and patients are already free to agree to terms that allow or prevent their data from being resold to insurers. It is not clear how data property rights would alter the picture.
Proponents of data property rights often claim they should be associated with some form of collective bargaining. The idea is that consumers might otherwise fail to receive their “fair share” of genetic-testing firms’ revenue. But what critics portray as asymmetric bargaining power might simply be the market signaling that genetic-testing services are in high demand, with room for competitors to enter the market. Shifting rents from genetic-testing services to consumers would undermine this valuable price signal and, ultimately, diminish the quality of the services.
Perhaps more importantly, to the extent that they limit the supply of genetic information—for example, because firms are forced to pay higher prices for data and thus acquire less of it—data property rights might hinder the emergence of new treatments. If genetic data is a key input to develop personalized medicines, adopting policies that, in effect, ration the supply of that data is likely misguided.
Even if policymakers do not directly put their thumb on the scale, data property rights could still harm pharmaceutical innovation. If existing privacy regulations are any guide—notably, thepreviously mentioned GDPR and CCPA, as well as the federal Health Insurance Portability and Accountability Act (HIPAA)—such rights might increase red tape for pharmaceutical innovators. Privacy regulations routinely limit firms’ ability to put collected data to new and previously unforeseen uses. They also limit parties’ contractual freedom when it comes to gathering consumers’ consent.
At the margin, data property rights would make it more costly for firms to amass socially valuable datasets. This would effectively move the personalized medicine space further away from a world of permissionless innovation, thus slowing down medical progress.
In short, there is little reason to believe health-care data is misallocated. Proposals to reallocate rights to such data based on idiosyncratic distributional preferences threaten to stifle innovation in the name of privacy harms that remain mostly hypothetical.
Data Property Rights and COVID-19
The trade-off between users’ privacy and the efficient use of data also has important implications for the fight against COVID-19. Since the beginning of the pandemic, several promising initiatives have been thwarted by privacy regulations and concerns about the use of personal data. This has potentially prevented policymakers, firms, and consumers from putting information to its optimal social use. High-profile issues have included:
Each of these cases may involve genuine privacy risks. But to the extent that they do, those risks must be balanced against the potential benefits to society. If privacy concerns prevent us from deploying contact tracing or green passes at scale, we should question whether the privacy benefits are worth the cost. The same is true for rules that prohibit amassing more data than is strictly necessary, as is required by data-minimization obligations included in regulations such as the GDPR.
If our initial question was instead whether the benefits of a given data-collection scheme outweighed its potential costs to privacy, incentives could be set such that competition between firms would reduce the amount of data collected—at least, where minimized data collection is, indeed, valuable to users. Yet these considerations are almost completely absent in the COVID-19-related privacy debates, as they are in the broader privacy debate. Against this backdrop, the case for personal data property rights is dubious.
The key question is whether policymakers should make it easier or harder for firms and public bodies to amass large sets of personal data. This requires asking whether personal data is currently under- or over-provided, and whether the additional excludability that would be created by data property rights would offset their detrimental effect on innovation.
Swaths of personal data currently lie untapped. With the proper incentive mechanisms in place, this idle data could be mobilized to develop personalized medicines and to fight the COVID-19 outbreak, among many other valuable uses. By making such data more onerous to acquire, property rights in personal data might stifle the assembly of novel datasets that could be used to build innovative products and services.
On the other hand, when dealing with diffuse and complementary data sources, transaction costs become a real issue and the initial allocation of rightscan matter a great deal. In such cases, unlike the genetic-testing kits example, it is not certain that users will be able to bargain with firms, especially where their personal information is exchanged by third parties.
If optimal reallocation is unlikely, should property rights go to the person covered by the data or to the collectors (potentially subject to user opt-outs)? Proponents of data property rights assume the first option is superior. But if the goal is to produce groundbreaking new goods and services, granting rights to data collectors might be a superior solution. Ultimately, this is an empirical question.
As Richard Epstein puts it, the goal is to “minimize the sum of errors that arise from expropriation and undercompensation, where the two are inversely related.” Rather than approach the problem with the preconceived notion that initial rights should go to users, policymakers should ensure that data flows to those economic agents who can best extract information and knowledge from it.
As things stand, there is little to suggest that the trade-offs favor creating data property rights. This is not an argument for requisitioning personal information or preventing parties from transferring data as they see fit, but simply for letting markets function, unfettered by misguided public policies.
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.
It’s been interesting to watch uncorporations (particularly LLCs and limited partnerships) evolve over the last twenty years or so. Perhaps the most interesting aspect of this evolution is what’s been happening in Delaware regarding contracting over fiduciary duties. This is particularly intriguing because it concerns a key area of difference between corporations and uncorporations — that is, the role of private ordering. See generally my Rise of the Uncorporation, particularly Chapters 7 and 8.
The story begins with Delaware’s adoption of Section 1101 of its LP and LLC acts, which gave firms the power to opt out of fiduciary duties.
Firms initially used this provision somewhat gingerly, and the courts responded with ginger applications, as discussed in my Uncorporation and Corporate Indeterminacy and Fiduciary Duties and Limited Partnership Agreements, 37 SUFFOLK U. L. REV . 927 (2004) (SSRN) .
For example, in Miller v. American Real Estate Partners, 2001 WL 1045643, at *10–11 (Del. Ch. Sept. 6, 2001), VC Strine held that an agreement giving a general partner complete discretion to manage and control the business didn’t authorize him to invest partnership funds in aid of his own venture. The court emphasized the importance of the agreement, noting that Delaware limited partnership law “reflects the doctrine of caveat emptor, as is fitting given that investors in limited partnerships have countless other investment opportunities available to them that involve less risk and/or more legal protection.” However, the court added:
[J]ust as investors must use due care, so must the drafter of a partnership agreement who wishes to supplant the operation of traditional fiduciary duties. In view of the great freedom afforded to such drafters and the reality that most publicly traded limited partnerships are governed by agreements drafted exclusively by the original general partner, it is fair to expect that restrictions on fiduciary duties be set forth clearly and unambiguously. A topic as important as this should not be addressed coyly. * * *
The Delaware Supreme Court in Gotham Partners, L.P. v. Hallwood Realty Partners, L.P. , 817 A.2d 160, 167–68 (Del. 2002) sounded a caveat on freedom of contract by stating in dictum that Delaware law didn’t allow elimination of fiduciary duties. The court echoed VC Strine in noting “the historic cautionary approach of the courts of Delaware that efforts by a fiduciary to escape a fiduciary duty, whether by a corporate director or officer or other type of trustee, should be scrutinized searchingly.”
Interestingly for present purposes, the court was unwilling to leave a gap-filling role to the implied contractual covenant of good faith and fair dealing.
However, the Delaware legislature responded to Gotham by amending the above statute to explicitly provide that fiduciary duties may be “eliminated” by the partnership agreement. Then Delaware Chief Justice Steele followed up with an article urging his fellow Delaware judges to enforce agreements in Delaware noncorporate cases. See Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies , 32 DEL. J. C. L . 1 (2007).
In general, as Rise of the Uncorporation notes in Chapter 8, limited partnerships (and LLCs) get more contractual freedom than corporations (which can only opt out of the duty of care) because they “almost always are the product of detailed bargaining. * * * [T]he limited partnership substitutes other constraints on managers for fiduciary duties, particularly high-powered owner-like incentives of managers and the owners’ greater access to the firm’s cash.”
Wood v. Baum, 953 A.2d 136 (Del. 2008) explicitly extended this contractual freedom to a publicly traded LLC, dismissing a complaint containing a strong allegation of a breach of monitoring that might have gotten attention in a corporate case under Stone v. Ritter, 911 A. 2d 362 (Del. 2006).
This leaves open what the Delaware courts might do post-financial crisis/Dodd-Frank in a case involving the near elimination of all fiduciary duties in a Blackstone-type entity fraught with conflicts of interest (here’s an earlier post on this situation).
We have a response, if not definitive answer, in VC Laster’s decision in Lonergan v. EPE Holdings, LLC, 5 A.3d 1008 Del.Ch.,2010. This was a publicly traded LP in which a general partner’s board sought a merger of two related entities. Here are the important provisions of the agreement (footnotes omitted):
Except as expressly set forth in this Agreement, neither [Holdings GP] nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Partnership or any Limited Partner and the provisions of this Agreement, to the extent that they restrict or otherwise modify the duties and liabilities, including fiduciary duties, of [Holdings GP] or any other Indemnitee otherwise existing at law or in equity, are agreed by the Partners to replace such other duties and liabilities of [Holdings GP] or such other Indemnitee.
* * *
Any standard of care and duty imposed by this Agreement or under the Delaware Act or any applicable law, rule or regulation shall be modified, waived or limited, to the extent permitted by law, as required to permit [Holdings GP] to act under this Agreement and to make any decision pursuant to the authority prescribed in this Agreement, so long as such action is reasonably believed by [Holdings GP] to be in, or not inconsistent with, the best interests of [Holdings].
The court summarized:
In light of these provisions, the only duties owed by Holdings GP flow from (i) contractual standards set forth in the Holdings LP Agreement and (ii) the implied covenant of good faith and fair dealing. The complaint does not identify any provision of the Holdings LP Agreement that the Proposed Transaction might violate. It relies solely on the implied covenant.
The court might have filled in in protection for the limited partners via narrow interpretation of the agreement and the implied contractual covenant of good faith and fair dealing. This would be consistent with the approach used in earlier cases like Miller, discussed above. Indeed, the plaintiff argued in Lonergan for application of a Revlon analysis and for broad disclosure duties. The court theoretically could hold that the agreement could preclude these duties only by explicit provisions and not by a blanket waiver of duties. However, the court declined the invitation (footnotes omitted):
When parties exercise the authority provided by the LP Act to eliminate fiduciary duties, they take away the most powerful of a court’s remedial and gap-filling powers. As a result, parties must draft an LP agreement as completely as possible, and they bear the risk of incompleteness. If the parties have agreed how to proceed under a future state of the world, then their bargain naturally controls. But when parties fail to address a future state of the world-and they necessarily will because contracting is costly and human knowledge imperfect-then the elimination of fiduciary duties implies an agreement that losses should remain where they fall. After all, if the parties wanted courts to be in the business of shifting losses after the fact, then they would not have eliminated the most powerful tool for doing so.
Respecting the elimination of fiduciary duties requires that courts not bend an alternative and less powerful tool into a fiduciary substitute. * * *To the extent the complaint seeks to re-introduce fiduciary review through the backdoor of the implied covenant, it fails to state a colorable claim.
The bottom line is that, as Congress and the SEC seek increase regulation of corporate governance through Dodd-Frank, Delaware is going in the opposite direction through uncorporations. There was a recent glimmer that Delaware might be up for a direct fight: in Parkcentral Global, L.P. v. Brown Inv. Management, L.P., 1 A.3d 291 (Del., 2010) the Delaware Supreme Court held that limited partners’ right of access to partnership books under Delaware law was not preempted by federal financial privacy regulations.
These cases potentially make the uncorporation an escape hatch for firms seeking a way out of Dodd-Frank. If they choose to use it, we might see a rather interesting confrontation between Delaware and the federal government.
Grant Hayden and Matt Bodie review my Rise of the Uncorporation in a forthcoming Michigan Law Review. Here’s the abstract of their article, The Uncorporation and the Unraveling of ‘Nexus of Contracts’ Theory:
This is a review of The Rise of the Uncorporation, by Larry E. Ribstein (Oxford University Press 2010). The Rise of the Uncorporation gives a compelling account of the increasing reliance on business forms other than the corporation. These new organizational forms – such as limited liability companies, limited liability partnerships, partnerships, and the like – give businesses greater freedom to structure themselves in ways that best facilitate their particular needs. And this, according to Ribstein, is an unqualified good, for it allows firms to operate more efficiently than if they were forced to assume an intensely regulated form.
Like most stories, though, this one has a heavy, and here it is the corporation. The corporate form, which dominated the landscape for much of the twentieth century, is contrasted with the uncorporation and presented as the product of forced, not free, choice. This is, perhaps, the most surprising (and welcome) aspect of the book, for the corporation has long been theorized as a product of contractual freedom and championed for its resulting efficiency. Now that we (with Ribstein’s help) have dispensed with the myth that the corporation is merely a nexus of contracts, we can focus our attention on the significant role that government plays in all forms of organizational form, corporate and otherwise.
More from the text:
Ribstein‘s narrative is a fascinating one. It takes the traditional law and economics story of the corporation and turns it on its head. Instead of seeing the corporation as the hero of our political economy, Ribstein casts it as the villain—or at least, Frankenstein‘s monster: a brutish creature that means well but cannot help itself from wreaking havoc. And Ribstein is quite clear that this creature was not the result of market adaptation through private agreements. No, this monster is a creation of the state—if anything, the market was forced to adapt to what the government had wrought. Now that the uncorporate hero has arrived on the scene, the economic potential of free organizational forms will be unleashed.
I have frequently discussed the ongoing jurisprudential drama in Delaware on how firms can avoid fiduciary duties.
The basic setup here is that Delaware allows LLCs and other unincorporated firms to completely eliminate fiduciary duties. But they have to do it carefully.
Here’s my most recent discussion of the state of play on what that means:
As I discussed recently, Delaware law * * * imposes an obligation of clear drafting of fiduciary waivers in order to take advantage of the statutory license to contract freely. See Ribstein & Keatinge §9:4, The Uncorporation and Corporate Indeterminacy, DirecTV Latin America, LLC v. Park 610, LLC, 2010 WL 305201 at *27 (S.D.N.Y., January 26, 2010) (Del. law), Kelly v. Blum, 2010 WL 629850 at *10, n. 70 (Del.Ch., February 24, 2010), and Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del.Ch., April 20, 2009).
One big question is whether the parties have to explicitly negate fiduciary duties, or whether it is enough to include language that clearly defines a non-fiduciary duty, without negating the default fiduciary duty.
A recent opinion by VC Strine is illuminating on that subject. Francis Pileggi gives his usual good analysis of Related Westpac LLC v. JER Snowmass LLC, C.A. No. 5001-VCS (Del. Ch. July 23, 2010). The case involved the frequent situation of active operating and passive financing members who disagree about the future of the business – the operator wants to push ahead, the investor wants to stop funding the venture. The court held that the investor did not breach contractual, good faith or fiduciary duties by declining to continue to contribute capital and by exercising his voting power. Mr. Pileggi cites the relevant language in the opinion, which I’ll repeat here (footnotes omitted):
The Operating Agreements represent an example of the contractual freedom parties can use under our law to craft an approach to operating an entity that fits their own needs. When, as the parties here did, they cover a particular subject in an express manner, their contractual choice governs and cannot be supplanted by the application of inconsistent fiduciary duty principles that might otherwise apply as a default.
Now some factual background on the agreements, from the opinion, again footnotes omitted:
The Operating Agreements make plain that JER Snowmass’s right to refuse to consent to a Major Decision that constitutes a Material Action was unqualified by any reasonableness condition. They do so by plainly stating that the approval of plans submitted by the Operations Manager was not to be “unreasonably withheld or delayed, except with respect to JER Snowmass, to the extent the modification constitutes a Material Action.” Material Actions are defined as anything that would “require additional Capital Contributions” or “involve any material change in the budget … or any line item therein.” Thus, as to Material Actions, JER Snowmass was clearly free to give or withhold its consent in its commercial interest. By contrast, the Operating Agreements make clear that JER Snowmass could not “unreasonably with[o]ld” consent on a range of other matters including taxes, terms of a “co-list” arrangement, and the removal of Westpac Investments LLC as the “Operations Manager” of Related.
The Operating Agreements also provide that the Operations Manager may issue capital calls to members. Under the Operating Agreements, “if any Member is required … to provide Additional Funds to the LLC[s] and shall fail to do so, such Failing Member’s sole liability, and the Contributing Member’s sole remedy, shall be expressly set forth in [the Operating Agreements] … [and][n]o Member … shall have any personal liability to provide such Additional Funds.” That remedy provides that the issuing member can choose to “either notify the other members that such Contributing Member is withdrawing such contribution from the LLC[s] … or … agree to contribute an amount equal to the Failing Member’s Default Amount.”
The relevant issue involved a material action as to which the agreement made clear that the member was free to withhold consent even in its own commercial interests.
All of this sounds unremarkable, except for the fact that there was no explicit fiduciary waiver. To see why that matters, let’s go back to my Indeterminacy article, linked above (footnotes omitted):
In Miller v. American Real Estate Partners, Vice Chancellor Strine refused to hold that the agreement authorized the general partner to invest partnership funds to protect his own venture instead of pursuing investments that would be less risky and more profitable for the partnership. No. Civ. A. 16788, 2001 WL 1045643, at *10–11 (Del. Ch. Sept. 6, 2001). The agreement gave the general partner full, exclusive and complete discretion to manage and control the business and affairs of the Partnership, to make all decisions affecting the business and affairs of the Partnership, and to take all such actions as it deems necessary or appropriate to accomplish the purposes of the Partnership as set forth herein. The agreement also provided:
Whenever in this Agreement the General Partner is permitted or required to make a decision (i) in its “sole discretion” or “discretion”, with “absolute discretion” or under a grant of similar authority or latitude, the General Partner shall be entitled to consider only such interests and factors as it desires and shall have no duty or obligation to give any consideration to any interest of or factors affecting the Partnership, the Operating Partnership or the Record Holders, or (ii) in its “good faith” or under another express standard, the General Partner shall act under such express standard and shall not be subject to any other or different standards imposed by this Agreement or any other agreement contemplated herein.
Vice Chancellor Strine held that the agreement not only failed explicitly to preclude the application of default fiduciary duties, but affirmatively revealed an intention to include such duties because the parties used a popular form but deleted language explicitly preempting default duties. The court also noted references to default fiduciary duties in the registration statement used to sell the partnership interests. Preemption of fiduciary duties therefore was not “plain” enough under Sonet, and so default substantive fairness and the duty of loyalty applied.
So VC Strine may have at least slightly shifted his position in the last decade to no longer require an explicit negation of fiduciary duties. Language inconsistent with the parties’ intent to impose fiduciary duties will be enough.
The cases, however, differ in a few respects. The most important difference is that Miller involved a general partner of a limited partnership – that is, a party that clearly had default fiduciary duties. Related Westpac involved a mere non-managing member. In my theory of fiduciary duties, fiduciary duties necessarily accompany open-ended management power. Therefore, while there were fiduciary duties that needed clearly to be negated in Miller, there was arguably no such duty to negate in Related Westpac. Could this explain VC Strine’s willingness in the later case to hold the duty negated without an explicit disclaimer?
The bottom line is that there’s still confusion in the Delaware cases not only about how to negate duties, but what must be negated. I’m awaiting further developments.
Meanwhile, I wonder when the drafting technology in Delaware will rise to the level of taking care of these problems. Why can’t the parties to sophisticated LLCs take the seemingly small extra step of explicitly defining and negating their duties?