Archives For LLCs

Nor are they the redundant fictional entity, “limited liability corporations.” This is a lesson that courts and commentators are finally, slowly, learning.  I highlighted this point last fall in discussing CML V, LLC v. Bax, 6 A.3d 238 (Del. Ch. Nov. 3, 2010), where VC Laster denied a creditor standing to sue derivatively for an LLC, carefully distinguishing LLCs and corporations.  The Vice Chancellor said:

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

Now Joshua Fershee teaches the same lesson in discussing CML in the Harvard Business Law Review Online:  LLCs and Corporations: A Fork in the Road in Delaware? Here’s part of the abstract:

Where legislatures have decided that distinctly corporate concepts should apply to LLCs – such as allowing piercing the veil or derivative lawsuits – those wishes (obviously) should be honored by the courts. But where state LLC laws are silent, courts should carefully consider the legislative context and history, as well as the policy implications of the possible answers to the questions presented. In making such decisions, courts should put forth cogent reasons for their decisions, rather than blindly applying corporate law principles in what are seemingly analogous situations between LLCs and corporations.

The members of an LLC chose the LLC as their entity, and they should enjoy both the benefits and burdens of that choice. Where courts refuse to acknowledge the distinct nature of LLCs, the promoters’ choice of entity is, at least in part, ignored. Vice Chancellor Laster respected the LLC as a form, as well as the legislature’s choice of language in the Delaware LLC Act. Future courts should follow suit.

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.

CALL FOR PAPERS

AALS Section on Agency, Partnerships, LLCs and Unincorporated Associations

2012 AALS Annual Meeting Washington, D.C.

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

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

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

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

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

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

Deadline Date for Submission:   June 1, 2011.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Packers, LLC?

Larry Ribstein —  1 February 2011

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

* * *

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

The court summarized:

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

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

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

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

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

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

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

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

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

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

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

My prior writings relating to this talk include:

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

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

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

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

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

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

Close Corporation Remedies and the Evolution of the Closely Held Firm

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Wilkes court was

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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