Archives For uncorporations

LLCs vs. corporations: explaining state variations in formations

Larry Ribstein —  17 July 2011

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  There is also an unpublished study to which our article is in part a response by Dammann & Schündeln (D & S).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.

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Ribstein & Lipshaw Unincorporated Business Entities 2011 Supplement

Larry Ribstein —  2 July 2011

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.

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The return of privlic equity

Larry Ribstein —  26 June 2011

It’s been over four years since the heyday of the last boom when I first discussed what I called “privlic equity” in an article about Blackstone’s proposed IPO.

So here we are post-bust, and according to the WSJ, they’re baack:

Apollo Global Management LLC became a public company in late March. Last year, KKR & Co. began trading on the New York Stock Exchange. * * * There is more to come. Oaktree Capital Group LLC is planning to sell $100 million of shares, while private-equity powerhouse Carlyle Group LLC is expected to come public in the next six months or so. Meanwhile, hedge-fund investor William Ackman is expected to sell public shares of a new hedge fund.

For those who were skeptical about this business form back in 2007, it’s worth noting that “skeptics acknowledge there is little evidence that being public crimps returns. Blackstone recently raised a $15 billion new fund despite the rough economic period.”

Some may wonder why “private equity” wants to go public.  The WSJ story points to the “irony. . . that many private-equity firms tell potential acquisition targets that becoming private through a sale to these firms will allow their businesses to prosper.” The article ineptly responds by parroting the privlic equity hype that “operating privately works best for companies undergoing change, but their investment businesses already are strong and can thrive as public companies.” Yeah, whatever.

I have a more cogent explanation, which I’ve discussed in several places, including the University of Chicago Law Review and my book, Rise of the Uncorporation.  I argue that the important feature of what I call “uncorporations,” including private equity firms like the ones noted in the WSJ article, is not whether they’re public or private but their form of governance. In a nutshell, uncorporations substitute partnership-type incentives for corporate-type monitoring.  The elements of partnership-type governance include making managers true owners and giving the owners greater access to the cash.  This can make sense for both publicly and privately held firms.

Here, for example, is my description of Blackstone in the Chicago article (304-05, footnotes omitted):

[T]he owners of the managing general partner of the publicly traded Blackstone Group own equity shares in the funds and will continue to receive directly a share of the carry. The Group, in turn, owns controlling general partnership interests in the funds. As in other publicly traded partnerships, taxing earnings, whether or not distributed, to the owners should make them more averse than corporate shareholders to earnings retention. Managers who retain earnings on which the unitholders are taxed are likely to be judged harshly in the capital markets and thus face constraints on future capital-raising.

As a tradeoff for partnership discipline and incentives, “privlic” equity firms eliminate the monitoring mechanisms that characterize the corporate form. The Blackstone Group prospectus thus correctly calls itself “a different kind of public company.” Blackstone Group unitholders get almost no formal control rights. The LLC that manages the Group is controlled by a board elected by the LLC members, not by the Group or its unitholders. The prospectus makes clear that the unitholders “will have only limited voting rights on matters affecting our business and . . . will have little ability to remove our general partner.”

Privlic equity firms also sharply restrict managers’ fiduciary duties. For example, The Blackstone Group limited partnership agreement provides that the general partner may make decisions in its “sole discretion” considering any interests it desires, including its own. The general partner may resolve any conflict of interest between the Group and the general partner as long as its decision is “fair and reasonable.” A unitholder challenging the decision has the burden of proof on this issue, and a decision approved by independent directors is conclusively deemed to be fair and reasonable and not a breach of duty. In addition, since the Group is a Delaware limited partnership, courts are likely to enforce these limitations on fiduciary duties.

This uncorporate structure is not for all firms.  As discussed in Rise of the Uncorporation, the form makes a lot of sense for the standard publicly traded partnership, which manages “natural resources, real estate, and other properties as these firms can commit to making distributions without compromising long-term business plans.” It may make less sense for more entrepreneurial firms that have a lot of business opportunities and need to give their managers control of the cash.  Private equity is somewhere in between.

My discussion of privlic equity in this early-2010 book ended on a bleak note appropriate to the times, noting that “privlic equity shares have melted down with the rest of the market” and “the  possibility that the firms will repurchase their newly cheap shares and become private again. It is not clear whether the privlic model ultimately will be seen as a short-lived fad of the financial boom, will make a comeback when the market does, or be seen as a transitional structure that will give rise to the publicly held uncorporation of the future.”

I also suggested that privlic equity might be the harbinger of a “convergence of corporate and uncorporate forms or some sort of reconfiguration of the divisions among large firms.”

It’s not clear from the WSJ article exactly what is happening in this resurgence of privlic equity. Among other things, I don’t know whether the new IPOs will use Blackstone-type techniques to avoid restrictions on partnership taxation of publicly traded partnerships, or will be tax corporations.  If the former, it would seem the firms will face pressures to make distributions, since the owners will be taxed on the income whether distributed or not.  Yet the WSJ article suggest the firms will have corporate-type “capital lock-in” (to use Margaret Blair’s term): “Mr. Ackman’s IPO would give him capital for investments that can’t be yanked by investors if they sour on him or the market.” 

The WSJ article indicates there’s still confusion about what’s going on with these firms.  But since going privlic may be here to stay, it’s time to try to understand their financial significance.  I suggested in the conclusion of Rise of the Uncorporation that this could be the harbinger of a new type of hybrid firm:

For example, regulators may insist that firms adopt uncorporate discipline before they can waive such important corporate features as shareholder voting and fiduciary duties. Also, publicly traded uncorporations arguably have the same need for inflexible rules as publicly held corporations. Regulators therefore might mandate features such as limited terms or regular distributions for firms that seek to opt out of standard corporate features. In short, the publicly traded partnership could become a distinct type of firm that straddles the corporate-uncorporate boundary.

In other words, we might finally have to face the failure of standard corporate-type governance and the need to replace it with something that works better than shareholder democracy and the business judgment rule.

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Ralph Nader, investor

Larry Ribstein —  24 June 2011

So how is Ralph Nader, the former scourge of GM and all things corporate, doing with his retirement fund?  The WSJ takes a peak:

In 2000, his Cisco stake was valued at $1 million, about one-third of his $3 million portfolio. As Cisco’s share price swooned in the years that followed, it has represented a smaller slice of his overall investment portfolio, which he said still is valued at about $3 million. At Thursday’s closing price, his stake is valued at $278,460.

I guess Nader is learning about diversification the hard way.

Like Frank Easterbrook, Michael Jensen and Mike Milken, among others, Nader seems to understand the agency costs of cash retention:

In a private letter to Cisco Chief Executive John Chambers sent June 13, Mr. Nader blasted the CEO for not doing enough to lift shares of the technology company and said “it is time for a long overdue Cisco shareholder revolt against a management that is oblivious to building or even maintaining shareholder value,” according to the letter. * * * Among the specific actions Mr. Nader suggested in the letter are the distribution of a one-time dividend of $1 a share and an increase in Cisco’s annual dividend to 50 cents from 24 cents. “If they can’t give shareholders value, then they have to give cash,” Mr. Nader said in an interview this week. . .

Nader does have cause for complaint:

Cisco’s shares  * * * are down nearly a third in the past year and are off 75% from their all-time, tech-bubble high. * * * Cisco, like many big tech companies, has been accumulating cash despite its weak growth. It holds $43 billion in cash, nearly half of its market value.

So Cisco is basically a very expensive money market fund.  Or possibly tax shelter, since it says most of the cash is “foreign earnings, which would be subject to taxes if the funds were brought back to the U.S.”

Nader says he’s an “adversary of corporate capitalism” but a “believer in capitalism.” True to form, Nader is thinking about organizing a shareholder revolt. 

But corporate accountability measures don’t necessarily work with cash cows that resist reform.  Nader seems to recognize this in trying to enlist hedge funder Carl Icahn to his cause. 

Yes, what Nader really wants is an uncorporation.

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The uncorporate solution to corporate cash hoarding

Larry Ribstein —  29 May 2011

Jason Zweig wrote Saturday in the WSJ about how companies are hoarding their cash. Microsoft, Cisco, Google, Apple and J & J “added $15 billion in cash and marketable securities to their balance sheets. Microsoft alone packed away roughly $9 billion, or $100 million a day. All told, the companies in the Standard & Poor’s 500-stock index are sitting on more than $960 billion in cash, a record.” The proportion of earnings paid as dividends is at the lowest level since 1936.

What are they planning to do with the money?  Well, MS paid almost precisely all of its additional cash, $8.5 billion, for Skype.  Zweig asks, “[w]as that torrent of cash burning a hole in Microsoft’s pocket?” 

The hoarding may be because firms don’t see opportunities in an uncertain, highly taxed and increasingly regulated economy.  But whatever the reason, Zweig is right in saying, following Benjamin Graham, that if they don’t have good uses for the cash they should give it back to the shareholders. Zweig notes that Graham proposed that investors insist on payouts of inappropriately hoarded cash and set formal dividend policies, with leading companies paying out two-thirds of their earnings.

But managers generally have the final say over dividend policies.  So what to do?  Well, as Henry Manne proposed long ago, takeovers can solve this problem.  More specifically, the kind of takeovers that turn publicly held corporations into private-equity managed uncorporations.  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. 

The uncorporation is not for all firms.  But, alas, it may be for an increasing number of firms, even former growth firms, this economy has beached. 

Meanwhile it would be nice to find away to create the kinds of growing firms that do have opportunities and might actually be able to use the corporate form.

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Taxing big uncorporations

Larry Ribstein —  7 May 2011

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.

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Private equity and financial distress

Larry Ribstein —  7 May 2011

I’ve written often, particularly in my Rise of the Uncorporation, of the upside disciplinary effect of uncorporate management.  This includes the salutary role of private equity (e.g., this recent post). But detractors argue that private equity-backed leveraged buyouts, by replacing equity with debt, make targets vulnerable to the disruption of bankruptcy. 

A recent paper by Stromberg, Hotchkiss and Smith, Private Equity and the Resolution of Financial Distress (also in the Harvard blog), relates to that claim.  Here’s the abstract:  

In order to understand the role of private equity firms in the restructuring of financially distressed firms, we examine the private equity ownership of 2,156 firms which obtained leveraged loan financing between 1997 and 2010. The economic downturn beginning in 2007 is associated with a marked increase in defaults of these highly leveraged companies; approximately 50% of defaults involve PE-backed companies. However, PE-backed firms are no more likely to default during this period than other firms with similar leverage characteristics. But defaulting firms that are private equity backed spend less time in financial distress and are more likely to survive as an independent reorganized company versus being sold to a strategic buyer or liquidated. The ability to restructure more efficiently seems to be affected by the PE sponsor’s financial as well as reputational capital. In contrast, recovery rates to junior creditors are lower for PE-backed firms.

In other words, analysis of private equity needs to look beyond the debt to the benefits of uncorporate governance in managing that debt.

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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.

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Chandler’s departure and the future of uncorporations

Larry Ribstein —  26 April 2011

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.

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Corporate governance, incentive compensation and the uncorporation

Larry Ribstein —  7 April 2011

Acharya, Gabarro and Volpin’s Competition for Managers, Corporate Governance and Incentive Compensation has interesting insights and data on both corporate governance and executive compensation debates.  In the final analysis, I think it’s most interesting for what it says about the uncorporation.  Here’s the abstract: 

We propose a model in which firms use corporate governance as part of an optimal compensation scheme: better governance incentivizes managers to perform better and thus saves on the cost of providing pay for performance. However, when managerial talent is scarce, firms compete to attract better managers. This reduces an individual firm’s incentives to invest in corporate governance because managerial rents are determined by the manager’s reservation value when employed elsewhere and thus by other firms’ governance. In equilibrium, better managers end up at firms with weaker governance, and conversely, better-governed firms have lower-quality managers. Consistent with these implications, we show empirically that a firm’s executive compensation is not chosen in isolation but also depends on other firms’ governance and that better managers are matched to firms with weaker corporate governance.

Some particularly interesting points in the paper:

  • Pay-for-performance compensation is greater in firms with weaker governance, thus indicating that these are substitutes.  Another reminder of the dangers of putting on blinders when evaluating and regulating corporate governance.
  • Executive compensation depends not just on a firm’s own governance, but on the governance of the firm’s competitors of comparable size.
  • Managerial quality also depends on firm governance. When a firm gets a better CEO, the quality of its governance decreases, and vice versa,

This paper shows that corporate governance and executive compensation are much more complicated not only than regulators’ simplistic assumptions, but even than some leading theories, such as Gabaix & Landier on the effect of firm capitalization (Why Has CEO Pay Increased So Much?, 123 QJE 49 (2008)) and Hermalin & Weisbach on CEO power (Endogenously Chosen Boards of Directors and Their Monitoring of the CEO, 88 American Economic Review 96 (1998)).  The authors note that the offsetting effects of governance and managerial quality “may explain why it has proven so hard so far to find direct evidence that corporate governance increases firm performance.”

Of particular interest for my work is this final observation in the paper:

A notable exception is the link between governance and performance found in firms owned by private equity: Private equity ownership features strong corporate governance, high pay-for-performance but also significant CEO co-investment, and superior operating performance. Since private equity funds hold concentrated stakes in firms they own and manage, they internalize better (compared, for example, to dispersed shareholders) the benefits of investing in costly governance. Our model and empirical results can be viewed as providing an explanation for why there exist governance inefficiencies in firms with dispersed shareholders that concentrated private equity investors can “arbitrage” through their investments in active governance.

This is another testament to the governance implications of the uncorporation.  For explanations of these implications, see my Rise of the Uncorporation, Chapter 8, and Partnership Governance of Large Firms.

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Posner on corporate fiduciary duties

Larry Ribstein —  30 March 2011

Francis Pileggi brings news of an interesting Posner opinion in CDX Liquidating Trust v. Venrock Associates, (7th Cir. March 29, 2011), a case decided under Delaware law.  As Mr. Pileggi notes, the case held, among other things, that disclosure of a conflict of a director’s interest may “insulate the agreement from attack, but does not, per se, protect the director from a claim for breach of fiduciary duty.”  This is an established principle, but benefits from Judge Posner’s clear articulation.  The case also raises some interesting procedural issues.

The case involved a VC’s (Venrock) bridge loan which provided for a substantial payment to the lender in the event of liquidation that would leave nothing left for the shareholders. As Posner says, “[t]he disinterested directors of Cadant [the borrower] * * * who voted for the loan were engineers without financial acumen, and because they didn’t think to retain their own financial advisor they were at the mercy of the financial advice they received from Copeland [who was a director both of the VC and the borrower] and the other conflicted directors.”

The borrower’s board approved a sale of assets for enough to pay off the creditors and preferred (including the VC) but not the common.  The sale was approved by a simple majority of both common and preferred voting together and the preferred voting separately.  The question is whether the bridge loans were a breach of the VC’s fiduciary duty.  Here’s Posner:

The accusation is that the directors were disloyal. They persuaded the district judge that disclosure of a conflict of interest excuses a breach of fiduciary duty. It does not. It just excuses the conflict. * * *

To have a conflict and to be motivated by it to breach a duty of loyalty are two different things—the first a factor increasing the likelihood of a wrong, the second the wrong itself. Thus a disloyal act is actionable even when a conflict of interest is not—one difference being that the conflict is disclosed, the disloyal act is not. A director may tell his fellow directors that he has a conflict of interest but that he will not allow it to influence his actions as director; he will not tell them he plans to screw them. If having been informed of the conflict the disinterested directors decide to continue to trust and rely on the interested ones, it is because they think that despite the conflict of interest those directors will continue to serve the corporation loyally.

I agree that disclosure of the conflict was not enough to eliminate the breach of fiduciary duty issue.  But should it be enough for liability to show that the disinterested directors relied on the interested one?

Well, the real problem here is that the trial judge dismissed as a matter of law without getting a jury determination of the issues.   Posner has some comments about that which get into nuances of procedure often ignored in teaching (and practicing) corporate law:

We note the questionable wisdom of granting a motion for judgment of law seven weeks into a trial that was about to end because the defendants declared that they were not going to put in a defense case. Reserving decision on the motion might have avoided a great waste of time, money, and judicial resources, as the case must now be retried from the beginning.

And because it will be retried Circuit Rule 36 directs that a new judge be assigned unless the parties stipulate otherwise. Either way the parties and the district court may want to rethink how the case should be submitted to the jury. The original trial was bifurcated along traditional lines, separating liability from damages, and with regard to liability for breach of fiduciary duty the proposed jury instructions required the plaintiff to prove duty, breach, causation, and injury. But the burden-shifting structure of the relevant Delaware law—normally applied by Chancery judges—can be difficult for lay jurors to grasp. Although rebutting the application of the business-judgment rule is similar to proving duty and breach, and proving “entire fairness” is similar to disproving causation and injury, the concepts are not identical. When compensatory damages are sought, proving or disproving that the challenged transaction was made at a “fair price” (evidencing “entire fairness”) might require the same evidence as proving or disproving damages. It may therefore make sense to reconsider on remand whether bifurcating liability and damages is the best approach to take in this case. Bifurcation tailored to the requirements of Delaware law might make the jury’s job easier. One possibility would be for phase one of a bifurcated trial to focus on the plaintiff’s evidence in support of rebutting application of the business-judgment rule and phase two to take up the question of “entire fairness” and, if necessary, damages. But this is a case-management issue, which was not addressed by the parties and is best left to the judgment of the district judge who will retry the case.

More broadly, the incredible uncertainty and complexity inherent inherent in this type of case is an argument for the modern “uncorporate” approach, which favors waiver of all fiduciary duties, including the duty of loyalty, and leaving these issues for custom determination in the agreement.  See my Rise of the Uncorporation, and Uncorporation and Corporate Indeterminacy.

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Death of a big law?

Larry Ribstein —  2 February 2011

The Recorder (HT ATL) asks (concerning W & S’s rolling takeover of Howrey):

Among the unknowns: What will be left of Howrey once lawyers have made up their mind about Winston, and what will happen with Howrey’s debt if most partners who receive offers accept them and no formal merger with Winston is completed? (In typical merger agreements, an acquiring firm would take on the assets and liabilities of the target firm, but it remains unclear whether a Winston-Howrey merger is officially off the table.)

Howrey supposedly has more than $100 million in accounts receivables, which W & S is giving the firm time to collect.  Good luck convincing the recalcitrant clients who are not looking forward to repeat business with Howrey.  

Thus, one consultant told The Recorder: “The work in process and accounts receivable become worth a fraction of what they are on the books.” And a lawyer said:

“If I was a Howrey partner, I wouldn’t be looking to figure out when I’ll get the rest of the money the firm owes me, I’d be looking to see when I have to pay the firm. Look at the Heller, Brobeck and Coudert dissolutions — that’s what happened there.”

This raises two immediate questions.  First, despite Winston’s best efforts to avoid this result, might there be some sort of de facto merger between Winston and Howrey resulting in Howrey’s assets and liabilities carrying over to Winston? I suspect that Winston has covered this base pretty thoroughly, but the whole area of partnership merger is fraught with confusion. See Bromberg & Ribstein on Partnership, Section 7.21.

Second, will the LLP shield protect all the Howrey partners from personal liability for debts in excess of Howrey’s assets?  This is a rather complex subject covered in detail in Chapter 3 of Bromberg & Ribstein on LLPs.

The broader story here is about the swift collapse of big law firms that have no real assets except the lawyers who, not bound by non-competes and no longer personally liable for the firm’s debts, can walk out the door any time.

For a discussion of the general Big Law death spiral, including the specific stories of the particular firms mentioned in above, see my Death of Big Law.

Update: I added the question mark at the end of the title of the post to clarify that I don’t know and am not trying to predict what ultimately will happen to Howrey.

In Corporate & Securities Law ,
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