Archives For unincorporated business entities

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

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.

It is well known that Delaware unincorporated entity statutes (e.g., 6 Del. Code Section 18-1101) permit the waiver of all fiduciary duties, not only of care, but also of loyalty.  Now along comes Lyman Johnson, a respected corporate scholar, to argue, in Delaware’s Non-Waivable Duties that those statutes violate the Delaware constitution (HT Pileggi). 

Johnson argues, in a nutshell, that whatever the statute says, the Delaware Chancery Court has inherent constitutionally-conferred equitable jurisdiction to decide the issue of enforceability of fiduciary waivers for itself, de novo, which neither a contract nor the legislature can remove.  Chancery judges cannot avoid their responsibility by “blithely” referring to an agreement or statute. 

I’m not persuaded.  It would take a long article to detail my objections.  Luckily I’ve written several on point.  Johnson cites two of my articles, from 1993 and 1997.  But I’ve written a lot since then, particularly on the issues Johnson covers.   See, e.g., The Uncorporation and Corporate Indeterminacy, The Rise of the Uncorporation (particularly Chapter 7) and many blog posts. 

The bottom line is that the courts have made their own analysis, taking the legislature’s judgment into account.  Johnson doesn’t like the tool the courts have used in many of these cases – that is, the implied good faith covenant, which he characterizes as an “untried concept” the courts have attempted to “clumsily retool.”  But he cites only a corporate case (Nemec v. Shrader, 991 A.2d 1120 (Del. 2010)), ignoring the sophisticated application of this doctrine in unincorporated cases (see, e.g., the article and book cited above and this recent blog post).

Johnson doesn’t seem to argue with the proposition that the courts could decide to accept the legislature’s judgment as to the enforceability of fiduciary waivers, which is what they’ve done.  His problem is that he doesn’t agree with their decision. He’d like them to make a “context-specific inquiry” as to “the degree of moral and commercial repugnance of the managerial behavior, the experience and sophistication of the Members, and the financial and strategic significance of the challenged dealings for the overall welfare of the LLC.”  He wants courts to consider not only on the parties’ interests, but also “the ramifications for business dealings more generally, the overall state of business morality being an important and legitimate societal concern.”

What about freedom of contract?  Johnson doesn’t say that no contract is safe — just those in firms, because they’re “creatures of statute”  and privileged legal “persons” with constitutional protections (citing, of course, Citizens United v. Federal Election Com’n., 130 S. Ct. 876 (2010)).  But now we’ve obviously come a long way from a constitutional argument based on equity jurisdiction.  And statutory-creation and “legal person” arguments, questionable in general for corporations, are particularly dubious for unincorporated firms, as I’ve discussed at length, most recently throughout my Rise of the Uncorporation.  [And, as I’m arguing in a forthcoming article, those arguments have little to do with Citizens United.]  There’s no way around the fact that corporations and uncorporations are fundamentally contracts.  Merely because they can be regulated does not make them not contracts – many relationships that are clearly contractual are also highly regulated.   See, e.g., Butler & Ribstein, Opting Out of Fiduciary Duties:  A Response to the Anti-Contractarians, 65 Washington Law Review 1 (1990).

Even Johnson recognizes the appropriateness of courts’ taking into account “the desirability of greater certainty and determinacy in intra-firm relations, and on allowing passive investors to exchange the possibility of greater risk from broad waivers for other perceived benefits.”  He qualifies this by saying “[i]nvestors customarily do not bargain for betrayal; at least not all of them do all of the time.”  But this is a judgment about what investors actually are contracting for – a judgment that courts, in fact, make repeatedly in construing uncorporate contracts under Delaware’s freedom of contract provision, as discussed in the sources cited above.

Johnson is concerned that “[t]here are well-recognized shortcomings with much ex ante bargaining,” including lack of sophistication, foresight and completeness.  Yes, contracts are imperfect.  But the parties, courts and legislatures do take this into account.  Again, this is policy, not constitutional law. 

Nor is it fiduciary law.  As I discuss extensively in Are Partners Fiduciaries, the fiduciary relationship depends on the nature of the duty undertaken, not on the parties’ relative bargaining positions. Perhaps courts should take the parties’ bargaining positions into account when enforcing waivers, but that’s just because it’s a contract, not because it’s a fiduciary relationship.

Johnson is concerned that Delaware’s uncorporate freedom of contract doesn’t take account of some types of fiduciary relationships.  The problem is that the examples he gives are not fiduciary relationships (see, again, Are Partners Fiduciaries?) For example, he’s concerned about whether a waiver would cover a breach of fiduciary duty by a promoter in connection with formation.  But as I wrote last summer, this isn’t properly a fiduciary duty.  He’s concerned about duties to creditors.  Again, not fiduciary.  See also Ribstein & Keatinge on LLCs, §9:1, n. 1.

Obviously this is a provocative and interesting article.  I’m glad Lyman wrote it.  I’m particularly happy to see somebody reflecting deeply on fundamental issues of uncorporate law.  I don’t expect Delaware to suddenly forfeit its strong advantage in uncorporate law based on this article.   I elaborate on the paper because it reflects a dying gasp of anti-contractarian thought.  Fortunately we have moved beyond these arguments.  The result is far from a catastrophe of helplessly skinned investors, but a productive movement toward expert judging and more careful and sophisticated ex ante contracting.  The biggest failing of this article is that it is firmly anchored in the past – to some extent a distant past.  Time to move on.

I’ve argued, e.g., in Rise of the Uncorporation, that a reason why the uncorporation beats the corporation for some types of firms is the high-powered incentives these firms offer their managers.  Sometimes the incentives may not be obvious because percentages, e.g., for “carried interest,” seem not to vary much across firms.  But that can be deceiving because it overlooks an important form of compensation – future fund flows to successful managers. 

Chung, Sensoy, Stern and Weisbach have some important evidence of this in their Pay for Performance from Future Fund Flows: The Case of Private Equity.  Here’s the abstract:

Lifetime incomes of private equity general partners are affected by their current funds’ performance through both carried interest profit sharing provisions, and also by the effect of the current fund’s performance on general partners’ abilities to raise capital for future funds. We present a learning-based framework for estimating the market-based pay for performance arising from future fundraising. For the typical first-time private equity fund, we estimate that implicit pay for performance from expected future fundraising is approximately the same order of magnitude as the explicit pay for performance general partners receive from carried interest in their current fund, implying that the performance-sensitive component of general partner revenue is about twice as large as commonly discussed. Consistent with the learning framework, we find that implicit pay for performance is stronger when managerial abilities are more scalable and weaker when current performance contains less new information about ability. Specifically, implicit pay for performance is stronger for buyout funds compared to venture capital funds, and declines in the sequence of a partnership’s funds. Our framework can be adapted to estimate implicit pay for performance in other asset management settings in which future fund flows and compensation depend on current performance.

With respect to other possible applications, consider the debate over the compensation of mutual fund managers, which I discuss in my recent article on Jones v. Harris

Peter Mahler discusses a recent NY close corporation case, Pappas v. Fotinas
which he describes as “a thoughtful, well-reasoned decision that sets forth the competing factual narratives and operative legal principles.” I defer to Mr. Mahler’s overall assessment of the opinion, and refer the reader to his detailed discussion of the case. But in one respect I disagree with the court’s reasoning.

In brief, the court declines to condition dissolution on giving defendants the right to buy out plaintiff as required under the NY statute. This might have been ok given that the parties had stipulated they weren’t seeking a buyout. The problem is that the court went further:

Dissolution here, where one of the three shareholders has died, and another has retired because of injury, is consistent with the real-world similarity between closely-held corporations and partnerships. Indeed, the Court noted in its January 2009 Decision After Hearing that, at the time 577 Baltic Street was purchased and the three shareholders commenced business from the property, Mr. Fotinos and Mr. Pappas described the enterprise to third parties as a partnership. Had Messrs. Pappas, Kalogiannis, and Fotinos chosen to conduct business as a partnership, the result would be clear.

It is “elemental” * * * [citing case] that, in the absence of agreement to the contrary, the death or withdrawal of a partner dissolves the partnership by operation of law, and a right to an accounting accrues to any partner or the partner’s personal representative in connection with the winding up of the partnership’s affairs. * * * That the same result obtains here would not offend the purpose or policies of Business Corporation Law § 1104-a.

Repeat after me: A CORPORATION IS NOT A PARTNERSHIP.

Is that clear? If not, let’s do it again:

A CORPORATION IS NOT A PARTNERSHIP.

Got it now?

At one time parties intending partnership nevertheless had to incorporate in order to get limited liability. The courts then had some basis for accommodating what they thought were the parties’ real intentions. Now uncorporations, and particularly the LLC, let the parties to closely held firms choose the business form they want. Indeed, more firms now are organizing as LLCs than as corporations. (For a history of these developments see my Rise of the Uncorporation.)

The upshot is that courts should now respect firms’ choice of form. So if the parties choose to incorporate, a court should not assume that they actually wanted to be anything other than a corporation.

Again, the court may have reached the result in Pappas given the parties’ no-buyout stipulation. But the court’s reasoning perpetuates the “incorporated partnership” confusion that has long infected the close corporation cases.

True, this may hurt some older firms that initially organized as close corporations during the bygone close corporation era and never switched. But ignoring the terms of the applicable statute creates costly unpredictability, particularly in the present age of the LLC.

I soon will be posting a paper that lays all this out. In the meantime, just remember:

A CORPORATION IS NOT A PARTNERSHIP.

Got it?

The latest supplement to Ribstein & Lipshaw Unincorporated Business Entities (4th Edition, 2009) is available online at my website. There you can also find the Supplement to the Teacher’s Manual.

This edition of my long-running casebook and its exhaustive teacher’s manual have been well-received. Ultimately I hope and expect this course will replace the current now-outmoded emphasis in the basic course on big publicly held corporations. Consider the following:

  • LLC formations are now outstripping corporate formations.
  • The unincorporated context inherently provides a better basis for a transactional-oriented course, and our book fully exploits this potential.
  • Law grads need more than ever to be able to hit the practice ground running. Although spending weeks on executive compensation and proxy access might be a nice way to use the headlines to lure the students into the materials, it doesn’t provide the basic training in transactional work that most law graduates. Which
  • Students easily can connect to the intimate and familiar context of the closely held firm, and the rapidly developing law of LLCs provides at least as much intellectual stimulation as the basic course.
  • The contractual framework of the unincorporated course is a good basis on which to build coverage of publicly held firms, which I envision as an upper class elective.

Yes, I know, the basic texts include partnership and LLC coverage. But it’s way too little to give students the training they need in the area.

So catch the wave. Read the book and the supplement.

When I last wrote on the carried interest debate I commented on the NYT’s Andrew Sorkin’s support for characterizing private equity managers’ carried interest as ordinary income rather than capital gains. This is supposed to be a simple change that cuts fat cat fund managers down to size and fairly distinguishes what is essentially compensation for managing a business, just like executives’ stock options, from investment income. But what if the distinction isn’t all that straightforward? I noted that

the fund managers are getting paid for the same sort of acumen or luck that underlies any successful stock market investing.  Why should it matter that they happen to be investing through a partnership, essentially borrowing from the investors and paying them interest in the form of the substantial share of the gains the investors get to keep?  * * * Of course none of these nuances matter if what you really want to do is to punish rich capitalists. 

I also observed that on policy grounds it makes no sense to target this efficient form of compensation. And more ominously I previewed the horse-trading that would accompany this supposedly straightforward change:

The high-powered compensation that Congress is considering attacking is common in venture capital and real estate, two industries whose health is important to any recovery.  * * * If they win their carve-outs, the new tax looks more like Swiss cheese than a return to economic reality. In general, this whole thing looks a lot more complicated than Sorkin would have us believe.

Today’s WSJ makes that clearer:

[The tax change] would be a huge hit to the estimated 6.5 million folks invested in real-estate partnerships, who own assets ranging from a local house to a commercial shopping center. The legislation also potentially hits any partnership invested in certain specified assets, including families who own, say, an auto dealership, fishing boat, construction company or securities. * * *

[B]ecause Democrats chose to target individuals who provide “investment management services,” and because this definition can easily encompass individual family members who manage family projects, entire partnerships could be subject to the higher taxes. Even worse, the higher rates would apply not only to investment gains, but to any gains from the sale of the partnership itself. So the provision would deny families the ability to sell their business at the normal capital gains rate. * * *

Democrats understand this problem, which explains why the House version included a specific carve-out for family farms and ranches held in partnership. The other family partnerships were told to sit back and let the Treasury Department clarify the legislation—and exempt them—via regulation. But if this tax hike is supposed to be about equitable treatment, why exempt some partnerships but not others? * * *

Democrats are rewriting a half century of partnership tax law with no hearings, no analysis and little debate. And they wonder why businesses are creating so few jobs.

In other words, it’s increasingly obvious that this change was never really about fairly treating like income alike but about fleecing fat cats. Indeed, I speculated three years ago that the move was just a way to gin up campaign contributions. Whether or not there was really any theoretical basis for taxing carry like ordinary income (and I’ve been skeptical) mattered little when the proposal got to the Congressional sausage factory. And now we find that it’s not so easy to target the fat cats without causing considerable collateral damage or ending up with even less defensible distinctions than we started with.

Maybe this carried interest move wasn’t such a great idea after all.

The rise of the LLC

Larry Ribstein —  17 June 2010

Last March I discussed a new article by Rodney Chrisman which shows “that LLCs are by far and away the predominant choice of business structure for newly-formed entities.” I noted then the article’s findings that LLCs are increasingly choosing to be taxed as S Corporations, indicating, as I said, that “the increase in LLCs therefore isn’t just a function of their liberation from the corporate tax. It’s about better and more flexible statutes, increased learning of lawyers and business people, and improved case law.” I also observed that “[t]he numbers suggest a shift in transactional work from corporations to uncorporations” and suggested that everybody get their copies of Ribstein & Keatinge, Rise of the Uncorporation
and Unincorporated Business Entities.

Peter Mahler has also caught onto Chrisman’s article. He stresses the “dramatic disparity in the percentage of new filings among certain states.” In particular, look at the states at the bottom:

States w/ Lowest LLC Percentages 2007

Florida

48%

California

41%

New York

40%

Illinois

38%

Mahler wonders why “a state as commercially important as New York [is] lagging so far behind in the LLC movement?” He gives three reasons: First, New York’s costly publication requirement for new LLCs but not corporations, which is basically a tax on business for the benefit of newspapers. Second, the problems with New York law, which I’ve documented several times (e.g.,). Third, New York has failed to update its statute.

Mahler kindly concludes:

If you’d like to learn more about the historical underpinnings and future of the LLC revolution, I highly recommend Professor Larry Ribstein’s new book, “The Rise of the Uncorporation”.

All of the large states suffer from their inability to devote the kind of care and attention to the development of LLC law that Delaware can and must do to maintain its cherished reputation as a center for business association formation. These are all signs of a race to the top in LLC law which Delaware wins because of its high-quality courts and highly responsive bar and legislature. Indeed, Bruce Kobayashi & I show in a recent paper evidence that Delaware’s courts are the key to its success in attracting larger LLCs.

Steve Bainbridge also discusses Chrisman’s article, noting that “[t]hese data reflect a considerable shift away from the corporate form and towards the LLC” and the point I stressed about LLCs electing to be taxed as S Corps, showing that it’s not all about tax.

Bainbridge concludes:

the growing number of cases in which the parties elect the LLC organizational form despite choosing to be taxed as a corporation suggests that the LLC has the potential to invade areas in which most commentators thought the corporate form would remain dominant.

Bainbridge says Chrisman’s data “raise some interesting questions”:

  1. Should corporation statutes concede the nonpublic field to LLCs and focus solely on the problems of public corporations, while providing basic rules for legacy nonpublic corporations?
  2. Should drafters of the Delaware and the Model Act seek to rewrite their statutes so as to provide a corporate form that can more effectively compete with the LLC to be the form of choice for all nonpublic entities? Or, in the alternative, to provide a corporate form that can more effectively compete with the LLC to be the form of choice for certain identifiable categories of nonpublic entities for which the corporate form is especially suited?

My answers are yes and no respectively. The close corporation was a transitional form whose time has passed. Uncorporations have distinct attributes that are suited to closely held firms and that should be presented in distinct statutory forms, as argued at length in my Rise of the Uncorporation, linked above. Corporate statutes should focus on the corporate domain of publicly held operating firms.

Although the corporation is not dead – it is still useful for larger businesses – it is no longer unquestionably dominant, even for large firms as also argued in my book. It’s time for all lawyers to finally learn about the alternatives to incorporation, for which I’ve suggested some reading above. Get to work.

We are very pleased to announce that Larry Ribstein is joining Truth on the Market.  TOTM readers that have been with us from the beginning might recall that we got our start back in 2005 covering at Ideoblog while Larry went on vacation.  For most of our readers, I suspect Professor Ribstein will require no introduction.  For the rest of you, Professor Ribstein is the Mildred Van Voorhis Jones Chair in Law and the Associate Dean for Research at the University of Illinois College of Law, prominent corporate law scholar, author of (most recently) The Law Market, Rise of the Uncorporation,  and Unincorporated Business Entities, and supplier on expert commentary on subjects including corporate law, unincorporated business entities, the death of big law, jurisdictional competition, Sarbanes-Oxley, financial regulation, the criminalization of corporate law, and the portrayal of capitalism in film.  We are thrilled to have Larry join the TOTM team and are looking forward to some exciting collaborations and projects to be announced.  In the meantime, welcome to Larry and Ideoblog readers and look out for his first post coming soon.