Facebook and LLCs

Several months ago Gordon Smith posted about a case involving allegations that Facebook's founder, Mark Zuckerberg, committed a variety of wrongs to the founders of a company called ConnectU for which he did some work pursuant to an agreement that might have been an agency or partnership. Gordon thinks the case has interesting implications for the obligations among a firm's founders.

While the case could develop along those lines, right now, as Gordon says, the case is "procedurally muddled." But there is much of interest in that muddle. In ConnectU LLC v. Zuckerberg, 482 F.Supp.2d 3 (D.Mass., 2007), the court dismissed the initial complaint in this case, which was brought by a Delaware LLC that had been formed with no members and no substantive agreement. Members were admitted pursuant to a later operating agreement dated retroactively to the time of formation, as permitted by the applicable Delaware statute (Del. Code Ann. Section 18-201).

The court held that notwithstanding that statute, since there were no members when the complaint was filed, which was between the time of formation and when the operating agreement was entered into, there was no federal diversity jurisdiction: a member-less LLC was not a citizen of any state. The plaintiff has attempted to solve the problem in the case by refiling in the name of ConnectU, Inc., into which ConnectU later merged.

There are several interesting issues here that aren't about the duties of founders or partnership law. First we have the crazy mess of so-called shelf LLCs -- firms created with no members. The problem is that since an LLC by statutory definition has to have members (which goes back to the partnership nature of an LLC), a shelf LLC is not an LLC on formation, as the court held in this case. This case illustrates that if the statutes are going to allow these shelf thingies, they really need to figure out what's happening prior to the admission of members. I discuss this in some detail in analyzing the failings of the Revised Uniform Limited Liability Company Act on this (as well as many other) scores in my Analysis of the Revised Uniform Limited Liability Company Act.

Second, the case illustrates the problem created by the current law of federal diversity jurisdiction, which for unincorporated firms insists on looking through the business associations to the citizenship of the members. As I document in some detail in Ribstein & Keatinge on LLCs, §10:6, this has given rise to an enormous amount of litigation in determining who is a member, and where the member is a citizen. If this limitation on diversity jurisdiction was supposed to relieve the burden on the federal courts, it sure hasn't worked. Even worse, from my perspective, is that this rule has the makings of producing even more federal law on what are basically state issues -- in this case, formation of an LLC. This often carries the cost of creating parallel lines of authority on LLC law, thereby weakening legal predictability.

Third, there's a choice of form issue. Corporations raise less of a diversity jurisdiction problem than partnerships and LLCs because the court only looks to the citizenship of the corporation. So many issues, including the one in ConnectU, won't arise, as I discuss in Important Role of Non-Organization Law:

Making the federal courts less available to non-corporate than to corporate firms could encourage firms to choose one form over another depending on whether they expect to litigate and prefer a particular forum. While diversity jurisdiction is unlikely to be an important choice of form factor, it may be a significant marginal factor when others are closely divided. Firms might prefer state courts for actions between the members because of better developed state law on internal firm governance. But they might prefer a federal court’s protection from local bias if they expect to frequently litigate outside their home states. Conversely, firms might prefer state courts if they expect to litigate mainly in their home states. This analysis suggests that larger interstate firms might want to incorporate from a diversity jurisdiction standpoint because this increases their ability to access federal courts when they need to avoid biased state courts while still being able to use state court for shareholder derivative actions. Also, as with other choice-of-form considerations, factors that encourage clienteles for particular forms can have a feedback effect on the standard form. In this case, diversity jurisdiction might reinforce governance and tax considerations in moving larger firms toward incorporation.

More broadly, this case has implications for the study of business associations.  In corporations the students learn some basic concepts about unincorporated firms, including obligations among founders.  But there's a lot of important detail that the basic course has to omit.  Which is why students really also need Unincorporated Business Entities.

Comments

[Francis Pileggi]

I thought of this post when I was reviewing the most recent changes to the Delaware LLC Act that now require an LLC Agreement in Section 18-201(d) at least to the extent the amendments to Section 18-101(7) and Section 17-101(12) indicate that an agreement will be implied if there is no oral or written LLC agreement. It is not clear what, if any, impact those recent amendments would have had if they applied in the above case, or if they would raise more questions than they answer, but in any event I felt compelled to add this comment to your post. Best regards.