Ideoblog

A few thoughts on LLCs at 20

As I recently reported, Suffolk Law School threw a 20th birthday party for LLCs.  Here's some quick observations from the conference.

First, for those of you who are unconvinced, LLCs are, in fact, a big deal.  For example, Ann Conaway reported on the recent data on Delaware LLCs:  490,000 in all, producing about the same percentage of Delaware's gross revenues as its booming business in big corporations.

Second, LLCs are getting into some very interesting niches.  A good example is non-profits. Bob Keatinge talked about use of LLCs particularly for profit/non-profit partnerships -- firms straddling the line between the profit and non-profit world.  I understand in talking to one of the practitioners in attendance that LLCs are being used to essentially fill the gap left by the states' failure to have separate statutes for charitable and non-charitable non-profits. 

I view this development in LLCs as somewhat ironic. My own theory has been that LLCs and other partnership-type firms actually enhance the profit orientation of firms by enabling more managerial accountability than in corporations. See my Uncorporating the Large Firm. LLCs accomplish this substituting discipline and incentives for monitoring devices such as fiduciary duties.  However, the same ability to modify fiduciary duties lets LLCs accommodate responsibilities to non-owners.  So the non-profit LLC illustrates the dominant characteristic of all unincorporated firms:  flexibility.

Ann Conaway also talked about "series" LLCs -- the device, originated in Delaware, that allows separate entities in one umbrella organization.  This has been considered a rather speculative and niche device -- so arcane that the uniform law commissioners refused to provide for it in the Revised Uniform Limited Liability Company Act.  But did you know that 1% of the 490,000 Delaware LLCs are series LLCs?  5000 firms gets beyond arcane.

All those firms are likely to generate some interesting legal issues.  For example, what do you do with a series that doesn't have a member?  The operating agreement is supposed to allocate all the income, but you can't really allocate to a member-less firm.

The main series question for me is how veil-piercing law applies.  (There was a fair amount of talk at the conference about veil-piercing generally).  This is still an unanswered question. 

I have assumed that a key objective of series provisions was to legislatively clarify that the series are separate and thereby inhibit judicial interference with that separation through veil-piercing.  But I wonder if all of the formalities required to create series don't encourage the courts to pierce when the formalities aren't observed. Or do the provisions in some statutes preventing piercing in LLCs merely for non-compliance with formalities operate to protect series LLCs?  I suppose we'll have to wait for some courts to instruct us.

Finally, there was some discussion in the last panel session about the future of LLCs. The big quesiton is whether abuses of the LLC form might kill the goose that has been laying the golden eggs of flexibility for 20 years. I have expressed my own concerns about abuse of the LLC (see my paper on Reverse Limited Liability).

I've also worried, including in my Uncorporating article linked above, that the spread of the "uncorporation" into the large firm realm might spark an adverse political reaction. I hope not, because I think that's been and promises to be a positive development.

Anyway, there's a lot happening in this realm that, sooner or later, will be big news in the so-called "corporate" world.

The Harvard blog goes uncorporate

I'm trying to broaden the Harvard Law School Corporate Governance Blog's horizons with a post there about uncorporate governance. Check it out.

The battle for the heart of Delaware uncorporations continues

In my Uncorporation and Corporate Indeterminacy, I contrast the indeterminacy of corporate law with the Delaware uncorporate cases, in which “Delaware lawmakers provide substantial coherence by focusing on the parties' contracts.” I backed this up with a detailed analysis of recent Delaware limited partnership and LLC cases.

This is consistent with Delaware Chief Justice Steele’s admonition, in Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 Del. J. Corp. L. 1,4 (2007) that “[c]ourts should recognize the parties' freedom of choice exercised by contract and should not superimpose an overlay of common law fiduciary duties, or the judicial scrutiny associated with them, where the parties have not contracted for those governance mechanisms in the documents forming their business entity.”

This emphasis on the contract is an important part of what I view as the heart of the uncorporation. 

Nevertheless, I worried in my article that "the judicial tendency to apply corporate rules is always lurking and that courts have not yet completely severed the uncorporate cases from corporate indeterminacy."

Recently Chancellor Chandler had an opportunity to come down on the side of applying the contract, in a case I described here. However, in a more recent limited partnership case, discussed here, Vice Chancellor Parsons went out of his way to read a proper purpose requirement for inspecting books and records into a limited partnership agreement that plainly did not have one.

Another shoe dropped Wednesday when Chancellor Chandler, in Fisk Ventures, LLC v. Segal, 2008 WL 1961156 (no link yet) refused to limit LLC members' clear veto power under an LLC agreement. Here’s some of what the Chancellor had to say about the plaintiff’s various attempts to read contractual, good faith and fiduciary duties into a contract that didn’t have any (some footnotes omitted):

The sine qua non of pleading an actionable breach is demonstrating that there was something to be breached in the first place. In other words, before the Court can start worrying about whether or not there was a breach, the Court needs to determine that there was a duty.In the context of limited liability companies, which are creatures not of the state but of contract, those duties or obligations must be found in the LLC Agreement or some other contract.FN34

FN34.See, e.g., Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 DEL. J. CORP. L. 1, 4 (2007) (“I conclude that parties to contractual entities such as limited liability partnerships and limited liability companies should be free-given a full, clear disclosure paradigm-to adopt or reject any fiduciary duty obligation by contract. Courts should recognize the parties' freedom of choice exercised by contract and should not superimpose an overlay of common law fiduciary duties....”).

* * * [T]he LLC Agreement endows both the Class A and Class B members with certain rights and protections. In no way does it obligate one class to acquiesce to the wishes of the other simply because the other believes its approach is superior or in the best interests of the Company. To find otherwise-that is, to find that the Court must decide whose business judgment was more in keeping with the LLC's best interests-would cripple the policy underlying the LLC Act promoting freedom of contract.FN35

FN35.See Larry E. Ribstein, The Rise of the Uncorporation 3 (Illinois Law and Economics Research Papers Series, Research Paper No. LE07-026, 2007) (“[U]ncorporate firms have flexible control rules and permit contractual modification or even elimination of fiduciary duties.”), available at http://ssrn.com/abstract=1003790; Sandra K. Miller, The Role of the Court in Balancing Contractual Freedom with the Need for Mandatory Constraints on Opportunistic and Abusive Conduct in the LLC, 152 U. PA. L.REV. 1609, 1616-17 (2004) (“The Delaware LLC statute stands out, however, for its lack of mandatory rules and its express policy to ‘give maximum effect to the principle of freedom of contract.’”); Larry E. Ribstein, Fiduciary Duty Contracts in Unincorporated Firms, 54 WASH. & LEE L.REV. 537, 594 (1997) (recognizing that the Delaware LLC act allows parties “to alter default duties in their agreements as long as they are held to good faith compliance with their contracts”). *

Although occasionally described in broad terms,the implied covenant is not a panacea for the disgruntled litigant. In fact, it is clear that “a court cannot and should not use the implied covenant of good faith and fair dealing to fill a gap in a contract with an implied term unless it is clear from the contract that the parties would have agreed to that term had they thought to negotiate the matter.”Only rarely invoked successfully, the implied covenant of good faith and fair dealing protects the spirit of what was actually bargained and negotiated for in the contract.

* * * [T]he Genitrix LLC Agreement eliminates fiduciary duties to the maximum extent permitted by law by flatly stating that members have no duties other than those expressly articulated in the Agreement. Because the Agreement does not expressly articulate fiduciary obligations, they are eliminated. * * *

Bottom line: Chief Justice Steele and Chancellor Chandler have made it clear that the contract controls uncorporations in Delaware. Hopefully the rest of the Delaware judiciary will get on board.

There is, however, one possible caveat to this analysis.  Chief Justice Steele suggests that the courts should not add duties to the contract.  Chancellor Chandler, saying that fiduciary duties not stated are eliminated, was also at pains to note that the agreement had eliminated them.  So what result here without an express elimination of duties? 

As discussed in my article linked above and in other writings, the Delaware cases have made it clear that the parties must contract carefully to waive fiduciary duties, as the parties did in Fisk. In other words, courts will add fiduciary duties to the express contract if the parties don't negate them. This can be reconciled with CJ Steele's admonition in this way: in the absence of contrary agreement, the fiduciary duties are part of the Delaware standard form contract, consisting of statutory and common law default rules. This seems sensibly consistent with the parties' usual expectations.

Update:  Here's Francis Pileggi's thorough analysis.

Obama vs. small firms

Steve Bainbridge comments on a proposal touted by Obama (one of its sponsors) that “would require the States to obtain beneficial ownership information for the corporations formed under their laws and to provide access to this information to law enforcement upon receipt of a subpoena or summons.” This is supposed to stop the misuse of business associations to engage in illegal activity. The co-sponsors are Carl Levin and Norm Coleman.

Steve wisely points out that this SOX-on-stilts would (perhaps unconstitutionally) place huge unfunded burdens on states; impose still more regulatory burdens on small firms – specifically, firms too small to have to register under the securities laws; and can be easily evaded, as by setting up offshore trusts (which, I would add, would push firms further out of regulatory reach).

Although this is an idiotic proposal, I can’t say that I oppose it because it would create a vast demand for my expertise on non-corporate entities. If the proposal reaches only corporations, LLCs and lps, for example, what about new types of entities?  If it reaches only entities created by filings, what about partnerships with silent partners? That would seem to be a significant loophole.  But if we try to rope them in, what is a "partnership" for purposes of this law?  In other words, the sponsors seem to believe that the creativity of business people will cease because the lawmakers wish it so.

But the bill would do a great deal of good for one area of the economy that is always looking for a handout -- lawyers. 

A call for papers on unincorporated business entities

This year as chair of the AALS Section on Agency, Partnerships and Limited Liability Companies I'm on a mission trying to get people interested in this area of the law.  Too often the business associations area is basically corporate law with a little agency and partnership thrown in. But as I've said in many ways and venues, this area is too important both intellectually and for training our students to be marginalized in this way.

Focusing on the theory, I've found a number of important implications from expanding my horizons to include unincorporated firms.  Among other things:  how many business forms should there be?  what are the implications of extending the jurisdictional competition data set from corporations to unincorporated firms?  what can we learn about the nature of mandatory and default rules by looking beyond standard-form corporations? 

In that vein, the Section is doing a call for papers this year that is designed to reach not only the usual agency/partnership crowd but also those doing research in corporate and related areas of law.  I hope this call encourages a wide range of papers in what I think is a rapidly growing area of law and scholarship. 

Anyway, here's our call for papers.  Let me have your proposals.

The AALS Agency, Partnerships and Limited Liability Companies Section is calling for papers for the 2009 AALS Annual Meeting in San Diego. We are interested in presentations on the application of modern theories and empirical methods of business associations to agency and unincorporated firms. The program has two goals: First, to show how these theories can be enriched by taking them outside the "box" of corporate law; and second, to show the relevance of agency and unincorporated firms to the mainstream of corporate theory and empirics. A non-exhaustive list of possible topics includes the nature and function of fiduciary duties, agency theory, the role and enforcement of contracts, jurisdictional competition and choice of form, the relationship of federal and state law, jurisprudence, international and institutional comparisons, and legal and economic history.

Please email either a draft paper if available, or if not an abstract and outline, to Larry E. Ribstein, University of Illinois College of Law, ribstein [at] law.uiuc.edu by no later than September 1, 2008.

Calling Doc Bricker

Today's WSJ has a story about the non-liability of cruise ship companies for malpractice by doctors on their ships:

Most ship doctors, despite typically wearing a crew uniform, are classified as independent contractors. . . . That's . . . a likely surprise to many of the millions of cruise passengers who will board ships during the coming peak cool-weather season in the Caribbean. In the eyes of many, the ship doctor is an integral part of the crew, like actor Bernie Kopell's amorous Dr. Adam "Doc" Bricker on the long-running television show "The Love Boat.". . . Cruise companies say it would be unfair to hold them responsible for treatment provided by the medical professionals because they don't oversee a doctor or nurse's medical training and certification. Some of the companies say they include a warning clause to that effect on passengers' tickets.

I haven't read the specific law, but the cruise companies' position arguably squares with the economic rationale for principals' non-liability for torts by independent contractors. Here's Judge Posner in Anderson v. Marathon Petroleum Company, 801 F.2d 936 (7th Cir. 1986):

Generally a principal is not liable for an independent contractor’s torts even if they are committed in the performance of the contract and even though a principal is liable under the doctrine of respondeat superior for the torts of his employees if committed in the furtherance of their employment. The reason for distinguishing the independent contractor from the employee is that, by definition of the relationship between a principal and an independent contractor, the principal does not supervise the details of the independent contractor’s work and therefore is not in a good position to prevent negligent performance, whereas the essence of the contractual relationship known as employment is that the employee surrenders to the employer the right to direct the details of his work, in exchange for receiving a wage. The independent contractor commits himself to providing a specified output, and the principal monitors the contractor’s performance not by monitoring inputs — i.e., supervising the contractor — but by inspecting the contractually specified output to make sure it conforms to the specifications. This method of monitoring works fine if it is feasible for the principal to specify and monitor output, but sometimes it is not feasible, particularly if the output consists of the joint product of many separate producers whose specific contributions are difficult (sometimes impossible) to disentangle. In such a case it may be more efficient for the principal to monitor inputs rather than output — the producers rather than the product. By becoming an employee a producer in effect submits himself to that kind of monitoring, receiving payment for the work he puts in rather than for the output he produces.

Maybe dressing the doctor up in a uniform should provide the basis for estoppel or fraud. But the ticket disclaimer arguably should take care of that. After all, it was enough to make a Washington passenger litigate in Florida in the Carnival Cruise case.

Unincorporated business entities: First in a series

I'm giving increasing attention to the general topic of unincorporated business entities. It was a focus of my work this summer (see The Rise of the Uncorporation, and my substantive analysis and empirical piece on the recent LLC uniform law). Also, this semester I've returned to teaching the course (after being away from it for two years) as a visitor at NYU. And I'm looking toward doing a fourth edition of my casebook, Unincorporated Business Entities, after putting together a longer than usual supplement this summer.

To give my thinking an outlet, I'm planning a series of posts here on the law and pedagogy of the UBE course. Today's question: what's the modern function of the unincorporated business entities course?

My approach to this issue has changed over the years. An important innovation of my Business Associations casebook since the first edition was to integrate agency and partnership with corporate law. This has since become standard practice in "corporations" casebooks. But I started to have serious second thoughts several years ago.  See Corporations or Business Associations?  The Wisdom and Folly of an Integrated Course, 34 Georgia L. Rev. 973 (2000). So now that my view has prevailed, why move away from it?

The quick answer is that the subject has significantly evolved over the last 20+ years, so the course must evolve as well. Though some corporate specialists haven't noticed, this area is way more sophisticated than it was at the time of the "Agency and Partnership" course at the time I first integrated it into Business Associations. The following are some advanced aspects of the topic:

• Connections with such topics as securities regulation, employment discrimination and diversity jurisdiction for choice of form purposes.
• Sophisticated planning to avoid unintentional agency and partnership relationships in complex transactions.
• Law firm economics, recognizing that law firms comprise an increasingly complex type of uncorporation.
• Contracting for fiduciary duties under the flexible but demanding fiduciary duty opt-out rules in Delaware and other uncorporation statutes.
• The diverse and interrelated remedies now available in uncorporations, including arbitration, oppression, derivative and direct suit and accounting.
• Debtor protection aspects of uncorporations and their interrelation with bankruptcy (on this, see my Reverse Limited Liability and the Design of Business Associations, 30 Del. J. Corp. L. 199 (2005).
• Management and control agreements.
• Buyout agreements and other alternatives to dissolution such as the I-cut-you-choose variation discussed in §12.11 of my UBE casebook.
• Complex share transfer restrictions playing on variations of the uncorporation bifurcation of financial and management rights (see the Asian Yard case in §7.02 of my casebook).
• The emerging law of LLC veil-piercing (no, it's just not the corporate standard, whatever the language of the opinions might lead you to believe).

All of this just scratches the surface. It follows that the vast majority of existing business organization teaching materials, by offering only the alternatives of a short course on uncorporations buried in the corporations course, or a slightly updated version of the outmoded agency and partnership course, miss the real story of the modern unincorporated business entities course that I try to present in my casebook and supplement.

The basic conundrum, though, is that because of the chaos of the modern corporate law school curriculum, students come into the UBE course with wildly diverse preparation. I deal with this by combining more advanced coverage with enough of the basics so that nobody's left high and dry.

Finally, there's the question of how much coverage in the basic course?  Some continued integration of the subjects is necessary, because uncorporations are too important to modern business law practice to be simply left out of the basic course.  (Indeed, if I had to choose, I might choose to leave out corporations.)  But there's something to be said for a skeletal presentation whose main function is to prepare the way for more advanced coverage, rather than risking conveying a false impression of adequate coverage. 

Hopefully all this will become clearer in subsequent posts in this series. Comments from both students and teachers are welcome.