ProfessorBainbridge.com

Is Carlyle even less shareholder friendly than the Green Bay Packers? Is that a bad thing?

Although the Green Bay Packers have been called the worst stock in America from a shareholder perspective, it looks like the Carlyle Group is going to take a run at the title. Steven Davidoff reports that:

It is quite possible that the Carlyle Group, the private equity firm that is preparing to go public, is proposing the most shareholder-unfriendly corporate governance structure in modern history.

It starts with the fact that Carlyle is providing its soon-to-be public shareholders with no power over the company. Carlyle shareholders will have no ability to elect directors. Instead, Carlyle intends for the company to be controlled by its management ....

Carlyle has eliminated the fiduciary duties applicable to most corporate directors. Instead, shareholders’ rights will be governed by Carlyle’s partnership agreement, which provides that the board can act in its sole discretion without good faith. If a conflict of interest arises between the shareholders and Carlyle, the managing general partner can obtain approval from a conflicts committee that will be conclusive. The conflicts committee will comprise the independent directors who are appointed by Carlyle. ...

Carlyle is requiring that public shareholders arbitrate all claims against the company. The arbitration must be confidential, meaning no one would ever even know about it unless it was required to be disclosed by another law. Class-action lawsuits are specifically barred.

Technically, of course, Carlyle is a limited partnership not a corporation. According to Carlyle's draft registration statement, Carlyle is going public as a Delaware limited partnership. As i discuss below, Delaware law allows a limited partnership agreement to limit--even eviscerate--fiduciary duties and litigation rights even if the partnership is publicly held. As a legal matter, the analogy to the corporate law rights of shareholders thus is inapt.

Setting aside the issues relating to litigation rights and mandatory arbitration, I'm not especially bothered by the governance provisions of Carlyle's set up. The de jure restrictions on Carlyle investors are analogous to the de facto limits on the powers of outside investors in a company that has a dual class capital structure. Indeed, a perceptive commenter at Davidoff's NY Times blog wrote that:

How is the Carlyle proposal significantly different from the arrangement at the NY Times, which leaves control of the company in the hands of the Sulzberger family even though they no longer own a majority of the stock? 

It's not, IMHO.

As I explained in a blog post commenting on Manchester United's decision to go public with a structure in which the insiders retained control by holding a class of stock having greater voting rights than the class of stock sold to outsiders:

I wrote about dual class stock in my article The Short Life and Resurrection of SEC Rule 19c-4, in which I explained that dual class stock structures established in an IPO (as is the case here) pose few concerns:

Public investors who do not want lesser voting rights stock simply will not buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate. In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off the firm offered in recompense.

Man U public investors will buy their shares knowing that the Glazers are in charge and will remain so by virtue of the dual class stock structure. They will know or should know that dual class stock presents a serious agency cost problem because incumbents who cannot be voted out of office are almost impossible to discipline. Public Man U investors thus implicitly will have accepted whatever trade-offs the deal entailed as appropriate compensation for that risk.

Put another way, the market will price the risk posed by dual class stock, providing investors who buy the lesser voting rights stock with a discount from the price they would have had to pay if they had had full voting rights. Those who buy the stock thus are paying the right price and are fully protected.

I don't see why the same analysis would not apply here.

But what about the mandatory arbitration provision? It's been a while since I taught Securities Regulation, but my recollection is that the SEC takes the position that shareholder rights under the securities laws cannot be subject to mandatory arbitration. Jennifer Johnson and Edward Brunet sharply criticized proposals to change that rule in their article Arbitration of Shareholder Claims: Why Change is Not Always a Measure of Progress:

Two Blue Ribbon business advisory panels have recently proposed arbitration to remedy the problems endemic to shareholder class action litigation. Critics have long assailed shareholder litigation as harmful to firms without conferring a corresponding benefit upon shareholders or the public. Contemporary criticism has focused on the circularity of the remedy in shareholder suits and the charge that even the potential for shareholder litigation harms the competitive edge of the U.S. financial markets. We contend that even accepting these criticisms at face value, arbitration is not the solution. The lure of arbitration as a panacea to cure the ills of litigation is based upon myths concerning modern arbitral realities. First, arbitrators apply substantive and undefined principles of fairness and equity rather than legal rules. Such decisions, once made, are virtually insulated from judicial review. While historically such a system constituted an efficient dispute resolution system between homogenous members of trade groups, modern consumer arbitration rarely takes place between those with any common understanding of applicable norms other than the law. Second, there is a hidden societal cost to moving to an arbitration system to redress securities law claims. Experience teaches us that mandatory arbitration causes the law to atrophy. This trend would be exacerbated in shareholder litigation, which is often based upon implied causes of action, that by their nature depend upon transparent judicial interpretation. Third, modern arbitration will not cure the ills of class action litigation. Arbitration today is no longer particularly quick or efficient in that it has incorporated many of the procedural appendages such as discovery that are common in litigation. However, the procedural protections against the most vexatious lawsuits against corporations would not operate in the world of arbitration. This danger would be intensified if class action arbitrations were allowed. This essay will critique the proposals calling for arbitration of shareholder claims and conclude that arbitration is not an attractive alternative to litigation.

As Lawrence Cunningham has argued, however, the US Supreme Court increasingly "administers a self-declared national policy favoring arbitration." The conflict between those precedents and the SEC's longstanding policy of refusing to allow a registration statement to become effective if the issuer seeks to compel mandatory arbitration of shareholder claims will be brought to a head by Carlyle. If the SEC refuses to let Carlyle's registration statement become effective, presumably Carlyle will seek some form of judicial review. But how would/ should such a claim come out? Let's defer that for a minute.

A separate question is whether state courts would enforce a mandatory arbitration provision insofar as state law-based claims involving such matters as breach of fiduciary duty are concerned. As noted, Carlyle's draft registration statement specifies that Carlyle is going public as a Delaware limited partnership. In an unpublished opinion, Aris Multi-Strategy Fund, LP v. Southridge Partners, LP, 2010 WL 2173839 (Del. Ch. 2010), former Chancellor Chandler enforced a mandatory arbitration clause in a limited partnership agreement and stated that:

... permitting limited partners to contractually agree to arbitrate their statutory rights-rather than assert those rights in court-is consistent with the manner in which Delaware has treated this issue in other contexts. In the corporate context, for example, parties can agree to submit advancement actions under 8 Del. C. § 145 to arbitration, notwithstanding the Court of Chancery's exclusive jurisdiction over section 145 actions.FN4 And in the limited liability company context, parties can agree to submit derivative actions against company management under 6 Del. C. § 18-110(a) and related statutes to arbitration, notwithstanding the Court of Chancery's jurisdiction over such matters.

Does Carlyle being publicly held change that result? I doubt it. In another unpublished opinion, Gerber v. Enterprise Products Holdings, LLC, 2012 WL 34442 (Del. Ch. 2012), VC Noble wrote that:

Our General Assembly, however, has determined that, with a very limited exception, a limited partnership agreement may eliminate the duties that any person may owe to the limited partnership or the holders of the partnership's LP units. See 6 Del. C. § 17–1101(d). That means that a limited partnership agreement may, with the imprimatur of Delaware law, permit self-dealing transactions between a limited partnership and its controller with almost no oversight by this Court. This raises the issue of just what protection Delaware law affords the public investors of limited partnerships that take full advantage of 6 Del. C. § 17–1101(d). If the protection provided by Delaware law is scant, then the LP units of these partnerships might trade at a discount or another governmental entity might step in and provide more protection to the public investors in these partnerships. Those issues, however, are not ones that this Court need or should address. The General Assembly has decided that this Court has only a limited role in protecting the investors of publicly traded limited partnerships that take full advantage of 6 Del. C. § 17–1101(d), and that is a role this Court must accept.

See also Miller v. Am. Real Estate Partners, L.P., 2001 WL 1045643, at *8 (Del. Ch. Sept. 6, 2001) (citing Sonet v. Timber Co., L.P., 772 A.2d 319, 322 (Del. Ch.1998)) (“But just as investors must use due care, so must the drafter of a partnership agreement who wishes to supplant the operation of traditional fiduciary duties. In view of the great freedom afforded to such drafters and the reality that most publicly traded limited partnerships are governed by agreements drafted exclusively by the original general partner, it is fair to expect that restrictions on fiduciary duties be set forth clearly and unambiguously.”).

If you can limit fiduciary duties by contract in the case of a public limited partnership, why wouldn't a mandatory arbitration clause be enforceable as well? And, if you can do that with respect to state law claims, why shouldn't you be able to do it with respect to federal claims?

In sum, FREEDOM OF CONTRACT + SUPREME COURT POLICY FAVORING ARBITRATION + MARKET WILL PRICE TERMS = the SEC policy is wrong. Mandatory arbitration clauses ought to be enforced as to both state and federal claims.

But what if Carlyle were a corporation? This post is already too long. So the short answer is: I think the result should be the same. And I bet Delaware will move in that direction. See Charles Nathan's post on the analogous issue of the enforceability of exclusive jurisdiction provisions:

In a recent decision, In re Revlon, Inc. Shareholders Litig., newly-appointed Vice Chancellor Laster suggested a solution. In dicta, he endorsed a Delaware entity’s right to mandate in its governance documents a chosen forum for the resolution of state law-based shareholder class actions, derivative suits and other intra-corporate disputes. Vice Chancellor Laster stated that “if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes.” Presumably, the Vice Chancellor had Delaware in mind.

Nathan goes on to discuss the legal issues at some length. In any case, assuming Laster wasn't simply trying to build up business for Delaware courts, there's no immediately obvious policy reason why the same result would not apply to mandatory arbitration provisions.

The interactive third edition of Klein, Ramseyer & Bainbridge's case book on Agency, Partnership, and Limited Liability Entities

I just got the author's copies of the new edition of our agency case book and I think it looks great. There are a lot of new features, including several new cases:

• Rash v. Intermediate, Ltd.
• Davis v. Loftus
• Sandvick v. LaCrosse
• Nemec v. Shrader
• RNR Investments Ltd. Partnership v. Peoples First Community Bank
• Fisk Ventures, LLC v. Segal
• Gottsacker v. Monnier
• Racing Investment Fund 2000 LLC v. Clay Ward Agency, Inc.
• R&R Capital v. Buck & Doe Run Valley Farms.

The book also contains many points for discussion, hypotheticals, and executive summaries.

I think the most exciting feature, however, is that this is our first interactive case book. Working with Foundation Press, we have created a learning resource we believe is more in tune with the ways that law students think and learn today. As we know, students are familiar with online legal research resources and accustomed to electronic materials. Accordingly, an electronic version of Agency, Partnerships and Limited Liability Entities accompanies the print version to provide students with interactive study and research tools that include:

• Hyperlinks to westlaw.com that provide full text of cases, statutes, Restatements, and articles
• A searchable text function that allows users to highlight and annotate selected text
• Live links to related websites and other online material

Each book includes a keycode that provides access to the online version of the book for 12 months. Students interested in purchasing only the online version may do so at store.westlaw.com. This should help make the case book both more user friendly and, at least in its digital form, less expensive.

Piercing the LLC Veil

Law professor Ann Conaway examines Delaware law on piercing the "corporate veil" (or should that be the "uncorporate veil"?) of LLCs, arguing that:

In light of the recent Delaware Supreme Court opinion in CML V v. Bax, the Supreme Court made clear that investors have a “choice” between a corporation and an unincorporated entity. That choice, according to the Supreme Court, affects the law that applies to the entity. As the Supreme Court made obvious in CML V, corporate law has no place in Delaware LLCs. Specifically, as regards to the “alter ego” test: (1) LLCs have no “corporate formalities” and to the extent an operating agreement imposes “formalities,” those formalities are meant solely for the parties to the agreement and do not affect limited liability; (2) the “dominant shareholder” factor is irrelevant in LLC law where a “dominant” member may be a non-economic member; and (3) “undercapitalization” by shareholders is also a non-relevant concept in LLC law, since members in an LLC are not required to make contributions to become members. In sum, the alter ego theory of corporate law is premised on pro rata ownership of stock and other mandatory corporate organizational and operational rules. Virtually no “mandatory” rules exist in LLC law.

She also addresses series LLCs and related issues. It's a nice, short treatment. Her conclusions are laregly consistent with the analysis I offered in my article Abolishing LLC Veil Piercing (May 2004). UCLA School of Law, Law-Econ Research Paper No. 04-11. Available at SSRN: http://ssrn.com/abstract=551724, in which I argued that:

Courts are now routinely applying the corporate law doctrine of veil piercing to limited liability companies. This extension of a seriously flawed doctrine into a new arena is not required by statute and is unsupportable as a matter of policy. The standards by which veil piercing is effected are vague, leaving judges great discretion. The result has been uncertainty and lack of predictability, increasing transaction costs for small businesses. At the same time, however, there is no evidence that veil piercing has been rigorously applied to affect socially beneficial policy outcomes. Judges typically seem to be concerned more with the facts and equities of the specific case at bar than with the implications of personal shareholder liability for society at large.

A standard academic move treats veil piercing as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. In doing so, veil piercing is called upon to achieve such lofty goals as leading LLC members to optimally internalize risk, while not deterring capital formation and economic growth, while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Abolishing veil piercing would refocus judicial analysis on the appropriate question - did the defendant - LLC member do anything for which he or she should be held directly liable?

Update: My post seems to have annoyed Professor Conaway, who gets quite pissy in a response insisting that her "'nice, short' treatment of Abolishing Piercing for LLCs in Delaware under an Alter Ego Theory is nothing akin to Professor Bainbridge’s article." Since it seems to have caused offense, I withdraw the word "nice."

Are uncorporations bad for "outside equity investors"?

Delaware lawyer Edward McNally thinks so:

In recent years, limited liability companies and limited partnerships have become the preferred form of entity for new businesses. In Delaware, for example, there are now more LLCs and LLPs formed each year than Delaware corporations. There are various reasons for this development, particularly the flexibility of management these alternative entities permit.

That is all fine when the entity has a single owner or a close-knit group of owners. But the story is very different when there are outside equity investors involved. Then the lack of a uniform governance structure in these alternative entities may cause problems. It is apparently for just that reason that few alternative entities have been used as a vehicle to issue publicly traded securities, such as limited partnerships or membership interests. Instead, entities formed as LLCs or LLPs frequently convert to the corporate form just before they go public.

The Delaware Court of Chancery's Sept. 30 decision in Brinckerhoff v. Enbridge Energy Co. illustrates the uncertainty involved in an alternative entity investment. 

He goes on to analyze the case and the problems it presents in considerable detail. It'll be interesting to see what Larry Ribstein thinks.

Update: Larry responds here.

Don't incorporate corporate law into LLCs

That's the short version of Joshua Fershee's analysis of the recent Delaware Supreme Court decision in CML V, LLC v. Bax:

LLCs are inherently different. And while a reasonable person may think LLCs should be analogous to corporations, the reality is that LLCs can be, but need not be, analogous to corporations. The nature of the LLC is such that those who form the LLC and do business with the LLC must contractually make the LLC analogous if that is what they desire. Default rules and gap fillers will not save the day in the LLC setting as they might in the corporate world.

... the Delaware Supreme Court missed an opportunity to, once and for all, make clear that LLCs and corporations are wholly different entities. While it is of little consequence in this case, in future situations, courts may still miss that point, and again inappropriately apply corporate concepts where the statute is not so clear.

I concur and encourage you to go read the whole thing.

Francis Pileggi links to other comentary on the case and offers his own commentary, along with a link to Larry Ribstein's analysis, here. Here's a direct link to Ribstein.

What happens when you get down to the last partner?

Larry Ribstein addresses the problem of what happens when a partnership gets down to its last member:

The basic problem is that the partnership statutes define a partnership as two or more persons, but don’t specify whether withdrawal of the penultimate partner triggers dissolution of the entity or, instead, a buyout plus continuation by the sole remaining partner.

In my view the answer is clear.

In a two-member partnership, the firm necessarily dissolves and is not continued on dissociation of one of the members because the remaining firm would not have the requisite two members to be a partnership.

Bromberg & Ribstein, §7.03(c), n. 13a. Although you can’t get that from the statute, it is a necessary implication of the definition of partnership.

Larry then elaborates at some length.

Sokol may not have been an inside trader, but he still was a bad agent

When my friend and co-author Bill Klein returned from a well-deserved vacation, he brought me not a present but a comment on my earlier posts on the Sokol affair. You'll recall, of course, that:

In a statement on Wednesday announcing the departure, Mr. Buffett said that Mr. Sokol had bought thousands of shares in the company, Lubrizol, a maker of lubricants, two months before Berkshire announced a $9 billion deal for the company. Shares of Lubrizol have risen 27 percent since the deal was announced two weeks ago.

We later learned that:

Investors were shocked to learn this week that David Sokol, a trusted lieutenant to Berkshire Hathaway Chairman Warren Buffett, had bought nearly $10 million worth of stock in Lubrizol just over a week before he suggested to Mr. Buffett that Berkshire should acquire the company. ...

"Dave's purchases were made before he had discussed Lubrizol with me and with no knowledge of how I might react to his idea," Mr. Buffett said in a news release on Wednesday. "Furthermore, he knew he would have no voice in Berkshire's decision once he suggested the idea."

Mr. Buffett said in the news release: "In our first talk about Lubrizol, Dave mentioned that he owned stock in the company. It was a passing remark and I did not ask him about the date of his purchase or the extent of his holdings."

Mr. Buffett told me on Friday that "everything in [the news release] is accurate." All he would add is that "I don't know of anything even remotely material that was omitted from the release."

Mr. Sokol's trading falls under what Stephen Bainbridge, an expert on securities ..., calls "an enormously gray area of the law."

Upon his return, Bill sent along this comment by email:

I just returned and read your post on Sokol and insider trading. I can understand the interest in whether there was a 10b-5 violation and the difficulty with finding one, but I think Sokol did wrong and wonder whether it might make sense to think of Reading v. Regem. Sokol received information about Lubrizol in his capacity as representative of Berkshire, not in his capacity as a prospective private investor. Forget about whether he intended to pitch the company to Buffett. Suppose that based on what he learned he concluded that the company was a dog and he then sold it short. And assume (as seems likely) that Berkshire does not engage in short selling. It seems to me that under Reading v. Regem, which is consistent with my ethical intuitions, that Sokol should not be allowed to keep his profit. One other angle: what would firms making pitches to Berkshire think if they knew that they were dealing with someone who might be looking out for his own private profit as well as the interests of his employer or maybe instead of the interests of his employer? Didn't Sokol impair the reputation of Berkshire among firms seeking a buyer and among investment bankers representing such firms?

I think that's almost certainly correct. The case to which Bill refers, Reading v. Regem, is a U.K. case we excerpted in our Business Associations case book. As I explain in my book, Agency, Partnership & Liabilitiy Companies (Concepts & Insights):

A British soldier stationed in Egypt during World War II fell into bad company—to wit, a smuggler who prevailed upon the sergeant to abuse his position with the military. While in uniform, the sergeant escorted the smuggler’s trucks through the streets of Cairo. By virtue of the sergeant’s presence, the trucks were allowed to pass civilian police checkpoints without being inspected. For these services, the smuggler paid the sergeant some £20,000. The army’s Special Investigation Branch found him out and seized his bank account and cash found in his apartment. Cheekily, the sergeant sued to recover the money.

The court rejected the sergeant’s claim, holding that an agent is required to pay over to the principal—here, His Majesty’s Government—any secret profits made as a result of his misuse of the agency position. The sergeant “[took] advantage of his service and violate[d] his duty of honesty and good faith to make a profit for himself.” Where “the wearing of the King’s uniform and his position as a soldier is the sole cause of his getting the money and he gets it dishonestly, that is an advantage which he is not allowed to keep.”

Although it is hard to see how His Majesty’s Government was injured in this case, as is often true in such cases, the law nevertheless holds that taking secret profits constitutes a breach of duty. Put another way, part of the agent’s duty of loyalty includes a responsibility not to use the agency position—let alone the principal’s property or facilities—for the agent’s own benefit without the principal’s consent.

We believe the same result would hold true on US law. And I agree with Bill that Reading teaches that Sokol would have state agency law problems even if he escapes, as I think he will, inside treading liability.

Fiduciary duties of employees

Robert Goddard reports on a pair of interesting cases from Scotland:

An employee does not owe the employer fiduciary duties by virtue of being an employee (see, e.g., Nottingham University v Fishel [2000] EWHC 221 (QB), [2000] ICR 1462). However, it has been recognised that the circumstances of the relationship may be such to give rise to a fiduciary relationship. In an opinion given last week - Samsung Semiconductor Europe Ltd. v Docherty [2011] CSOH 32 - Lord Glennie found that such circumstances were present in the case before him.

This strikes me as most curious. Under US law, employees typically will be deemed agents of their employer. Hence, Restatement (Third) of Agency § 7.07 provides that “an employee is an agent whose principal controls or has the right to control the manner and means of the agent's performance of work.” The Restatement elsewhere (§ 1.01) provides that all employees are agents, and that “[a]s agents, all employees owe a duty of loyalty to their employers.” Hence, although “employers do not generally owe fiduciary duties to employees,” “an employee normally owes fiduciary duties to his employer.” Combs v. PricewaterhouseCoopers, 382 F.3d 1196, 1200 n. 2 (10th Cir.2004)."

Having said that, Justice Felix Frankfurter famously observed that "[t]o say that a man is a fiduciary only begins analysis; it gives direction to further inquiry." We would then go on to ask whether the employee had breached his duties by engaging in the specified conduct. Whether that would lead to the same of a different result as the Scottish cases would be highly fact specific.

Business Entity Comparison

The Arizona Business Law Lawyer » Blog » offers up the following chart comparing the various forms of business organizations:

 

Business Entity Landscape: Corporation, Partnership, LLC, etc.

LLCs are not corporations

The Business Law Prof Blog mentions a pet peeve of mine:

Now that LLCs are the entity of choice, I like using LLC cases for this discussion [of limited liability]. Of course, from time to time this can make the discussion even more murky because courts don't often carefully distinguish the entity types.  Case in point:  the Sturm case discussed above.  The court repeatedly referenced the LLC as the "corporation."  The court explained that in Connecticut, "A limited liability company is analogous to a corporation for purposes of piercing the corporate veil."  Still, I'd much prefer if, after this determination is made, the court would refer to the entity as the "LLC" or the "company."  A little precision on this point would be much appreciated in the classroom.  I suspect it might help in practice, too. 

The conflation of LLCs and corporations has led to serious doctrinal errors, as I explain in Abolishing LLC Veil Piercing:

Courts are now routinely applying the corporate law doctrine of veil piercing to limited liability companies. This extension of a seriously flawed doctrine into a new arena is not required by statute and is unsupportable as a matter of policy. The standards by which veil piercing is effected are vague, leaving judges great discretion. The result has been uncertainty and lack of predictability, increasing transaction costs for small businesses. At the same time, however, there is no evidence that veil piercing has been rigorously applied to affect socially beneficial policy outcomes. Judges typically seem to be concerned more with the facts and equities of the specific case at bar than with the implications of personal shareholder liability for society at large.

A standard academic move treats veil piercing as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. In doing so, veil piercing is called upon to achieve such lofty goals as leading LLC members to optimally internalize risk, while not deterring capital formation and economic growth, while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Abolishing veil piercing would refocus judicial analysis on the appropriate question - did the defendant - LLC member do anything for which he or she should be held directly liable?

"Is Delaware uncorporate law unconstitutional?"

Lyman Johnson offers up a thoughtful analysis of the titular question in a new paper:

Abstract: This Article disputes the view - seemingly settled among scholars, judges, and lawyers - that recently - enacted statutes in Delaware legally permit fiduciary duties to be waived in noncorporate business associations. The argument is a rarity in business law because it is a constitutional argument, not one initially based on policy considerations or statutory interpretation, and it seeks to harmonize judicial review of fiduciary duties in noncorporate businesses with that in Delaware corporations, where waivers are not permitted. Delaware’s Constitution vests the Delaware Court of Chancery with general equity jurisdiction and powers of a kind that cannot be curtailed by legislative action. Consequently, neither the new and much-heralded waiver statutes, nor the private agreements they endorse, have divested Delaware courts of their traditional power and responsibility over fiduciary duties in limited liability companies (LLCs) or partnerships.

In addition to raising a serious and unresolved separation-of-powers issue for Delaware, the practical consequences of the argument made here are far-reaching. First, the argument casts substantial doubt on the efficacy of all those provisions in extant partnership and LLC agreements that seek to eliminate fiduciary duties. Second, the argument challenges the judges of the Court of Chancery to reassert their constitutional authority - and responsibility - over this field of jurisprudence and restore time-honored fiduciary duties to the law of unincorporated business associations in Delaware. The judges can exercise their inherent power to articulate fiduciary duties both where private agreements fail to address that subject at all and, where agreements do address the subject of duties ex ante - including agreements with waivers - the judges ex post should apply traditional duties in the manner a particular context may, to achieve commutative justice, equitably require. The key point is that, in every case, that specific determination must be made judicially; it cannot, by the constitutional nature of equity, be made a priori and categorically, either by the General Assembly or private contract or both together. Third, the law of noncorporate business associations in Delaware is, accordingly, far more indeterminate than widely believed and more indeterminate than the law of other states, thereby more closely resembling Delaware corporate law in this regard.

Larry Ribstein responds in a detailed (by blog standards, anyway) post. It's a nice example of how to conduct a scholarly argument: Thoughtful, respectful, constructive disagreement. He Who Must Not be Named could learn a lot from this example.

We get mail re Olmstead

I posted the other day on the controversial new Florida Olmstead decision that adversely affects the viability of single member LLCs. We got mail from a couple of readers following up on that post:

I just read your recent blog post regarding the Olmstead case.  There is currently a Florida Bar committee working on a legislative fix.  However, you might find it interesting that the "exclusive remedy" language in the proposed legislation only applies to multi-member LLCs.  The primary justification for the fix is to mirror Florida's limited partnership law, where it is well established that a charging order is the exclusive remedy.  Under the limited partnership law, the policy objective is to protect the non-debtor partners.  However, because there is no such thing as a single-member partnership, the partnership law does not provide a reason to protect single-member LLCs.  My guess is they want to fix the multi-member issue now (which should easily be passed by the legislature) and perhaps fight the single-member battle another day.

And yet another:

The Eleventh Circuit has now decided the case as to which it sought advice from the Florida Supreme Court in Olmstead. Quoting from pages 6 and 7 of the decision:

"Here, Defendants have membership interests in single-member LLCs. Where an LLC has only one member, no need exists to protect the interests of other members by restricting judgment-creditors to a charging-order remedy. So, a judgment-creditor is not barred from pursuing the remedy available under section 56.601, which allows a court to levy upon a defendant's interest in stock in a corporation, including a membership interest in an LLC. The district court, thus, properly granted the FTC's motion to compel the surrender of assets."

Single member LLCs and Olmstead

From Bus Law Prof:

The Florida Supreme Court recently issued the Olmstead v. Federal Trade Commission case.  The case's holding is that F.S. 608.433 (4) allows a court to order a debtor to surrender "all right, title, and interest" in the debtor's single-member LLC to satisfy an outstanding judgment, unlike many other states where the sole remedy is a charging order.  Although the case was based on a single-member LLC, the Court's rationale could extend to multi-member LLCs as well.

This case is probably the death knell for single-member LLCs in Florida until the Florida legislature fixes the sole remedy issue.  Also, because this is a case of first impression in the United States under this type of wording of the statute, it may be precedential to other jurisdictions with similar wording.

My ABA Committee on Corporate Laws colleague Stuart Ames sent along this excerpt from his forthcoming book on Florida business entities:

In Federal Trade Commission v. Olmstead, 528 F. 3d 1310 (11th Cir. 2008), the Court of Appeals certified the following question to the Florida Supreme Court:  “Whether, pursuant to Fla. Stat. § 608.433(4), a court may order a judgment-debtor to surrender all “right, title and interest” in the debtor’s single-member limited liability company to satisfy an outstanding judgment” (i.e., is “reverse veil piercing” permitted).  The certified question was answered in the affirmative by the Florida Supreme Court in a five-to-two decision rendered on June 24, 2010.  Olmstead v. Federal Trade Commission, 2010 WL 2518106 (Fla.). Although ss. 608.433(4) appears to limit the right of a judgment creditor to obtain a charging order and be only an assignee of the member’s economic interest, the Olmstead decision permits the creditor to foreclose on the membership interest of the debtor. Unless the decision is overturned by legislation, it is expected that this decision will have a profound effect on the way single-member LLCs are used in business transactions and for asset-protection and estate planning purposes and may dissuade the formation of such entities in Florida.  Moreover, as the dissent in the opinion pointed out, the decision may also have implications for the protection afforded to an LLC and its members in a multi-member LLC.  See also, In re: Ashely Albright, 2003 Bankr.Lexis 291 Bank. (D.Colo. April 4, 2003), in which the Bankruptcy Court, applying Colorado law, permitted a bankruptcy trustee of a member of a single-member Colorado LLC to control the LLC and reach its assets, noting that “To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with ‘peppercorn’ co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse [to the assets of the LLC].”  For a discussion of “reverse piercing” in the corporate context, see Section III.D of the Overview to Florida Business Corporations.

On the subject of LLC veil piercing, see my article Abolishing LLC Veil Piercing, which argues that:

Courts are now routinely applying the corporate law doctrine of veil piercing to limited liability companies. This extension of a seriously flawed doctrine into a new arena is not required by statute and is unsupportable as a matter of policy. The standards by which veil piercing is effected are vague, leaving judges great discretion. The result has been uncertainty and lack of predictability, increasing transaction costs for small businesses. At the same time, however, there is no evidence that veil piercing has been rigorously applied to affect socially beneficial policy outcomes. Judges typically seem to be concerned more with the facts and equities of the specific case at bar than with the implications of personal shareholder liability for society at large.

A standard academic move treats veil piercing as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. In doing so, veil piercing is called upon to achieve such lofty goals as leading LLC members to optimally internalize risk, while not deterring capital formation and economic growth, while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Abolishing veil piercing would refocus judicial analysis on the appropriate question - did the defendant - LLC member do anything for which he or she should be held directly liable?

On reverse veil piercing, see my earlier post Outsider reverse veil piercing:

The Inexorable (?) Rise of the LLC

Recent decades have seen the creation of several new forms of limited liability entities that offer credible alternatives to the corporate form for nonpublic businesses. Among these “uncorporations”[1] are the limited liability partnership, the limited liability limited partnership, and, perhaps most importantly, the limited liability company (LLC).

Recent empirical research by Professor Rodney D. Chrisman confirms that the LLC has become the dominant choice of form for newly formed nonpublic business organizations. Specifically, the number of new LLCs formed in the United States in 2007 was almost twice the number of new corporations (1,375,148 LLCs versus 747,533 corporations). Interestingly, the margin in favor of the LLC was even higher in Delaware, approaching 3 to 1 in the corporate capital of the US (112,982 versus 34,144).[2]

The following table provides state-by-state data on the formation of, respectively, LLCs, corporations, and limited partnerships, between 2004 and 2007:[3]

 

State	Total 2004-2007 New LLCs		Total 2004-2007 New Corps		Total 2004-2007 New LPs
	Total	%	Total	%	Total	%
AL	57,427	71.55%	22,337	27.83%	495	0.62%
AK	7,753	70.35%	2,956	26.82%	312	2.83%
AZ	179,554	76.85%	49,571	21.22%	4,516	1.93%
AR	31,413	58.06%	22,052	40.76%	638	1.18%
CA	239,362	37.58%	381,253	59.86%	16,340	2.57%
CO	184,094	71.84%	69,919	27.29%	2,237	0.87%
CT	96,834	91.31%	8,884	8.38%	328	0.31%
DE	366,657	68.16%	135,017	25.10%	36,231	6.74%
DC	13,472	75.27%	4,032	22.53%	395	2.21%
FL	469,174	42.34%	631,550	56.99%	7,372	0.67%
GA	160,679	53.06%	138,462	45.72%	3,683	1.22%
HI	27,679	70.29%	11,279	28.64%	419	1.06%
ID	36,457	72.44%	13,210	26.25%	662	1.32%
IL	94,733	35.09%	172,348	63.84%	2,906	1.08%
IN	70,932	62.61%	41,150	36.32%	1,209	1.07%
IA	30,521	64.65%	16,375	34.68%	316	0.67%
KS	30,270	64.53%	16,174	34.48%	461	0.98%
KY	56,571	73.94%	19,166	25.05%	775	1.01%
LA	105,530	82.65%	21,371	16.74%	777	0.61%
ME	15,707	61.31%	9,758	38.09%	155	0.60%
MD	111,324	66.48%	55,423	33.10%	699	0.42%
MA	49,587	52.64%	43,427	46.10%	1,188	1.26%
MI	186,480	71.00%	75,136	28.61%	1,028	0.39%
MN	75,223	60.74%	46,811	37.80%	1,813	1.46%
MS	41,189	68.78%	17,824	29.76%	872	1.46%
MO	113,881	80.50%	25,877	18.29%	1,713	1.21%
MT	33,079	71.50%	12,958	28.01%	230	0.50%
NE	16,301	54.35%	13,383	44.62%	311	1.04%
NV	150,148	51.98%	128,921	44.63%	9,813	3.40%
NH	30,449	82.17%	6,428	17.35%	180	0.49%
NJ	206,800	72.75%	76,223	26.81%	1,253	0.44%
NM	32,330	77.55%	8,740	20.96%	619	1.48%
NY	189,610	38.02%	306,675	61.49%	2,427	0.49%
NC	117,222	58.21%	82,900	41.17%	1,257	0.62%
ND	4,895	46.55%	5,014	47.68%	607	5.77%
OH	163,060	77.19%	45,899	21.73%	2,277	1.08%
OK	56,700	68.96%	24,382	29.65%	1,143	1.39%
OR	85,045	71.67%	32,845	27.68%	775	0.65%
PA	103,840	44.51%	115,130	49.35%	14,320	6.14%
RI	14,334	64.90%	7,570	34.28%	182	0.82%
SC	84,698	79.63%	20,507	19.28%	1,163	1.09%
SD	8,174	58.59%	5,429	38.91%	348	2.49%
TN	44,838	60.98%	27,246	37.05%	1,447	1.97%
TX	225,613	51.65%	143,884	32.94%	67,331	15.41%
UT	84,800	70.38%	33,684	27.96%	2,001	1.66%
VT	12,715	74.01%	4,465	25.99%	--	--
VA	131,702	62.29%	78,237	37.00%	1,504	0.71%
WA	113,621	68.64%	50,694	30.63%	1,208	0.73%
WV	17,496	72.72%	6,379	26.52%	183	0.76%
WI	105,581	83.92%	19,420	15.44%	807	0.64%
WY	21,381	61.50%	12,918	37.16%	467	1.34%
Tot.	4,906,935	58.22%	3,321,293	39.41%	199,393	2.37%

 

In total, approximately 1.5 million more new LLCs were formed between 2004 and 2007 than were new corporations (on a cumulative national basis).

These data reflect a considerable shift away from the corporate form and towards the LLC. As recently as 2002, more new corporations were formed each year than new LLCs (on a cumulative national basis).[4]

Chrisman further relates data showing an interesting shift in taxation of LLCs:[5]

Tax Years	Sole Proprietorships		Partnerships		S-Corporations		C-Corporations
	Total	%	Total	%	Total	%	Total	%
2002-2003	76,866	53.35%	145,372	15.36%	13,856	58.14%	7,279	51.57%
2003-2004	92,460	41.85%	178,734	16.38%	25,442	67.50%	3,503	16.37%
2004-2005	146,061	46.60%	194,987	15.35%	41,602	65.90%	6,455	25.93%
2005-2006	152,869	33.27%	164,938	11.26%	43,915	41.93%	9,582	30.56%
Tot.	468,256	325.00%	684,031	72.30%	124,815	523.68%	26,819	190.02%

 

As one might expect, the vast majority of LLCs choose under the check the box regulations to be taxed as though they were sole proprietorships or partnerships. The data also show, however, that the number of LLCs electing to be taxed as S-Corporations or C-Corporations is growing at a significant rate.  This is especially true for LLCs electing to be treated as S-Corps.

Chrisman speculates that:

[P]ractitioners are beginning to see benefits to the LLC state-law form beyond merely limited liability and partnership taxation that would make them want to use an LLC even when S-Corporation or perhaps C-Corporation taxation is preferable.  For instance, the enormous flexibility and contractual nature of the LLC may provide advantages such as clearly negotiated and defined fiduciary duties and only the desired formalities.  Further, in many states, the LLC may provide asset protection that goes beyond even that provided by the corporation.[6]

On the other hand, it may be that parties are electing S-Corporation tax treatment for their LLCs for tax-driven reasons:

S-Corporation taxation is certainly less complex for most businesses than partnership taxation…. Further, S-Corporation taxation provides the opportunity for tax-free reorganization, a benefit not available to entities taxed as a partnership.  Perhaps most importantly, S-Corporation taxation allows the opportunity to avoid significant self-employment taxes as opposed to entities taxed as sole proprietorships or partnerships.[7]

In either case, 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.

As someone who has devoted his professional career to the study of the corporation, and has argued the superiority of the corporate form, these 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?

---

[1] I use Larry Ribstein’s neologism as a generic encompassing all unincorporated limited liability entities. See Larry E. Ribstein, The Rise of the Uncorporation (2010), which I have found quite helpful in framing my thinking on these topics.

[2] Rodney D. Chrisman, LLCs are the New King of the Hill: An Empirical Study of the Number of New LLCs, Corporations, and LPs Formed in the United States Between 2004-2007 and How LLCs were Taxed for Tax Years 2002-2006, 15 Fordham J. Corp. & Fin. L. 459, 460 (2010). Chrisman further reports that the LLC also is displacing preexisting uncorporation forms. In 2007, for example, new LLCs were formed at a rate 34 times greater than that of new limited partnerships. Id. at 462. 

[3] The table is adapted from Chrisman, supra note 2.

[4] See Howard M. Friedman, The Silent LLC Revolution: The Social Cost of Academic Neglect, 38 Creighton L. Rev. 35, 37 (2004).

[5] The table is adapted from Chrisman, supra note 2.

[6] Chrisman, supra note 2, at 485.

[7] Id. at 488.

A Question About Best Efforts Clauses in Employment Agreements

A question for any employment lawyers out there:

Employment agreements often contain a best efforts clause, such as the following: "employees shall devote their full working time, attention and efforts to the Company's business and shall not, directly or indirectly, engage in any other business or commercial activities which shall conflict or interfere with or distract from in any way the performance of the employee's responsibilities to the Company or which involve any activities similar to the business conducted by the Company."

Why are these clauses necessary in light of the fiduciary duties of agents? Indeed, I have seen many cases (e.g., Singer v General Automotive and Rash v. J.V. Intermediate, Ltd in which such clauses were present, but the court decided the case on the basis of fiduciary duties. So why is the clause needed? Belt and suspenders?