ProfessorBainbridge.com

Delaware moves into B-Corp market

Usha Rodrigues:

From the Harvard Law School Forum on Corporate Governance and Financial Regulation, via Allen M. Terrell, Jr. of Richards, Layton & Finger, comes a summary of proposed amendments to the Delaware General Corporation Law. I had heard about the elimination of the vote in second-step mergers, but the public benefit corporation was news to me.

It sounds a lot like the benefit corporation legislation that's been spreading across the country (see this chart by Haskell Murray.  At first blush I was surprised to see Delaware contemplating this kind of social enterprise legislation, since it's not really a stakeholders' rights kinda state.  But on further reflection I guess a "let a thousand flowers bloom" attitude makes sense for Delaware's let-the-market-decide, opt-in attitude.  Here's the description:

In general, under the proposed legislation, a public benefit corporation would be a corporation managed in a manner that balances the stockholders’ pecuniary interests, the interests of those materially affected by the corporation’s conduct, and one or more public benefits identified in its certificate of incorporation. To this last point, each public benefit corporation would be required, in its certificate of incorporation, to identify itself as a public benefit corporation and to state the public benefits it intends to promote. The proposed legislation generally defines “public benefits” as positive effects (or minimization of negative effects) on persons, entities, communities or interests, including those of an artistic, charitable, cultural, economic, educational, literary, medical, religious, scientific or technological nature. ...

I'm not surprised to see Delaware make this move and I think there's something other than "let the market decide" going on here. 

As the leader in corporate law, Delaware has always been quick to adopt new developments so as to preserve its market share. After all, franchise taxes from business organizations are arond 20% of delaware revenues, an income stream the state will do just about anything to maintain. When LLCs became popular, for example, Delaware agressively moved to capture the dominant share of large LLCs.

Thus, as Haskell Murray observed not too long ago (2 Am. U. Bus. L. Rev. 1):

Currently, it is not crystal clear whether Delaware corporate law is flexible enough to give comfort to the social entrepreneur, but as described above, there are a number of other options for the social entrepreneur. Additionally, the Delaware legislature is traditionally extremely responsive to the needs of the market, and one suggested solution in this Article is to have Delaware amend its corporate statute to explicitly provide social entrepreneurs with the flexibility they seek.

And so, once again, we see Delaware hedging its bets. Just as it positioned itself to lead the LLC phenomenon in case LLCs displaced corporations, it is positioning itself to lead the B Corp phenomenon in case it starts to make major inroads on the choice of form.

Bainbridge's study aids for corporation law, agency & partnership, and/or business associations courses

Bainbridge on Agency, Partnerships & LLCs:

The emergence of the limited liability company has kindled renewed interest in unincorporated business associations among legal scholars. This revival was further stimulated by the multiple revisions made to the Uniform Partnership Act in the 1990s. By lending new intellectual respectability to the study of unincorporated business associations, these developments stimulated the supply side of the curricular equilibrium. Courses on unincorporated business associations have thus sprung up at many law schools. A number of very fine casebooks compete for that market, including one co-edited by the author of this volume. This text is intended to provide students taking a course in unincorporated business associations with a reader-friendly, highly accessible overview of the law and economics of unincorporated business associations. In addition, students taking a basic course in corporations or business associations may find this volume helpful as a more expansive treatment of the law of agency, partnership, and limited liability companies. The text does not shy away from bringing theory to bear on doctrine. While the text has a strong emphasis on the doctrinal issues taught in today’s unincorporated business associations classes, it also places significant emphasis on providing an economic analysis of the major issues in that course. Agency, Partnership and Limited Liability Companies thus offers not only with an overview of the black letter law of unincorporated business associations, but also a unifying method of thinking about the subject. Using a few basic tools of law and economics — such as price theory, game theory, and the theory of the firm literature — the reader will come to see the law in this area as the proverbial “seamless web.”

Bainbridge on Corporation Law:

Corporations classes present students with two related problems: First, many students have trouble understanding the cases studied because they do not understand the transactions giving rise to those cases. Second, Corporations classes at many law schools are taught from a law and economics perspective, which many students find unfamiliar and/or daunting. Yet, with few exceptions, corporate law treatises and other study aids have essentially ignored the law and economics revolution. 

This book is intended to remedy these difficulties. The pedagogy is up-to - date, with a strong emphasis on the doctrinal issues taught in today’s Corporations classes and, equally important, a mainstream economic analysis of the major issues in the course. As such, the text is coherent and cohesive: It provides students not only with an overview of the course, but also (and more importantly) with a unifying method of thinking about the course. Using a few basic tools of law and economics-price theory, game theory, and the theory of the firm literature-students will come to see corporate law as the proverbial “seamless web.” Finally, the text is highly readable: The style is simple, direct, and reader- friendly. Even when dealing with complicated economic or financial issues, the text seeks to make those issues readily accessible.

 

Agency Authority at the Corporate Apex

The following question was posted over at one of the LinkedIn groups I follow:

... does the Chairman in a shareholding company have the right to give power to someone else to sign in the contract and documents of the company, who is usually gives him this authority?

As I explain in Agency, Partnerships & LLCs:

Corporate employees, especially officers, are agents of the corporation.[1] Curiously, however, neither an individual director nor even the board as a whole is regarded as agents of the corporation.[2] An individual director, as such, “has no power of his own to act on the corporation’s behalf, but only as one of the body of directors acting as a board.”[3] As for the board, when it acts collectively, the board functions as a principal rather than as agent. Unless shareholder approval is required, after all, the act of the board is the act of the corporation. Consequently, the board can be said to personify the corporate principal.

In my now out of print book Corporation Law and Economics, I addressed the issue in more detail:

Suppose a newly appointed CEO wishes to hire an Administrative Assistant. If the CEO signs an employment contract with a prospective assistant, purporting to act on behalf of the corporation, will that contract be binding on the firm? The answer to that question depends on whether the CEO has authority as that term of art is used in agency law. Accordingly, we must (briefly) digress into agency law and the authority of agents.

1. The agency relationship defined

The agency relationship, in its broadest sense, includes any relationship in which one person (the agent) is authorized to act on behalf of another person (the principal). More specifically, an agency relationship arises when there is a manifestation of consent by the principal that the agent act on the principal’s behalf and subject to the principal’s control, and the agent consents to so act.[1] The requisite manifestation of consent can be implied from the circumstances, which makes it possible for the parties to have formed a legally effective agency relationship without realizing they had done so. Corporate employees, especially officers, are generally regarded as agents of the corporation.[2]

Curiously, neither an individual director nor even the board as a whole are regarded as agents of the corporation.[3] In a sense, when the board acts collectively, it functions as a principal in agency law terms. Unless shareholder approval is required, after all, the act of the board is the act of the corporation. As to the individual director, recall that he “has no power of his own to act on the corporation’s behalf, but only as one of the body of directors acting as a board.” [4]

2. Authority of agents

An agent may have either actual, apparent, or inherent authority to enter into contracts on behalf of the corporate principal. Likewise, in some settings, the corporation may be estopped from denying the authority of its employees. Determining whether an agent had the requisite authority in any given situation can be challenging. The differences between the various categories of authority are complex and subtle. In addition, many of the categories overlap—it is not at all uncommon for more than one type of authority to be present in a single transaction. Finally, the courts are not always precise when using labels. For example, estoppel and inherent authority are often called apparent authority. For our purposes, however, it is critical for you to understand that the legal consequences of an agent’s actions do not depend on the type of authority at hand. For purposes of determining whether or not the corporate principal is bound by the contract vis-à-vis the third party to the transaction, authority is authority and the different types of authority are essentially irrelevant.

Why then does the law distinguish between different categories of authority? A former student of your author claimed that it was a deliberate attempt to confuse people, which called to mind the old joke—”just because you’re paranoid doesn’t mean you aren’t being followed.” As Justice Holmes once observed, albeit in a different context, “common sense is opposed to the fundamental theory of agency.”[5]

It will be helpful to focus for a moment on the two basic types of authority: “actual authority” and “apparent authority.” Consider the following hypothetical: Pam owns Whiteacre. Alan is her real estate broker and, indisputably, her agent. Ted is an outsider who claims that Alan entered into a contract on Pam’s behalf to sell Whiteacre. Suppose Ted seeks to prove the existence of authority by evidence relating to communications between Pam and Alan, such as a letter from Pam to Allen in which Pam directed Alan to sell Whiteacre. In this instance, Ted is attempting to establish the existence of actual authority. In contrast, suppose Ted seeks to establish authority by evidence relating to communications from Pam to Ted. Suppose Pam sent Ted a letter in which she said that she had ordered Alan to sell Whiteacre. In this case, Ted is trying to establish apparent authority. Importantly, the contract will be no less binding if Ted proves apparent authority rather than actual. The difference between actual and apparent authority thus arises out of the way in which Ted seeks to prove that Alan was authorized to enter into the contract. In other words, the different categories of authority really are ways of classifying the proof the plaintiff must offer to bind the principal to the contract.

Actual authority exists when the agent reasonably believes the principal has consented to a particular course of conduct.[6] Actual authority can be express, as where the principal instructs the agent to “sell Whiteacre on my behalf.” In the corporate context, express actual authority is usually vested in officers by a resolution of the board and/or a description of the officer’s duties set forth in the bylaws.[7] Actual authority can also be implied, however, if the principal’s acts or conduct are such the agent can reasonably infer the requisite consent. An agent has incidental actual authority, for example, to use all means reasonably necessary to carry out a particular result expressly mandated by the principal. A pattern of acquiescence by the board in a course of conduct may also give rise to implied actual authority to enter into similar contracts in the future.[8]

A contract entered into by an agent, purportedly on the principal’s behalf, can be binding even if the agent lacks actual authority. Apparent authority exists where words or conduct of the principal lead the third party to reasonably believe that the agent has authority to make the contract.[9] Of particular importance with respect to the authority of corporate officers is the concept of apparent authority implied by custom. Suppose the board of directors instructed the CEO not to hire an assistant. The CEO thus lacked actual authority. The CEO nonetheless signs a prospective assistant to an employment contract that purports to be binding on the corporation. Is it binding? If the assistant (the third party) knew that that the corporation had placed the CEO in that position and its was customary for CEOs to have authority to hire assistants, the CEO will have apparent authority by virtue of that custom and the contract will be binding.[10] The economic rationale for this rule should be self-evident—it is the basic concept of the cheaper cost avoider. Sound social policy dictates that the loss be put on the party who could have most cheaply avoided it. Here the corporation’s position, by definition, is idiosyncratic. Most firms let their CEOs hire assistants. Its cheaper for the few idiosyncratic principals to take precautions than for all job applicants to be obliged to take precautions.

3. Authority of corporate officers

Most of the case law on the apparent authority of corporate officers relates to the powers of presidents. Corporate presidents are regarded as general agents of the corporation vested with considerable managerial powers. Accordingly, contracts that are executed by the president on the corporation’s behalf and arise out of the ordinary course of business matters are binding on the corporation.[11]

Cases dealing with the authority of subordinate officers are much rarer. As to vice presidents, a number of (mostly older) cases hold they have little or no implied or apparent authority to bind the corporation. Accordingly, they have only such authority as is expressly conferred on them in the bylaws or by board resolution.[12] The corporate secretary is assumed to be the custodian of the corporation’s books and records. Accordingly, the secretary has actual authority to certify those records. Otherwise, however, the secretary has no authority other than that conferred on him by the bylaws or board resolutions.[13]

An important line of cases limits the implied and apparent authority of corporate officers to matters arising in the ordinary course of business. In the leading decision of Lee v. Jenkins Bros., the Second Circuit held:

The rule most widely cited is that the president only has authority to bind his company by acts arising in the usual and regular course of business but not for contracts of an “extraordinary” nature. . . .

Apparent authority is essentially a question of fact. It depends not only on the nature of the contract involved, but the officer negotiating it, the corporation’s usual manner of conducting business, the size of the corporation and the number of its stockholders, the circumstances that give rise to the contract, the reasonableness of the contract, the amounts involved, and who the contracting third party is, to list a few but not all of the relevant factors. In certain instances a given contract may be so important to the welfare of the corporation that outsiders would naturally suppose that only the board of directors (or even the shareholders) could properly handle it. It is in this light that the “ordinary course of business” rule should be given its content.[14]

As Lee suggests, there is no bright line between ordinary and extraordinary acts. It seems reasonable to assume, however, that acts consigned by statute to the board of directors will be deemed extraordinary.[15] Consequently, for example, the eight acts specified in MBCA § 8.25(e) that a board of directors may not delegate to a committee doubtless are extraordinary in nature. (Of course, once the board has made its decision with respect to an extraordinary matter, implementation of that decision can be delegated to officers.)

In general, when one must decide a particular action is ordinary or extraordinary, the following factors seem especially pertinent:[16] How much of the firm’s assets or earnings are involved? Suppose a corporation running a video tape rental store has $10,000 in cash available. A decision to spend $50 to buy a new tape would be ordinary, a decision to spend $5,000 to establish a line of compact discs for rent probably would be regarded as extraordinary. How much risk is involved? A decision to buy one tape is not very risky and would be an ordinary action, while a decision to open a new store might be very risky and therefore extraordinary. A decision to buy tapes on installment where the purchase price is paid off in three months probably would be seen as ordinary. A decision to take out a thirty year loan probably would be seen as extraordinary. How long will the action have an effect on the corporation? How much would it cost to reverse the decision? A decision to open a new store might be very expensive to reverse, as the corporation might not be able to get out of the lease if things went bad. Such a decision thus would be extraordinary.

As to most matters falling in the gray area between ordinary and extraordinary, a small host of decisions could be cited on either side.[17] There is relatively little consistency of outcome in this area. Courts are divided, for example, as to whether such basic matters as filing a lawsuit[18] or executing a guarantee of another corporation’s debts are ordinary or extraordinary.[19] One is tempted to remind them that Emerson’s famous dictum against a fetish for consistency holds only that a “foolish consistency is the hobgoblin of little minds.”

How should cases falling between the extremes be resolved? Put bluntly, the authority of corporate officers should be regarded as virtually plenary. Only matters expressly reserved to the board by statute, the articles of incorporation, or the bylaws should be deemed “extraordinary” and, consequently, beyond the scope of senior officers’ authority.

One rationale for this position is suggested by simple statutory interpretation. recall that both the MBCA and Delaware law provide that the business of the corporation “shall be managed by or under the direction of a board of directors.”[20] The use of the disjunctive prior to the phrase “under the direction of” suggests that the statute’s drafters anticipated that the corporation would be managed by its officers with the board mainly exercising oversight authority. Unless a decision is expressly reserved to the board, the statutory language thus contemplates that a corporation may act through its officers subject to review by the board.

This reading of the statute comports with modern board practice. The de facto role of the board in most large public corporations consists of providing informal advice to senior management (especially the CEO) and episodic oversight. An extensive definition of extraordinary acts thus seems a needless formality.

An alternative justification for the proposed rule rests on the costs the existing rule imposes on third parties. Persons who do business with a corporation do so at some peril of discovering that their transaction will be deemed to implicate an extraordinary act and, accordingly, required express board action. An expansive definition of extraordinary matters increases this risk. Transaction costs thus increase in several respects. An expansive variant of the rule creates uncertainty, obliging third parties to take costly precautions. They may insist, for example, on seeing an express authorization from the board. Uncertainty about the outer perimeters of the rule also encourages opportunism by the corporation. If contracts dealing with extraordinary matters are voidable, the corporation effectively has a put with respect to the transaction. Uncertainty as to the enforceability of a contract gives the board leverage to extract a favorable settlement of the third party’s claims.

California’s New LLC Act – Call Keith Bishop Laocoon, But He Foresees A Mess!

On Friday, Governor Brown signed SB 323 (Vargas) into law. It was chaptered by the Secretary of State the same day.  Section 20 of the bill adds the California Revised Uniform Limited Liability Company Act (RULLCA) to the Corporations Code as a new Title 2.6.  The RULLCA will become operative on January 1, 2014 (See new Corporations Code Section 17713.13).  The existing Beverly-Killea Limited Liability Company Act found in Title 2.5 is repealed as of that same date unless a later enacted statute, that is enacted before that date, deletes or extends that date.

Out with old, in with the new, what could be wrong with that?  It turns out plenty.

At the most fundamental level, the repeal of the Beverly-Killea Act as to existing limited liability companies is unconstitutional.

Fascinating. I think he's got a point.

via calcorporatelaw.com

In Delaware, limited partners who make their beds must lie in them

Edward McNally reports on In re: Encore Energy Partners LP Unitholder Litigation, C.A. 6347-VCP (August 31, 2012):

Delaware limited partnership agreements frequently have provisions governing how to deal with conflict of interests between the GP, the limited partners and the owners of the GP.  This decision sets out the language needed to protect the GP and its owners from attacks in conflict transactions when the deal is approved by a conflicts committee.  If the committee acts in the subjective good faith belief the transaction is in the best interests of its constituency, an attack alleging objective unfairness will be dismissed.

This then may be the definitive guide to drafting limited partnership agreements.  And while the Court recognizes that the decision offers little protection for limited partners, it points out that is part of the risk they bear when they invest in such LPs.

I'm particularly struck by the discussion at 36-37:

The near absence under the [limited partnership agreement] of any duties whatsoever to Encore‘s public equity holders presumably would discourage risk averse investors unwilling to take a leap of faith from investing their money in an enterprise controlled by the General Partner and its Affiliates. But, the right to enter into good and bad contracts makes the implied covenant an ersatz substitute for the warning 'caveat emptor.‘ Investors apprehensive about the risks inherent in waiving the fiduciary duties of those with whom they entrust their investments may be well advised to avoid master limited partnerships like Encore. Having decided to take a leap of faith and to reach for the kind of returns a master limited partnership investment might yield, however, Plaintiffs cannot reintroduce fiduciary review through the backdoor of the implied covenant [of good faith]. Rather, Delaware law "give[s] maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements."

I think that's basically sound. As I explain in Agency, Partnership & Liabilitiy Companies:

Default statutory rules provide cost savings comparable to those provided by standard form contracts, because both can be accepted without the need for costly negotiation. At the same time, however, because the default rule can be modified by contrary agreement, idiosyncratic parties wishing a different rule can be accommodated. Given these advantages, a fairly compelling case ought to be required before we impose a mandatory rule. Indeed, mandatory rules seem justifiable only if a default rule would demonstrably create significant negative externalities or, perhaps, if one of the contracting parties is demonstrably unable to protect itself through bargaining.

Does this justification for freedom of contract extend to the fiduciary duties of LLC members? [Or a limited partnership?] ...

Fiduciary duties function as gap-fillers; they provide rules to govern the parties’ conduct in the absence of agreement. Where the parties have gone to the effort of bargaining over specific matters, however, there is no gap to be filled. Instead, absent negative externalities or other forms of market failure, the basic principle of freedom of contract mandates that courts respect the bargain struck by the parties. Consequently, to invoke fiduciary obligation to trump actual contracts sets the process on its head. Worse yet, doing so often results in an unjustified windfall. When the parties entered into their bargain, the price paid by each member for an LLC interest (or what have you) reflected their estimate of the trade offs inherent in that investment, including the protections (or lack thereof) provided by the operating agreement. Allowing parties to subsequently invoke fiduciary obligation to escape a bargain that turned out badly gives them an undeserved second bite at the apple. Put another way, the parties made their bed and courts ought to let them—indeed, make them—lie in it.

Delaware seems to agree.

The case also contains an interesting discussion of the meaning of the term "good faith." One might wonder whether subjective intent/believe that one is acting contrary to the company's interests is really the right standard, but that's a question for another day.

How far will Delaware courts allow an agreement to permit self-dealing in an LLC?

On a listserv to which I belong, a member asked:

How far will Delaware courts allow an agreement to permit self-dealing in an LLC? The case I've found allowing the most leeway is Gerber v. Enterprise Products Holding, LLC (Del. Ch. Jan. 6, 2012). Any comments on whether this case shows the wisdom or the folly of Delaware law? Does anyone have a better case to offer?

The question generated some interesting comments, including:

• It is pretty clear that under Delaware limited partnership and LLC law, the partnership/operating agreement can entirely legitimize self-dealing, subject to the non-waivable contractual covenant of good faith and fair dealing.  What’s remarkable about Gerber is the extent to which the case permits an agreement to restrict the operation of the non-waivable duty of good faith and fair dealing: “Because Enterprise Products GP relied upon The 2009 Morgan Stanley Fairness Opinion, Enterprise Products GP is conclusively presumed to have acted in good faith in deciding to use the Special Approval process…. Absent contractual modifications, Gerber could plead a breach of the implied covenant. Therefore, the question squarely before the Court is: can a plaintiff plead that a defendant breached the implied covenant when the defendant is conclusively presumed by the terms of a contract to have acted in good faith?  The answer is, no." Gerber v. Enterprise Products Holdings, LLC, et al., C.A. No. 5989-VCN, 2012 WL 34442  at *12 (Del Ch., Jan. 6, 2012).
• I agree with [the preceding writer] on the law but have argued that equity can still prevent it .... The Supreme Court of Delaware in I believe the CML case last year in rejecting a creditor derivative suit even in insolvency botched history in saying that since LLCs did not exist in 1776 then the right to bring them could not have been equitably preserved in the 1792 Constitution which enshrines equity as of 1776.  The problem with that reasoning is that derivative suits appear not to have then existed for corporations either, but arose in the early 18th century. So if CML is extended to fiduciary duty waivers then complete waivers will stand unscathed but if someone can get the Court to see its historical error in CML maybe waivers could be attacked on equitable grounds on a case by case basis.
• Indeed, equity developed to address the formal limitations of the law.  To hold that equity does not apply because a particular form did not always exist seems to me quite strange.
• Perhaps this is a situation in which Delaware courts feel constrained by legislation and do not recognize their historic power, or perhaps this is a situation in which Delaware courts recognize the attractiveness of expansive reading of permissible waiver in attracting the formation of limited partnerships and LLCs under Delaware law.

It was at this point that I jumped in, observing that:

I commend to everyone's attention a wonderfully helpful article by Del Sup Ct Justice Jack Jacobs, 8 Del. L. Rev. 1, Delaware Law Review 2005 THE UNEASY TRUCE BETWEEN LAW AND EQUITY IN MODERN BUSINESS ENTERPRISE JURISPRUDENCE. He reads Delaware Sup Ct precedents as "sending a clear message that if there is a conflict between equitable principles and clear, bright line rules of corporate law, law trumps equity." (12) He continues at 15 by opining that: "I view the Supreme Court's apparent movement away from equity not as an attempt to get rid of equity, but as a mid-course adjustment--an effort to create a “bright line” around equity to enable practitioners and their clients to predict when otherwise legally valid corporate acts would become subject to equitable nullification."

Turning to the question at hand, there are not many brighter line statements than Sections 18-1101(b) and 17-1101(c) of the LLC and LP Acts,  each of which states that the policy of their respective Act is to give “maximum effect to the principle of freedom of contract and to the enforceability of limited liability company/partnership agreements.”

In effect, I'm arguing that the Delaware LLC statue draws a bright line around contractual adjustments to fiduciary duties" that excludes application of the equity principles set out in cases like Schnell v. Chris-Craft.

In my book, Agency, Partnerships & LLCs, I argue that:

Many LLC statutes stand as exemplars of freedom of contract; they consist mostly of default rules that the parties are free to vary or even derogate. The ULLCA, for example, allows variations on and departures from the statute in all but a handful of areas.[1] The Delaware statute goes even further, expressly providing that: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”[2]

In Elf Atochem North America, Inc. v. Jaffari,[3] Elf and Jaffari formed a joint venture formally structured as a Delaware LLC. The operating agreement contained an arbitration clause requiring that any arbitration (and/or any judicial proceeding to enforce an arbitral award) take place in California. Elf claimed that Jaffari had breached his fiduciary obligations and filed a derivative suit against Jaffari in Delaware. Citing the Delaware statutory provision on freedom of contract, and the social policies favoring arbitration as a mode of dispute resolution, the court held that the operating agreement was binding on both the LLC and its several members. “The basic approach of the Delaware Act is to provide members with broad discretion in drafting the Agreement and to furnish default provisions when the members’ agreement is silent.” Analogizing LLCs to limited partnerships for this purpose, and noting the policy of freedom of contract recognized by Delaware limited partnership law, the court further noted that “[o]nce partners exercise their contractual freedom in their partnership agreement, the partners have a great deal of certainty that their partnership agreement will be enforced in accordance with its terms.”

The Jaffari result makes sense not only in light of the statutory policy of freedom of contract, but also efficiency considerations. Default statutory rules provide cost savings comparable to those provided by standard form contracts, because both can be accepted without the need for costly negotiation. At the same time, however, because the default rule can be modified by contrary agreement, idiosyncratic parties wishing a different rule can be accommodated. Given these advantages, a fairly compelling case ought to be required before we impose a mandatory rule. Indeed, mandatory rules seem justifiable only if a default rule would demonstrably create significant negative externalities or, perhaps, if one of the contracting parties is demonstrably unable to protect itself through bargaining.

Does this justification for freedom of contract extend to the fiduciary duties of LLC members? The default rules under the ULLCA § 409 depend on whether the LLC is managed by its members or by a manager. In manager-managed LLCs, the managers have a duty of care and loyalty to the members. In contrast, members of a manager-managed LLC have no duties to the LLC or its members by reason of being members. Where the LLC is managed by its members, however, all members of a member-managed LLC have a duty of care and loyalty to the organization and fellow members.

Should those duties be subject to contractual variation and/or derogation?[4] The ULLCA permits modification, but not elimination, of the duty of loyalty. The operating agreement thus may not “eliminate the duty of loyalty” but may “identify specific types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable....”[5] In addition, the operating agreement may “specify the number or percentage of members or disinterested managers that may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty.”[6] The agreement also may modify, but not “unreasonably reduce the duty of care....”[7] In contrast, the Delaware LLC statute far more permissively provides that fiduciary “duties and liabilities may be expanded or restricted by provisions in a limited liability company agreement.”[8]

Although it is still early days, courts appear to be giving full effect to the principle of freedom of contract even in this controversial area. A widely cited Ohio decision, McConnell v. Hunt Sports Enterprises,[9] for example, involved the formation of an LLC to buy a NHL hockey expansion franchise to be located in Columbus, Ohio. After the LLC’s members failed to obtain public financing of a hockey arena, Nationwide Insurance offered to build an arena that would be leased to the LLC. LLC member Lamar Hunt, purporting to act on the LLC’s behalf but without authority to do so, rejected the offer. In a series of meetings over the next several weeks, Hunt and his cronies among the LLC’s members persisted in rejecting that offer, while LLC member John McConnell and his supporters wanted to accept it. McConnell and his supporters thereupon formed a separate team ownership group that accepted Nationwide’s offer and, moreover, was awarded the franchise. Hunt sued, alleging breach of fiduciary duty and contract claims.

The court noted that the LLC operating agreement expressly allowed members to compete with the LLC. Focusing on the plain language of the relevant provision, which authorized LLC members to engage in “any other business venture of any nature,” the court held that McConnell’s group was free to pursue their own bid for the NHL franchise despite being members of an LLC that had been formed for that same purpose. Unfortunately, in going on to discuss Hunt’s contract based claims, the court muddied the waters somewhat by implying that the result might have been different if Hunt had not rejected the Nationwide proposal. The opinion is nevertheless significant for its strong “affirmative” answer to “the question [of whether] an operating agreement of a limited liability company may, in essence, limit or define the scope of the fiduciary duties imposed upon its members.”

As with Jaffari, this result is consistent not only with the statute but also with economic theory. Fiduciary duties function as gap-fillers; they provide rules to govern the parties’ conduct in the absence of agreement. Where the parties have gone to the effort of bargaining over specific matters, however, there is no gap to be filled. Instead, absent negative externalities or other forms of market failure, the basic principle of freedom of contract mandates that courts respect the bargain struck by the parties. Consequently, to invoke fiduciary obligation to trump actual contracts sets the process on its head. Worse yet, doing so often results in an unjustified windfall. When the parties entered into their bargain, the price paid by each member for an LLC interest (or what have you) reflected their estimate of the trade offs inherent in that investment, including the protections (or lack thereof) provided by the operating agreement. Allowing parties to subsequently invoke fiduciary obligation to escape a bargain that turned out badly gives them an undeserved second bite at the apple. Put another way, the parties made their bed and courts ought to let them—indeed, make them—lie in it.

More LLC veil piercing silliness

LLC Law Monitor blog reports that:

The Federal District Court in New York granted summary judgment to pierce the veil of a Delaware limited liability company in Soroof Trading Development Co. Ltd. v. GE Fuel Cell Systems LLC, No. 10 Civ. 1391(LTS)(JCF), 2012 WL 209110 (S.D.N.Y. Jan. 24, 2012). The court found the LLC to be the alter ego of its members, but did not explain how Delaware’s requirement of unfairness or injustice was met. ...

... it appears unlikely that a Delaware court would have pierced the veil of the LLC on the facts recited by the Soroof court. The threshold in Delaware to pierce the veil of a corporation or LLC is high. Generally fraud, illegality, or other egregious facts must be present, and the Delaware courts “have only been persuaded to ‘pierce the corporate veil’ after substantial consideration of the shareholder-owner’s disregard of the separate corporate fiction and the degree of injustice impressed on the litigants by recognition of the corporate entity.” Midland Interiors, Inc. v. Burleigh, No. CIV.A. 18544, 2006 WL 3783476, at *3 (Del. Ch. 2006). SeeFrancis Pileggi’s discussion of Midland Interiors, here.

The Soroof opinion is not an isolated instance of a court straining to pierce the veil of an LLC. Last month I posted here about Colorado’s Martin v. Freeman case, where the veil of a single member LLC was pierced without any showing of wrongdoing. Both cases support Professor Stephen Bainbridge’s thesis that “veil piercing achieves neither fairness nor efficiency, but rather only uncertainty and lack of predictability.” Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 U. Ill. L. Rev. 77, 78.

The excised bulk of the post contains a detailed treatment of the facts, issues, and holding, which I highly commend to your attention. (HT: Pileggi)

LLC Controlling Member Fiduciary Liabilities

Editor’s Note: Chancellor William Chandler is a partner at Wilson Sonsini Goodrich & Rosati, and former Chancellor of the Delaware Court of Chancery. This post is based on a WSGR Alert by Chancellor Chandler and Ryan McLeod. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Services Company; links to other posts in the series are available here.

via blogs.law.harvard.edu

Very useful analysis by former Delaware Chancellor Chandler.

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.