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Daniel S. Kleinberger: Why Justice Cardozo Was Right, and Chief Justice Steele Is Wrong

Why Justice Cardozo Was Right, and Chief Justice Steele Is Wrong

© Professor Daniel S. Kleinberger[i]

“Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm’s length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”[ii]

“[We must] come to grips with the reality that the contractual relationship between parties to limited partnership and limited liability company agreements should be the analytical focus for resolving governance disputes-not the status relationship of the parties. When the parties specify duties and liabilities in their agreement, the courts should resist the temptation to superimpose upon those contractual duties common law fiduciary duty principles analogized from the law of corporate governance.”[iii]

As the sole vocal and out-of-the closet conservative on my faculty, I am loathe to contradict a judge who quotes Ronald Reagan with approval[iv] and believes that contracts and entrepreneurial activity are not malum in se.  Nonetheless, on the question of fiduciary duty, for at least 10 reasons, I must side with Justice Cardozo rather than Chief Justice Steele.

In his recent writings, Justice Steele:

  1. contrary to history, tars as an interloper from corporate law any notion of fiduciary duty in limited partnerships (LP or LPs) and limited liability companies (LLC or LLCs);
  2. notes correctly that the Delaware LP and LLC statutes[v] do not codify managerial fiduciary duty but draws the wrong inference from that fact;
  3. oversimplifies contract law, suggesting that contract law is at odds with fiduciary duty;
  4. argues incorrectly that, because Delaware courts have not found fiduciary duties inherent in arm’s length contractual relationships, fiduciary duty has no inherent place in relationships where one or more persons “manage other people’s money;”[vi]
  5. ignores the role of property law in the law of business organizations;
  6. annuls sub silentio the fiduciary consequences of agency law;
  7. relies on a misstatement of law in a Chancery Court opinion – i.e., that an LLC is solely a creature of contract – and thereby ignores any question of public policy other than radical contractarianism;
  8. premises his argument on an unrealistic assumption – namely that all participants in limited partnerships and limited liability companies are sophisticated and well advised;
  9. ignores some of the practical consequences of replacing fiduciary duty entirely with contractual obligation; and
  10. overestimates the ability of transactional attorneys to anticipate subsequent machinations of the contractual structures that such attorneys create.

 

As a Matter of History, Chief Justice Steele’s Etymology of Fiduciary Duty is Incorrect

            At the beginning of his Freedom article, the Chief Justice refers to fiduciary duty as “puritanical”[vii] and states:  “Throughout this article, when I refer to fiduciary duties, I refer to the corporate-like fiduciary duties of loyalty and care that have been applied to LPs and LLCs by Delaware courts.”[viii]  He made a similar characterization in a 2007 article,[ix] and with this characterization he portrays the duties of loyalty and care as strangers in and noxious to the law of unincorporated business.

But within limited partnerships and LLCs fiduciary duty does not come from corporate law.  Rather, under U.S. law (including the law of Delaware) the partnership relationship has always been characterized as fiduciary.[x]  As for limited liability companies, the LLC is in the partnership tradition, not the corporate one – especially in Delaware.[xi]  It is therefore simply wrong to characterize fiduciary duties in limited partnerships and limited liability companies as a corporate blot on the LLC/LP escutcheon.

The error is more than technical.  Under current Delaware limited partnership law:

[A] general partner of a limited partnership has the liabilities of a partner in a partnership that is governed by the Delaware Uniform Partnership Law in effect on July 11, 1999 (6 Del. C. § 1501, et seq.) to the partnership and to the other partners.[xii]

The statute’s reference to the 1999 general partnership act links the Delaware limited partnership act to Delaware’s version of the 1914 Uniform Partnership Act.  Although the 1914 Act did not entirely codify fiduciary duties, there is no question that such duties applied to general partners.[xiii]

Thus, fiduciary duty is a central part of the law of limited partnerships; there are no corporate footprints here.  The same is true for LLCs, given the LLC’s Act close connection to the Limited Partnership Act.[xiv]  Recognizing fiduciary duties within an LLC reflects the tradition of partnership law, not the invasion of corporate concepts.[xv]

No Fiduciary Duties in the LP and LLC Acts – Not Quite and Not Important

            After quoting statutory provisions that permit the restriction and elimination of fiduciary duty, Chief Justice Steele asserts that “the statutes do not provide any fiduciary duties, default or mandatory.”[xvi]  As explained above, that statement is incorrect with regard to the limited partnership statute, which remains linked to a general partnership statute for inter alia the purposes of stating the obligations of general partners.

In any event, why does the lack of codification matter when the Delaware corporate statute also omits any such codification?  Put another way, if the absence of codification invites Delaware courts to read fiduciary duty out of the law of LLCs, the same invitation applies to corporate law.

 

Fiduciary Duty is Not Antipathetic to Contract Law

            The Chief Justice writes as if giving “maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements,”[xvii] somehow puts Delaware LLC and LP law at odds with fiduciary duty. But fiduciary duty and contract law co-exist.[xviii]  Indeed, Cardozo’s “punctilio of an honor most sensitive” was applied largely because the co-venturers’ agreement left open the pivotal question.[xix]

Delaware’s Arms-Length Cases Are Logically Inapposite to Chief Justice Steele’s Analysis

            Chief Justice Steele appears to argue that Delaware contract law in general supports the elimination of fiduciary duties within LLCs and LPs:

Under Delaware contract jurisprudence, Delaware courts have limited their application of default duties to the implied contractual duty of good faith and fair dealing. Thus, Delaware courts have apparently concluded that the parties would have agreed only to the implied contractual duty of good faith and fair dealing. Notably, the Delaware courts, in the contracts context, have determined that parties would not provide the fiduciary duty of loyalty. Absent specific language in the contract creating a fiduciary relationship, a court would be loathe to revert to a fiduciary duty of loyalty and hold the defendant liable for acting in his own best interest–so long as the implied contractual duty of good faith and fair dealing was met.[xx]

These assertions are relevant only if the Chief Justice is arguing that what has been sauce for the “arm’s length” goose ought to be sauce for LP/LLC gander.  Thus, the assertions seem to assume the point at issue – namely, whether an arm’s length contractarian view ought to prevail in a business organization context that has involved fiduciary duties for more than a century.

The Law of Business Organizations is also about Property Law

Although LLCs and LPs certainly involve contractual relationships, these business organizations also involve property rights.  Partners and LLC members own something; they are more than parties to an agreement.[xxi]  By suggesting a hegemony of contract, Justice Steele inadvertently trivializes (or eliminates) the role of property law.  The proposed shift in perspectives means a shift in responsibilities and remedies.  “Fiduciary relationships are commonly characterized by one party placing property or authority in the hands of another, or being authorized to act on behalf of the other.”[xxii] Once courts stop thinking about managers as handling other people’s money, of course the way is open to abandon “the punctilio of an honor the most sensitive” and exalt “the morals of the marketplace.”[xxiii]

 

What of the Law of Agency?

            Long before there were LLCs and even long before there were partnerships, there were agency relationships.  Under the law of agency, “when one person (a ‘principal’) manifests assent to another person (an ‘agent’) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act,” then an agency results. [xxiv]  And, emphatically, “[a]gency is [a] fiduciary relationship.”

            Within an LP or LLC, some person or persons inevitably agree to act on the entity’s behalf.  They thus serve as agents for the enterprise, and absent some superseding rule they are subject to the fiduciary duty of loyalty and the duty of care as a matter of agency law.[xxv]

The Chief Justice does not address agency law, but for his thesis to prevail he must also annul agency law principles as they apply to limited partnerships and limited liability companies  – at least where those performing the agent/management function have an ownership interest in the entity.[xxvi] 

 

Neither a Limited Partnership nor a Limited Liability Company is Solely a Creature of Contract

            Chief Justice Steele cites with approval a Chancery Court decision that states:  “limited liability companies … are creatures not of the state but of contract.”[xxvii]  This proposition supports the Chief Justice’s argument that only contract law principles should apply to the relationship of LLC members and managers.

            The proposition is, however, demonstrably incorrect.  An LLC depends for its existence on a statute that empowers the LLC’s formation[xxviii] and recognizes the LLC’s existence as an entity separate from its owners.[xxix]  More importantly – at least as a practical matter – each LLC owes to its sovereign the liability shield that protects the LLC members from automatic vicarious liability for the debts of the entity.[xxx]

            To the extent that Chief Justice Steele’s argument rests on the assertion that an LLC is a contract and nothing more, the argument must fail.[xxxi]

 

The Conceptual Ubiquity of Sophisticated LLC Members

with the Opportunity and Power to Bargain – An Assumption that Vitiates the Rule

            The Chief Justice makes clear a fundamental premise:  his analysis presupposes “sophisticated parties”[xxxii] who “had a bargained-for exchange when entering the relationship.”[xxxiii]  This premise fundamentally limits the reach of the Chief Justice’s analysis.

As the Chief Justice himself notes, his analysis does not extend to passive investors,[xxxiv] which must constitute some material portion of limited partners in Delaware limited partnerships and non-managing members in manager-managed LLCs.  As for the assumed “bargained-for exchange,” certainly many Delaware LLCs and limited partnerships involve the type of genuine ebargaining that would make a contract law formalist smile.  But just as certainly, some Delaware enterprises involve “take it or leave it” offerings by sophisticated promoters.

The Chief Justice is proposing a rule for a hypothetical world – a world comprising solely  entrepreneurs whose sophistication, bargaining power, and access to legal expertise make good results plausible when fiduciary duty is no longer the starting point.  Outside the confines of the hypothetical world, the rule is extremely dangerous.

This point is perhaps most salient for a set of LLC users rarely, if ever, discussed in the literature of Delaware LLCs.  Presumably, Delaware LLCs are the vehicle of choice not only for the sophisticated venturers from throughout the world but also for myriad local (Delaware-based) “mom and pop” entrepreneurs.  Some of these entrepreneurs may fit the hypothetical world – i.e., sophisticated, inclined and able to bargain, willing and able to pay the high transaction costs for sophisticated counsel.  But – unless Delaware’s small business economy is unique in the U.S. – many of these moms and pops are outside the Chief Justice’s assumptions.

What are the consequences of the Chief Justice’s argument for these folks – that they organize under the law of some other state?

Unexamined Practical Consequences of Replacing Fiduciary Duty

Entirely with Contractual Duty

The Chief Justice asserts that “if the parties intended to apply traditional fiduciary duties to their relationship, they could easily add a provision stating precisely that in the agreement.”[xxxv]  However, it is not clear whether such a precise statement would achieve the desired result.  If no fiduciary duty exists even as a default rule, does contract law have the power to provide fiduciary-duty-like rules of interpretation and remedy?

            For example, given a fiduciary relationship, any ambiguity in contractual language is construed against the party with the fiduciary duty.  Among other benefits, this rule limits the dangers of the parol evidence.  Can an agreement impose such a rule of construction, or is the party benefitting from the contractual provision limited to contra proferentem?

            As to remedies, the duty of loyalty allows disgorgement (or constructive trust) without need to prove damages.  Does a contract have the power to establish such a remedy?[xxxvi]

 

Overestimating the Prescience of Transactional Attorneys

            Doubtlessly, those attorneys who advise sophisticated clients within the hypothetical world are all inordinately skilled.[xxxvii]  But when we deal with abuse of power, ex post often has an advantage over ex ante:

The open-ended nature of fiduciary duty reflects the law’s long-standing recognition that devious people can smell a loophole a mile away. For centuries, the law has assumed that (1) power creates opportunities for abuse and (2) the devious creativity of those in power may outstrip the prescience of those trying, through ex ante contract drafting, to constrain that combination of power and creativity. For an attorney to advise a client that the attorney’s drafting skills are adequate to take the place of centuries of fiduciary doctrine may be an example of chutzpah or hubris (or both).[xxxviii]

 

 


[i]Professor of Law and Founding Director of the Mitchell Fellows Program, William Mitchell College of Law, St. Paul, MN 55105, A.B. Harvard 1972; J.D. Yale Law School 1979.  This essay is based in part on two other works:  (i) a 2005 essay (initially unpublished), “Seven Points to Explain Why the Law Ought Not Allow the Elimination of Fiduciary Duty Within Closely Held Businesses – Cardozo Is Dead; We Have Killed Him,” later published in India in G. Radhika (ed.), Fiduciary Obligations: Legal Perspectives (Amicus Books. Icfai U. Press 2008); and (ii) a paper presented at the 2lst Century Commercial Law Forum – Tenth International Symposium 2010,School of Law, Tsinghua University, Beijing, “Delaware Dissolves the Glue of Capitalism:  Exonerating from Claims of Incompetence Those Who Manage Other People’s Money,” to be published in the United States under the same title in 38 William Mitchell L. Rev.  ___ (Issue 2) (forthcoming 2012). As always, my work depends on the love, support, and insights of Carolyn C.S. Kleinberger.

[ii] Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928) (Cardozo, J.)

[iii] Myron T. Steele, “Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 Del. J. Corp. L. 1, 25 (2007) (hereafter: Steele, Judicial Scrutiny) (emphasis added).

[iv]  Myron T. Steele, “Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies,” 46 Am. Bus. L.J. 221, 222 (2009) (hereafter Steele, Freedom).

 

[v] Unless otherwise stated, all references to statutes are to Delaware statutes and all references to limited partnerships and limited liability companies are to enterprises formed under the law of Delaware.

[vi] Daniel S. Kleinberger, “Delaware Dissolves the Glue of Capitalism:  Exonerating from Claims of Incompetence Those Who Manage Other People’s Money,” 38 William Mitchell L. Rev.  ___ (Issue 2) (forthcoming 2012).  The author came upon the phrase “other people’s money” in a play of that title, written by Jerry Sterner.  In 1991, the play was produced as a movie (with some changes in plot), starring Danny DeVito, Penelope Ann Miller and Gregory Peck.

[vii] Steele, Freedom at 223.

[viii] Id. at 222, n.6

[ix] Steele, Judicial Scrutiny at 25 (arguing that courts must not “superimpose upon those contractual duties common law fiduciary duty principles analogized from the law of corporate governance”).

[x] E.g. Continental Ins. Co. v. Rutledge & Co., Inc., Civ.A. No. 15539, 1999 WL 66528 at *5 (Del.Ch. Jan. 26, 1999) (holding that the fiduciary duty inherent in a limited partnership did not arise before the formation of the partnership); Cantor Fitzgerald, L.P. v. Cantor, No. 16297, 2000 WL 307370 at *21-22 (Del.Ch. Mar. 13, 2000) (presupposing that general partners owe fiduciary duties; discussing when limited partners might also owe fiduciary duties)

[xi] The Delaware LLC Act is modeled on the Delaware Limited Partnership Act.  Elf Atochem N. Am., Inc. v. Jaffari, 727 A2d 286, 290 (Del. 1999) (“The Delaware Act has been modeled on the popular Delaware LP Act. In fact, its architecture and much of its wording is almost identical to that of the Delaware LP Act.”) (footnotes omitted). See also Carter G. Bishop & Daniel S. Kleinberger, Limited Liability Companies: Tax and Business Law, ¶ 14.01[2] (1994, Supp. 2011-1).

[xii] Del. Code Ann. tit. 6, § 17-403(b).  This rule is subject to the partnership agreement and to other provisions of the Act. Id.

[xiii] See e.g. Debakey Corp. v. Raytheon Service Co., No. 14947, 2000 WL 1273317 at *18 (Del.Ch. Aug. 25, 2000) (“It cannot be doubted that RSC, as a partner in and as managing partner of the joint venture, owed fiduciary duties to its remaining partners, the plaintiffs.”)

[xiv] See note 11, supra.

[xv] The fact that partnership fiduciary duty may be similar in some contexts to corporate fiduciary duty does not prove that the latter has been transplanted into the former.  Indeed, the history of partnership law proves the contrary.  A far better explanation is that Delaware courts have recognized that fiduciary duty in the context of business organizations is about management power.  E.g. Metro Communication Corp. BVI, v. Advanced Mobilecomm Tech., Inc., 854 A2d 121, 130, 155 (Del. Ch. 2004) (resolving claims that managers of a Delaware LLC had made misleading statements or failed to correct previously made misleading statements by holding that the Delaware Supreme Court’s decision in a corporate case, Malone v. Brincat, 722 A2d 5 (Del. 1998), states a rule that transcends entity type) (Strine, V.C.).

[xvi] Steele, Freedom at 272.

[xvii] Id. at 226 (quoting Del. Code Ann. tit. 6, §§ 17-1101 and 18-1101(b)).

[xviii] E.g. Restatement (Second) of Contracts §§ 161(d) (“A person’s non-disclosure of a fact known to him is equivalent to an assertion that the fact does not exist …. where the other person is entitled to know the fact because of a relation of trust and confidence between them.”) and193 (“A promise by a fiduciary to violate his fiduciary duty or a promise that tends to induce such a violation is unenforceable on grounds of public policy.”)  See also In re Marvel Entertainment Group, Inc., 273 B.R. 58, 72-73 (D.Del. 2002) (assuming that a “claimed breach of fiduciary duty [could be] an allegedly unfair contract,” and holding that “the limitations period [on the fiduciary claim] begins to run when the contract is formed”) (citing Kahn v. Seaboard Corp., 625 A.2d 269, 271, 274 (Del.Ch. 1993)).

[xix] Meinhard v. Salmon, 164 N.E. 545, 552 (N.Y. 1928 (Andrews, J., dissenting) (arguing that the pivotal question was the agreed-upon scope of the original venture, which should have determined the rights of the co-venturers to participate in a subsequent venture).

[xx] Steele, Freedom at 234-35 (footnote omitted).

[xxi] Del. Code Ann. tit. 6, §§ 17-701 (“A partnership interest is personal property.”) and 18-701(“A limited liability company interest is personal property.”).

[xxii] High Valley Concrete, L.L.C. v. Sargent, 234 P.3d 747 (Idaho 2010) (quoting Country Cove Dev., Inc. v. May, 143 Idaho 595, 603, 150 P.3d 288, 296 (2006)).

[xxiii] Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928).

[xxiv] Restatement (Third) of Agency, §1.01.  See also Restatement (Second) of Agency § 1 (“Agency is the fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act.”)

[xxv] See Restatement (Second) of Agency § 14A, Agent and Partner (stating that “the rights and liabilities of partners with respect to each other and to third persons are largely determined by agency principles”); RUPA § 301(1) (“Each partner is an agent of the partnership for the purpose of its business.”);  Del. Code Ann. tit. 6, § 18-402 (“Unless otherwise provided in a limited liability company agreement, each member and manager has the authority to bind the limited liability company.”)

[xxvi]Under the Chief Justice’s paradigm, partners and members will lack fiduciary protection regarding the management activities of fellow owners, but the entity itself will have fiduciary protection when hiring a non-owner to perform management functions.  But if, as hypothesized, “sophisticated parties bargain for the obligations and duties provided in an LLC agreement,” Steele, Freedom at 237, why should the entity housing such owners need the fiduciary protections of agency law?

[xxvii] Steele, Freedom at 223, n. 10 (citing Fisk Ventures, LLC v. Segal, No. 3017-CC, 2008 Del. Ch. LEXIS 158, at *28 (Del. Ch. May 7, 2008)).

[xxviii] Del. Code Ann. tit. 6, § 18-201(b) (“A limited liability company is formed at the time of the filing of the initial certificate of formation in the office of the Secretary of State or at any later date or time specified in the certificate of formation if, in either case, there has been substantial compliance with the requirements of this section.”)

[xxix] Id. (“A limited liability company formed under this chapter shall be a separate legal entity, the existence of which as a separate legal entity shall continue until cancellation of the limited liability company’s certificate of formation.”).

[xxx] 6 Del.Code Ann. tit. 6, § 18-303(a).

[xxxi] I must leave for another day a discussion of what policy issues result from the dependence of this “contractual organization” on the sovereign.  My point here is that any proposition deduced from the assertion that “liability companies … are creatures not of the state but of contract” is factually flawed.

[xxxii] Steele, Freedom at 241, n.71

[xxxiii] Id. at 225.

[xxxiv] Id. at 225 and 241, n.71

[xxxv] Steele, Freedom at 242.

[xxxvi] Delaware courts have held that a person can be liable for aiding and abetting breach of fiduciary duty where the duty arises from a contract.  Gotham Partners, L.P. v. Hallwood Realty Partners, L.P.,

817 A.2d 160, 172 (citing Fitzgerald v. Cantor, No. CIV. A. 16297-NC,1999 WL 182573 (Del.Ch. March 25, 1999) at *1).

[xxxvii] As a matter of fact, this assertion genuinely fits all the Delaware lawyers with whom it has been my pleasure to work on several Uniform Laws projects and within the ABA Business Law Section’s Committee on Limited Liability Companies, Partnerships, and Unincorporated Entities.

[xxxviii] Carter G. Bishop & Daniel S.Kleinberger, LIMITED LIABILITY COMPANIES: TAX AND BUSINESS LAW, ¶ 14.05[4][a][ii]] (1994, Supp. 2011-1).