Mohsen Manesh: What is the Practical Importance of Default Rules under Delaware LLC and LP Law?
What is the Practical Importance of Default Rules under Delaware LLC and LP Law?
University of Oregon School of Law
December 14, 2011
I have one principal contribution to make to this symposium, which is to suggest that although Chief Justice Myron Steele’s provocative assertion—that there are and should be no default fiduciary duties under Delaware LLC and LP law—is interesting as a theoretical matter, it probably has limited practical importance. Sophisticated parties can and will contract to avoid undesirable default rules. And LLCs and LPs with passive (presumably unsophisticated) investors have contractually created an almost de facto rule eliminating fiduciary duties. Thus, even if one believes Chief Justice Steele’s thesis is problematic, the problem it creates affects only a small portion of Delaware’s alternative entity universe.
Bargained-For Exchange among Sophisticated Parties
As others in this symposium have noted, Chief Justice Steele limits his analysis to LLC and LP agreements that are the product of a “bargained for exchange” among “sophisticated” parties. But it is among this very group that the debate as to default rules is likely to have the least relevance. Regardless of the default rules that apply to LLCs and LPs, as long as Delaware law affords the maximum freedom of contract to deviate from such rules, sophisticated parties can and will contract for their desired result. By hypothesis, sophisticated parties are aware of the default rules, understand they are not inescapably bound to such rules and will bargain for different rules if the default rules are undesirable. If fiduciary duties apply as the default, sophisticated parties that want to eliminate or modify such duties can and will easily do so. If, on the other hand, no fiduciary duties apply as the default, as Chief Justice Steele advocates, sophisticated parties can just as easily impose corporate-like fiduciary duties (or some subset of such duties) by simple reference to such duties in the terms of the LLC or LP governing agreement.
To be sure, Chief Justice Steele would disagree with this analysis. He argues that it is easier (or, to use his jargon, it would reduce “contracting costs”) to contractually recreate fiduciary duties in a world where no fiduciary duties is the default (i.e., Chief Justice Steele’s preferred world) than to selectively eliminate limited aspects of fiduciary duties in a world where fiduciary duties are the default (i.e., the world in which we currently live). But it is not clear that this is true. In a world where fiduciary duties apply as the default, parties wishing to retain only a discrete aspect of the fiduciary duties (for example, a restriction on self-dealing transactions) may simply eliminate all fiduciary duties (which Chief Justice Steele agrees may be achieved “at little cost”) and then draft an explicit contractual provision prescribing the specific conduct that default fiduciary principles would otherwise normally prescribe (which Chief Justice Steele suggests would be also simple to draft). Although Chief Justice Steele raises the concern that such provisions will “necessarily appear contradictory,” LLC and LP agreements eliminating all fiduciary duties but also restricting self-dealing transactions are quite common, and there is little reason to believe the Delaware courts would have trouble interpreting such agreements. Thus, it seems that regardless of the default rule, if the default rule is undesirable, sophisticated parties can and will readily contract to avoid it.
LLC and LP Agreements imposed on Passive Investors
In contrast to LLCs and LPs bargained for by sophisticated parties, Chief Justice Steele excludes from his analysis LPs and LLCs that involve passive (presumably unsophisticated) investors, who purchased or otherwise acquired their units and were not involved in the formation or negotiation of the underlying LLC or LP agreement. Perhaps because such entities bear closer resemblance to public corporations, Chief Justice Steele would retain fiduciary duties as a default for such entities.
But even if default rules continue to apply fiduciary duties to LLCs and LPs that involve passive investors, such rules will be largely irrelevant. This is because LLCs and LPs with passive investors still retain the statutory right to contract out of the default rules, and my recent work suggests that almost all such entities actually do. In a study forthcoming in the Journal of Corporation Law, I find that 88% of publicly traded Delaware LLCs and LPs—firms that have sold units to disaggregated, largely passive public investors—have either entirely waived all fiduciary duties owed to investors or eliminated any liability arising from the breach of such duties. This finding is perhaps unsurprising given that for publicly traded LLCs and LPs, the firm’s governing agreement is not the product of a give-and-take bargaining process between the firm and sophisticated investors sitting around a negotiating table, but rather drafted exclusively by the firm’s promoters and offered to public investors on a take-it-or-leave-it basis. And although my results are limited to the relatively few extant publicly traded Delaware LLCs and LPs, it is not unreasonable to believe that private LLCs and LPs with passive investors eliminate fiduciary duties with similar frequency.
Thus, even putting aside the problems of bifurcating default rules for sophisticated and unsophisticated parties that Callison and Vestal as well as Johnson have noted, the ultimate default rules in this context prove largely irrelevant. Given the statutory freedom of contract to deviate from default rules, LLCs and LPs with passive investors regularly eliminate fiduciary duties. In this sense, debating whether fiduciary duties should apply as a default in the context of LLCs and LPs with passive investors is like debating whether the fiduciary duty of care should apply as a default in the context of public corporations. The debate is largely academic: in practice, the de jure default rule applying such duties has been all but replaced with a de facto practice eliminating the same.
Limited Practical Relevance for Delaware
So, for whom are Delaware’s default rules regarding fiduciary duties relevant? Perhaps it is those Delaware residents—those “mom and pop” businesses, as Kleinberger describes them—who may be legally unsophisticated but desire to use the LLC form to obtain limited liability and pass-through partnership tax treatment for their small business. Such “users” of Delaware LLC law may be unaware of Delaware’s default rules or lack the resources to competently tailor a governing agreement to contractually alter any undesirable aspects of the default rules. And, to the extent one believes that most of these unsophisticated business owners would prefer a regime in which fiduciary duties apply, adoption of Chief Justice Steele’s interpretation of Delaware law could create undesired consequences.
But even if Chief Justice Steele’s default rules would harm unsophisticated “mom and pop” businesses, as Callison and Vestal, Kleinberger and Cunningham all suggest, note that in Delaware, a state that is largely a haven for attracting out-of-state alternative entity charters, where the ratio of LLCs to actual residents will soon approach one-to-one, it is unlikely that a significant percentage of Delaware’s 550,238 LLCs fall into the “mom and pop” category. Thus, if Chief Justice Steele’s interpretation of Delaware LLC and LP law is in fact problematic, the problem it creates affects only a small portion of the Delaware LLC and LP universe.
 See generally Myron T. Steele, Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies,46 Am. Bus. L.J. 221 (2009).
 Id. at 225, 241 n.71.
 See Del. Code Ann. tit. 6, § 17-1101(c) (governing LPs); id. § 18-1101(b) (governing LLCs).
 For examples of LLC agreement provisions eliminating all fiduciary duties see Fisk Ventures, LLC, 2008 WL 1961156, *11 (Del. Ch. May 7, 2008), aff’d, 984 A.2d 124 (Del. 2009) (interpreting the following provision to eliminate all fiduciary duties of LLC members: “No Member shall have any duty to any Member of the Company except as expressly set forth herein or in other written agreements.”); In re Atlas Energy Resources LLC, 2010 WL 4273122, *12 (Del. Ch. Oct. 28. 2010) (interpreting the following provision to eliminate all fiduciary duties of officers and directors in a manager-managed: “Except as expressly set forth in this Agreement or required by law, none of the Directors, nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Company or any Member.”).
 See Steele, supra note 1, at 240 (“[I]f we proceed from a baseline of no default fiduciary duty, adding in a wholesale provision adopting Delaware’s fiduciary duty principles could also be easily achieved—without much cost.”). For an example of a LLC agreement provision that creates corporate-like fiduciary duties by reference, see Och-Ziff Capital Management Group LLC, Second Amended and Restated Limited liability Company Agreement, in Annual Report (Form 10K), exhibit 3.2, § 5.23 (Nov. 13, 2007), available at http://www.sec.gov/Archives/edgar/data/1403256/000119312508064885/dex32.htm (“Except as otherwise expressly set forth in this Agreement or required by the Delaware Act, (i) the duties and obligations owed to the Company by the Officers and Directors shall be the same as the duties and obligations owed to a corporation organized under DGCL by its officers and directors, respectively, and (ii) the duties and obligations owed to the Members by the Officers and Directors shall be the same as the duties and obligations owed to the shareholders of a corporation under the DGCL by its officers and directors, respectively.”).
 See Steele, supra note 1, at 240-41.
 Id. at 240 (“I agree that a wholesale elimination of duties in an LLC agreement comes at little cost….”).
 Id. (“If we assume no default fiduciary duties, the parties need only explicitly provide for a self-dealing proscription. The contract is much easier to draft….””).
 For example, In re Atlas Energy Resources LLC, 2010 WL 4273122 (Del. Ch. Oct. 28. 2010), Vice-Chancellor Noble held that the LLC agreement at issue eliminated all common law fiduciary duties of the LLC’s officers and directors, but replaced such duties with a contractually defined fiduciary obligation of good faith. Id. at *12. In dismissing the complaint against the defendant officers and directors, the Vice Chancellor noted that “[a]lthough Plaintiffs accuse certain defendants of conduct that might constitute breach of traditional fiduciary duties, they do not allege that the Individual Defendants engaged in conduct [violating the contractually defined duty of good faith].”
 See Steele, supra note 1, at 241 n. 71.
 See generally Mohsen Manesh, Legal Asymmetry and the End of Corporate Law, 34 Del. J. Corp. L. 465 (2009).
 Mohsen Manesh, Contractual Freedom under Delaware Alternative Entity Law: Evidence from Publicly Traded LPs and LLCs, 37 J. Corp. L. (forthcoming 2012), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1939920.
 Id. at Part III.A.
 See J. William Callison and Allan W. Vestal, “Triple Error: Chief Justice Steele and Default,” The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/j-william-callison-and-allan-w-vestal-triple-error-chief-justice-steele-and-default/.
 Lyman Johnson, Untitled Comment, The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/lyman-johnson/.
 Compare Manesh, Contractual Freedom, supra note 13 (finding that 88% of all publicly traded Delaware LPs and LLCs have either eliminated all fiduciary duties or eliminated any liability arising from the breach of any fiduciary duties) with J. Robert Brown, Jr. & Sandeep Gopalan, Opting Only In: Contractarians, Waver of Liability Provision, and the Race to the Bottom, 42 Ind. L. Rev. (2009) (finding that all but one corporation in the Fortune 100 has provisions eliminating liability for breaches of the fiduciary duty of care).
 Daniel S. Kleinberger, “Why Justice Cardozo Was Right, and Chief Justice Steele Is Wrong,” The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, at http://blogs.law.widener.edu/delcorp/?page_id=335&preview=true.
 See Callison and Vestal, supra note 15 (“In our view, it is unlikely that 112,000 new [Delaware] LLCs involved sophisticated parties with the resources to enter customized governance structures, just as it is unlikely that the LLC form was chosen because it provides parties with the maximum ability to customize their relationship.”).
 See Kleinberger, supra note 18 (“Presumably, Delaware LLCs are the vehicle of choice not only for the sophisticated venturers from throughout the world but also myriad local (Delaware-based) ‘mom and pop’ entrepreneurs … many of [whom] are outside the Chief Justice’s assumptions.”).
 John Cunningham, Untitled Comment, The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/john-cunningham-dec-9-2011/ (“It seems clear that the Chief Justice meant the article to apply to what, in practice, is only a minute percentage of actual Delaware LLCs.”).
 See Bruce Kobayashi & Larry E. Ribstein, Delaware for Small Fry: Jurisdictional Competition for Limited Liability Companies, 2011 U. Ill. L. Rev. 91, 116 (finding that among closely held LLCs with 50 or more employees that form outside of their home state, more than 61% are formed under Delaware law); Jens Dammann & Matthias Schundeln, Where are Limited Liability Companies Formed? An Empirical Analysis (June 28, 2010) p.3, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1633472 (finding that among closely held LLCs with 5,000 or more employees that form outside of their home state, more than 95% are formed under Delaware law); see also Mohsen Manesh, Delaware and the Market for LLC Law: A Theory of Contractibility and Legal Indeterminacy, 52 B.C. L. Rev. 189, 201-02 (2011) (finding that every LLC filing for or completing an initial public offering during a recent 6 year period was organized under Delaware law); Mohsen Manesh, Legal Asymmetry, supra note 12, at 476 (finding that every LLC and LP filing for or completing an initial public offering during a recent three-plus year period was organized under Delaware law); Manesh, Contractual Freedom, supra note 13, at Appendix A (noting that every publicly traded LLC and LP organized under domestic law, save one, is organized in Delaware).
 As of 2010, the population of natural persons in Delaware was 897,934, up from 783,600 in 2000, See U.S. Census Bureau, Delaware QuickFacts (2010), available at http://quickfacts.census.gov/qfd/states/10000.html. At the same time, at the end of 2010, Delaware was home to 550,238 LLCs, with 82,027 new LLCs formed during 2010 alone. See A. Gilchrist Sparks, “Legislative Developments in Delaware’s “Alternative Entities”, Harvard Law School Forum on Corporate Governance and Financial Regulation, at http://blogs.law.harvard.edu/corpgov/2011/09/08/legislative-developments-in-delaware%E2%80%99s-%E2%80%9Calternative-entities%E2%80%9D/.