Triple Error: Chief Justice Steele and Default
Contractual Duties in Delaware Limited Liability Companies and Limited Partnerships
By J. William Callison and Allan W. Vestal[1]
In a recent law review article Delaware Chief Justice Myron Steele argues that Delaware courts should interpret Delaware’s limited liability company (“LLC”) and limited partnership (“LP”) statutes as not including any default fiduciary duties.[2] Therefore, he argues that the only fiduciary duties in Delaware LLCs and LPs arise from the parties’ express contract. Although such thought-piece musings from most state court jurists would not be particularly significant, the fact that Chief Justice Steele writes from a significant business law state means that attention is given to what he says.
Having given Chief Justice Steele’s article due attention, we begin this essay with our conclusion that Chief Justice Steele’s position is both wrong and dangerous, and that it runs counter to the prevailing point of view of many lawyers and scholars who have carefully considered fiduciary duty issues in unincorporated business entities. We believe that the prevailing, and correct, view is that recently expressed by a federal district court – namely, that common law fiduciary duties exist in LLCs when the state LLC statute does not contain fiduciary language.[3] In this respect, we believe that our position is conservative and traditional, and that Chief Justice Steele’s position is radical and revolutionary.
Further, we note that prior Delaware decisions, including decisions by the Delaware Supreme Court, operate against a background in which fiduciary duties exist as a default rule and that the Delaware legislature has modified Delaware LLC and LP law without rejecting this background. In our view, only the Delaware legislature should make the underlying policy decision that would make Delaware an outlier state, perhaps the sole outlier state, in which fiduciary duties do not exist as a default rule.
We argue that Chief Justice Steele is in error in three identifiable ways, which we elaborate in the remainder of this essay.
- 1. The Initial Error: Puritans Not Byzantines.
Chief Justice Steele is somewhat imprecise as to what it is he opposes. He seems to reject the notion of any default starting point when dealing with fiduciary duties, what he describes as “the wholly Byzantine approach, whereby parties must define the duties and rights they intend to keep while simultaneously disclaiming other duties that the parties wish to exclude,” which, he argues “adds unnecessary chaos into the parties’ contract negotiations, thereby increasing their contracting costs.”[4]
To the extent he is arguing against any default rule on fiduciary duties, Chief Justice Steele’s musing is silly. Of course every business organization statute has to have a default position on fiduciary duties, a place where analysis begins when the parties are silent in their agreement as to the existence of fiduciary duties. Even if the default position is to have no fiduciary duties absent the affirmative express agreement of the parties, the parties can, and frequently do, bargain to customize their agreement to reflect the calculus of their deal. Or, as Bing Crosby put it: “Everybody has to be somewhere.”[5] Even if Chief Justice Steele means to suggest that it is inherently more chaotic to eliminate or modify fiduciary duties than it is to create and define them – not a correct proposition in our view – every business organization has a fiduciary duty default rule. The question is what the default rule is, not whether there is one.
We note in passing that Chief Justice Steele further muddles the issue by confusing the question of default rules – where the parties start their negotiation – with the question of mandatory rules – the range of permissible ends to which the parties may negotiate. Thus he argues that “default fiduciary duties violate the strong policy favoring freedom of contract enunciated by Delaware’s legislature.” He is correct that the Delaware legislature has strongly endorsed freedom of contract. But that endorsement conflicts with mandatory rules, or rules as to which the ability of the parties to negotiate modifications has been restricted, not with default rules that are fully amendable.
The whole point of default fiduciary duties is to start somewhere. We assume that Chief Justice Steele’s position is, consistent with the tenor of his entire article, that no fiduciary duties exist when the parties’ agreement does not provide for a specific set of rules of conduct. Not that there is no default, but rather that the default is no fiduciary duties
Thus it seems to be Puritans, not Byzantines, about which Chief Justice Steele is really concerned, as when he rejects “the commonly accepted puritanical default fiduciary duty norm.” It isn’t having a default rule on fiduciary duties for Delaware LLPs and LLCs to which Chief Justice Steele objects, it’s having a default rule that provides for any affirmative fiduciary duties. Perhaps if Chief Justice Steele were in Massachusetts he would be more accepting of Puritans. Notwithstanding geography, we point Chief Justice Steele’s argument out for what it is, namely a glorification of the contractarian focus on particular, individual business arrangements and a rejection of any societally imposed limitations on individual actions, even as a starting point that is susceptible to modification and, in Delaware and some other states, elimination by contract.
We believe Chief Justice Steele’s proposition is in error, for reasons of both theory and efficiency. It is those errors to which direct our attention in the following sections.
- 2. The Second Error: The Want of a Theory, Yet Again.
We have argued that the drafters of unincorporated business organization statutes should proceed from a clearly articulated theory when structuring fiduciary duty defaults.[6] Chief Justice Steele seems to disagree.
Chief Justice Steele’s position would establish, at least on an unincorporated business organization level, a “Bladerunner” world in which participants are susceptible to pillage and plunder, unless there is an agreement not to pillage and plunder. Default fiduciary duties establish a different regime which recognizes that people enter business relationships in which pillage and plunder are not the norm. The position advocated by Chief Justice Steele, having default rules that contain no fiduciary duties, advances no clearly articulated underlying theory except perhaps nihilism. We don’t believe that serves society well.
We have noted that there are three theoretical approaches that show some promise with respect to structuring fiduciary duties: party autonomy, communitarianism and structuralism. Unincorporated business organizations, through which autonomous persons carry on business for mutual advantage, are inherently tense. At some level, they are collective organizations, business communities, with collective attributes that involve sharing of profits, management, and control. At another level, they are associations of autonomous persons, each of whom has the independent capacity to pursue his or her own interests. Further, the association conceives of persons as autonomous individuals who exist prior to the collective, and it is only through voluntary association that they enter the community. Having agreed to associate, the question becomes the extent to which the persons surrender their autonomy in favor of reciprocity. It is unlikely that such persons would seek to completely surrender their autonomy but, at the same time, the ideal of reciprocity recognizes the mutual benefits of cooperative arrangements.
In our view, the legal system has long struggled with the balance between party autonomy and community, and business organization law can be viewed as a set of rules mediating autonomy and community. Fiduciary duty rules are implicated in this engagement. We think that the existing approach, whereby LLCs, and partnerships come with a set of default fiduciary duty rules (community and reciprocity) that can be modified by the parties’ contractual arrangement (autonomy) strikes the right balance. We are not alone in this view, as legislatures and courts generally have reached similar conclusions.
Chief Justice Steele’s argument shifts the scales rightward, in favor of complete party autonomy without recognition of countervailing communitarian values. This can be seen by his quotation from Ronald Reagan – “If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.” – which at its core is a renunciation of community in favor of complete individual autonomy. While we agree that a world can be build around that construct, we also think that those who advocate for such a world must start with a theoretical argument as to why the individual autonomy position should be chosen as a starting point. Chief Justice Steele’s article, although it strides toward the autonomy conclusion, fails to make any argument concerning why it is the right starting place, and why the traditional balanced model should be tossed into the ash heap of history.
We also think Chief Justice Steele is in error about who ought to be adopting the underlying theory. Although we recognize that courts can validly establish policy at times, we believe that since LLCs are statutory creatures, enacted initially against a background of partnership and corporate law, any deviation from traditional fiduciary norms, should be undertaken by the legislature and not by the courts. Although Chief Justice Steele argues that the legislature amended the Delaware LLC Act “to clarify that, to the extent that default fiduciary duties exist, as determined by Delaware courts, those duties can be eliminated,” in our view this is an incorrect analysis. First, the Delaware LLC Act, as written, provides, “[t]o the extent that, at law or in equity, a member or manager has duties (including fiduciary duties), . . . the duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement.”[7] The statute does not state that the existence of default duties is to be “determined by Delaware courts.” We agree that Delaware courts can, do and have delimited the default duties, but it is an entirely different proposition for courts to determine the existential question of whether there are default fiduciary duties.
Second, the statutory language concerning expansion, restriction and elimination is inconsistent with a perspective that duties are created only by contract. If one were to draft duties whole-cloth, there would be nothing to expand, modify or eliminate.
Third, the most recent legislative iteration of the statutory provision was enacted in response to the Delaware Supreme Court’s Gotham Partners dictum to the effect that parties cannot eliminate fiduciary duties by contract in a limited partnership.[8] In Gotham Partners, the Chancery Court held and the Supreme Court affirmed, that the defendant general partner’s self-dealing conduct did not comply with the contractual provisions set forth in the parties’ limited partnership agreement, and therefore that the general partner breached its duties to the partnership. However, the Delaware Supreme Court also responded to dictum in the Chancery decision by stating that the Delaware statutes’ basic approach is to allow partners/members the broadest possible discretion in drafting their agreements and to furnish answers only when the partners have not expressly made provisions in their agreement. In that situation, the court stated, “a court will ‘look for guidance from statutory default rules, traditional notions of equity, or other extrinsic evidence.’ But, if the limited partnership agreement unambiguously provides for fiduciary duties, any claim of a breach of a fiduciary duty must be analyzed generally in terms of the partnership agreement.” There cannot be a clearer statement of the Delaware Supreme Court’s understanding that there are fiduciary duties as a default rule. When the Delaware legislature reacted to Gotham Partners and amended the statutes to permit contractual elimination of fiduciary duties it did so against existing, long-standing, background in which fiduciary duties existed in Delaware as a common law default rule. If the legislature had desired to empower the Delaware courts to walk away from common law principles, it could have done so expressly. The legislature not having done so, there is no room for activist judges to avoid common law fiduciary duty default rules. An expression of legislative license for a court to overturn long-standing common law concepts needs to be clearer than the words “to the extent that . . . a person has duties.”
- 3. The Third Error: Efficiency.
Chief Justice Steele believes that having no default fiduciary duties would be more efficient than having default fiduciary duties. He argues that “the costs of default fiduciary duties outweigh the minimal benefits that they provide,” and that “default fiduciary duties add significant contracting and litigation costs.” We think that, again, Chief Justice Steele is in error.
We take as a given that the most efficient arrangement of default fiduciary duties for an unincorporated business organization form is when the statutory default most closely approximates the end to which the largest number of participants would bargain.[9] For Chief Justice Steele’s formulation to maximize efficiency it would have to be true that the largest number of participants would negotiate to a deal which included no fiduciary duties. Such an assertion beggars belief.
Chief Justice Steele’s article demonstrates that a journey’s terminus often depends on its starting point. In his case, he starts with a perspective that “sophisticated parties bargain for the obligations and duties provided in an LLC agreement. The choice of the LLC form was an intentional form, chosen by sophisticated parties because that form provides the contracting parties with the maximum ability to customize their relationship.” He also states that nearly 112,000 new Delaware LLCs were formed in 2007. In our view, it is unlikely that 112,000 new 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. Many LLCs, in Delaware and elsewhere, are formed for traditional reasons – limited liability and efficient, non-corporate taxation – and involve members who lack the resources or the desire to customize the terms of their relationship.
To be fair to Chief Justice Steele, his article recognizes this fact and attempts to adapt to it. For example, he states that courts should not imply default duties “where an operating agreement provides for a specific set of conduct [sic];” he assumes that each partner, member and manager had a bargained-for exchange when entering the relationship and that the agreement is not one that is imposed on a passive member who simply purchased LLC units; and he notes that he focuses only on sophisticated parties entering into an LLC and that he does not imply that the analysis would apply to passive members who are not involved in the LLC’s formation. However, this begs a large efficiency question since courts would then need to engage in a multivariate calculus equation in which sophistication, involvement, level of bargained-for exchange, and other factors would need to enter a determination of whether there are default rules and the extent to which they apply. We think it is much more efficient to assume, as Delaware courts long have, that there are default fiduciary duties and then to consider the parties’ specific contract with respect to the expansion, modification or elimination of such duties, as the statute permits.
Further, even inside a single LLC there can be sophisticated members, unsophisticated members, sophisticated members who accept an operating agreement without extensive bargaining, sophisticated members who relied on other sophisticated members to bargain and who therefore were passive and uninvolved, etc. To the extent Steel’s position is that there are different starting points for different members it is unworkable. Finally, one of the authors of this Article has participated in drafting many lengthy agreements among sophisticated parties. He notes that he has never seen an operating agreement that fully explicates the fiduciary duties of members and managers, although almost all agreements modify or eliminate duties. He suspects that some of the parties would be quite dismayed to learn that courts, acting as common law courts based on facts and agreements presented to them, might hold that LLC managers can self-deal because there is no express duty of loyalty and can act in whatever fashion they may choose because there is no express duty of care. These sorts of policy decisions are best left to legislators, acting prospectively, rather than courts, acting retrospectively.
However one cuts it, Chief Justice Steele argues that the cost of applying any default fiduciary duty is outweighed by its benefit since default duties add unnecessary costs to contracting, add unexpected litigation costs and since “any benefit . . . is limited because the LLC, by its nature, is designed to be a highly customized vehicle, determined primarily by contract.” It is our view that “private ordering” itself creates costs borne by people and firms that are not necessarily engaged in private bargaining. Without default fiduciary duties, parties who form LLCs will spend money and time negotiating fiduciary duty rules, whether or not they ultimately deviate from what would have been the default rule. One cannot assume that the aggregate benefits of private ordering outweigh its aggregate costs, and Chief Justice Steele provides no empirical evidence to the contrary.
Further, based on our experience, we do not think it is apparent that starting with a panoply of default duties and then contracting for modification or elimination of those duties is more difficult then starting with a blank slate and drafting a full set of duties. It is relatively standard in a real estate transaction to state that the parties can engage in competitive activities, even if they might otherwise constitute LLC opportunities and even without disclosure, and such language does not require extensive negotiation. It is very non-standard to start with a blank slate and to then draft a set of duties, and that task assumes both prescience and high drafting competence and cost. Although one could theoretically draft relatively simple language to the effect that “All fiduciary duties of loyalty and care [as set forth in the Revised Uniform LLC Act] apply to the Company’s members and managers; provided however that members and managers can engage in competitive activities that would otherwise constitute Company opportunities without disclosure,” thereby accomplishing the same thing as default duties with modification or elimination, one is left questioning the significance of the difference. In our opinion, default fiduciary duties, however defined by the courts or the legislature, is the much more efficient route to the ultimate destination, whether or not that destination involves private bargaining. We have elsewhere noted that customized terms can be drafted to fit particularized situations, this can involve high drafting costs, risk of drafting or negotiating error, uncertainty regarding terms’ validity, lack of judicial precedent regarding the term’s meaning or effect, and uncertainty arising from lack of investor or other third-party familiarity with the terms.[10] The purpose of default rules is to enhance efficiency, and a default fiduciary duty rule is no exception.
Finally, we would note that Chief Justice Steele’s efficiency musing is undercut by his curiously narrow conception of the parties’ agreement. He strays from his contractarian roots by arguing that fiduciary duties exist only if they are expressly agreed to by the parties. Chief Justice Steele writes that “the courts should analyze LLC agreements by the parties’ agreement alone,” that “[courts] have no reason to assume that parties to an LLC agreement would have provided for fiduciary duties in the contract,” that courts should assume “a clean slate where the organic agreement crafts the rights and duties owed,” and that parties could then “focus their arguments specifically on the agreements they made.”
In our view, Chief Justice Steele leaves no room for implied contracts or for the establishment of duties based entirely on the nature of the parties’ business relationship. If the agreement (presumably written or oral) says nothing, duties are nonexistent. However, even the staunchest contractarian scholars have taken the position that nature of fiduciary duties depends on the parties’ contract and that, for example, there might be partnerships in which partners can act selfishly and take opportunities for themselves, not because they have modified their fiduciary duties, but because their contractual relationship does not contemplate a duty not to usurp.[11] We have argued against this contractarian position in the past, but even accepting its validity we note that it is much more nuanced than a statement that fiduciary duties can only be found in the parties’ express contract. We think the contractarian position goes beyond written and oral manifestations of contract and considers the nature of the parties’ particular relationship. There may be cases under the contractarian construct when parties cannot compete, usurp, self-deal, etc. not because there is a writing preventing such conduct but because the particular nature of their contractual relationship embodies a proscription on such conduct.
- 4. Conclusion.
We conclude that Chief Justice Steele is in error in three basic, but different, ways. He misunderstands the nature of the process by which parties move from statutory fiduciary duty defaults, he fails to supply an underlying theory for his position and is wrong that the courts and not the legislature should adopt such a theory, and he is greatly in error on his efficiency argument. Not a bad day’s work.
Of Chief Justice Steele’s three errors, the second is perhaps the most important. To propose such a sweeping change in the unincorporated business law regime without having an underlying theory is inappropriate. As Leon Trotsky observed, “The end may justify the means as long as there is something that justifies the end.” Chief Justice Steele is much too silent about what justifies his radical end.
In the end perhaps we have all been too quick to treat Chief Justice Steele’s musings as a serious policy proposal. He may have been merely floating a provocative trial balloon to invite further discussion. If so, he has confirmed yet another insightful observation by Trotsky: “If we had had more time for discussion we should probably have made a great many more mistakes.”
[1]Bill Callison is a partner in the Denver, Colorado office of Faegre and Benson LLP. Allan Vestal is Professor of Law and Dean at Drake University Law School.
[2] 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). See also Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 Del. J. Corp. L. 1, 5-6 (2007) (“[A] critique of this Delaware courts’ disposition of limited partnership and limited liability company governance disputes, through the lens of common law fiduciary duty rather than contractual analysis, will demonstrate that the later is more efficient, more consistent with the parties’ business judgment . . . and fulfils any rational view about appropriate public policy.” We, having a different rational view about public policy, have previously attacked this extreme contractarian view. See J. William Callison & Allan W. Vestal, Contractarianism and Its Discontents: Reflections on Unincorporated Business Organization Law Reform, 42 Suffolk Univ. L. Rev. 493 (2009). The Delaware statutes, like those in a number of other states, do not contain any provision setting forth fiduciary duties. In other states, the statutes contain express fiduciary duty provisions and Chief Justice Steele’s analysis is likely inapplicable.
[3] Executive Center III, LLC v. Meieran, 2011 WL 4704274 (E.D. Wis. 2011). The court stated:
There is growing consensus that common law fiduciary duties should apply to the operations of LLCs. See, e.g., Credentials Plus, LLC v. Calderone, 230 F.Supp.2d 890, 899 (N.D.Ind.2002) (“Indiana LLCs, being similar to Indiana partnerships and corporations impose a common law fiduciary duty on their officers and members in the absence of contrary provisions in LLC operating agreements.”); Purcell v. S. Hills Invs., LLC, 847 N.E.2d 991, 997 (Ind.Ct.App.2006) (“In line with the district court’s opinion in Credentials Plus, we now hold that common law fiduciary duties, similar to the ones imposed on partnerships and closely-held corporations, are applicable to Indiana LLCs.”); Patmon v. Hobbs, 280 S.W.3d 589, 594 (Ky.Ct.App.2009) (stating “this Court finds that Kentucky limited liability companies, being similar to Kentucky partnerships and corporations, impose a common-law fiduciary duty on their officers and members in the absence of contrary provisions in the limited liability company operating agreement.”); Gottlieb v. Kest, 141 Cal. App. 4th 110, 152 (Cal.App.2d Dist.2006); People v. Pacific Landmark, LLC, 129 Cal.App.4th 1203, 1211–1216 (Cal.App.2d Dist.2005); Maxemus Entertainment, LLC v. Josey, 35 Conn.L.Rptr. 454, p.*3 & fn. 4 (Super.Ct.2003)(applying Rest.2d Judgments, sec. 59(3)(a) to limited liability companies); Bushi v. Sage Health Care, PLLC, 203 P.3d 694, 699 (2009); Sandra K. Miller, What Fiduciary Duties Should Apply to the LLC Manager After More Than a Decade of Experimentation?, 32 Iowa J. Corp. L. 565, 611–612 (taking issue with Justice Roggensack’s Gottsacker concurrence). But see WAKA, LLC v. Humphrey, 2007 Va. Cir. LEXIS 96, at *9–*10 (May 2, 2007).
Logic dictates the same. Fiduciary duties exist to protect people who are affected by the actions of those who control businesses. Therefore, it would not make any sense if the expectation for a business to act fairly were to be different simply due to the business owners’ choice of form—an LLC, in this case. If that were so, every dishonest owner could simply elect to operate its business as an LLC and claim that no fiduciary duties applied to its actions.
For these reasons, the Court finds that common law fiduciary duties apply to LLCs.
[4] Myron T. Steele, Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L. J. 221, 224 (2009).
[5] http://www.authorsden.com/visit/viewshortstory.asp?id=29206. See also, Sunny Skylar, Gotta Be This or That (http://lyricsplayground.com/alpha/songs/g/gottabethisorthat.shtml ) (as performed by Benny Goodman):
If you ain’t wrong, you’re right;
If it ain’t day, it’s night
If you ain’t sure, you might
Gotta be this or that
If it ain’t dry, it’s wet
If you ain’t got, you get
If it ain’t gross, it’s net
Gotta be this or that
If it ain’t sis, you can’t miss
It’s got to be your brother
Can’t you see it’s gotta be
One way or the other
If it ain’t full, it’s blank
If you don’t spend, you bank
If it ain’t Dee, it’s Frank
Gotta be this or that
[6] J. William Callison & Allan W. Vestal, “They’ve Created a Lamb With Mandibles of Death”: Secrecy, Disclosure, and Fiduciary Duties in Limited Liability Firms, 76 Ind. L.J. 271 (2001); J. William Callison & Allan W. Vestal, The Want of a Theory, Again, 37 Suffolk U. L. Rev. 719 (2004).
[7] §18-1101(d).
[8] Gotham Partners, L.P. v. Hallwood Realty Partners, L.P. 817 A.2d 160, 167-68 (Del. 2002).
[9] Allan W. Vestal, Not ‘Like Sailors or Idiots or Infants’: Social Welfare Based Limits on Private Ordering in Business Association Law, 8 European Bus. Org. L. Rev. 71 (2007).
[10] See J. William Callison, Venture Capital and Corporate Governance: Evolving the Limited Liability Company to Finance the Entrepreneurial Business, 26 J. Corp. L. 97, 116 (2000). In addition, lawyers may have an institutional bias toward standardized terms, even when a customized term is optimal for the client, and behavioral psychology phenomena may discourage deviation from standardized terms. Id.
[11] See, e.g., Larry E. Ribstein, A New Age?: Are Partners Fiduciaries?, 2005 U. Ill. L. Rev. 209 (2005); Larry E. Ribstein, The Revised Uniform Partnership Act: Not Ready for Prime Time, 49 Bus. Law 45 (1993). Chief Justice Steele acknowledges this, “Professor Ribstein explains that ‘the existence of default fiduciary duties depends solely on the structure of the parties’ relationship that is, on the terms of their express or implied contract.’”