Freedom of contract and default contractual duties in delaware limited partnerships and limited Liability companies

American Business Law Journal

Volumn 46, Issue 2, 2009, Pages 221-242

  Steele, Myron T ^a  

^a Supreme Court of Delaware ^*  (United States)

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EID: 67650290860     PISSN: 00027766     EISSN: 17441714     Source Type: Journal    
DOI: 10.1111/j.1744-1714.2009.01078.x     Document Type: Article

References (97)

1. The Delaware General Corporation Law (DGCL), DEL. CODE ANN. tit. 8, §§101(b)(7) & 122(17) (2009),
2. provides substantially less freedom in contracting for fiduciary duties than the DLLCA, DEL. CODE ANN. tit. 6 § 18-1101 (2009),
3. and the Delaware Revised Uniform Limited Partnership Act (DRULPA), DEL. CODE ANN. tit. 6, § 17-1101.
4. Over the same time period, the per annum number of new corporations has decreased.
5. Both DRULPA, DEL. CODE ANN. tit. 6, § 17-1101,
6. and DLLCA, DEL. CODE ANN. tit. 6, § 18-1101, originally gave full effect to freedom of contract principles between the parties and, further, allowed for the modification of any judicially created fiduciary duties.
7. Remarks to State Chairpersons of the National White House Conference on Small Business (Aug. 15, 1986), available at http://www.reagan.utexas. edu/archives/speeches/1986/081586e.htm.
8. See Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 167-68 (Del. 2002).
9. See also Myron T Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 DEL. J. CORP. L. 1 (2007) (holding "that, while a limited partnership agreement could provide for contractually created fiduciary duties substantially mirroring corporate common law fiduciary duties, a limited partnership agreement could not 'eliminate' the fiduciary duties or liabilities of a general partner.").
10. 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. Fiduciary duty, in this article, does not refer to the implied contractual duty of good faith and fair dealing. Instead, I specifically identify when I do discuss that implied contractual duty. Compare Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 795 A.2d 1 (Del. 2001),
11. aff'd, 840 A.2d 641 (Del. 2003) and Gotham Partners, L.P v. Hallwood Realty Partners, L.P., C.A. No. 15754-NC, 2000 Del. Ch. LEXIS 141 (Sept. 27, 2000) with Gotham Partners, 817 A2d 160.
12. DEL. CODE ANN. tit. 6, §§17-1101(d) & 18-1101(c).
13. The statute provides that, "[t]o the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement ... ." Id. § 18-1101(c). The legislature, here, did not provide for any default fiduciary duties. Instead, the legislature provided the court with the task of determining whether to apply any default fiduciary duties.
14. See, e.g., Twin Bridges LP v. Draper, No. 2351-VCP, 2007 WL 2744609, at *20 (Del. Ch. Sept. 14, 2007) ("Unless the partnership agreement preempts fundamental fiduciary duties, a general partner is obligated to act fairly and prove fairness when making self-interested decisions.").
15. Fisk Ventures, LLC v. Segal, No. 3017-CC, 2008 Del. Ch. LEXIS 158, at *28 (Del. Ch. May 7, 2008) ("In the context of limited liability companies, which are creatures not of the state but of contract, those duties or obligations must be found in the LLC agreement or some other contract.").
16. See, e.g., DEL. CODE ANN. tit. 6, §18-1101(b) ("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.").
17. See, e.g., Robert Cooter & Bradley J. Freedman, The Fiduciary Relationship: Its Economic Character and Legal Consequences, 66 N.Y.U. L. REV. 1045, 1045 (1991) ("Fiduciary relationships have occupied a significant body of Anglo-American law and jurisprudence for over 250 years, yet the precise nature of the fiduciary relationship remains a source of confusion and dispute.").
18. DEL. CODE ANN. tit. 6, §§ 17-101-17-111 & 18-101-18-1109.
19. See supra note 7and accompanying text discussing fiduciary duties.
20. See Steele, supra note 5, at 10 ("In August 2004, the General Assembly amended the Delaware Revised Uniform. Limited Partnership Act to express its intent to establish legislative policy in derogation of the common law's fiduciary duty principles and to give maximum effect to the principle of freedom of contract.").
21. See Wood v. Baum, 953 A.2d 136 (Del. 2008);
22. Fisk Ventures, LLC v. Segal, No. 3017-CC, 2008 Del. Ch. LEXIS 158, at *28 (Del. Ch. May 7, 2008);
23. Twin Bridges LP v. Draper, No. 2351-VCP, 2007 WL 2744609, at *20 (Del. Ch. Sept. 14, 2007).
24. Fisk Ventures, 2008 Del. Ch. LEXIS 158;
25. Twin Bridges, 2007 WL 2744609.
26. Wood, 953 A.2d 136.
27. DEL. CODE ANN. tit. 6, § 17-1101. The identical language is found in the DLLCA. Id. § 18-1101(b) ("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.").
28. Id. § 17-1101(d).
29. The identical language is found id. § 18-1101(c) ("To the extent that, at law or in equity, a partner or other person has duties (including fiduciary duties) to a limited partnership or to another partner or to another person that is a party to or is otherwise bound by a partnership agreement, the partner's or other person's duties may be expanded or restricted or eliminated by provisions in the partnership agreement; provided that the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing.").
30. Id. § 18-1101(a).
31. The same language is found in. DRULPA. Id. § 17-1101(b) ("The rule that statutes in derogation of the common law are to be stricdy construed shall have no application to this chapter.").
32. Gotham Partners, L.P. v. Hallwood Realty Partners, L.P, 817 A.2d 160, 167-68 (Del. 2002).
33. See Steele supra note 5 and accompanying text.
34. The only Delaware alternative entity statute to provide for standards of conduct is the Delaware Revised Uniform Partnership Act (DRUPA), which is modeled after the Revised Uniform Partnership Act of 1994. Although Delaware adopted standards of conduct at DEL. CODE ANN. tit. 6, § 15-404, Delaware deviated from the Uniform Partnership Act with its enactment of section 15-103(f) specifying that the partnership agreement may: provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including breach of fiduciary duties) of a partner or other person to a partnership or to another partner or to another person diat is a party to or is otherwise bound by a partnership agreement; provided, that a partnership agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.
35. Subsection (d) of title 6 also states that: "It is the policy of this chapter to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements." DEL. CODE ANN. tit. 6, § 15-103(d).
36. DEL. CODE ANN. tit. 6, § 18-1101(c).
37. Gotham Partners, 817 A.2d at 167.
38. ROBERT L. SYMONDS, JR. & MATTHEW J. O'TOOLE, SYMONDS & O'TOOLE ON DELAWARE LIMITED LIABILITY COMPANIES 9-47 - 9-48 (Aspen. Publishers ed., 2007).
39. Metro Comm'n Corp. v. Advanced Mobilecomm. Tech., Inc., 854 A.2d 121, 141 (Del. Ch. 2004).
40. Id. at 142.
41. As one commentator has explained: Courts typically do not attempt to explain why fiduciary duties are imposed in formal fiduciary relationships. Many of these relationships have been considered fiduciary in nature for centuries, and any attempt to explain that status seems unnecessary. By contrast, courts are incessantly attempting to rationalize the law governing informal fiduciary relationships. D. Gordon. Smith, The Critical Resource Theory of Fiduciary Duty, 55 VAND. L. REV. 1399, 1413 (2002).
42. Another commentator has suggested that the standards of conduct set forth in DRUPA at best articulate "degrees of accountability for partners" that may be modified by contract. See Ann E. Conaway, The Multi-Facets of Good Faith in Delaware: A Mistake in the Duty of Good Faith and Fair Dealing; A Different Partnership Duty of Care; Agency Good Faith and Damages; Good Faith and Trust Law, 10 DEL. L. REV. 89-112 (2008).
43. This commentator has also challenged the "creation" of a fiduciary "duty of loyalty" by Justice Cardozo in Mdnhard v. Salmon, 164 N.E. 545 (N.Y. 1928).
44. Meinhard is the seminal partnership case in which Justice Cardozo, without citing to any relevant partnership statute - although New York had adopted the UPA in 1914, at the time the lease was being renegotiated - articulated a "duty of finest loyalty." Id. at 546.
45. As this commentator surmised, "the outcome must be explained by the court's reference to the actions of 'agents.'" See ROBERT R. KEATINGE & ANN E. CONAWAY, KEATINGE AND CONAWAY ON CHOICE OF BUSINESS ENTITY: SELECTING FORM AND STRUCTURE FOR A CLOSELY-HELD BUSINESS (2008).
46. No. 3017-CC, 2008 Del. Ch. LEXIS 158 (May 7, 2008).
47. Id. at *41-43.
48. Id. at *1.
49. Id. at *28.
50. Id. at *34.
51. Gotham Partners, 817 A.2d at 167.
52. Fisk Ventures, 2008 Del. Ch. LEXIS 158.
53. No. 3803-CC, 2008 Del. Ch. LEXIS 115 (Aug. 15, 2008).
54. DEL. CODE ANN. tit. 6, § 18-805.
55. Petitioners also argued that the waiver should be unenforceable under Delaware law. DEICODE ANN. tit. 6, § 18-109(d) (2009) provides: In a written limited liability company agreement or other writing, a manager or member may consent to be subject to the nonexclusive jurisdiction of the courts of, or arbitration in, a specified jurisdiction, or the exclusive jurisdiction of the courts of the State of Delaware, or the exclusivity of arbitration in a specified jurisdiction or the State of Delaware, and to be served with legal process in the manner prescribed in such limited liability company agreement or other writing.
56. Except by agreeing to arbitrate any arbitrable matter in a specified jurisdiction or in the State of Delaware, a member who is not a manager may not waive its right to maintain a legal action or proceeding in the courts of the State of Delaware with respect to matters relating to the organization or internal affairs of a limited liability company. Id.
57. R&R Capital, 2008 Del. Ch. LEXIS, at *28-30.
58. -2007 WL 2744609 at *20.
59. Id. at *12.
60. Id. at *20.
61. I argue that Delaware courts did not previously engage in this analysis because, in Gotham Partners, the Supreme Court of Delaware concluded that statutes prescribed the default fiduciary duties. The 2004 amendment changed that entire calculus and it is now incumbent upon the courts to engage in this policy analysis. The courts, thus far, have had only limited opportunity to readdress this new language. Under the appropriate circumstance, which has not arisen yet, I postulate that a Delaware court would apply an economic analysis to determine whether any default fiduciary duties apply.
62. ROBERT COOTER & THOMAS ULEN, LAW AND ECONOMICS 201 (3d. ed. 2000).
63. DEI., CODE ANN. tit. 6, §18-1101(b).
64. See Ann E. Conaway, Why No Respect: Tfie Contractual Duties of Good Faith and Fair Dealing in Delaware, http://papers.ssni.com/sol3/papers. cfm?abstract-id=994624# ("If freedom of contract in unincorporated entity law means anything, then business courts must be willing to jettison entrenched corporate principles and embrace the aged tenets of contract law. . . including the contractual duty of good faith and fair dealing . . . and other policing techniques permitted under a contractual regime.").
65. See supra notes 3.1.-38 and accompanying text.
66. COOTER & ULEN, supra note 46, at 184.
67. Id. at 202.
68. Id. at 199.
69. Compare AmerisourceBergen. Corp. v. LaPoint, 956 A.2d 642 (Del. 2008) (interpreting a merger agreement, even where arguably self-interested conduct, under contract principles and not fiduciary duties),
70. with Jack B. Jacobs, Entity Rationalization: A Judge's Perspective, 58 BUS. LAW. 1043 (2003) ("[I]n cases where the governing instrument displaces fiduciary duty principles in their entirety, the court will employ contract law principles, but will apply them in a manner that protects the interests of investors.").
71. See generally Fisk Ventures, 2008 Del. Ch. LEXIS 158.
72. -2007 WL 2744609 at *20.
73. DEL. CODEANN. tit. 6, §18-1101(c) ("the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.");
74. DEL. CODE ANN. tit. 6, § 18-1101(e) ("a limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.");
75. DEL. CODE ANN. tit. 6, §17-1101(d) ("the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing.");
76. DEL. CODE ANN. tit. 6, § 17-1101(f) ("a partnership agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.").
77. DEL. CODE ANN. tit. 6, § 18-1101(b).
78. COOTER & ULEN, supra note 46, at 202.
79. See Paul M. Altman & Srinivas M. Raju, Delaware Alternative Entities and the Implied Contractual Covenant of Good Faith and Fair Dealing Under Delaware Law, 60 BUS. LAW. 1469 (2005).
80. Professor Smith establishes a framework for understanding what relationships give rise to fiduciary dudes. Although fiduciary duties would not apply to a traditional contract, he argues that "strategic alliances," potentially in the form of an LLC, is a hard case under his model. Smith, supra note 30, at 1476. The central theme of my article, though, focuses on the fact that, by choosing the LLC form and not contracting for fiduciary duties, the parties determined, for themselves, that no fiduciary duty is necessary. I argue that it is improper for the court, in a paternalistic fashion, to apply default fiduciary duties despite the parties' deliberate and bargained-for choice.
81. COOTER. & ULEN, supra note 46, at 202.
82. Notably, LLCs do not always fall into the definition proposed by Smith that "fiduciary relationships form when one party (the 'fiduciary') acts on behalf of another party (the 'beneficiary') while exercising discretion with respect to a critical resource belonging to the beneficiary." Smith, supra note 30, at 1402. In some situations, the members may only rarely exercise discretion, leaving the entire task of management up to a third party.
83. In many situations, parties imprudently form contracts - and Delaware courts do not meddle in the process to provide fiduciary duties to correct for ill-advised contract terms. For instance, imagine if Delaware courts, to the horror of negotiated acquisition lawyers, began applying fiduciary duty concepts to merger agreements between sellers and acquirers. Instead, Delaware courts, loathe interpreting contracts using extrinsic evidence beyond the specific terms included in an agreement itself. See United Rentals, Inc. v. RAM. Holdings, Inc., 937 A.2d 810, 835 (Del. Ch. 2007) ("The Court must emphasize here that the introduction of extrinsic, parol evidence does not alter or deviate from Delaware's adherence to the objective theory of contracts. As I recently explained to counsel in this case, the private, subjective feelings of the negotiators are irrelevant and unhelpful to the Court's consideration of a contract's meaning, because the meaning of a properly formed contract must be shared or common. That is not to say, however, that a party's subjective understanding is never instructive. On the contrary, in cases where an examination, of the extrinsic evidence does not lead to an obvious, objectively reasonable conclusion, the Court may apply the forthright negotiator principle. Under this principle, the Court considers the evidence of what one party subjec-tively 'believed the obligation to be coupled with evidence that the other party knew or should have known of such belief.' " (citations omitted).
84. The ability of a court to "add" terms to a contract is known as an "implied in fact" contract and is solely determined by the parties' intent. See RESTATEMENT (SECOND) OF CONTRACTS § 204 (1981). This section is titled, "Supplying an Omitted Essential Term." It provides: "When the parties to a bargain sufficiently defined to be a contract have not agreed with respect to a term which is essential to a determination of their rights and duties, a term which is reasonable in the circumstances is supplied by the court." The Commentary to section 204 further provides: The process of supplying an omitted term has sometimes been disguised as a literal or a purposive reading of contract language directed to a situation other than the situation that arises. Sometimes it is said that the search is for the term the parties would have agreed to if the question had been brought to their attention. Both the meaning of the words used and the probability that a particular term would have been used if the question had been raised may be factors in determining what term is reasonable in the circumstances. But where there is in fact no agreement, the court should supply a term which comports with community standards of fairness and policy rather than analyze a hypothetical model of the bargaining process.
85. Id. Terms may also be added by the default provisions of the applicable organic law governing the entity, for example, DLLCA or DRLUPA. Once terms are set in a contract, the contractual covenant of good faith and fair dealing attaches to the performance and enforcement of those terms.
86. See RESTATEMENT (SECOND) OP CONTRACTS § 205 (1981) ("Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement," (emphasis added)). The contractual duty of good faith and fair dealing does not provide a method for courts to add terms to contracts. For an explanation that the implied covenant of good faith and fair dealing cannot provide the basis for "adding or implying" terms to a contract,
87. see Ann E, Conaway, The Multi-Facets of Good Faith in Delaware: A Mistake in the Duty of Good Faith and Fair Dealing; A Different Partnership Duty of Care; Agency Good Faith and Damages; Good Faith and Trust Law, 10 DEL. L. REV. 89, 96-109 (2008).
88. See, e.g., Larry E. Ribstein, A New Age?: Are Partners Fiduciaries?, 2005 U. ILL. L. REV. 209 (2005) [hereinafter Ribstein I];
89. Larry E. Ribstein, Fiduciary Duty Contracts in Unincorporated Firms, 54 WASH. & LEE L. REV. 537 (1997).
90. Ribstein I, supra note 64, at 212.
91. Id. at 212-13.
92. Id. at 213.
93. Id.
94. W. Professor Conaway makes an interesting argument that the fiduciary duties being applied by business courts in the alternative entity context are not "partnership" or "LLC" fiduciary duties but are instead corporate duties that are being misapplied. See Conaway, supra note 63, at 110-14. Certainly at this juncture, no business court has undertaken a principled examination of what a "fiduciary duty" encompasses in the LLC context.
95. Ribstein I, supra note 64, at 213.
96. One empirical analysis, based upon a questionnaire mailed to practitioners in different states, demonstrates that many LLCs, across the country, are formed without adequate legal representation. Sandra K. Miller et al., An Empirical Glimpse into Limited Liability Companies: Assessing the Need to Protect Minority Investors, 43 AM. BUS. L.J. 609 (2006). In this article, I focus only on sophisticated parties entering into a Delaware LLC. I do not imply that this analysis would apply to all members, specifically passive investors, who are not involved in the formation of the LLC nor does this analysis apply to other states.
97. Ribstein, I, supra note 64, at 214.