Contractual freedom under Delaware alternative entity law: evidence from publicly traded LPS and LLCS.

• Author: Manesh, Mohsen
• Position: Limited partnerships, limited liability companies

1. INTRODUCTION II. CONTRACTUAL FREEDOM UNDER DELAWARE ALTERNATIVE ENTITY LAW A. Fiduciary Duties Under Delaware Alternative Entity Law B. Academic Debate and Uncorporate Substitutes 1. Mandatory Distributions 2. Limited Lifetime and Mandatory Liquidation 3. Managers as Full-Fledged Owners C. Absence of Empirical Evidence III. METHODOLOGY A. Data Set B. Method of Legal Analysis 1. Fiduciary Waiver and Exculpation Provisions 2. Uncorporate Substitutes 3. Right to Elect Managers C. Limitations of Methodology IV. FINDINGS A. Fiduciary Duties 1. Waiver Provisions 2. Exculpation Provisions 3. No Waiver or Exculpation B. Uncorporate Substitutes 1. Mandatory Distributions 2. Mandatory Liquidations C. Right to Elect Managers D. Corporate Accountability Versus Uncorporate Substitutes V. ANALYSIS A. Fiduciary Duties ' Limited Role 1. Pockets in which Fiduciary Duties Live 2. The Contractual Constraints that Subsist B. Publicly Traded Alternative Entities as Uncorporations 1. Mandatory Liquidations 2. Mandatory Distributions 3. Managers as Full-Fledged Owners C. Absence of Other Corporate Governance Tools VI. CONCLUSION I. INTRODUCTION

   The fiduciary duties owed by the directors and officers of a Delaware corporation to the firm and its shareholders are mandatory. In general, these duties cannot be waived or modified by contract. (1) The fiduciary duties owed by the managers of an unincorporated Delaware alternative entity, in contrast, are not.

   Since August 1, 2004, limited partnerships (LPs) and limited liability companies (LLCs, and collectively with LPs, alternative entities) organized under Delaware law have been permitted to contractually modify, limit, and even eliminate the fiduciary duties of their managers arising under common law. (2) While there has been an extensive academic debate as to whether alternative entity firms should be permitted to contractually limit or waive fiduciary duties (3)--something that Delaware corporations cannot--there is little empirical evidence as to whether and to what extent such firms actually exploit this contractual freedom. (4)

   This study provides empirical evidence of the extent to which LLCs and LPs take advantage of the contractual freedom afforded under Delaware alternative entity law to limit or wholly eliminate the application of default fiduciary duties. Specifically, this study analyzes the operating agreements of every publicly traded LLC and LP organized under Delaware law as of June 2011. Although publicly traded LLCs and LPs (often referred to as master limited partnerships or MLPs) (5) represent only a small portion of the broader Delaware alternative entity landscape, (6) the number and size of these publicly traded firms have in recent years undergone dramatic growth, making them an increasingly significant part of the business world. (7) Perhaps more importantly, unlike their privately held counterparts, publicly traded alternative entities provide a ready window into contractual freedom as it is practiced under Delaware alternative entity law.

   In analyzing the operating agreements of publicly traded alternative entities, this study seeks to answer two basic questions. First, to what extent do LLCs and LPs take advantage of the contractual freedom afforded under Delaware alternative entity law to wholly eliminate the fiduciary duties of managers? Second, to what extent do Delaware alternative entities adopt so-called "uncorporate" substitutes--certain contractual devices designed to incentivize and discipline managers--in lieu of traditional fiduciary duties to limit agency costs?

   This study makes two principal findings. First, notwithstanding the ongoing academic debate, as a practical matter, fiduciary traditionalists have lost the battle to protect fiduciary duties from contract--at least in the publicly traded sphere. Of the 85 firms studied, 75 (or 88%) either totally waive the fiduciary duties of managers or eliminate liability arising from the breach of fiduciary duties. Second, despite the frequent use of contractual provisions to waive or eliminate liability arising from the breach of fiduciary duties, publicly traded alternative entities have either not adopted uncorporate substitutes or, more commonly, adopted uncorporate substitutes that only trivially constrain managerial discretion. Thus, this study suggests that publicly traded alternative entities have largely utilized the freedom of contract to reduce managerial accountability to investors without committing to significant offsetting constraints on managerial discretion. Although this study by no means settles the ongoing academic debate, it has implications for both sides of that debate.

   This Article proceeds as follows. Part II briefly outlines the legal framework under which alternative entities may contractually waive or limit the fiduciary duties of managers. It also describes the uncorporate substitutes that alternative entity firms may use in place of such duties. Part III then describes the methodology of this study as well as the limitations of the methodology. Part IV describes the findings of the study. Finally, Part V analyzes these findings and considers their implications.

2. CONTRACTUAL FREEDOM UNDER DELAWARE ALTERNATIVE ENTITY LAW

   The treatment of fiduciary duties under Delaware alternative entity law is, perhaps, most striking when compared to Delaware corporate law. In the corporate context, Delaware's importance is well known. Although corporations can choose to incorporate under the law of any state, (8) over half of all publicly traded corporations and nearly two-thirds of the Fortune 500 are incorporated in and governed by the laws of Delaware, (9) a tiny state that accounts for only 0.3% of the United States' population (10) and only 0.4% of the nation's GDP. (11)

   Whatever the reasons for Delaware's longtime dominance in the corporate context, (12) all evidence indicates that today Delaware enjoys similar dominance with respect to alternative entities. (13) This is especially true for larger alternative entity firms that have assets, revenues, or potential liabilities that may justify the expense of organizing out-of-state. (14)

   When utilized by larger firms, however, the alternative entity form reflects a governance structure much like the traditional corporate form. Specifically, like the corporate form, in which all managerial control is vested in a centralized body (the board of directors), (15) larger firms utilizing the alternative entity form provide for strong centralized management (16)--vesting all control in a general partner in the case of LPs or a manager or board of managers in the case of LLCs.

   Because managers in both the corporate and alternative entity contexts are entrusted with tremendous control and discretion over the firm, its business, and its assets, the law imposes certain fiduciary duties on managers. These legally enforceable duties are aimed, in part, to ensure that managers--those who have control of the firm--exercise that control in a manner that is consistent with the interests of the firm's owners--the shareholders or "unitholders," as they are often referred to in the alternative entity context. Put differently, fiduciary duties are legal constraints imposed to limit the "agency costs" that arise when a firm's managers exercise their control in a manner that is inconsistent with the interests of the firm's owners. (17) Although both corporate and alternative entity managers owe fiduciary duties, the manner in which these two bodies of law treat such duties is surprisingly different.

   1. Fiduciary Duties Under Delaware Alternative Entity Law

      Under Delaware corporate law, the officers and directors of a corporation owe the corporation and its shareholders the fiduciary duties of care and loyalty. (18) These duties are not found in Delaware's corporate statute but are judge-made, arising in common law under principles of equity. (19) More importantly, these duties are mandatory. Although Delaware's corporate statute is often described as "enabling," affording business planners and investors broad latitude to privately order the rules of internal firm governance, (20) in general, the fiduciary duties owed by corporate directors and officers may not be waived or modified. (21)

      As with Delaware corporate law, under Delaware LP and LLC law the managers of a firm owe the firm and its investors the same fiduciary duties of care and loyalty. (22) But unlike Delaware corporate law, Delaware alternative entity law has long allowed firms to contractually limit or even eliminate the fiduciary duties of managers through the terms of the firm's operating agreement. (23) As such, under Delaware alternative entity law, managers owe fiduciary duties as a default, in the absence of an agreement to the contrary. (24) Fiduciary duties, however, are not mandatory.

      As if to confirm this point, Delaware's LP and LLC statutes make clear the intent "to give maximum effect to the freedom of contract." (25) Indeed, in response to a 2002 Delaware Supreme court opinion raising doubts as to the outer limits of the freedom of contract with respect to fiduciary duties, (26) the Delaware legislature amended the state's LP and LLC statutes for the specific purpose of confirming that fiduciary duties may be not only contractually limited, but also eliminated altogether. (27) Today, the Delaware LLC act provides that

      to the extent that, at law or in equity, a ... manager ... has duties (including fiduciary duties) to [the LLC] or [any] member ... [the] manager's ... duties may be expanded or restricted or eliminated by provisions in the [LLC operating] agreement; provided, that the [LLC operating] agreement may not eliminate the implied contractual covenant of good faith and fair dealing. (28) The Delaware LP act includes a virtually identical provision. (29)

      Thus, under Delaware alternative entity law, the degree to which firms may contractually tailor or even...