Default rules and fiduciary duty waivers in alternative entities: policy issues and empirical insights.

Author:Miller, Sandra K.
Position::I. Introduction to Alternative Business Entity Legislation Policy Questions through V. Empirical Research and Legal Policy, p. 147-186 - Author abstract
  1. INTRODUCTION TO ALTERNATIVE BUSINESS ENTITY LEGISLATION POLICY QUESTIONS II. CONTRACTUAL FREEDOM: A TWO-EDGED SWORD A. The Corporate Context: The Duty of Loyalty Encompassing Good Faith Preserved B. The Non-Corporate Context: The Duty of Loyalty Eliminated or Curtailed C. Many States Permit the Elimination of Duties but Still Limit Indemnification D. Problems with the Contractual Model: Contextualizing this Empirical Study 1. Unlevel Playing Field, Inefficiencies, Complexity, Human Error, and Unfairness 2. The Value of Empirical Research on Business Community Expectations III. A STUDY OF EXECUTIVES' VIEWS ON DUTIES AND WAIVERS A. The Sample B. The Survey and the Scenarios C. Major Findings 1. Default Built-in Duties: A Majority Agreed the Law Should Provide a Default Duty of Loyalty but not a Default Duty of Care in the Absence of an Operating Agreement 2. Waivers: Where an Agreement Was Posited, Most did not Agree that the Law Should Enforce a Waiver of the Duty of Loyalty 3. Waivers: Where an Agreement Was Posited, Most Agreed that the Law Should Enforce the Waiver of the Duty of Care 4. Greater Support for Waiver of the Duty of Care than for Waiver of the Duty of Loyalty in Both Private and Public Hypothetical Companies 5. Higher Support for Waivers in Private than in Public Company Hypothetical Scenarios 6. Reported Willingness to Invest in Company with Waiver and Overall Astuteness with Regard to Waivers 7. Understanding of Director Liability IV. IMPLICATIONS A. Do Values of Honesty, Candor, and Fairness Trump Contractual Freedom? B. The Duty of Care Transgression: "Like Shaving Pigs--Much Squeal and Little Wool"? C. Should Managers of Public Entities be Held to a Higher Standard? D. Are Indemnification Rules and Fiduciary Duty Waivers Well-Understood by the Business Community? V. EMPIRICAL RESEARCH AND LEGAL POLICY A. Limitations and Suggestions for the Design of Future Studies B. Policy Issues Ahead 1. Different Rules for Public and Private Entities and Outer Limits on "Private Ordering" 2. Updating the Nexus of Contracts Vision: The Role of the Sovereign and Equity 3. Does Private Ordering Require Increased Ethics Training in Law and Business Schools? VI. CONCLUSION I. INTRODUCTION TO ALTERNATIVE BUSINESS ENTITY LEGISLATION POLICY QUESTIONS

    Imagine a privately-owned nursing home that is operated by a Limited Liability Company (LLC) manager with a bad gambling habit. The manager engages in several self-interested transactions, drains the facility of cash, and does a poor job of managing the facility. Patients and passive investors alike find themselves in peril. To what extent should the law protect the manager from damage suits by investors who entrusted their money to the nursing home venture? What if instead, the LLC manager had carefully managed the nursing home, but had engaged in dishonest, self-interested conduct? Should a default, built-in duty of loyalty and/or duty of care apply in the above circumstances in the absence of an LLC operating agreement? If an agreement had been executed, should the manager have the freedom to self-protect against investor lawsuits through the elimination of the duty of loyalty and the duty of care? Should the rules differ for public and private LLCs? Should stricter waiver rules apply when a manager has acted dishonestly and/or deliberately?

    The above questions have assumed increased importance now that litigation experience with contractual waivers in publicly-traded LLCs and master limited partnerships (MLPs) has led Delaware Chief Justice Leo E. Strine, Jr. and Vice Chancellor J. Travis Laster to recommend an end to the ability to contractually eliminate the duty of loyalty in certain diversely held Delaware alternative business entities. (1) Chief Justice Leo E. Strine, Jr. and Vice Chancellor J. Travis Laster argue that expansive contractual freedom has not led to case law providing general principles that would serve as guidelines fostering predictable and reliable business practices. (2) They recommend a framework that would prohibit waivers of the duty of loyalty, permit waivers of the duty of care, and create a new presumption that in appropriate cases presumes the duty of care has been waived in diversely-held alternative entities. (3)

    Is there indeed justification for treating violations of the duty of care and the duty of loyalty quite differently in alternative entities? What are the expectations of the business and investor communities regarding duty of loyalty as compared to duty of care transgressions? To gain some insight into executives' perceptions of and comprehension of the duty of loyalty, the duty of care, and waivers of these duties, a short questionnaire was sent to 117 executives, to which 45 responded. The executives were presented with a duty of loyalty and a separate duty of care scenario. The findings showed that the respondents indeed held quite different expectations of how the law should work in the duty of loyalty scenario as compared to the duty of care scenario. Respondents' support for a built-in, default duty of loyalty was significantly greater than for a built-in, default duty of care. Moreover, respondents displayed greater support for enforcement of the waiver of the duty of care than for the waiver of the duty of loyalty. The lowest level of support for waivers overall was shown where the breach involved the duty of loyalty in a hypothetical public company.

    The findings of rather radical differences in expectations regarding the hypothetical duty of loyalty scenario and duty of care scenario are interesting and potentially relevant to the overall policy question of whether alternative business entity legislation should treat the duty of loyalty and the duty of care differently and whether different rules should apply to privately and publicly-owned enterprises. If business entity legislation is to be efficient, the default rules and constraints on fiduciary duty waivers should be consistent with the expectations and values of the stakeholders affected--i.e., the expectations of the business and investor communities as well as the community at large. (4) Until now, scholars have not empirically studied whether investors or business executives hold different views and expectations regarding the duty of loyalty as compared to the duty of care. Such data could help gauge the business and investor community's likely reactions to proposals to treat waivers of the duty of loyalty differently from waivers of the duty of care in public and private alternative entities.

    Following this introduction, Part II provides background information regarding the rise of enabling contractual legislation in the corporate and non-corporate contexts. It focuses on the problems with unfettered contractual freedom and on alternative approaches to contractual freedom in current LLC legislation. Part III presents the results of a small empirical study of executive views regarding default duties and waivers in public and private hypothetical entities. Part IV discusses the implications of the research against the backdrop of literature on trust. Part V provides a critique of the survey, formulates suggestions for future research, recommends tempering the Nexus-of-Contracts paradigm with aspects of a Concession/Stakeholder vision of business entities, and suggests changes in ethics training in the law school curriculum.


    The drive for increased contractual freedom in business entity regulation began in a time of escalating damage awards during the 1970s. [5] In the public company corporate arena, lawyers and others were concerned that directors would resign because of escalating legal exposure. (6) In the private company context, a quiet revolution unfolded that brought with it unprecedented contractual freedom. Nearly 40 years later, this trend has continued in alternative entities. However, there is a growing sense that contractual freedom should be curtailed, at least in diversely-held Delaware alternative entities, and that predictable constraints on contractual freedom are difficult to achieve under a purely contractual model. (7)

    1. The Corporate Context: The Duty of Loyalty Encompassing Good Faith Preserved

      In the corporate arena, increased control over legal liability of directors was sought largely in response to Smith v. Van Gorkom, (8) the landmark 1985 Delaware Supreme Court decision that held outside directors liable for gross negligence for approving a merger without informing themselves of the value of the company. (9) Delaware's response, soon followed by legislatures across the country, was to enact so-called "enabling legislation." (10) This enabling legislation did not expressly modify the director's duty of loyalty to act in the best interests of the corporation and its shareholders or to exercise care in discharging his or her duties. (11) Instead, it permitted articles of incorporation to eliminate liability for monetary damages arising from breaches of fiduciary duties except for any breach of the duty of loyalty to the corporation or its stockholders, for acts or omissions not in good faith, intentional misconduct, knowing violations of the law, and for several other designated types of serious wrongdoing delineated in the statute. (12) This duty of loyalty encompasses not only the duty to further the best interests of the corporation and to avoid self-interested conduct, but also encompasses a subsidiary element of good faith. (13) One way or another, non-exculpable conduct in the Delaware corporate arena is tied to some level of subjective wrong-doing either through deliberate, conflicted self-interested conduct or through a conscious disregard of one's duties. (14)

      The pre-Disney decision in In re Caremark International Derivative Litigation, involving a failure to pick up officers' receipts of kickbacks, established that there could be liability for a sustained or...

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