The best of both worlds: default fiduciary duties and contractual freedom in alternative business entities.

AuthorMiller, Sandra K.
PositionIV. Economic and Empirical Factors B. The Empirical Data 4. Mixed Picture on Active Negotiation through VI. Conclusion, with appendices and footnotes, p. 320-345
  1. Mixed Picture on Active Negotiation

    Another recent study by Michelle M. Harner and Jamie Marincic suggests a bit more of a mixed picture than Professor Manesh's study. (181) Professors Harner and Marincic analyzed 129 publicly available LLC operating agreements. (182) In addition to observing widespread use of waivers (73%) and provisions authorizing competition (68%), they found evidence of groupings of contractual provisions that suggested active negotiation had taken place and other groupings that appeared to be indicative of overreaching. (183) For example, a regression analysis revealed that there was a significant association between modification of the duty of loyalty and the requirement of unanimous consent to change the operating agreement--a relationship that could be indicative of active negotiation. The professors also found relationships between duty of loyalty waivers and management protections such as indemnification and veto rights. They also found a relationship between the elimination of managers' personal liability and the absence of buy-out rights. These pro-management relationships suggest that managers may have significant leverage in determining the terms of the agreements. (184)

  2. Vulnerability of Going Private

    The vulnerability of LLC investors to going-private squeeze-outs was recently documented in an empirical study by Professor Brent Horton. (185) Professor Horton examined the operating agreements of 86 publicly traded unincorporated business associations. (186) The study found that approximately 85% contained operating agreements with special approval provisions. (187) Professor Horton noted that about 58% of the LP agreements contained a broad statement eliminating fiduciary duties. (188) Special approval provisions typically create a special committee of independent directors to review transactions that present conflicts between the general partner and limited partners. If the LLC operating agreements provide that the approval by the special committee procedure is conclusive evidence of fairness and reasonableness, it may be challenging to obtain effective judicial review of a transaction that has been authorized by the special approval committee. (189) The findings strongly suggest that there is little room for negotiating provisions such as those that strongly favor the general partner or majority interestholder. Further, as noted below in Part V, one wonders whether the public investors fully appreciated the potential legal risks inherent in this type of investment.

  3. Studies on Practitioner Experience Raise Questions About Disparities in Negotiating Power

    Professor Franklin A. Gevurtz recently conducted a survey of 53 attorneys. (190) The sample mainly came from attorneys who volunteered for the survey in response to a posting on a listserv of the Committee on LLCs, Partnerships and Unincorporated Entities of the Business Law Section of the American Bar Association. (191) The survey consisted of 36 telephone interviews and 17 participants who responded in writing to gain insight into why so many LLCs are being formed in Delaware. (192) When selecting a state other than that of the LLC's principal place of business, 49 of the 50 attorneys said that they chose Delaware. (193) Thirty of the attorneys stated that Section 18-1101 (Delaware's provision permitting the elimination of duties) was one of the main reasons that they preferred Delaware, which indicates that they had included provisions waiving or eliminating fiduciary duties. (194) Of the 30 who stated that 18-1101 impacted the decision to form LLCs in Delaware, 17 (57%) responded affirmatively when asked whether this depended upon the client's expected role. (195) The survey results suggested that the two most important reasons for selecting Delaware include Delaware's legal infrastructure (i.e., the Delaware courts and well-developed case law) and the appeal that the Delaware law has to those planning to be managers or majority owners of LLCs. (196)

    Professor Gevurtz's study did not include a large sample from which results could be analyzed for statistical significance, but the analysis provides extremely interesting insight into the popularity of Delaware's provisions. The fact that so many attorneys said that the attractiveness of the waiver provisions depended on the expected role of the client raises questions about the equality of the bargaining power of managers and controlling LLC members. As more fully discussed below, this issue should be studied separately for closely held and publicly traded LLCs.

    Concerns about the possibility of an unequal contractual playing field and disparities in the negotiating power between controlling members and minority members of LLCs are not new. Two studies conducted by Professor Miller in 2003 and 2006 raised questions about the relative degree of legal representation of majority, as compared to minority, LLC investors. (197) In the 2001 study, over 3,000 surveys were distributed to attorneys in California, Delaware, New York, and Pennsylvania, to which 770 responded. (198) Approximately 56% indicated that they had frequently represented clients who owned a majority in the LLC, whereas only 20% indicated that they frequently represented the minority. (199) In the second survey, to which 517 attorneys responded from Colorado, Delaware, Kentucky, Minnesota, Montana, and New York, approximately 84% indicated that they had represented clients with a controlling interest in LLCs with a minority owner who actively participates in the business, and only 67% said that they had represented clients with a minority interest. (200) When asked about their experience representing majority versus minority clients in LLCs involving passive minority investors, 64% of practitioners indicated that they had often or sometimes represented the controlling members, while only 55% indicated that they had often or sometimes represented the passive minority investors.

    Professor Miller's 2006 survey also showed that a number of LLCs are formed without LLC operating agreements (40%). (201) In the 2006 survey, 85% of respondents had formed simple, no-frills LLC agreements for a modest fee. (202) The 2001 survey reported that 68% believed that many LLC operating agreements are formed based on form agreements that are not extensively negotiated. (203) As more fully discussed in Part V, Miller's findings have significant implications regarding the default fiduciary duty question in Delaware.

    In conclusion, empirical data to date reflects a prevalence of fiduciary duty modifications or waivers in publicly traded LPs and LLCs. Other types of non-fiduciary-duty-related constraints--so-called "uncorporation substitutes"--were not seen to the extent anticipated. As more fully discussed in Part V, the studies are relevant to the question whether limitations on waivers and unlimited indemnification provisions should be developed for publicly traded companies, privately traded companies, both, or neither. Moreover, the reported widespread use of simple, no-frills LLC agreements is highly relevant to the current debate as to whether default fiduciary duties should exist as a matter of legal policy, particularly to address the needs of small business.

    1. Investor Optimism: Does It Reduce the Likelihood that People Will Contractually Self Protect?

      As indicated in the above empirical studies, there is some question as to whether there is a level contractual playing field such that investors could obtain contractual self*protection if they so desired. Even assuming that the context permits contractual self-protection, the phenomenon of investor optimism bias may make it unlikely that people will indeed be moved to perceive risks and adopt contractual self-protections. Optimism bias is a cognitive bias under which people underestimate the likelihood of their own risks of an adverse event taking place. (204) For example, in one study, subjects estimated their own chances of divorce at zero, even though they quite accurately estimated the overall divorce rate at 50%. (205) Another study showed that cigarette smokers were dramatically more likely than non-smokers to underestimate their own risks of cancer, heart attack, and stroke. (206) Professor Robert Prentice has been a pioneer in using behavioral science research to inform legal policy surrounding fiduciary duties. (207) In discussing the question of whether a fiduciary duty should be extended to the broker-dealer relationship, Professor Prentice has argued that mere warnings or disclosures regarding conflicts of interest are not sufficient to lead people to self-protect, partly due to the phenomenon of investor optimism. (208)

      1. IMPLICATIONS & RECOMMENDATIONS: CONTRACTUAL FREEDOM TEMPERED BY CONSTRAINTS

      The above economic and empirical data have far-reaching implications for the development of internal governance law for unincorporated business entities. Default fiduciary duties may well be extremely important to small businesses. Largely unrestricted fiduciary duty waiver and indemnification provisions could leave investors in publicly traded LLPs and LLCs largely unprotected from management abuse or misconduct. It is not clear whether investors fully appreciate the risks they are assuming by acquiescing to elimination of fiduciary duty.

    2. The Default Fiduciary Duty Question and Small Business

      With regard to the question of whether default fiduciary duties should be acknowledged and preserved, the census data on small business enterprises coupled with the empirical data showing widespread usage of simple, no-frills LLC operating agreements are quite relevant. Professor Miller's study--finding that 85% of practitioners sometimes or often used simple, no-frills agreements for a modest fee (209)--suggests that default statutory terms, such as fiduciary duty terms, are likely to be of great importance to a vast segment of businesses. The 2010 census...

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