August 18, 2010
Gordon Smith on Manesh on "Delaware and the Market for LLC Law"
Posted by Gordon Smith

Mohsen Manesh's new paper, Delaware and the Market for LLC Law, is a fascinating project, and I am grateful to him for allowing us to feature his paper in the Junior Scholars Workshop. Like Larry Ribstein and Bob Lawless, I admire Mohsen's scholarly ambition, but I feel like this paper has some distance to travel before it is complete.

Mohsen begins with the claim that Delaware lacks the sort of market power in the competition for LLC charters that it has in the competition for corporate charters. His evidence for this claim is the lack of price discrimination in LLC taxes. Like Larry and Bob, I am skeptical of this claim, but I am willing to play along for the sake of argument. I am more interested in his examination of contractability and indeterminacy under LLC law, and my interest in these arguments eventually leads me back to Mohsen's initial claim regarding Delaware's supposed lack of market power.

Indeterminacy in corporate law is often said to play a crucial role in enhancing Delaware's market power. On the nature of indeterminacy in corporate law, Mohsen observes: "Delaware corporate law, and in particular its judge-made law of fiduciary duties, tends to favor contextual, fact-intensive standards over bright-line rules." Note that the charge of indeterminacy is not necessarily an indictment of Delaware law. Indeterminacy is probably inherent and almost certainly desirable in fiduciary law. The somewhat counterintuitive claim that this indeterminacy enhances Delaware's market power is based on two observations: (1) indeterminate law is hard to copy, and (2) indeterminate law increases the importance of judges (and Delaware has the best judges).

So far, so good. Now the crucial move: Mohsen asserts that LLC law is less indeterminate than corporate law because LLCs are "creatures of contract." In Mohsen's words:

Virtually all of the default provisions specified in the Delaware LLC Act may be superseded or otherwise contractualized by the terms of a LLC’s governing agreement. As a result, many of the mandatory and indeterminate provisions that are imposed under Delaware corporate law—including the judge-made law of fiduciary duties—may be contractually waived, modified or clarified under Delaware LLC law.

According to Mohsen, one implication of this contractability is that LLCs can avoid the cost of uncertainty inherent in corporate law. I have several problems with Mohsen's argument.

First, Mohsen selects an unfortunate example to illustrate the mandatory indeterminacy of Delaware corporate law. He argues that DGCL Section 271, governing the sale of "all or substantially all" of a corporation's assets is a mandatory provision, meaning that it "cannot be modified, clarified or otherwise waived by the terms of a corporation's governing documents." While the statute does not expressly allow for contrary terms in the corporate charter, the process for selling assets is often subject to contractual specification. If powerful shareholders want a say in the sale of assets -- even when that sale constitutes less than "all or substantially all" of a corporation's assets -- they simply have to insert a negative covenant into their deal terms.

Second, while Mohsen illustrates how an LLC's governing documents could "contractualize" certain matters that, in a corporate context, might be evaluated under a mandatory, indeterminate, fiduciary standard, he does not provide evidence that LLCs routinely avail themselves of this opportunity. He rightly acknowledges that drafting highly specified contracts is expensive and difficult, and that should lead him to ask: would most Delaware LLCs invest in such contracts? The answer to this question depends on what these LLCs look like, and I agree with Bob Lawless that it would be nice to know more about this. Are most of these LLCs Mom-and-Pop businesses? Or are they non-operating companies? In any event, my guess is that the vast majority of Delaware LLCs are tightly controlled by one individual or parent company, thus eliminating the need for highly specified contracts.

Third, if one of the major advantages of LLCs is contractability, which reduces indeterminacy, why are so many LLCs formed in Delaware? Mohsen observes that many states have copied Delaware's LLC Act, which provides that its principal policy is "to give the maximum effect to the principle of freedom of contract." If contractability is the key feature of LLC law, why don't other states compete more effectively with Delaware? Under Mohsen's theory, contractability reduces indeterminacy, which implies that Delaware judges have no special advantages. Rather than puzzling over Delaware's lack of market power, I am left puzzling over Delaware's success in attracting LLC formations when its product has no discernible advantages.

By the way, Larry Ribstein disagrees with Mohsen on this point, arguing, "The contractual nature of LLCs increases the value of Delaware courts’ contract-enforcement technology." In other words, the important thing about Delaware is how the judges will interpret future contracts, and that feature of the Delaware system is not easily replicated by other states. This seems plausible to me, but it is in tension with the notion that contractability reduces indeterminacy and, thus, poses a significant challenge to Mohsen's paper.

Fourth, Mohsen dismisses the importance of the contractual duty of good faith and fair dealing too quickly, arguing, "the Delaware courts have made clear that the implied contractual covenant is doctrinally distinct and substantially narrower than the open-ended fiduciary duties imposed by corporate law." The Delaware courts have certainly made statements like this, but my sense is that the treatment of this doctrine is far more complex than Mohsen gives credit. Indeed, earlier this summer, I heard Chief Justice Steele address two distinct lines of cases involving the contractual duty of good faith and fair dealing and suggesting that these precedents were in serious conflict.

In the end, all of my points revolve around a single complaint, namely, that Mohsen exaggerates the extent to which the contractability of LLCs reduces indeterminacy when compared to corporations. Given that his argument rests on this claim, however, it is a point worth arguing.

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