Creatures of Contract: A Half-Truth About LLCs

Mohsen Manesh is Associate Professor at University of Oregon School of Law. This post is based on a recent article authored by Mr. Manesh, and is part of the Delaware law series; links to other posts in the series are available here.

“The half truths of one generation tend at times to perpetuate themselves in the law as the whole truth of another, when constant repetition brings it about that qualifications, taken once for granted, are disregarded or forgotten.” [1] Chief Justice Cardozo, then sitting on the New York Court of Appeals, wrote these eloquent words in the early 20th century to describe the doctrine of consideration in contract law. But today, these words might well be applied to the most popular form of business entity, the limited liability company (“LLC”).

The half-truth is this: that LLCs are “creatures of contract.” Courts reflexively use this maxim to describe LLCs, the contract being, of course, the LLC agreement that governs the rights and obligations of the parties that own and manage the entity. [2] The judicial reflex to use this maxim is especially pronounced in Delaware, where today LLCs outnumber corporations by more than two to one. [3] Undoubtedly, Delaware courts have been spurred in part by the state’s LLC statute, which, like the LLC statute of many other jurisdictions, baldly asserts as its guiding policy “to give the maximum effect to the principle of freedom of contract and to the enforceability of [LLC] agreements.” And because Delaware LLC law, like its corporate law, enjoys an outsized influence in the business world, courts in other jurisdictions have now predictably embraced the “creatures of contract” mantra, too.

But to describe LLCs as “creatures of contract,” while perhaps a useful shorthand, is simply misleading. It is a half-truth, but not the whole truth. Therefore, the singular aim of my forthcoming article, written to mark the 25th anniversary of the Delaware LLC Act (hereinafter the “LLC statute”), is to puncture the persistent fantasy that LLCs are merely “creatures of contract.” LLCs are also creatures of statute. And they are also creatures of equity. This claim is not normative; it is a legal reality.

When courts invoke the “creature of contract” maxim, they are making two descriptive claims about LLCs: first, that the LLC represents a contractual relationship and, second, that the terms of the parties’ contract—the LLC agreement—enjoy primacy over statutory or judge-made rules in defining the rights and obligations of the participants within the entity. Yet, both Delaware’s LLC statute and the equitable power of its state courts complicate this simplistic conception of LLCs.

Specifically, the LLC statute includes various provisions that make the legal relationship of LLC parties incongruent with the relationship of ordinary, common law contract parties. These statutory provisions run the gamut, from how an LLC is created to the remedies available for breach of an LLC agreement. Moreover, the LLC statute includes certain mandatory provisions, relating to the implied covenant of good faith and the jurisdiction of Delaware courts, that make clear the “maximum” freedom of contract currently afforded by the statute is not an “absolute” freedom. The very existence of these mandatory statutory provisions undermines the fantasy that LLCs are mere “creatures of contract” unconcerned with statutory rules.

Like the LLC statute, the equitable discretion of the Delaware courts also fundamentally shapes the rights of the participants within LLCs. By recognizing default fiduciary duties among LLC parties, applying a more assertive version of the implied covenant of good faith, and embracing a novel form of aiding and abetting liability, the courts have developed judicial doctrines that have made the legal relationship among LLC participants unlike the relationship among common law contract parties. More notably, courts have also exercised their equitable discretion to effectively curb the freedom of contract in LLCs, by narrowly interpreting the express terms of LLC agreements and, more controversially, asserting a constitutional right to disregard such terms where compelled by equity. Cases like Haley v. Talcott[4] In re Atlas Energy[5] and In re Carlisle Etcetera [6] (and cases from the closely analogous limited partnership context like Morris v. Spectra Energy [7] and Brinkerhoff v. Enbridge Energy [8] demonstrate that the freedom of contract—no matter how expertly exercised—cannot prevent judicial scrutiny motivated by principles of equity.

Thus, my article shows that LLCs embody a complex interaction of contract terms, statutory rules, and judicial doctrine. Consequently, LLCs are creatures of contract and creatures of statute and creatures of equity. This is true under Delaware law—the focus of my article—but to the extent other jurisdictions’ law follow Delaware’s lead, it is true elsewhere, too.

Acknowledging this fact does not mean that legislatures or the courts must or should take a more regulatory or interventionist role in the internal governance of LLCs. [9] Instead, it simply acknowledges the reality that the freedom of contract—the freedom of LLC parties to define their rights and obligations within the LLC—exists only within confines delineated by the legislature and judiciary. Stated differently, the freedom of contract is not an inexorable feature of LLCs, but a policy choice made by the legislature and the judiciary. It is a policy choice that favors ex ante certainty and predictability—through the judicial enforcement of express bargained-for rights and obligations—over ex post judicial policing. It is a policy choice that favors permitting LLC parties the freedom to strike tailored bargains to meet their idiosyncratic needs over the value of applying unwaivable, mandatory rules to all LLCs.

Conceding these points would not only bring clarity to the law, it would highlight the real reasons for contractual primacy in LLCs. It would alert LLC parties as well as jurists and legislators to the active and pervasive role the latter two play in defining the rights and obligations of the participants within the entity. And it would illuminate the potential limits to the freedom of contract in LLCs—where the policy of unrestrained contracting must be balanced against and, in some cases, succumb to other competing policies.

A draft of the complete article is available here.

Endnotes

1Allegheny College v. National Chautauqua County Bank of Jamestown, 159 N.E. 173, 174 (N.Y. 1927).(go back)

2See, e.g., Travelcenters of America, LLC v. Brog, 2008 WL 5272861, *2 (Del. Ch. Dec. 5, 2008) (Chandler, C.) (“It is well settled that [LLCs] are primarily creatures of contract, and in this case, the LLC Agreement is the contract.”).(go back)

3As of December 31, 2016, the number of domestic Delaware LLCs was more than double the number of domestic Delaware corporations and nearly nine times the number of domestic Delaware limited partnerships:

Active as of December 31, 2016
LLCs 827,611
Corporations 298,025
Limited Partnerships 90,626

Email, dated June 20, 2017, from Cheryl L. Wyatt, Technical Support Manager, Delaware Secretary of State Division of Corporations (on file with author).(go back)

4Haley v. Talcott, 864 A.2d 86 (Del. Ch. 2004).(go back)

5In re Carlisle Etcetera LLC, 114 A.3d 592 (Del. Ch. 2015).(go back)

6In re Atlas Energy Res., LLC, 2010 WL 4273122 (Del. Ch. Oct. 28, 2010).(go back)

7Morris v. Spectra Energy Partners (DE) GP, LP, 2017 WL 2774559 (Del. Ch. June 27, 2017).(go back)

8Brinckerhoff v. Enbridge Energy Company, Inc., 159 A.3d 242 (Del. 2017).(go back)

9Indeed, as I have previously argued, there is a strong policy argument in favor of freedom of contract and against equitable intervention by the courts:

[O]ne factor that must be weighed in every case is the central importance of certainty and determinacy in business relationships generally and LLCs in particular. To the extent the courts exercise their … equitable power to override the express terms of a particular LLC agreement, the courts undercut the ability of all parties to rely on such agreements. Such uncertainty complicates business planning and promotes costly litigation. It risks undermining parties’ bargained-for risk allocation and the contractual and extra-contractual mechanisms upon which that allocation was based. Put differently, even putting aside Delaware’s statutory mandate, the freedom of contract and the enforceability of bargained-for agreements are intrinsically important values that must be considered in any equitable analysis.

Mohsen Manesh, Equity in LLC Law?, 44 Fla. St. U. L. Rev. [Part V.A] (forthcoming 2017), at https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2776728, discussed on the Forum here.(go back)

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