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E-MailLast month I discussed the emerging importance of what I call “uncorporate” governance – that is governance characteristic of partnership-type firms – for large, publicly held firms. As elaborated in my Uncorporating the Large Firm, a critical aspect of these firms is that they substitute distributions, liquidation rights and high-powered managerial incentives for traditional corporate monitoring devices, particularly including fiduciary duties.
The Delaware legislature does effectuate this “substitution” by explicitly letting LLCs eliminate all duties except for “the implied contractual covenant of good faith and fair dealing” (6 Del. Code §18-1101; there are similar provisions for other unincorporated firms). By contrast, the Delaware provision on fiduciary duty modification in corporations (DGCL §102(b)(7)) prohibits waivers of the duty of loyalty and “for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” And as I discussed in Uncorporation and Corporate Indeterminacy, Delaware courts have enforced waivers consistent with the statutes.
But will Delaware courts apply corporate restrictions on waivers to publicly held uncorporations. In particular, might they interpret the “good faith” qualifier in the uncorporation statutory waiver provisions as similar to corporate-type good faith, which has been interpreted as part of the fiduciary duty of loyalty (see Stone v. Ritter, 911 A.2d 362 (Del. 2006))? Until very recently, the Delaware Supreme Court had never held that fiduciary duties could be waived in any publicly held firm.
That has now changed thanks to the Delaware Supreme Court’s recent opinion in Wood v. Baum. The case involved Municipal Mortgage & Equity, LLC (“MME”), at the time of the case a NYSE-listed Delaware LLC with 2500 record holders (see MME 2006 10K). The question in the case was whether the plaintiff had adequately alleged facts justifying excusing demand in a derivative suit as futile. Under the controlling Aronson standard in Delaware, in a case like this one involving an independent board the plaintiff had to show that the directors had an incentive to protect themselves from a substantial risk of personal liability. The court noted that:
under the Operating Agreement and the [Delaware Limited Liability Company Act] the MME directors’ exposure to liability is limited to claims of “fraudulent or illegal conduct,” or “bad faith violation[s] of the implied contractual covenant of good faith and fair dealing.”
Where directors are contractually or otherwise exculpated from liability for certain conduct, “then a serious threat of liability may only be found to exist if the plaintiff pleads a non-exculpated claim against the directors based on particularized facts.” Where, as here, directors are exculpated from liability except for claims based on “fraudulent,” “illegal” or “bad faith” conduct, a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter, i.e., that they had “actual or constructive knowledge” that their conduct was legally improper. Therefore, the issue before us is whether the Complaint alleges particularized facts that, if proven, would show that a majority of the defendants knowingly engaged in “fraudulent” or “illegal” conduct or breached “in bad faith” the covenant of good faith and fair dealing. We conclude that the answer is no.
With respect to bad faith, the complaint alleged, among other things, that the defendants had “breached their Caremark duties by “fail[ing] properly to institute, administer and maintain adequate accounting and reporting controls, practices and procedures,” which resulted in a “massive restatement process, an SEC investigation, and loss of substantial access to financial markets.” (footnotes omitted). These allegations may have raised a good faith issue under Stone. Nevertheless, the court said:
the Complaint does not purport to allege a “bad faith violation of the implied contractual covenant of good faith and fair dealing.”The implied covenant of good faith and fair dealing is a creature of contract, distinct from the fiduciary duties that the plaintiff asserts here. The implied covenant functions to protect stockholders’ expectations that the company and its board will properly perform the contractual obligations they have under the operative organizational agreements. Here, the Complaint does not allege any contractual claims, let alone a “bad faith” breach of the implied contractual covenant of good faith and fair dealing. Nor, as discussed above, does the Complaint contain any particularized allegations that the defendants acted with the requisite scienter (in “bad faith”). (footnotes omitted)
The court concludes: “Given the broad exculpating provision contained in MME’s Operating Agreement, the plaintiff’s factual allegations are insufficient to establish demand futility. (emphasis added)”
In short, the directors had no fiduciary duties under the agreement, and no incentive to protect themselves from liability for breach of any such duties. Although this case did not involve particularized allegations of self-dealing, there is no apparent reason why the court’s reasoning should not cover such allegations as well.
If publicly held firms can waive fiduciary duties in the LLC form, why should they not be able to do so in the corporate form? Should the Delaware legislature take the next seemingly logical step and carry the complete exculpation approach over to corporations from uncorporations? Seventeen years ago, in the wake of Delaware’s initial adoption of broad fiduciary opt-out provisions for limited partnerships, I predicted that would happen, in my Unlimited Contracting in the Delaware Limited Partnership and its Implications for Corporate Law, 17 J. Corp. L. 299 (1991). I argued that the absence of other corporate-type protections made fiduciary duties even more important in unincorporated firms, so that if the latter could opt out, a fortiori corporations should be able to do so. Also, if publicly held corporations could opt out by simply disincorporating, why force them to take this procedural step? Perhaps, as discussed in Uncorporating the Large Firm, corporations should be distinguished from uncorporations on the basis that the latter offer disciplinary and incentive devices that make fiduciary duties less necessary in this context. There is also an argument for letting firms and investors choose between two distinct approaches to opting out of fiduciary duties.
In any event, it now seems clear that publicly held unincorporated firms can opt out of fiduciary duties in Delaware. It remains to be seen whether my initial prediction that this permission will extend to publicly held corporations ultimately will prove to be correct.
