Equity in LLC Law?

To what extent does equity play a role in limited liability company (“LLC”) law? To what extent do courts retain the judicial discretion “to do right and justice” [1] in circumstances in which the LLC statute and the applicable LLC agreement do not otherwise offer an adequate remedy to an aggrieved LLC member or manager?

This question is particularly relevant in Delaware, which plays an outsized role in LLC law due to its status as the leading legal haven for LLCs. Unlike many other states’ statutes, Delaware’s LLC statute purports to “give maximum effect to the principle of freedom of contract and to the enforceability of [LLC] agreements.” [2] Exercising this freedom of contract, LLC parties routinely agree to limit or wholly eliminate fiduciary duties, the judge-made duties that courts have traditionally applied to ensure equity in business associations. And in deference to the LLC statute, Delaware courts have found themselves robotically enforcing these agreements, without ever seriously questioning whether such enforcement is fair, reasonable, or just given the circumstances. Thus, until recently at least, based on statute and precedent, the role of equity in LLCs seemed clear: Equity is subordinate to the freedom of contract and the express terms of the agreement governing an LLC.

But, as I argue in a forthcoming article, Equity in LLC Law?, the Delaware Chancery Court’s decision in In re Carlisle Etcetera [3] has upended this basic precept of LLC law and practice. Carlisle suggests that, as a state constitutional matter, Delaware courts need not sheepishly defer to the state’s LLC statute or the express terms of an LLC agreement. Instead, where justice dictates a different result, Carlisle suggests that Delaware courts retain the equitable power to apply fiduciary standards or recognize other equitable rights or duties, despite the statutorily mandated freedom of contract. Thus, Carlisle represents a true paradigm shift. It inverts the long assumed supremacy of contract over equity in LLC law. Instead, the freedom of contract must be exercised always in the shadow of equity.

The ruling in Carlisle is a result of the peculiarly constitutional basis for equity in Delaware. Specifically, Article IV, Section 10 of the state constitution has long been interpreted to (i) constitutionally vest the Delaware Chancery Court with equity jurisdiction equivalent to that of the High Court of Chancery in Great Britain at the time of the separation of the American colonies; and, more importantly, (ii) constitutionally prohibit the state legislature from restricting the Chancery Court’s equity jurisdiction to less than this irreducible minimum. [4]

Yet, as pointed out in a 2011 article by Professor Lyman Johnson, [5] the Delaware LLC statute does just that. By purporting to authorize contractual restrictions of fiduciary principles or other historically equitable rights or duties, the LLC statute unconstitutionally empowers private individuals to do what the Delaware legislature cannot do directly—that is, to curtail the Chancery Court’s equity jurisdiction.

Shortly after the publication of Professor Johnson’s 2011 article, the Delaware Supreme Court took up the constitutional issue for the first time in CML V, LLC v. Bax. [6] In Bax, the high court flatly dismissed the applicability of this state constitutional provision to LLCs based upon the simplistic notion that LLCs (unlike partnerships and corporations) did not exist at the time of American independence and, therefore, are not subject to the constitutionally protected equitable powers of the Delaware Chancery Court.

Carlisle, however, rejects the reasoning of Bax, decrying it as a “radical form of constitutional originalism.” [7] Instead, Vice Chancellor Laster concluded in Carlisle, “I cannot accept the contention that because the nascent practice of entity law as it existed at the time of the colonies’ separation had not yet envisioned LLCs, they fall outside the domain of equity.” [8] In reaching this conclusion, the vice chancellor recognized the judicial power to enforce historically equitable rights and duties, notwithstanding the express terms of the LLC statute or governing LLC agreement.

So, does Carlisle signal the demise of Bax and a resurgent role for equity in LLC cases? There is reason to believe the answer is yes. Since Bax was decided, changes in both Delaware’s LLC statute and its state bench suggest the underlying reasoning of Bax—based upon a “purely contractarian” view of LLCs—no longer has purchase in Delaware. These changes have eroded Bax’s continued viability as binding precedent.

Still, even if Carlisle portends the demise of Bax and a reinvigorated role for equity, the overt consequences will be modest in practice. Equity is unlikely to upend the hundreds of thousands of agreements governing Delaware LLCs today. Both policy and pragmatic considerations suggest that the Delaware courts will be exceedingly sparing in the use of their constitutionally vested equitable powers. This is true even in cases involving publicly traded LLCs, and their limited partnership ilk, where the governing agreements often bear all the hallmarks of one-sided contracts of adhesion. Consequently, the express terms of LLC agreements, including fiduciary waivers, will continue to be routinely enforced in the vast majority of cases.

But what Carlisle means is that the Delaware courts need not unquestioningly defer to the express language of an LLC agreement in every conceivable circumstance—especially when presented with conduct that is manifestly opportunistic, exploitative, or otherwise inequitable. Accordingly, the practical role of equity in LLC law and governance will be more subtle than overt. The very existence of an unwaivable judicial power “to do right and justice” may serve as a prophylactic deterrent against brazen overreach or exploitation. Put differently, freedom of contract will subsist, but it will be exercised always in the shadow of the Delaware courts’ equitable powers.

The full article is available here.