Interview with Delaware LLC Experts and Practice Manual Co-Authors John Cunningham and Vernon Proctor: Part II
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Last week's post presented an interview with John Cunningham who, along with co-author Vernon Proctor, recently published the pictured practice manual called Drafting Delaware LLC Agreements. John, whose practice focuses on entity formation, addressed some important issues involving Delaware LLCs from the perspective of the drafter of the LLC agreement. In this Part II of the interview, we get Vern's perspective on Delaware LLCs as a seasoned litigator. As John explained last week, "Vern is the guy who makes sure that the book’s analysis of Delaware law is correct. Vern has an amazing knowledge of Delaware statutory and common law."
It's no surprise that John teamed up with Vern as his Delaware law expert. Vern is a founding partner of Proctor Heyman LLP in Wilmington, Delaware, where he has a diverse corporate litigation and counseling practice relating to Delaware business entities, primarily in the Delaware Court of Chancery. Vernon has lectured widely on subjects of Delaware corporate and limited partnership law, and he has served on the editorial boards of leading Delaware law publications. For ten years, he was a member of the Corporation Law Council of the Delaware State Bar Association, a group of attorneys that considers and recommends proposed changes to the Delaware General Corporation Law. He is currently a member of the Alternate Entities Committee of the Delaware State Bar Association, which serves the same function with respect to Delaware statutes governing general partnerships, limited partnerships, and limited liability companies.
In the following interview, Vern answers questions that I suspect are on the minds of many Delaware and non-Delaware lawyers, particularly litigators, whose practices deal with the evolving LLC form.
Mahler: There's a vast body of Delaware case law that lawyers should be aware of in forming Delaware LLCs. If you had to mention just the three or four most important cases, which would they be?
Proctor: As we say in the book, the most important (and, until recently, the only) Delaware Supreme Court opinion construing the Delaware Limited Liability Company Act is Elf Atochem N.A. v. Jaffari, 727 A.2d 286 (Del. 1999). There, the Court provided a comprehensive overview of the structure of the statute, highlighting freedom-of-contract principles and the manner of ascertaining mandatory, default and permissive provisions of the Act. Last month, the Supreme Court decided Olson v. Halvorsen, 2009 WL 4846616 (Del. Dec. 15, 2009), in which it affirmed a Chancery Court holding that the statute of frauds applies to Delaware LLC agreements, notwithstanding the Act’s express allowance of oral and implied LLC agreements. One of the most significant recent trial court decisions in the LLC area is Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. Apr. 20, 2009), where the Court of Chancery examined the efficacy of certain contractual attempts to restrict or eliminate common law fiduciary duties and applied the USACafes doctrine (directors of corporate general partners may owe fiduciary duties to the limited partners of the limited partnership, not just to the corporate general partner and its owners) in the LLC context. Finally, in R&R Capital, LLC v. Buck & Doe Run Valley farms, LLC, CA # 3803-CC (Del. Ch. Aug. 19, 2008), the Court of Chancery held as a matter of first impression that an LLC member could contractually waive its statutory right to seek judicial dissolution of a Delaware LLC, despite the absence from the statute of the phrase “unless otherwise provided in the LLC agreement.” As always in Delaware, check the unreported decisions!
Mahler: On the basis of your Delaware LLC litigation practice, are there any important tips you have for lawyers drafting Delaware LLC agreements?
Proctor: As with any contract drafting, be as precise as you possibly can. This “goes double” for any effort to modify or eliminate common law fiduciary duties pursuant to Section 18-1101 of the Act. Drafters sometimes purport to eliminate all common law fiduciary duties from the deal, but they may inadvertently create their own contractual fiduciary standards. Litigation concerning LLC agreements often turns on whether the subject provisions are ambiguous or unambiguous. If there is an unambiguous “plain meaning,” litigations can often be decided quickly and inexpensively on the pleadings or on summary judgment, rather than requiring expensive discovery and a trial on a “search for the parties’ intent.”
Mahler: Do you think there are any important issues of malpractice or unauthorized practice that non-Delaware lawyers should consider in deciding whether to form Delaware LLCs? In forming these LLCs, should these lawyers always associate themselves with Delaware lawyers?
Proctor: The Delaware LLC Act is a complex statute. If I were a New York lawyer charged with drafting a Delaware LLC agreement for a New York client, particularly for the first time, I would certainly consult with an experienced Delaware LLC practitioner at an early stage of the process. Even transactional lawyers should be aware of such basic concepts as what constitutes the unauthorized practice of law in their home jurisdictions as well as in Delaware: Rule 5.5 of the Delaware Lawyers’ Rules of Professional Conduct provides the principal guidance on that score. Try to ascertain what constitutes practicing law “in another jurisdiction…on a temporary basis.” Never hold yourself out as a Delaware attorney if you’re not licensed to practice there. Make all appropriate disclosures of your bar admissions and experience to your client before accepting the assignment. Check the language of your malpractice policy as well. It’s all common sense.
Mahler: Section 1101(b) of the Delaware LLC Act permits the parties to LLC agreements to eliminate fiduciary duties in these agreements, but not the implied contractual covenant of good faith and fair dealing. Does the covenant provide Delaware LLC members with most or all of the protection they'll need against manager fiduciary breaches?
Proctor: As a litigator, I’m always reluctant to rely heavily on the implied contractual covenant of good faith and fair dealing, except in those rare cases where the LLC agreement unambiguously eliminates both fiduciary duties and liability for breach of contract. For one thing, Delaware courts have been parsimonious in applying the implied covenant. If a provision of the LLC agreement expressly covers the issue as to which the implied covenant claim is made, the claim fails as a matter of law. The court will imply a contractual term only on rare occasions where the agreement is silent.
Mahler: Is there also a difference with respect to damages?
Proctor: In breach of fiduciary duty cases, the Court of Chancery has considerable flexibility, as a court of equity, in fashioning a damage award that will make the LLC or an aggrieved member whole. Where there is an actionable breach of contract, Delaware courts will apply a traditional expectancy or reliance damages measure in most cases. There doesn’t seem to be a fixed standard in implied covenant cases, however. In a few such decisions, the court awarded consequential damages, such as legal fees. To sum up, the implied covenant – standing on its own, at least – is a rather poor substitute for fiduciary protections, whether common law or contractual.
Mahler: By its terms, Section 18-108 of the Delaware LLC Act permits LLCs to indemnify managers and other persons "from and against any and all claims whatsoever." Does this mean that LLCs can indemnify managers even for breaches of the Implied Covenant?
Proctor: I read the language of Section 18-108 very straightforwardly. The power to indemnify against “any and all claims whatsoever” means what it says and covers implied covenant claims as well as contractual and fiduciary claims. This may appear to be inappropriate in view of Section 18-1101(b)’s prohibition of eliminating the implied covenant from LLC agreements and Section 18-1101(e)’s preservation of all liabilities for “bad faith violation[s]” of the implied covenant. Given the sweeping language of Section 18-108, however, I would be very surprised if a “public policy” exception was read into the statute by a court to effect a carveout for implied covenant claims. The Court of Chancery has already stated that you can’t construe Section 18-108 in light of the constraints on indemnification contained in the analogous corporate statute, Section 145 of the Delaware General Corporation Law. See, e.g., Bernstein v. TractManager, Inc., 953 A.2d 1003, 1009-10 & n.23 (Del. Ch. 2007).
Mahler: What do you see as the two or three most important unanswered legal issues in Delaware LLC formations on which you'd like to see rulings from the Delaware Supreme Court?
Proctor: Given recent articles by jurists and legal scholars that question the efficacy of common law fiduciary duties in the LLC context, I’d like to see the Delaware Supreme Court rule definitively on the question of whether such duties even exist. Lower court decisions assume a positive answer to the question in determining whether such duties have been restricted or eliminated pursuant to Section 18-1101(b), but there hasn’t been much analysis of the underlying threshold question. Given my understanding of older partnership cases and the evolution of the LP and LLC statutes over time, I suspect that an affirmative answer would be given to that question. I’d also like to see the Supreme Court eventually resolve the issue discussed above concerning indemnity for implied covenant breaches. Otherwise, most LLC cases seem to be resolved on traditional principles of contract interpretation. That’s probably the way it should be.
Mahler: Vern, many thanks for your thoughtful analysis, and congratulations to you and John on publishing a very fine practice manual.
Interview with Delaware LLC Experts and Practice Manual Co-Authors John Cunningham and Vernon Proctor: Part I
In almost all states, the limited liability company in recent years has become the business organization form of choice for closely held entities. By far the most popular LLC Act for use in forming sophisticated LLCs is the Delaware Act. There are presently something like 7 million U.S. LLCs of which approximately 600,000 are Delaware LLCs.
As a New York practitioner who handles all types of messy disputes between business co-owners, I know first hand the outsized claim of Delaware law on jurisdictional choice of entity as well as the powerful influence of Delaware decisional law even in disputes involving non-Delaware entities. I also know -- because it's written right into the Delaware LLC Act -- that freedom of contract is the cornerstone of Delaware LLC jurisprudence, and therefore nothing contributes more to the long-term health and welfare of a Delaware LLC -- or any LLC, for that matter -- than having a carefully planned, comprehensive, forward-looking, well-drafted operating agreement.
In 2009, Wolters Kluwer Law & Business published what quickly has become the preeminent formbook and practice manual on forming Delaware LLCs entitled Drafting Delaware LLC Agreements. The co-authors are John M. Cunningham and Vernon R. Proctor. I am very pleased to present this first of a two-part interview of the authors of this extremely well-written and user-friendly manual, which also includes a CD containing over two dozen sample Delaware operating agreements.
In this first part of the interview I talk with John Cunningham (pictured left), a member of the New Hampshire and Massachusetts bars whose practice focuses on forming LLCs for business start-ups and on restructuring existing businesses. Among his many achievements John was a principal drafter of the New Hampshire LLC Act. He is not only the co-author of Drafting Delaware LLC Agreements but also is the sole author of Drafting Limited Liability Company Operating Agreements, the leading U.S. general (i.e., non-state specific) LLC formbook and practice manual. I hope you find the interview, which begins after the jump, as interesting and useful as I did.
Mahler: John, who are the principal readers for whom you and Vern wrote your book and what is the book’s main purpose?
Cunningham: We wrote the book for Delaware and non-Delaware lawyers who represent clients in Delaware LLC formations. The book’s purpose is to provide these lawyers with all of the basic knowledge and practice tools—including, above all, model LLC agreements—they will need in order to handle these formations at a high level of competence and efficiency.
Mahler: How have you and Vern allocated the work of writing and updating your book?
Cunningham: I’m the principal idea man and the scrivener. Vern is the guy who makes sure that the book’s analysis of Delaware law is correct. Vern has an amazing knowledge of Delaware statutory and common law.
Mahler: Pardon my nosiness, but do you and Vern ever disagree about significant issues in the book?
Cunningham: Frequently; and sometimes on very basic issues. For example, I think that under the first sentence of DLLC Act § 18-402, it’s clear that the members of Delaware LLCs have broad voting powers on LLC fiduciary matters such as indemnifications. Vern disagrees. But since other leading Delaware lawyers support Vern’s view, I’ve yielded on this issue. But the key point here for lawyers handling Delaware formations is this: When in doubt, resolve arguable ambiguities in the DLLC Act by careful drafting in your LLC agreement. Under the freedom-of-contract provision of DLLC Act § 18-1101(b), you can be very confident that your drafting will be legally valid. That’s the approach Vern and I take in our book when we disagree on key issues of Delaware statutory or common law.
Mahler: In your view, what constitutes a good Delaware LLC form?
Cunningham: First of all, lawyers forming Delaware LLCs shouldn’t think in terms of “a” form but rather in terms of sets of forms. On the basis of their ownership structure, their management structure and their federal tax structure, there are 10 quite distinct types of Delaware LLCs. To be fully equipped to form these LLCs, you need 29 main forms. For example, the provisions in LLC agreements for Delaware single-member LLCs owned by individuals should be significantly different from those owned by entities; for Delaware multi-member LLCs, you need separate forms for those with general partnership management structures, limited partnership management structures and corporate management structures; and for a Delaware series LLC, you need a highly specialized form.
Mahler: And once you decide upon the basic template that's right for the structure of the particular LLC, what optimal form features should one look for?
Cunningham: Above all, the form should identify in its captions all of the business organization law issues, tax issues and other issues likely to be relevant to the type of LLC for which it is drafted. In the case of manager-managed multi-member LLCs taxable as partnerships, this means more than 200 principal and subsidiary issues, including, for example, member dissociation issues, manager fiduciary issues, buy-sell issues, dispute resolution issues, and a slew of federal tax issues. Finally, Vern and I share the common-sense view that all good Delaware forms should be written in plain English that, for the most part, even non-specialists can understand on a careful first reading.
Mahler: What principal types of knowledge do you think lawyers need in order to form Delaware LLCs competently?
Cunningham: Above all, they need a detailed knowledge of the provisions of the DLLC Act relevant to Delaware LLC formations. By our count, this includes about 168 main provisions. And they need to be able to categorize each of these provisions accurately as mandatory, definitional, default, non-self-enabling permissive and self-enabling permissive, since these characterizations can critically affect how you negotiate specific issues in an LLC deal. But they also need a lot of “meta-knowledge”—that is, knowledge that is based on the relevant statutory and case law but that is essentially know-how on how to perform key Delaware formation tasks. These tasks include choosing between Delaware LLCs and Delaware corporations for clients; and choosing whether to form clients’ LLCs under the Delaware LLC act or some other act.
Mahler: What main factors do you think lawyers should consider in choosing between the DLLC Act and non-Delaware acts?
Cunningham: The issue is complex, but here are some key considerations:
- If you’re representing the promoter of an investment LLC who will appoint the LLC’s manager and who wants him or her to have substantial protection from member fiduciary claims, you should generally form the LLC under the Delaware LLC Act. This is because the Delaware Act provides greater scope and flexibility in drafting these protections in LLC agreements than any other act; and because DLLC Act § 18-1101(b) and the Elf Atochem case go very far in ensuring the validity of these protections.
- If your clients’ LLC’s businesses will involve substantial financial stakes and a significant risk of internal disputes, you need to form the LLC under the DLLC Act in order to ensure access to the Delaware Court of Chancery—in my view, the best business court in the U.S. I recently formed an investment LLC with 100 members and an initial capitalization of $600 million. I couldn’t imagine forming that LLC under any non-Delaware LLC act even though none of its members resides in Delaware. The key factor was the excellence and efficiency of the Court of Chancery.
- Not that there aren’t reasons for not forming LLCs under the Delaware Act. For example, it’s often said that “everybody’s second choice is Delaware”—i.e., that when an LLC has two or more members and none of them wants to use the others’ LLC act, you should use the Delaware Act. This saying sometimes makes sense. However, the DLLC Act is tricky, and you shouldn't form LLCs under it unless you have the necessary expertise. And do you really want to have to try LLC internal disputes in Wilmington, Delaware?
Mahler: John, thanks for taking the time to share your expertise with my readers. I look forward to learning even more from your co-author, Vern Proctor, in next week's Part II interview.
