The Siren Song of Unlimited Contractual Freedom

Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations (Robert W. Hillman and Mark J. Loewenstein eds.) (Edward Elgar Publishing, 2015, Forthcoming)

Harvard Law School John M. Olin Center Discussion Paper No. 789

33 Pages Posted: 18 Aug 2014 Last revised: 30 Aug 2014

See all articles by Leo Strine

Leo Strine

University of Pennsylvania Law School; Wachtell, Lipton, Rosen & Katz; Columbia Law School

J. Travis Laster

Court of Chancery of the State of Delaware

Date Written: August 1, 2014

Abstract

One frequently cited distinction between alternative entities — such as limited liability companies and limited partnerships — and their corporate counterparts is the greater contractual freedom accorded alternative entities. Consistent with this vision, discussions of alternative entities tend to conjure up images of arms-length bargaining similar to what occurs between sophisticated parties negotiating a commercial agreement, such as a joint venture, with the parties successfully tailoring the contract to the unique features of their relationship.

As judges who collectively have over 20 years of experience deciding disputes involving alternative entities, we use this chapter to surface some questions regarding the extent to which this common understanding of alternative entities is sound. Based on the cases we have decided and our reading of many other cases decided by our judicial colleagues, we do not discern evidence of arms-length bargaining between sponsors and investors in the governing instruments of alternative entities. Furthermore, it seems that when investors try to evaluate contract terms, the expansive contractual freedom authorized by the alternative entity statutes hampers rather than helps. A lack of standardization prevails in the alternative entity arena, imposing material transaction costs on investors with corresponding effects for the cost of capital borne by sponsors, without generating offsetting benefits. Because contractual drafting is a difficult task, it is also not clear that even alternative entity managers are always well served by situational deviations from predictable defaults.

In light of these problems, it seems to us that a sensible set of standard fiduciary defaults might benefit all constituents of alternative entities. In this chapter, we propose a framework that would not threaten the two key benefits that motivated the rise of LPs and LLCs as alternatives to corporations: (i) the elimination of double taxation at the entity level and (ii) the ability to contract out of the corporate opportunity doctrine. For managers, this framework would provide more predictable rules of governance and a more reliable roadmap to fulfilling their duties in conflict-of-interest situations. The result arguably would be both fairer and more efficient than the current patchwork yielded by the unilateral drafting efforts of entity sponsors.

Keywords: Alternative entities, contractual freedom, standardization, transaction costs, defaults, fiduciary duty

JEL Classification: G32, G34, G38, K22

Suggested Citation

Strine, Leo and Laster, J. Travis, The Siren Song of Unlimited Contractual Freedom (August 1, 2014). Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations (Robert W. Hillman and Mark J. Loewenstein eds.) (Edward Elgar Publishing, 2015, Forthcoming) , Harvard Law School John M. Olin Center Discussion Paper No. 789, Available at SSRN: https://ssrn.com/abstract=2481039

Leo Strine (Contact Author)

University of Pennsylvania Law School ( email )

3501 Sansom Street
Philadelphia, PA 19104
United States

Wachtell, Lipton, Rosen & Katz ( email )

51 W 52nd St
New York, NY 10019
United States
212-403-1178 (Phone)

Columbia Law School ( email )

435 West 116th St
NEW YORK, NY 10027

J. Travis Laster

Court of Chancery of the State of Delaware ( email )

DE
United States

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