I was just reading a paper by Chief Justice Strine and Chancellor Laster that is forthcoming in Cornell Law Review. An idea in thepaper is that
(a) a lot of LLC equity is sold to outsiders (that is, investors not involved in setting up the firm), and
(b) outsiders should want certain protections such as the “duty of loyalty”, yet
(c) LLC articles often waive the duty of loyalty.
The question then arises of why LLC articles would choose an inefficient clause like that, because it would reduce the attractiveness of LLC equity to outside investors and make capital more expensive to the LLC founders. One answer is that maybe the clause isn’t inefficient after all; a duty of loyalty causes too much litigation. Let’s rule out that answer and suppose the clause is inefficient. The paper’s answer is, I think, that it’s hard to write in all the specific provisions for zillions of future contingencies that one would need to replace the judicial doctrine of the duty of loyalty. That’s true, but it doesn’t explain why the Duty needs to be made mandatory.
I have a suggestion. It’sthat the reason for incomplete contracts is contract-reading costs, not contract-writing costs. This applies to LLC’s very well. A big reason to have an LLC is to write special clauses into the articles beyond what could be written into corporate articles. As the article notes, the LLC articles get very long and intricate as a result. It also notes that they are written by the founders, and not by the investors. But that means the articles are hard to read. Investors must fear they contain a “boobytrap clause”. Even if the Duty of Loyalty is not waived in boldface as the first article, a waiver might be snuck in somewhere in the middle, with clever phrasing. Thus, each investor would have to read every sentence of the articles to look for boobytraps. Moreover, since the founders might use very clever lawyers as drafters, each investor has to hire very clever lawyers as readers. That’s expensive, so investors assume things like the Duty of Loyalty are going to be waived somewhere, and the founders might as well put the waiver in boldface at the start. But this means the equity owned by minority investors is not so valuable, and so the founders can’t sell it for as much, and so both founder and investor lose out. Both would prefer a mandatory default of a duty of loyalty.
Or, more mildly, both would prefer a rule that if the duty of loyalty is waived, it must be waived in the first 50 words of the articles, so the waiver will be easy to find.
Contract-reading costs is also a theory of boilerplate. Boilerplate, if it is truly word for word, is safe. The problem is that it is inflexible. And contract-readings costs can perhaps explain why so much of the work of a young lawyer is boring. One escape from the trap of inefficient boilerplate or incompleteness is that big companies will commit in advance to having their lawyers read every word of long contracts. If both sides know the lawyers are going to do that, though, the associates will never find anything and will feel like their long hours of reading are completely useless. That’s why the reputational commitment to always spending thousands of dollars on young lawyers is reading; ex post, it’s useless because they never find anything wrong. The problem for LLC’s is that investors can’t commit to hiring good lawyers to read the contracts, so they’ll be tempted to skip the reading, which means the writers are tempted to put in the boobytrap clauses. That’s game theory stuff, which my paper works out (without too much complexity in the math).
The Strine-Laster paper cites Mohsen Manesh and Marcel Kahan & Michael Klausner on contracting costs. I took a quick skim just now, and they don’t seem to include my contract-reading cost idea. Kahan and Klausner’s article is 4 years earlier than mine, of course, and I published mine in a rather obscure economics journal, so law profs will not have read it and it hasn’t gone viral yet in the scholarly world. See Mohsen Manesh, Express Contract Terms and the Implied Contractual Covenant of Delaware Law, 38 J. Corp. L. 1 (2013); and Marcel Kahan & Michael Klausner, Standardization and Innnovation in Corporate Contracting (Or “The Economics of Boilerplate”), 83 VA. L. REV. 713 (1997) . My article is:
Eric Rasmusen "Explaining Incomplete Contracts as the Result of Contract- Reading Costs," in the BE Press journal,Advances in Economic Analysis and Policy. Vol. 1: No. 1, Article (2001). http://www.bepress.com/bejeap/advances/vol1/iss1/art2. Much real-world contracting involves adding finding new clauses to add to a basic agreement, clauses which may or may not increase the welfare of both parties. The parties must decide which complications to propose, how closely to examine the other side's proposals, and whether to accept them. This suggests a reason why contracts are incomplete in the sense of lacking Pareto- improving clauses: contract- reading costs matter as much as contract- writing costs. Fine print that is cheap to write can be expensive to read carefully enough to understand the value to the reader, and especially to verify the absence of clauses artfully written to benefit the writer at the reader's expense. As a result, complicated clauses may be rejected outright even if they really do benefit both parties, and this will deter proposing such clauses in the first place. http://rasmusen.org/published/Rasmusen_01.negot.pdf