CORPORATE TRANSACTIONS & COMPLIANCE BLOG

Delaware’s Alternative Entities – On the Cutting Edge of Business Trends

By: Heather Jefferson, COGENCY GLOBAL INC. on Mon, Jun 18, 2012


Delaware Alternative Entities

Businesses from all types of industries have looked to Delaware as the jurisdiction in which to form their alternative business entities. According to the Delaware Division of Corporations 2011 Annual Report, there are over 945,000 active Delaware business entities.

Why Delaware?

The “Why Delaware?” question has been asked so frequently that, often times, lawyers and business people, nationally and internationally, assume that Delaware is one of the preferred jurisdictions for forming new business entities because, “it is just done that way.”

The Delaware judiciary, the lawyers and the legislature all collaborate to keep Delaware at the forefront for business. This, combined with a technology-focused Division of Corporations of the Delaware Secretary of State’s office, continues to make Delaware the jurisdiction of choice for businesses.

Evolution of Business Entities in Delaware

Historically, the Delaware corporation was the business entity of choice for most business transactions. The case law precedents for Delaware corporations regarding director duties, shareholder rights and creditors’ rights creates certainty for the various constituents of the corporation.

The rise of the use of the alternative business entity began in the 1980s with the use of the limited partnership in the oil and gas markets. Generally, the limited partnership vests management in a general partner and grants limited rights to investors through a limited partnership interest. For the limited partners, there is potential for a big upside on investment return with perhaps little-to-no management or investment authority; love your GP or gather enough votes under the limited partnership agreement to vote it out, if removal is not restricted under the terms of the partnership agreement. There is Delaware case law discussing this business entity and many important cases on the law governing the fiduciary duties owed by a general partner to its limited partners.

Created in 1988, the Delaware Business Trust (DBT) legislation was an effort to compete with other states’ common law trusts. The DBT would soon become the darling of the mutual fund industry. Delaware saw an opportunity to codify the common law trust into another alternative business entity, the business trust. The DBT offered the mutual fund industry some certainty based on very flexible legislation, access to the Delaware Court of Chancery for disputes (a litigation venue that other states could not match in terms of speed, sophistication and expertise) and something called a “series.”  The series was a unique characteristic that could allow the mutual fund industry to create fund families that were all segregated in terms of liability and assets, yet could be managed under one trust agreement. As a result, a large majority of the major mutual fund families came to Delaware, including Vanguard and Franklin Templeton.

Finally, in 1992, the granddaddy of all the alternative business entities, the Limited Liability Company (LLC), came to Delaware with the enactment of the Limited Liability Company Act. While a relatively new creature, the LLC is dramatically outpacing corporate formations. Current trend information from the Delaware Secretary of State demonstrates the predominance. More LLCs were formed than corporations over the past 5 years. In the year 2011 alone, 93,219 LLCs were formed compared to 31,472 corporations[1].

Advantages of the Delaware LLC

The LLC has advantages over its corporate cousin. The LLC offers the flexibility to draft an operating agreement which sets forth the unique terms of each business deal. All types of management and membership structures can be created, including a series. The LLC is commonly referred to as a “creature of contract.”[2] The operating agreement is the contract. There is no general liability imposed on an LLC’s member or manager as compared with the limited partnership where the GP does have general liability on behalf of the entity. This form of entity became the preferred vehicle in the structured finance industry and for bankruptcy remote entities.

For many corporate practitioners this is very different than the corporation born out of the enabling Delaware General Corporation Law (the “DGCL”). The DGCL sets forth the law of how a corporation will operate. The case law interprets the DGCL and business takes comfort in the caliber and quality of the Delaware jurists writing these opinions. The LLC Act is a “default” statute. If the operating agreement doesn’t expressly state the terms with respect to a particular part of the LLC’s operations, the Act will provide the default language. Parties can, and often do, create business relationships that are unique to the terms of their deals. The LLC entity structure allows for these unique deals and provides a contractual entity by which to do business.  One must look to the operating agreement to determine the parties’ intentions and if silent, then “default” to the Act. There are limited sections of the Act that will apply regardless of what an operating agreement states; two such examples are dissolution and distributions.

Generally, the Delaware courts make a distinction between the corporate case law and the case law governing the LLC. The courts have noted that the law governing the corporation and its constituents may or may not apply to this contractual alternative business entity depending on the content of the operative agreement. The Delaware legislature, along with the advice and comment of the Delaware Bar, continues to update the LLC Act, the DBT Act and all the other alternative business entity laws to keep Delaware’s legislation current and responsive to the market. 

Delaware
Continues to Lead

Many states look to Delaware’s legislation not only to keep their own state’s business legislation competitive, but will look to Delaware’s vast body of case law to guide court decisions. The “Why Delaware?” question is almost an afterthought nowadays. Delaware continues to be the leader in alternative entity formations for good reason!


[1] See Delaware Division of Corporations 2011 Annual Report.  
[2] The Delaware Business Trust and the Limited Partnership are also considered “creatures of contract.”

 

This article is provided for informational purposes only and should not be considered, or relied upon, as legal advice.