CRITICAL DISTINCTIONS BETWEEN TEXAS AND DELAWARE LLC LAW
Texas is becoming an increasingly popular destination for businesses choosing to form an LLC. In this continuing legal education (CLE*) credit-eligible program, we’ll highlight some meaningful differences between Texas and Delaware business entity law and demonstrate how practitioners must be wary of these key differences through a study of relevant statutes and cases.LEARN MORE
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Join Byron F. Egan and Daniel Lewis of Jackson Walker LLP in Dallas as we discuss some of the distinctive aspects of LLC laws, including certain fundamental provisions of Texas Business Organizations Code (BOC) and the Delaware Limited Liability Company Act. We’ll also cover relevant Texas and Delaware cases and applicable federal, Texas, and Delaware tax considerations. Mr. Egan is the principal author of “EGAN ON ENTITIES: Corporations, Partnerships and Limited Liability Companies in Texas,” a CSC publication.
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Annie: Hello, everyone, and welcome to today's webinar, "Critical Distinctions Between Texas and Delaware LLC Law." My name is Annie Triboletti, and I will be your moderator.
Joining us today are guest speakers Byron Egan and Daniel Lewis from Jackson Walker. And with that, let's welcome Byron and Daniel.
Byron: Well, good morning and howdy. We're going to be talking about LLCs today, and we're going to be talking particularly about those formed in Delaware and Texas because those are two states that are very popular domiciles for LLC formation. We do have in both Texas and Delaware five forms of business entity to choose from — the corporation, the general partnership, the limited partnership, the limited liability partnership or LLP, and the limited liability company, the LLC, which is our real subject today. There'll be references to "Egan on Entities," which is my book, and there'll be information as to how you can get it from LexisNexis and CSC.
We have some statistics from the secretaries of state of Texas and Delaware. But the essence of these statistics is that we're forming in Texas LLCs at a 14 to 1 ratio over for-profit corporations. Let me repeat that. Fourteen LLCs are formed in Texas every year or at least last year compared to one for-profit corporation. In the Delaware scenario, the ratio is four to one, four LLCs for every corporation. The result is that we now have many more LLCs than corporations in both Texas and Delaware. So here are the details or statistics.
The LLCs in Texas are organized under the Texas Business Organizations Code, which is a codification of all the business entity statutes in Texas. It's a hub-and-spoke approach, where the spokes are the chapters that deal with the particular forms of entities, like Section 100, etc. would be for the LLCs, and then the earlier sections of the code would be the hub provisions, such as definitions, where you form, where you file, mergers, indemnification, etc. So that's the structure in Texas.
Delaware is much simpler. It's all in the Delaware Limited Liability Company Act.
Daniel, do you want to talk about taxes because that's a pretty important distinction?
Daniel: Sure. Thanks, Byron. So yeah, the key difference here will be double tax treatment as opposed to flow-through treatment. So corporations are going to be taxed both at the corporate level and then at the shareholder level, whereas the idea with an LLC is that unless you kind of opt out of this default treatment, you're just going to be taxed at the member level.
So the Tax Cuts and Jobs Act in 2017 sort of changed several things about rates and then a few other things that are flagged here, like the immediate corporate deduction of depreciable tangible assets, even assets from a third party, as well as the interest deduction being limited to 30% of EBITDA. Partnerships and LLCs, on the other hand, although they don't have that flat rate at the entity level, you're going to see individual rates apply. So that could go up to 37% plus your Medicare Contribution Tax.
Another thing to have on your radar besides federal income tax, when you're thinking about Delaware versus Texas as your state of incorporation or state of formation, that Texas will also have some margin tax. This is due by May 15th each calendar year for taxpayers, and it's going to apply as a blanket rule to all business entities, but then it's going to make some pretty crucial carve-outs here.
So if you're a general partnership that's not an LLP and all your partners are individual people, like actual natural persons, and 90% of your gross income is from this kind of narrowly defined passive income sources, then you don't have to sweat this. Likewise sole proprietorships don't have to worry about the Texas margin tax either.
And the tax base for this is going to be basically compensation or cost of goods sold, with this 70% of business revenue or total revenue cap. And while this kind of looks like an income tax and it kind of sounds like an income tax, the Texas Supreme Court says you would be wrong. In 2012, they held that this is not an income tax and so it is applicable.
So basically you're going to make a fraction here where you figure out your gross receipts or Texas gross receipts, apologies, and divide by aggregate gross receipts. And then your tax rate will be applied to the Texas portion of the tax base and is three-quarters of a percent, with some exceptions on retail and wholesale businesses, which are going to be half of that rate.
So what's the cash out here? Well, the Texas margin tax is going to change your calculus for entity selection a little bit, but it's probably not going to be . . . not necessarily going to change the result.
The LLC, as Byron noted at the outset, is apparently about 14 times more popular in Texas than the corporation, and you can see part of that has to do with the flexibility an LLC offers. For example, here it can elect to be taxed as a corporation or partnership. So you've got more wiggle room to do what you need to do.
Delaware doesn't have the Texas franchise tax or Texas margin tax, but it does have kind of its own tax you've got to watch out for. It's going to tax corporations at a rate of 8.7%, which is kind of high relative to other states. But there's a really, really big exemption that may very well kind of be the exception that follows the rule here. If you're a corporation maintaining a statutory corporate office in the state but you're not really doing business within the state of Delaware, then this is not going to apply to you. And likewise, if you're a corporation whose activities within the state of Delaware are only maintaining and managing your intangible investments, this also will not apply to you. And I would suspect that most of our listeners here today are not out there really doing business in Delaware by and large. You're mostly just looking at Delaware as a place to incorporate or if you're an LLC a place of form.
Speaking of LLCs, so Delaware's state income tax does not apply at the entity to an LLC unless you've elected that. Instead, the LLC members are generally going to be subject to a Delaware personal income tax, which can get up to 6.6%. But like we saw with corporations in Delaware, there's some pretty wide exceptions that most everyone is going to fall into. So if you're a non-resident individual member of an LLC or a partnership, which again I suspect most of our listeners would be, although there's probably a handful of Delaware folks out there today, then you only have to worry about the income attributable to sources in Delaware, which again is probably not going to apply to a lot of people who are listening here. And so many out-of-state corporations, LLCs, and partnerships that are not resident in Delaware and don't have any income from business attributable to Delaware can really avoid material Delaware income tax liability.
Okay. So now we'll take a little bit of a look at some LLC vocabulary as it pertains to Texas. So the owners of a Texas LLC are its members, and they are basically analogous to shareholders in a corporation or the limited partners in a limited partnership. And the managers of an LLC are roughly equivalent to the directors of a corporation and can be elected by the LLC's members just like a corporation's directors can be elected by the shareholders.
Now, under the Texas Business Organizations Code, an LLC can be structured so that the members can manage it kind of like in the case of a closed corporation or a general partnership. So in that case, the members are more analogous to the general partner or GP in a general or limited partnership but without personal liability for the entity's obligations. So that's a pretty key difference there.
Under the TBOC, an individual, corporation, partnership, LLC, or other person can be a member or a manager. So you could have a situation where you've got an LLC with a corporation as the sole manager, just like it's possible to have a limited partnership with a sole corporate general partner.
And now let's look a little bit at Delaware. So LLCs formed under Delaware law are going to be governed by the Delaware Limited Liability Company Act. Just as in Texas, the owners of a Delaware LLC are called members, and they're like stockholders of a Delaware corporation.
So in Texas, we've got our LLC formation and governing documents considerations to think about here. So you form your LLC when you file your certificate of formation with the Texas Secretary of State along with a little filing fee. So it's pretty straightforward to form it. You file a certificate of formation. The initial certificate of formation has to have a number of requirements, including a kind of recent change on one of those requirements in January of this year so I'll be sure to flag that.
So number one it's got to have the LLC's name. It has to state that the entity is an LLC. It has to say the period of its duration, unless it's just going to have a perpetual duration, in which case no need. It has to state the purpose of the LLC, which can be maximally broad and just say any lawful purpose for which LLCs may be organized, which is a little bit more typical, but sometimes people spell out the purpose a little more particularly. We also need the certificate of formation to have the address of its initial registered office and the name of its initial registered agent at that address.
Number six, so this is where we get into some more recent changes, the initial mailing address of the filing entity. So that's new as of January 1st this year.
We also need the certificate of formation to say if the LLC is going to have a manager or managers, it's got to have a statement to that effect and it's got to give the names and addresses of the initial manager or managers. Or if the LLC is not going to have managers, it's got to have a statement to that effect and it's got to give the names and addresses of the initial members.
Number eight, it's got to have the name and address of each organizer. That's just basically the person who's kind of teeing up this certificate of formation to be filed.
And last, number nine, it needs specified information if the LLC is going to be a professional LLC.
So if you want to change the managers in your LLC, that does not require an amendment to the certificate of formation. Since September of last year, it's almost a year now, changing from manager-managed to member-managed or vice versa is done by amending the company agreement, and we'll talk more about the company agreement later, or the certificate of formation. The LLC is required to update its management information each year on the public information report that it files with the Texas Comptroller of Public Accounts.
Okay. So continuing with the certificate of formation in Texas, an LLC's existence begins when the Secretary of State files the certificate of formation, unless it provides for delayed effectiveness as authorized under the TBOC. So that would just be where your certificate of formation says instead of this is going to be effective upon filing by the Secretary of State, instead I want this to start on this particular date and then everything is kind of it just hits pause until that date and then the entity begins to exist.
An LLC may also be formed under a plan of conversion or a plan of merger, in which case the certificate of formation must be filed with the certificate of conversion or the certificate of merger, but it doesn't have to be filed separately.
A Texas LLC may generally be formed to conduct any lawful business, subject to a few limitations of other statutes that regulate particular businesses, and generally an LLC has all the powers that a Texas corporation or limited partnership would have, again subject to a few restrictions that other statutes or its governing documents might impose on it.
So the name of an LLC needs words or an abbreviation to designate its nature. So somewhere in the name we need to see some magical words, and these magical words are "limited liability company" or "limited company" or an abbreviation like LLC.
The name can't be the same as or deceptively similar to any other domestic or foreign filing entity's name unless that other entity consents in writing. So if Byron has already set up Egan LLC, I can't set up Egain LLC or something that sounds really similar unless he consents in writing and says, "That's okay. Daniel can set this up. I'm okay with it."
The certificate of formation may contain any other provisions that are not inconsistent with law, which again this is just kind of LLCs generally just give you a little more flexibility to work with than corporations do. So this is another area where you just see that flexibility show up.
The TBOC provides that, except as otherwise provided in an LLC certificate of formation or its company agreement, the affirmative vote, approval, or consent of all members is required to amend a certificate of formation. So basically everyone has got to be okay with whatever this key change to the certificate of formation is going to be. You can't, as the default rule, just kind of reach a basic majority and say good enough. Everyone has got to be on board.
So kind of a new little tidbit to flag here. Since September of last year, under the TBOC, an LLC's governing documents may provide that any internal affairs claim has to be brought only in a court in Texas. In Salzberg, which is a Delaware case pretty recently back in 2020, the Delaware Supreme Court held that its Delaware law validates forum selection provisions in a certificate of incorporation for internal affairs claims, including claims under the Securities Act. So bringing things into a little bit more alignment there.
All right. Now we've been talking about the certificate of formation. Let's take a look at the company agreement. This is not so much on the slides, but for anyone who's a little bit confused about what the differences of these are, I've heard it said it that you can think of the certificate of formation as being a little bit like an entity's constitution, and then the company agreement or its LLCA is going to be kind of like statutes. One is just kind of the basic, foundational governing document, and then the other one adds more to that and fleshes more things out, but it's not kind of the . . . it doesn't give like the skeleton that everything gets added to in the way that a certificate of formation does. So hopefully that kind of helps people understand a little bit of the difference here.
So the company agreement, most of a Texas LLC's organization and management provisions as well as terms governing its securities are going to be found in its company agreement. That's usually going to have provisions that are pretty similar to what you would find in a limited partnership agreement or in a corporation's bylaws.
So under the TBOC, the company agreement can be written, or subject to the statute of frauds you could have an oral company agreement. I still have not gotten to come across that in my practice, but who knows, maybe one day I will. And it controls the majority of the LLC's governance matters. Generally, it will trump default TBOC provisions that relate to LLCs. Although be aware Section 101.054 is going to contain certain non-waivable provisions.
So as an example, under the TBOC, the company agreement or the certificate of formation may only be amended by unanimous member consent. But if you provide for a different way to amend, in either of the documents, like maybe just one manager consent instead of unanimous member consent, then that's fine. You can amend it in that way. But you've got to say so in one of those documents to kind of opt out of that default.
A Texas company agreement will usually have provisions about capital accounts and other financial and tax provisions, again that are akin to what you would find in a typical limited partnership agreement. But the TBOC does not require that the members ever approve the company agreement, file it with the Secretary of State, or otherwise make it public. So that's a pretty key difference in the company agreement from the certificate of formation as well.
Nevertheless the members may wish to approve the company agreement and express their desire to be contractually bound under the company agreement, and this can facilitate the company agreement's enforcement and its treatment as a partnership agreement for federal income tax purposes. And again, why is it being treated as a partnership agreement under federal income tax purposes? That goes back to what we talked about with tax treatment, where an LLC is generally going to be a flow-through entity and taxed the way that a partnership would be.
Under the TBOC, a company agreement is enforceable by or against the LLC regardless of whether the LLC has signed or otherwise expressly adopted the company agreement. So that one strikes me as a little bit counterintuitive, but there you have it. Even if people didn't give their signatures, it can be used against the entity.
So looking a little bit more at Texas company agreements, the TBOC provides that a single-member LLC's company agreement is enforceable even though there's only one party. So if I want to set up Daniel LLC and I'm going to be the only member, even though there's no one else really that is in involved in this entity with me, it can be enforceable.
Under the TBOC, a member has no right to withdraw and can't be expelled from the company unless the company agreement provides otherwise.
And finally a member who validly exercises his or her right to withdraw under a company agreement provision is entitled to receive the fair value, which valuation can get contested and the TBOC does not give us a definition, to receive the fair value of the member's interest within a reasonable time unless a company agreement provides otherwise. So again, seeing a lot of that LLC flexibility there in the way it's governed.
So looking now at Delaware formation and governing documents. Let's look at Delaware certificate of formation. The certificate of formation, just as in Texas, must include the LLC's name, the address of its registered office, its registered agent's name and its address for service and process, and then any other matters the members determined to include. So a little bit less info needed than you would need in Texas, but you've still got to have all those basics there. And it is formed upon filing its certificate a formation with the Delaware Secretary of State.
So let's look at Delaware company agreements or LLCAs. In Delaware, the agreement is referred to as the limited liability company agreement, as opposed to under Texas law we saw it's being referred to as the company agreement.
The term "limited liability company agreement" is pretty broadly defined under Delaware law to be the principal governing document of a Delaware LLC and to encompass any agreement, written or implied, of the member or members as to the affairs of a limited liability company or its business. So again, pretty broad, kind of giving that blank canvas to work with again. I'll probably keep reiterating LLCs tend to give you a lot of flexibility.
A limited liability company agreement is not subject to any statute of frauds in Delaware law interestingly enough.
A member, manager, or an assignee of an LLC is bound by the LLC agreement whether or not it was a signatory of it. So again, just as kind of some of the Texas law is about enforcement whether or not you've signed struck me personally as a little counterintuitive sometimes, that is kind of paralleled here in Delaware to an extent.
An LLC agreement may be amended according to its terms or, if the LLC agreement does not provide for amendment, its members' unanimous approval. So that's also pretty similar to Texas, where we're going to kind of default to unanimous member approval, but you also are free to come up with kind of your own rule for amendment.
And just as in Texas you can have a single-member LLC, you can in Delaware also.
Let's see. So flipping back to Texas and looking at management a little bit, if an LLC is manager-managed, its managers are going to oversee its business and affairs, and they're basically going to function like a board of directors would in a corporate context. And it can designate officers and other agents to act on the LLC's behalf.
A manager can be an individual, like a natural person. It could also be a corporation, or it could be some other entity. And an LLC may have a single manager that's a corporation or other entity.
However, the certificate of formation or the company agreement may provide that the LLC's members will manage some or all the LLC's business and affairs. So an LLC could be organized to run without managers, kind of like a closed corporation, or structured so that managers run the day-to-day operations, but members have significant approval rights.
A lot of JV or joint venture agreements are going to include things like that, where maybe I'm going to be a minority shareholder or an equity holder in an LLC, but I'm a little worried that Byron is going to do something shady and so I want to give him some capital to work with, but I don't want him to be able to start doing all sorts of crazy, unpredictable things. So our LLC agreement can have some provisions about, well, Daniel gets certain approval rights over paying down this kind of debt or about entering into a merger or something like that, and that kind of gives me a little bit of foreseeability with my investment, a little bit of negotiating power and things like that.
The company agreement should specify who has the authority to obligate the LLC contractually or to empower others to do so, and it should dictate the way its managers or its members, if it's going to be member-managed, the way they can manage the LLC's business and affairs.
The company should specify how managers are going to be selected, how long is their term going to be, and if things go badly, can we remove them and if so, how do we do that.
So since September of last year, so it's still a fairly new provision, the TBOC authorizes governing documents to contain emergency provisions that provide alternative governance provisions, like action without a quorum or something to that effect during an emergency.
The TBOC provides that the following are agents of an LLC. So one, any officer or other agent who is vested with actual or parent authority, two, each manager to the extent that management is vested in that manager, and three, each member to the extent that management of the LLC has been reserved to that member.
If a person named in Section 101.254(a) of the TBOC takes an act to apparently carry on the LLC's business in the usual way, maybe they're going to sign a document in the name of the LLC, then that person binds the LLC unless they lack authority to act for the LLC and that other third party they're working with knows they lack authority. So lenders and others dealing with an LLC can determine with complete certainty who's got ability to bind the LLC if they check its certificate of formation, its company agreement, and resolutions, just like in the corporate context. So wherever verification of authority is unusual in the corporate context, it's also going to be unusual in the LLC context.
And then looking at management in Delaware, under Delaware law provisions relating to management are pretty much completely comparable to Texas law, and by and large we're just going to let parties do what they say they're going to do in their LLC agreement.
So with that, Byron, I will pass it on to you to talk about fiduciary duties.
Byron: Fiduciary duties are an important reason that people choose an LLC over a corporation. If you're going to have a corporation, there are certain basic fiduciary principles that are going to be applicable, and you have relatively limited authority to vary them.
On the other hand, the Texas Business Organizations Code and frankly Delaware law doesn't specifically specify whether members or managers have fiduciary or other duties. It doesn't even attempt to define them. It simply implies that these duties may exist under statutory provisions that permit a company agreement to expand or restrict them. And a company may even limit or eliminate liabilities for breaching them. So if you're going to be able to restrict or eliminate, then the implication is that they exist.
So in a manager-managed LLC, the manager's duty and in the case of a member-managed LLC the member's duty would be to the LLC, and it would be generally assumed to be fiduciary duty in nature. The frame of reference would be the fiduciary duties of corporate directors if the company agreement doesn't say otherwise, which of course gets back to Daniel's point that in an LLC you have great flexibility of defining what the duties of the members and managers are, and people typically do so. Your manager fiduciary duty could also be determined by reference to partnership law or the law of agency. There is a lot of case law that defines fiduciary duties, and that's both in Texas and Delaware.
By analogy to corporate directors, managers would have the duties of obedience, care, and loyalty, and those would be considered fiduciary duties. And the managers would have the benefit of the business judgment rule. That means that the courts would defer to the informed business judgment of the managers, not absolutely, but the frame of reference would be if there was an informed judgment and that related to a business matter, then the court is typically not going to second-guess the elected manager.
Now, like a director, you're going to be as a manager liable to the members for a breach of duty, and it would be really a duty to the entity itself. And that's an important distinction. The duty is owed by the manager to the entity. Now the members may enforce the manager's duty in the name and on behalf of the LLC and that the recoveries would belong to the LLC.
Now there is some provision in our statutes that allows a court in a closely held LLC to provide that the members could enforce those fiduciary duties directly as if it were not a fiduciary relationship to the entity as a whole but to the members individually. But in any event, whether members owe a fiduciary duty to the members of the LLC is going to be determined by reference to corporate principles unless, as again Daniel says, the company's governing documents provide otherwise.
Sections 101.052, 101.054, and 101.401 allow company agreements to expand, restrict, or waive duties, including fiduciary duties, and liabilities of managers, members, officers, and other persons to the LLC or to its members or managers. That's a great contractual flexibility. To the extent that any or all fiduciary duties are waived, essentially there would be no fiduciary duty to breach, and therefore eliminating liabilities for breach of that duty wouldn't be necessary because there wouldn't be any liability because there wouldn't be any duty.
Now another section of the TBOC, and this applies to corporations as well as LLCs and partnerships, allows for the limitation or elimination of liability to the LLC or its owners or members for breaches of fiduciary or other duties, and in the case of a member-managed of those members with management responses except for a breach of the duty of loyalty, an act in bad faith, or a transaction by which the person received an improper personal benefit. So that is applicable to corporations as well as to LLCs.
But the other provisions that I cited above allow in the company agreement to expand, restrict, or waive any duties, including fiduciary duties and that would include the fiduciary duty of loyalty. Hence, most company agreements are going to rely on 101.054 as a practical matter.
A company agreement restricting or eliminating fiduciary duties could read as follow and this is something that I cobbled together reading the statutes and the case law. This agreement is not intended to and does not create or impose any fiduciary other duty on any member or manager. So we're not creating any duty by disagreement. Furthermore the members, managers, and the company, to the fullest extent permitted by law, which is really unlimited, to the extent that the TBOC limits the duties, then the parties agree that those duties are eliminated and that whatever duties remain under this agreement are going to be contractual in nature. So your damages are going to be contract damages, which would be essentially the measure of damage to be actual damages. Whereas if it's a fiduciary duty breach, the action is going to be an action in tort and punitive damages would be applicable. So these are very important provisions. And when you say contractual, you're really dealing with a measure of damages for a breach.
And then, of course, this is a contract among the parties, and as Daniel said, you don't always trust your other investors. So you're going to have some restrictions on what the managers are going to be able to do, and these are contractual provisions that you're going to build into your document. Needless to say, among sophisticated people that's going to be a highly negotiated provision.
And unlike Delaware, in Texas you do not have a common law duty of good faith and fair dealing in all contractual relationships. Rather the duty arises only when a contract creates or governs a special relationship between the parties. It may be present in an LLC, for instance where there's unequal bargaining power, but the key is that's not a robust document, a cause of action in Texas, but it is in Delaware, which is a very important distinction. You find very few good faith and fair dealing cases in Texas. Whereas in Delaware, it's a ripe area to go before the chancellor and argue your case.
While there are no reported cases in Texas as to whether a contractual duty of good faith and fair dealing exists between members in an LLC or between members and managers, it's likely that a duty of good faith and fair dealing does exist in those relationships. But the case law is far between.
Delaware in its statutes includes provisions that emphasize the principles of freedom of contract and enforceability of the company agreement. But Texas does not have such a provision. Although 101.401 indicates that there's a lot of latitude, as we discussed before, in modifying the duties. So it essentially gets you to the same place. When I said to the same place, that means you can effectively eliminate your fiduciary duties in Texas as you can in Delaware.
101.255 provides that, unless a company agreement or a certificate of formation provides otherwise, a transaction between an LLC and one or more of its members or managers an insider transaction. In other words, it's going to be valid notwithstanding the fact that there is an insider relationship if the following are satisfied, and that is the material facts are disclosed to the governing authority or they're known and it's approved by disinterested parties, or the transaction is fair.
In a joint venture, the duty of a manager to all members could be an issue since the managers would often have been selected to represent the interests of particular members. And that could be addressed by structuring the LLC to be managed by members who would then appoint representatives to act for them in the operating agreement and to run the business in the name of the members.
Delaware does not, like Texas, codify member or manager fiduciary duties by statute, but recognizes that LLCs can eliminate those duties. There's been a fair bit of litigation, and the upshot of it is that the court in one case found references to fair dealing in the company agreement, and by that they assumed that a fiduciary relationship was created and so held. The legislature of Delaware was concerned about that, and while it adopts a contractarian approach that says that you can eliminate fiduciary duties, it does say that unless eliminated or modified in the governing documents, common law fiduciary duties apply to LLCs.
Now, in Delaware, you can't be coy. You've got to be very clear as to what you're doing, and there are many cases where parties, very sophisticated parties have bargained around what the duties of the managers to the members are, whether they're fiduciary in nature, and so on and so forth. And when they get through the very complicated provisions and a lawsuit arises, sometimes the courts just look through it and say, "You tried to do it, but you didn't succeed. The result is you have left the full panoply of common law fiduciary duties in place." Hence the difference in the right word and the almost right word can be the difference in lightning bolt and lightning bugs. Very important.
There are several cases involving limited partnerships that are analogous and that sort of create the reference to implied covenant of good faith and fair dealing. There's one case that is particularly striking, the Gerber case, where the agreement provided that an affiliate could enter into a transaction with the company if a fairness opinion was received that the transaction was fair. So the parties got a fairness opinion that the transaction was fair to the entity as a whole. But the court said, no, that's not adequate because it ignored the fairness to the limited partners. So that was a situation where the general partner was trying to take the company private and reap a great benefit and got a fairness opinion to the whole company. And the court said, "No, that's not adequate. It should have been tailored to the limited partners." There are other cases that have a similar effect.
Another case, the El Paso Pipeline case, the conflicts committee determined the transaction with the general partner was fair and in the partnership's best interest, but the committee's analysis focused on whether the transaction would enable the partnership to increase its distributions rather than whether it was paying too much for the assets. So once again the court looked at the transaction and said it's not fair and invalidated the transaction.
Caremark is another doctrine that is in Delaware that's not in Texas. In the Marchand v. Barnhill case, Blue Bell Creameries, a small Delaware corporation headquartered in Texas made and distributed ice cream, and it had to recall its products because there was a listeria infection. A lawsuit followed, a lawsuit with a derivative suit. And the Delaware Supreme Court held that while Blue Bell had food safety regulations in place and complied with those regulations, nonetheless the board did not have a committee overseeing food safety. There was no board-level process to address food safety issues and no process by which the board was expected to be advised of food safety reports. So while management got that information and thought it was doing the right thing, the court said the board has this duty to oversee and that it failed. Hence, there's a lawsuit, and it suggests that boards of Delaware corporations have to be very, very involved in these mission critical operations of the company. Whereas in Texas we would have a business judgment rule applicable and the court would not be second-guessing what the directors did.
The Boeing case is a recent example of Caremark being [inaudible 00:48:49]. There, the plaintiffs sued Boeing's board to recover costs associated with a crash from a couple of jetliners. It alleged directors failed to monitor themselves airline safety before the crashes and didn't appropriately respond. So the short of it is directors have a duty in Delaware to be active in addressing the safety issues of a company. But as I said, it hasn't been adopted.
So we ought to talk about joint ventures. And Daniel, do you want to do that?
Daniel: Sure thing. So a joint venture is a relationship usually between two or three entities that have a defined objective. It's usually going to take the form of a contract or an entity. And so you'll often hear this in the industry simply called a JV. Traditionally, a JV was thought of as a limited purpose general partnership. But today a JV is almost always going to be an LLC.
And so contributions to a JV can range from an established business unit with people and knowledge to cash or a license of IP. Maybe one party has the technology, but they don't have the funds and/or the marketing muscle or something, and the other party has that, but they don't have the technology. So if they form a JV, they can put their skills, talents, and resources together and create some synergy there.
So expectations range from development of a product or a project to just a standalone business, where maybe your exit strategy is, hey, one day we're going to take this public or we're going to sell this JV, in which case we're going to have a lot of transfer restrictions in our LLC agreement to make sure no one is exiting or trying to sell in an unexpected way.
And so, in the U.S., an LLC is the entity of choice for JVs, and again, like we keep saying throughout, because of that flexibility you can add so many provisions that are going to be helpful if you're a JV, if you're using an LLC agreement.
So if we think about Texas law, Dernick Resources Inc. is a situation that illustrates the dangers of using the term "joint venture" in a contractual agreement that might not actually be a joint venture. That was an oil and gas drilling and production contract that called itself a joint venture agreement. And uh-oh, that was held to create some fiduciary duties and have some rather unintended results. So just be aware of that. And if you want to learn a little bit more about that, you can check out "Egan on Entities," Section 1.5.
Energy Transfer Partners, another Texas case we're highlighting here involved a series of preliminary agreements between Energy Transfer Partners and Enterprise Product Partners. So ETP and Enterprise entered into these preliminary agreements and said that obligations of the parties are going to be conditioned on executing a definitive joint venture agreement and approvals by their respective boards. No definitive JV agreement ever was signed. The parties proceeded to spend a lot of time and money on the project, and they were kind of holding themselves out to the public as a joint venture that has been formed, it's getting marketed. And the parties' marketing efforts did not produce enough commitments to ship through the new pipeline to meet their agreed minimum threshold.
So as tends to happen when things go south, a lawsuit cropped up. So Enterprise terminated its participation in the project and shortly after that entered into agreements with another large pipeline company. And ETP was not thrilled, so they sued Enterprise in state court and said, "Hey, I thought we had this JV agreement. You breached it. And if we've got this JV agreement, you have some fiduciary duties that you owe."
So not withstanding express provisions in their preliminary agreements that no party was going to be bound until definitive agreements were signed, ETP said, and the jury agreed with them, the parties' ensuing conduct served to form a Texas law general partnership, and so Enterprise's negotiation and agreement with that other pipeline breached their fiduciary duty of loyalty. And that had some pretty hefty consequences to the tune of $535 million. But the Texas Supreme Court held that no partnership was created because the NDA and the letter of intent specifically provided that no party was bound to proceed with the transaction unless and until a definitive agreement was executed, and that never happened.
So it almost feels a little bit silly, but you've got to be real careful about if you start to enter into these preliminary agreements that kind of spell out obligations and condition things, you've got to make sure you actually follow through with that. And it also is kind of an interesting little example of how even when you don't have definitive documents, like for a moment there it looked like, before we got to the Texas Supreme Court, that, hey, maybe ETP has got something here, where, yeah, we didn't have a definitive document. But this could kind of start to look like a general partnership. So you've just got to be aware of that.
And that brings us to business combinations. Byron, would you like to take us through that?
Byron: Sure. Basically, Texas law allows an LLC to merge with one or more LLCs or other entities. You've got to have a written plan of merger. It's got to be approved as provided in the governing documents, and that's typically going to require the members to approve it. You can also convert to another form of entity.
And Delaware is essentially going to be the same as Texas in terms of normal mergers. But Texas has something unique. It will allow any form of entity to merge into itself, which is effectively dividing itself, and form one or more new entities. And it's an efficient way to divide up a company by a plan of merger without going through a variety of assignments. The key to that though is that you cannot do that to prejudice the rights of creditors.
Delaware has a similar concept. They allow mergers. But when you get down to a divisive merger, Delaware only allows it in the case of an LLC or a limited partnership.
And so indemnification, Daniel, do you want to quickly run through that?
Daniel: Sure. So we'll try and keep this quick since we're basically out of time. But a Texas LLC may, but it doesn't have to, indemnify its members, managers, officers, or other persons, and it's only subject to some narrow restrictions that can be set out in the certificate of formation permission or the company agreement.
Indemnification restrictions that apply to corporations in Texas don't apply to Texas LLCs. So it's important that you've got a long-form indemnification provision, for example, the one provided in "Egan On Entities," Section 5.6., just because of that discrepancy between corporations and LLCs, it's going to be crucial. As opposed to Delaware law, which provides an LLC with broad power to indemnify and advance costs of defense to its members, managers, and others and really is content to leave things to the LLC agreement. So it's not going to be subject to quite the same restraints.
And so the key here is if you're an LLC in Texas, you've really got to watch that indemnification provision. You still do need to in Delaware, but it's not going to have maybe quite the same ramifications that it would in Texas.
So I believe we are out of time now, but want to thank everyone for joining and listening. I had a good time talking about this. I think Byron did too. And we appreciate all of you tuning in.