July 16, 2008

posted by Dave Hoffman

First impressions from perspective of a practitioner & corporate bus dev/VC type:

1. The paper, on a quick read-through, seems like a rather muddy blend of legal and business issues. It would be helpful if these issues could be more distinctly separated, to make evaluation of the idea easier. E.g., the discussion of the hosting company opportunity and the 5th "what could go wrong" point about question of whether or not people would have energy enough to rate each other's contributions seem out of place in a legal analysis. If I had receieved this in the days when I was a corporate VC, I'd have thrown the document back over the transom for a lot more work.

2. A further example of this problem is the following: "Overly vigorous application of 'know your customer' rules or anti-money laundering statutes might drive banks to require individual 'real world' identification of all participants – creating privacy risks and, more likely, transaction costs that discourage or deter the kind of transient participation that is optimal."
(a) I'm not sure that "overly" is appropriate here. It sounds like "we wish that reality wouldn't spoil out really cool idea." But if you really want to get the ball rolling, you can't rely on wishful thinking. What does the law require? How will you deal with it?
(b) The paper also mentions discussions with state regulators, but isn't KYC a federal requirement?
(c) Frankly, I am also unconvinced that the anonymity of the people involved is a value worth protecting. A counter-argument: if you want to preserve your privacy, don't claim the protections of state law to limit your liability.

3. The securities issue may also need some work. The paper says that compensation will be based solely on one's own efforts. But it also mentions opportunities to game the system, bereakdown of the peer evaluation system, etc. The peer evaluation system itself, even if it works, needs to be demonstrated to be something other than a popularity contest. Maybe it's a long way to Howey (i.e., *primarily* on the efforts of others), but it's not yet convincing that one's comepnsation will necessarily be based primarily on one's own efforts. Maybe another reader can comment more knowledgeably on that point. But I don't see how the point allocation provision in the agreement addresses this issue.

4. Do people learn about renvoi anymore? "The law of the State of Vermont shall apply to this Agreement **without regard to principles of conflicts of law.**" This gaffe does not lend credibility to the project or create a professional impression, esp. coming from a law prof. Please be more careful, to put it mildly.

I was one of the people who e-mailed Dave off-line. I was surprised, quite honestly, about a number of problems in this agreement, and contacted Professor Johnson, who tells me this is a student-generated form, reviewed by a Vermont lawyer, and invited me to make my concerns public.

This is of some more than passing interest to me, as I've been honored to be able to join Larry Ribstein on the fourth edition of his Unincorporated Business Associations, which I used as the casebook in my Agency, Partnership, & LLC course last semester. (This was already a dynamite book, in my view, reflecting Larry's encyclopedic mastery of the subject; we are making it even more business planning and problem-oriented, with a substantially expanded teachers' manual.) So Larry and I have also been chatting a little bit about this form, particularly in view of our focus on the different business organization statutes as standard forms in themselves, and the relationship of customized agreements to the default provisions in the standard form.

As a long-time practitioner, I concur with Andy Sutter's general observations both about the business concept and the form that has been presented here. As I understand the Vermont virtual company model (from Prof. Johnson's short memo), it contemplates a kind of "wiki-agreement" for a kind of "wiki-company" that is contemplated to be formed under changes to Vermont law that eliminate the need for any hard copy filing, notices, etc.

And as I understand the wiki-company concept, it is sort of entrepreneurship without entrepreneurs, for you Star Trek TNG fans, sort of a Borg-like virtual blob that creates economic value added (in the broadest sense of things with utility, even if not measured in money, but the agreement seems to contemplate real money distributions) by entirely collective action. (Joseph Schumpeter is rolling over in his grave.) Membership in the wiki-company is transient; nobody appears to have any actual authority to do anything without a vote. Members sort of appear and disappear, contribute whatever they might contribute to the wiki-company.

Given that good drafting involves translating a business concept into the language of the law with proper accommodation to regulatory rules, default rules, and those aspects of the arrangement that are capable of expression in precise language and those that are not, it helps to understand the business concept, and I confess I'm still not quite what this one is. Having said that, it seems to me Andy's last comment is on target: there are a number of gaffes in this draft impacting the overall credibility of the project. Indeed, this is not going to be exhaustive, but here's a sampling:

- What jumped out at me was the inclusion of a sub-chapter S election for what purports to be a member-managed LLC. A sub-S election has nothing to do whatsoever with LLCs. It is an election to have a traditional corporation deemed to be a partnership for tax purposes. Prof. Johnson explained to me that it had something to do with avoiding K-1s at the outset, but that means the company would be incorporated, and file the election form with the IRS, not organized as an LLC. There is the possibility of forming as one kind of entity and merging or converting to another, but that's not what this does.

- Paragraph 1 on work product needs a lawyers' attention to precision: This appears to be a work for hire provision, contemplating that what the members impart to the wiki-company belongs to the wiki-company. What does it mean to create work product in the course of company projects when everything is virtual, and we are dispersed around the world on our our computers? One would hope Wiki only owns what I actually send it! Not to mention who has the right to license it back out? See below on management decisions.

- The default rule in LLC statutes is that members cannot be admitted without the unanimous consent of all existing members (see ULLCA 502). The business concept here appears to be that members float in and out. But the agreement never says how it is a member is admitted, much less gets points (apparently it is some sort of mutual evaluation).

- There is unnecessary surplusage. Why does this agreement need to repeat the default aspects of the LLC act, like there is no personal liability? Or having assets escheat to Vermont?

- This is a member-managed LLC. It appears no member has actual authority to do ANYTHING. Everything is by vote. So Wiki member A sends in a piece of code to the wiki company. Member B says: let's license out Member A's code. Then there's a vote. I'm not quite sure how do you run a company that way.

- Do the members have any fiduciary duties to each other? Inquiring minds want to know!

- I was puzzled by what the last paragraph meant when it said that any contract executed by an unauthorized member was "invalid." Is this an attempt to address the apparent authority issue? This may have some effect as among the members, but the third party may have some to say about apparent authority or inherent agency power (as to the latter, however, not under the 3d Restatement of Agency, which eliminates the concept.)

This has potential as a thought experiment about the relationship between managers and investors that hybrid organizations like the LLC or the limited partnership try to address. I'd be wary about using this as a real form! Better yet, I'd encourage any Vermonters inclined to do something like this to pop down to Boston and take in my class.

I appreciate the comments and suggestions -- and hope for more. But feel the need to clarify some issues.

1. The draft does not contemplate a subchapter S election. Instead, it says that the LLC will elect taxation as a C corporation. Normally, that wouldn't make sense, because it would create an additional layer of taxation. But there are special reasons here to avoid having to file reporting forms for all members before the company has realized any net gains.

2. Jeff's description of the goal --creation of a company that works somewhat like a wiki -- is fairly accurate. He asks how a company can operate that way. Clay Shirkey's book (Here Comes Everybody) and Benkler's work on social production (Wealth of Networks) make clear why self-selection for roles can lower production and coordination costs.

3. The draft is silent about how one becomes a member of the virtual company LLC because various different companies might make different decisions (some imposing qualifications, some not). In addition, the key question is how to become an "active member" (entitled to vote and rate others' contributions). The agreement is, of course, designed to modify the default rule -- which I understand is permitted under Vermont law.

4. Paragraph 1 is not a "work for hire" agreement -- it is an assignment of copyright (and other ip rights). There is no reason that assignment cannot be interpreted in light of the scope of the work undertaken in pursuit of the company mission. And it would help resolve current uncertainty regarding who owns IP rights to works created by collaborating online groups.

5. The point about "know your customer" rules is that the "customer" ought to be considered the company itself. This is indentified as a risk because having to give full identity for every transient member of a wiki-like collaboration would be cost-prohibitive or unduly chilling.

6. The reason for the explicit coverage of apparent authority is that these provisions, once included in the articles of the LLC, can become binding on third parties.

7. One goal is in fact to avoid imposing fiduciary duties on members vis-a-vis each other in most contexts. It is also true that no one will have general authority to manage the company -- the goal being to vest powers to act on behalf of the company by vote among active members. Can a company be operated this way? Well, there are many examples of effective collaborative action online. But this is inherently an experimental effort.

8. good point re renvoi.

9. It is central to the project that the participants will be pooling attention and effort, not capital. That helps with the securities issues and many other issues.

10. I agree that the paper mixes business and legal issues. It was written as a status report on the project -- partly with the hope of soliciting additional suggestions and input. The underlying hypothesis is that there is an unoccupied space in the possibility map: collective appropriation of peer production (self-selection by contributors who rate each other's contributions and collectively own their work product). My hope and expectation is that the law can adapt to make this possible, even though many potentially applicable doctrines and regulations were not developed with that possibility in mind.

Thanks again for the comments.

drj

Re Sub S, you are right. I misread that. Now at least I understand the logic. So you are going to check the box to be taxed as a C corp just to avoid K-1s? Okay. That seems weird because generally in startups you want to have an LLC rather than a C corp (even if you may need a C corp later for rounds of VC financing) so you can pass through early stage losses. Where does the cash come from to pay the service providers? Won't the company have operating losses the members would want passed through?

Re dealing with the apparent authority issue because of a provision in the articles? I think not. Member A, without authority, goes down to Office Max, and signs a purchase order as member of Wiki for $2,000 worth of computer paper. Wiki refuses to pay. Office Max sues Wiki. I think Office Max still has a good apparent authority claim, particularly under the 3d Restatement. Who is the least cost avoider on the issue of authority in that case? Wiki, with this idiosyncratic scheme, or Office Max checking the LLC records in Montpelier for every customer that walks in and opens an account? We've certainly created a nice law school exam question.

Do people learn about renvoi anymore? "The law of the State of Vermont shall apply to this Agreement **without regard to principles of conflicts of law.**"

OK, I admit I didn't learn about renvoi. What's wrong with this language, which I see in form agreements everywhere?

The ultra-sophisticated know that the "without regard to principles of conflicts of law" language is redundant in light of Restatement (Second) of Conflicts Section 187.

Thanks for the attention to renvoi.

A. First, what is renvoi? It's the subject taught in the first case in pretty much any conflicts casebook. I ditched my old casebook years ago, since I realized that the whole subject can be avoided (for deal lawyers) with a properly written choice of law clause. So I don't remember the exact cite. But the gist was that an English guy died in France. Was he testate or intestate? I don't recall. Point is that under French law, the law of his nationality was to decide the disposition of his estate. Under English law, the law of the place where he dies was to decide this disposition.

The difficulty is that "law" of a jurisdiction **includes the choice of law rules** of that jurisdiction. This sets up a kind of "hall of mirrors" effect, where the substantive law about disposition of his estate becomes impossible to determine (without some deus ex machina, slice of the Gordian knot, or other external intervention). That bouncing back and forth is renvoi.

B. As for the ultra-sophisticated comment from Bill S., thank you for that interesting info. A few observations about its usefulness, though:

(a) In 20+ years of transactional practice on the 2 coasts (Wall Street, L.A. and Silicon Valley), I never heard anyone refer to the Restatement of anything in the context of contract drafting or negotiation. I see that you practiced in the Midwest; this may be a cultural difference.

However, please take a look at the excellent "Negotiating and Drafting Contract Boilerplate" (ALM 2003) by Tina Stark (admittedly a NYC practitoner and law prof) @120-121. Although she acknowledges the view of some that the language is unnecessary, she still incorporates it into her "classic" recommended clause, and explains that it's to avoid renvoi. Interestingly, when she paraphrases the view that the language is unnecessary, she doesn't refer to the Restatement, but rather to the fact that courts apply their own choice of law rules (@121 & n. 69). Apropos of which, see (b) below.

Regardless of whether you think Stark's view normative, she provides at least descriptive evidence of customary practice in the major coastal commercial centers.

(b) As a matter of prudence, I think there's a good argument against relying on the Restatement. You don't know to what extent it has been adopted as law by the highest court in a state where a suit might be filed. California, for example, has some exceptions to the application of Rule 187 (though not about the aspect you mention). Rather than researching the law of all 50 states, it's much cheaper for the client if you just write a few extra words. What's the harm?

(c) As a drafting habit, it's also safer to adopt this language as a default. That's because many transactions involve parties outside the US, whose courts for sure won't give a hoot about the Restatement.

C. In the instant case, there are a couple of further interesting problems (though I'm not a Vermont lawyer, so I could all the more easily be wrong about it).

First, where does the arbitration take place? It isn't clear that the arbitration has any connection to the US. If outside it, the arbitrator will not care about the Restatement. (BTW, as for arbitration clauses, which as a matter of policy and on advice of litigator colleagues I avoid as much as possible, the one in the draft is not adequate. Are arbitration awards, orders and judgements to be final or not, for example? If they are, in what courts may they be entered for enforcement? See e.g. Chapter 8 of Stark's book. And even Stark's short-form arbitration clause, BTW, still includes the choice-of-law rule exception, @203).

Second, there isn't any limitation that the signatories to the contract have to be US residents. This could create big problems for the enforceability of the arbitration clause and even of the choice of law clause, if a signatory decided to sue in a foreign jurisdiction. But even if a court were disposed to respect the choice of law clause, why not give them what is now fashionably called a "nudge" (a/k/a an attempt at idiot-proofing) against renvoi?

A final BTW: one reason I don't like arbitration clauses is that sometimes you may need an injunction. You can get something like this from an arbitrator, but then you may have contentious issues afterwards, see, e.g., http://williampatry.blogspot.com/2007/06/arbitration-and-injunctive-relief.html . Since a lot of my practice involves IP, including trade secrets, I prefer for my clients to be able to go to court directly rather than creating more delay and more issues to litigate. I've also used something like the hybrid arbitration clause mentioned in the Patry blog entry, with a carve-out for equitable relief.