INTRODUCTION II. THE LAW OF LLCS III. PRIOR STUDIES IV. EMPIRICAL EXAMINATION OF LLC OPERATING AGREEMENTS: METHODOLOGY V. EMPIRICAL EXAMINATION OF LLC OPERATING AGREEMENTS: RESULTS A. Weakening Protections 1. Authorizing Competition 2. Waiving the Business Opportunity Doctrine 3. Modifications of Traditional Fiduciary Duties a. Drag-Along Rights b. Judicial Dissolution B. Strengthening Protections 1. Amending the Operating Agreement 2. Transferability 3. Withdrawal Rights 4. Tag-Along Rights 5. Limitation of LLC's Purposes 6. Required Distributions 7. Limited Life 8. Ownership Stakes Held by Management C. Summary VI. WHAT MOTIVATES CONTRACTING AROUND DEFAULTS? A. Testing for Efficiency B. Other Explanations C. Protecting Vulnerable Owners VII. CONCLUSION I. INTRODUCTION
Since the first enabling statute was passed in 1977, limited liability companies, or LLCs, have exploded in popularity. There are now over 2.2 million LLCs, dwarfing the number of traditional corporations by almost 40% while continuing to grow at a rapid pace. (1) Companies ranging from the neighborhood lawn care service provider to Chrysler and Fidelity organize as LLCs. (2) Publicly traded companies as well as the exchanges they trade on are LLCs. (3) Several of the largest privately held companies in the world similarly choose the LLC business form. (4)
A common reason to adopt the LLC structure is to achieve limited liability protection with only single taxation of profits. This advantage, however, has long been attainable through competing partnership and corporation forms. (5) But LLCs combine this limited liability with almost complete contractual flexibility. Practically every corporate law mandatory rule aimed at protecting owners, such as manager fiduciary duties, is only a default for LLCs. The protections apply by default, but LLCs are free to waive or modify them as desired. The contractual freedom "contractarian" approach is built on the expectation that sophisticated LLC owners are capable of crafting optimal governance provisions that may or may not include traditional protections. Because traditional corporate protections impose costs on the firm and its owners, waiving them can be desirable when parties adequately protect themselves through other, more efficient means. Eliminating fiduciary duties, for example, may reduce what managers charge to run the firm, and the elimination could be entirely appropriate if manager opportunism is constrained through other means.
Not everyone thinks that traditional protections should be merely defaults for LLCs, however. Eliminating owners' standard protections can be problematic if those owners are not sophisticated and underestimate the protections' value. Because mandatory corporate law rules exist to align manager and owner interests, waiving that protection opens the door to value-reducing opportunism. For example, unsophisticated owners who waive managers' fiduciary duties without adopting substitute protections may later be surprised to have no recourse when managers engage in self-dealing. The results are undesirable from both efficiency and equity grounds. For this reason, traditional owner protections are mandatory for corporations and cannot be waived even if the parties wish to do so. The need to protect vulnerable owners of corporations is deemed superior to the efficiency gains that might result through sophisticated bargaining.
The desirability of treating mandatory corporate protections as only default provisions for LLCs therefore boils down to an issue of how LLCs' contractual freedom is used. Are sophisticated owners using LLC statutes' flexibility to construct more efficient arrangements than are permissible under corporate law? Are unsophisticated owners induced to waive protections, giving rise to the potential for opportunism that motivates mandatory protections for corporations? Or are LLCs neglecting to take advantage of contractual freedom and instead choosing the LLC form solely for tax reasons? Despite the importance of these questions in light of LLCs' emerging dominance, little systematic effort has been spent in understanding whether and to what extent LLCs use their contractual freedom to allocate owner rights and responsibilities. (6) For example, Professor Larry Ribstein, in several influential pieces, argued forcefully in favor of LLC contractual freedom because of its superior potential for crafting efficient owner protections. (7) LLCs must actually avail themselves of the flexibility for this situation to be the case, yet Ribstein never conducted a systematic analysis of LLCs' operations to determine if or how his theory played out in practice. On the opposite side of the debate, Leo Strine and J. Travis Laster, Delaware Supreme Court Chief Justice and Delaware Court of Chancery Vice Chancellor, respectively, recommend sacrificing contractual flexibility in favor of mandatory LLC owner protections because of a perceived need to help vulnerable owners. Such a recommendation again requires knowing how LLCs actually use contractual flexibility to draft their governance provisions. (8) Others have similarly argued for and against reining in LLCs' contractual freedom based on behavior reported in a handful of prominent cases. (9)
I address this disconnect through an in-depth analysis of privately owned LLCs' operating agreements--the LLC analog of corporate charters and bylaws that allocate rights, responsibilities, and protections among owners and managers. (10) I analyze a set of 283 operating agreements to determine when and how default terms are modified. I find that parties regularly use LLCs' contractual flexibility to reduce or eliminate traditional owner safeguards in ways not replicable under corporate law. For instance, LLCs often eliminate fiduciary duties; authorize owners and managers to compete directly with their companies; waive the corporate opportunity doctrine; and even eliminate owners' right to seek judicial dissolution. These actions significantly cut back the protections enjoyed by owners of traditional corporations and other organizations. For many, therefore, the decision to organize as an LLC involves more than just achieving single tax treatment of profits.
But LLCs also add various protections to their operating agreements that are neither required nor apply by default, filling some of the void from reducing default protections. These include a regular dividend distribution; a specified business purpose; a limited lifetime; a restriction on majority owners' ability to sell their ownership stake; and aligning owner and management interests by compensating LLC management with significant profit shares.
Many LLCs therefore are discarding default judicial and statutory protections that are mandatory for corporations, and employing substitute safeguards. This more finely tailored approach has the potential to maximize entity value and create efficient governance relationships in ways not replicable through traditional corporate law. If parties were contracting around default terms in pursuit of efficiency, one prediction of the contractarian approach is that we would expect an inverse relationship between reductions and additions: as traditional corporate protections are circumscribed, other protections would be written in to fill the void. However, I find no significant relationship between the subtraction of and addition to owner protections, either among LLCs as a whole or among those LLCs identified as likely to have more sophisticated parties. This finding suggests that when LLCs wield their contractual freedom, they do not systematically do so to trade off traditional corporate protection for better substitute contractual terms as envisioned by contractarian proponents.
On the other hand, I find that LLCs identified as likely to have more vulnerable minority owners--those owners who invest little in the LLC and are less likely to seek sophisticated legal counsel--adopt significantly fewer owner safeguards than LLCs with less vulnerable owners. This result suggests that LLCs may instead be using their contractual freedom to set up later opportunism by managers and majority owners.
These findings have several implications. First, they shine a light into the dark space of LLC operations. Despite their significance as a form of doing business, LLCs remain understudied because privately held companies are not subject to disclosure requirements. This Article shows what LLCs are actually doing, which is useful for studying a wide variety of questions in this increasingly important field.
The results also provide concrete evidence for the evolving debate on whether LLCs require mandatory owner protections. Much of the discussion has suffered from a lack of knowledge about how LLCs use their contractual flexibility. Because I find little evidence for sophisticated bargaining and instead evidence of opportunism, the results suggest both a greater need for minority owner protections and that the cost to sophisticated LLCs of implementing protections may be small. However, because LLCs currently modify protections in such diverse ways, implementing new protections must be done carefully, and imposing mandatory rules could bring significant costs.
Part II provides the basics of the LLC organizational form. I describe LLC fundamentals, including relevant judicial and statutory safeguards, and compare these to the law of competing types of business organizations. I also introduce the debate surrounding the need for mandatory LLC owner safeguards and show how it revolves around largely untested assumptions about how LLCs behave in the real world.
Part III summarizes the existing empirical literature on LLC operating agreements and shows the continued need to understand what motivates LLCs' decision to modify default protection provisions. Parts IV and V provide the results of my study of private LLC operating agreements. I...
How Do LLC Owners Contract Around Default Statutory Protections?
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COPYRIGHT GALE, Cengage Learning. All rights reserved.
COPYRIGHT GALE, Cengage Learning. All rights reserved.