LLCs and the private ordering of dispute resolution.

Author:Molk, Peter
Position:Limited liability companies
 
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  1. INTRODUCTION II. THE SPREAD OF DISPUTE RESOLUTION PROVISIONS TO BUSINESS ENTITIES III. METHODOLOGY IV. EMPIRICAL RESULTS: DISPUTE RESOLUTION PROVISIONS IN LLC OPERATING AGREEMENTS A. Choice of Law 801 B. Choice of Forum: Exclusive Forum and Mandatory Arbitration 1. Exclusive Forum Clauses 2. Mandatory Arbitration C. Service of Process D. Books and Records E. Procedural Rules 1. Fee-Shifting and Other Cost Allocation 2. Jury Waivers F. Summary G. Relationship to Exculpation and Waiver V. IMPLICATIONS VI. CONCLUSION I. INTRODUCTION

    An emerging question in U.S. business law is the extent to which the organizational documents of a business entity may set the rules for resolving internal disputes. Contracting about dispute resolution is a routine aspect of commercial contracting. The parties may select where disputes are resolved or specify particular aspects of dispute resolution, such as access to a jury or allocation of costs. Until recently, however, private ordering of litigation procedures within business entities was often overlooked. This changed when companies began to adopt provisions in corporate charters and bylaws that limited shareholder litigation by restricting the courts in which parties could litigate or by requiring unsuccessful plaintiffs to pay the other side's costs.

    On the one hand, terms that eliminate traditional dispute resolution procedures have the benefit of reducing litigation expenses and streamlining dispute resolution, potentially making the firm more valuable. on the other hand, terms that restrict the ways in which owners can hold managers accountable could open the door to greater management agency costs that devalue the firm. The controversial use of these terms in corporations ultimately prompted a legislative response by Delaware that restricted the use of fee-shifting and mandatory arbitration clauses in Delaware stock corporations--the need to constrain agency costs and protect shareholders' access to the courts apparently outweighed the potential efficiencies that these terms promised.

    Missing from this discussion is the extent to which non-corporate business entities set ex-ante rules for resolving disputes among their entity's constituents. Non-corporate entities bridge the two chapters in the story of the spread of provisions that alter the dispute resolution process, as they involve both explicit contracting and the use of a business form. This Article begins to map this uncharted area with an empirical study of the practice of limited liability companies (LLCs).

    LLCs are a ubiquitous and growing form of business organization, with more than two million LLCs in the United States. (1) Despite the prevalence of LLCs, the terms under which they operate are largely unknown and understudied, in part because the operating agreements of privately owned LLCs are not filed or otherwise broadly available. This Article addresses this problem by using an original data set of privately owned LLC governing documents developed by one of the authors. (2) Within this body of privately owned LLC operating agreements, this Article identifies and charts terms that set the rules for resolving disputes among the LLC's constituents: members, managers, and the entity itself. In doing so, it provides a baseline for the study of dispute resolution in LLCs and the use of arbitration in this context, as well as illustrating with concrete examples the range of litigation provisions that could be used within corporations and other business entities.

    The Article begins in Part II with a brief overview of the emerging use of provisions to govern disputes within business entities, particularly stock corporations. Part III details the methodology and the development of the data set. Part IV reports the results, and Part V offers implications from the analysis for the study of LLCs, corporations, and business organizations more broadly.

  2. THE SPREAD OF DISPUTE RESOLUTION PROVISIONS TO BUSINESS ENTITIES

    Commercial and consumer contracts often include provisions that shape future litigation between the contracting parties. A fairly common example is a clause that selects an exclusive forum for the resolution of a covered dispute. (3) Other provisions alter particular procedural rules, instituting limits on discovery, setting rules about who covers litigation fees and costs, and limiting or eliminating available damages and remedies. (4)

    Until recently, however, private ordering of litigation within business entities was often ignored. In the corporate context, charters and bylaws generally did not include provisions to shape intracorporate litigation. Clauses choosing the law and the forum seemed unnecessary--the internal affairs doctrine ensured that the law of the incorporation state applied to intracorporate disputes, and suits by tradition were filed in the state of incorporation. (5)

    Things changed in the early 2000s. The emergence of multiforum mergers and acquisitions (M&A) litigation sparked interest in shaping shareholder litigation through terms in corporate organizational documents. shareholder suits challenging corporate deals were increasingly filed outside the state of incorporation, often in multiple states at once. (6) A prominent solution to this perceived problem--advocated by judges, lawyers, and scholars--was to add an exclusive forum selection clause to the corporate charter or bylaws that would limit the jurisdictions in which litigation could be brought. (7)

    In 2013, the Delaware Chancery Court explicitly approved these exclusive forum clauses, finding such a bylaw to be facially valid in Boilermakers v. Chevron (8) Corporations have since increasingly adopted these clauses in corporate charters and bylaws. (9) Their use and acceptance also laid the groundwork for another type of dispute resolution provision: fee-shifting. In May 2014, the Delaware Supreme Court held an aggressively drafted fee-shifting bylaw facially valid in ATP Tour v. Deutscher Tennis. (10) This decision led to lobbying, legislation, and debate on the wisdom of allowing corporations to curtail shareholder suits. (11)

    Ultimately, legislation was passed in Delaware in 2015 to limit the spread of fee-shifting provisions. (12) The statutory response prohibits Delaware stock corporations from adding fee-shifting provisions to their charter or bylaws. At the same time, the legislation sanctions use of exclusive forum clauses, allowing Delaware corporations to include such terms, so long as they do not exclude Delaware courts as a permissible forum. (13)

    These developments suggest no impending end to the debate over respecting companies' private ordering solutions on the one hand, while protecting less sophisticated investors via mandatory rules on the other. Yet, because separate statutes govern separate classes of business organizations, the current debate over protecting the business law litigation process has a gaping hole. Judicial and statutory responses--aimed specifically at corporations--do not spill over to their non-corporate partnership and LLC counterparts. Delaware's exclusive forum and fee-shifting legislation reaches only stock corporations, leaving partnerships and LLCs unaffected by these limitations, despite the similar importance of the dispute resolution process for investors in these entities.

    The gap in the debate is unfortunate. Non-corporate entities not only account for a significant portion of business entities and national commerce, (14) but they also provide a missing connection between the use of dispute resolution provisions in commercial contracts and in the organizational documents of business entities. LLC statutes similar to Delaware's reflect a fundamental commitment to private ordering and freedom of contract. (15) Ignoring how dispute resolution terms are employed in this permissive environment misses a valuable perspective from the frontier of organizational law.

    Moreover, an often overlooked aspect of the arguments in the corporate context is their reliance on developments within the non-corporate space. According to the Delaware Chancery Court, the exclusive forum corporate bylaws at issue in Boilermakers v. Chevron could not "fairly be argued to regulate a novel subject matter: the plaintiffs ignore that, in the analogous contexts of LLC agreements and stockholder agreements, the [Delaware] Supreme Court and this court have held that forum selection clauses are valid." (16) A richer understanding of non-corporate entities bolsters these arguments.

    However, despite isolated cases in which LLCs and similar non-corporate organizations have altered dispute resolution provisions, no systematic inquiry has been undertaken into how LLC governing documents structure the dispute process. (17) We remedy this oversight. We provide an empirical study of intrafirm dispute resolution provisions adopted by LLCs, revisiting this category of private ordering in light of changes in corporate law and practices. Using an original data set developed by one of the authors, (18) this Article charts the use of provisions in privately owned LLC operating agreements-the LLC functional analogue of corporate charters and bylaws--to set the rules for resolving disputes among the LLC's constituents.

  3. METHODOLOGY

    Unlike publicly traded corporations, privately held LLCs are generally not required to make their operating agreements available for public inspection. one could address this issue by studying only publicly traded LLCs, whose governing documents are made public pursuant to regulatory requirements, (19) but the number of such entities is a mere handful, (20) and analyzing such an unrepresentative sample risks providing few generalizable lessons. We therefore choose to examine...

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