Private Ordering of Exit in Limited Liability Companies: Theory and Evidence from Business Organization Contracts

• Date: 01 December 2016
• Author: Suren Gomtsian
• Published date: 01 December 2016
• DOI: http://doi.org/10.1111/ablj.12087

Private Ordering of Exit in Limited

Liability Companies: Theory and

Evidence from Business

Organization Contracts

Suren Gomtsian*

INTRODUCTION

Where statutes fall short, contracts can fill the gap. Businesses partners

encounter many problems both while structuring their relations and

*PhD researcher at Tilburg University, Department of Business Law;, Tilburg Law and

Economics Center (TILEC), the Netherlands; e-mail: s.gomtsyan@tilburguniversity.edu.

Part of this research was conducted at Fordham Law School, where I was a Visiting

Research Fellow. Earlier versions of this article received a prize for the best paper of a

young scholar at the Second International Law and Economics Conference at Bilkent Uni-

versity and the Sixth Annual Conference of the Spanish Association of Law and Econom-

ics. The article benefited from excellent comments by Michael Asimow, Benjamin Engst,

Tim Friehe, Juan Jose Ganuzo, Martin Gelter, Gillian Hadfield, Lin Lin, Michal Shur-Ofry,

William Simon, Kathryn Spier, Eric Talley, Christoph Van der Elst, David Walker, and the

participants of the Second International Law and Economics Conference at Bilkent Uni-

versity in Ankara, Turkey, the Second Conference for Junior Researchers at Stanford Law

School in Stanford, California, the Annual Meeting of the National Business Law Scholars

Conference at the Seton Hall University School of Law in Newark, New Jersey, the Annual

Conference of the Spanish Association of Law and Economics in Santander, Spain, the

Annual Meeting of the German Law and Economics Association in D€usseldorf, Germany,

the Annual Conference of the European Association of Law and Economics in Vienna,

Austria, the 2015 International Junior Faculty Forum at Stanford Law School, the First

Conference on Empirical Legal Studies in Europe at the University of Amsterdam, the

Netherlands, and a TILEC work-in-progress meeting in Tilburg, the Netherlands. Special

thanks to the editors of the American Business Law Journal, especially Laurie Lucas and Ter-

ence Lau, and two anonymous referees for many suggestions and thoughtful and thor-

ough comments. I gratefully acknowledge financial support provided by the “Research

Talent” grant from the Netherlands Organization for Scientific Research (NWO).

V

C2016 The Author

American Business Law Journal V

C2016 Academy of Legal Studies in Business

677

American Business Law Journal

Volume 53, Issue 4, 677–744, Winter 2016

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later during the functioning of the venture.

1

Examples include the defi-

nition or calculation of each party’s contribution and of corresponding

voting rights,

2

self-dealing by one of the parties,

3

opportunistic renego-

tiation of cooperation terms with the aim of extracting more benefits

from the project,

4

deadlocks in decision making,

5

and the resulting

paralysis of the firm.

6

Transactional lawyers have designed different

contractual provisions dealing with these problems in cases where legis-

lative solutions are deemed insufficient or inappropriate. For example,

under many circumstances, they can be efficiently and effectively solved

by private ordering of interest or share transfers.

7

Contingent owner-

ship provisions (explicit and implicit options)

8

encourage investments;

limit agency, moral hazard, and holdup problems;

9

prevent escalations

1

See, e.g., Steven R. Salbu & Richard A. Brahm, Strategic Considerations in Designing Joint

Venture Contracts, 1992 COLUM.BUS.L.REV. 253, 254 (1992).

2

See id. at 291.

3

See,e.g., Zohar Goshen, Conflicts of Interest in Publicly-Traded and Closely-Held Corporations: A

Comparative and Economic Analysis,6T

HEORETICAL INQUIRIES L. 277, 280–81 (2005); Douglas

K. Moll, Minority Oppression and the Limited Liability Company: Learning (or Not) from Close

Corporation History,40W

AKE FOREST L. REV. 883, 956–57 (2005).

4

See, e.g., Edward B. Rock & Michael L. Wachter, Waiting for the Omelet to Set: Match-Specific

Assets and Minority Oppression in Close Corporations,24J.C

ORP. L. 913, 928 (1999).

5

See,e.g., Jonathan Macey, The Nature of Conflicts of Interest Within the Firm,31J.CORP.L.

613, 628 (2006); Meghan Gruebner, Note, Delaware’s Answer to Management Deadlock in the

Limited Liability Company: Judicial Dissolution,32J.C

ORP. L. 641, 646–49 (2007).

6

See, e.g., Macey, supra note 5, at 628.

7

This study relies on data from the operating agreements of nonlisted limited liability com-

panies (LLCs). Hence, more appropriate is the use of the terminology applied in the con-

text of LLCs such as “interest transfer” instead of “share transfer,” “unit” instead of

“stock,” “operating agreement” or “limited liability company agreement” instead of

“shareholders’ agreement,” and “member” instead of “stockholder.”

8

Put and call options are explicit options, while tag- and drag-along rights can be consid-

ered as implicit options where a party can put its interest to a third-party buyer or can call

the interests of other parties, respectively. Gilles Chemla et al., An Analysis of Shareholder

Agreements, 5 J. EUR.ECON.ASS’N93, 95 (2007).

9

See Margaret M. Blair, Locking in Capital: What Corporate Law Achieved for Business Organiz-

ers in the Nineteenth Century, 51 UCLA L. REV. 387, 402 (2003) (describing holdup as a prob-

lem economists have identified in which “one partner might use the threat of walking

away from the business (and possibly forcing dissolution) to extract a greater share of the

rents from the others (or a smaller share of the losses)”).

678 Vol. 53 / American Business Law Journal

of conflicts; and provide business partners with swift means for exiting

investments.

10

In publicly traded firms, liquid equity markets perform the role of

contingent ownership structures, allowing minority investors to exit,

and creating conditions for new controlling investors to appear.

11

In

partnerships, notwithstanding restrictions on the transferability of part-

nership interests,

12

the right of each partner to force the dissolution of

the firm ensures an equivalent result.

13

The situation is different in

nonlisted limited liability firms where the members, because of locked

investments, depend more heavily upon each other for major decision

making.

14

This explains the importance of private ordering of interest

transfers in ensuring successful cooperation in nonlisted limited liability

firms, particularly where the probability of private benefit extraction or

holdup is high.

In spite of this need, business partners often overlook governance

planning.

15

They are more likely to direct attention toward the econom-

ic side of the business and limit the design of the governance structure

to the most obvious matters—allocation of ownership and voting

10

See Chemla et al., supra note 8, at 100–03; Georg N€

oldeke & Klaus M. Schmidt, Sequen-

tial Investments and Options to Own, 29 RAND J. ECON. 633, 639–48 (1998).

11

See infra notes 37–39 and accompanying text.

12

Unlimited liability of a general partner coupled with the right to bind the partnership

creates a reasonable expectation for each partner to block the entry of new partners with

governance rights because the actions of an arriving partner can endanger not only the

other partners’ investments, but their personal wealth as well. See LARRY E. RIBSTEIN,THE

RISE OF THE UNCORPORATION 52 (2010); Henry Hansmann & Reinier Kraakman, The Essen-

tial Role of Organizational Law, 110 YALE L.J. 387, 424–25 (2000). Although limited liability

alleviates this concern, the active role of members in the governance of nonlisted firms can

still generate a legitimate motive to limit the transferability of investments.

13

See infra note 45.

14

See infra notes 40–44 and accompanying text.

15

See, e.g., George W. Dent, Jr., Gap Fillers and Fiduciary Duties in Strategic Alliances,57BUS.

LAW. 55, 80 (2001) (explaining the use of simple contracts in strategic alliances as a way to

preserve trust between the partners); Jason M. Hoberman, Note, Practical Considerations for

Drafting and Utilizing Deadlock Solutions for Non-Corporate Business Entities, 2001 COLUM.BUS.

L. REV. 231, 242 (noting that enthusiasm about engaging in a new venture complicates

advanced contractual planning).

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