The limited liability company (LLC) is not only a widespread business form for non-listed firms but also is used by listed companies. There were twenty publicly traded US LLCs in September 2013—all formed in Delaware. Two more Delaware LLCs have joined their ranks since then (the number of IPOs by limited partnerships, another “uncorporate” business form, is greater—26 Delaware LPs went public during the last two years). Since Delaware rules on LLCs, with very few exceptions, are cast as defaults, the LLC operating agreement is the primary source of governance. This is in stark contrast to listed corporations that have to comply with mandatory governance structures imposed by the law. The question is whether the controlling insiders of publicly traded LLCs contract around the statutory default rules to create governance structures that entrench their control, limit their accountability, or are oppressive towards outside investors in any other way? To the extent that LLCs are subject to less prescriptive regulation, do they “distort” long-established corporate governance practices and investor protection mechanisms common for corporations?
In a recent article published in the Delaware Journal of Corporate Law and available here, I show that governance in listed LLCs differs from the traditional governance structure of corporations. Particularly, the founding members of the twenty listed LLCs often had effective control over the boards and faced fewer formalities during decision-making. I suggest, however, that this distortion does not swing the pendulum of investor protection strongly in the direction of insiders. As an alternative to the default instruments of investor protection, LLC agreements include provisions that balance the rights of different constituencies. Nevertheless, these provisions are not always identical in terms of the strength of the offered protection. Hence, other factors—such as the ownership structure of these firms, dividend policies, board composition and board practices, market forces, and the standardization of the governance structures—fill the gaps as substitutes for legal rights. Publicly traded LLCs combine different contractual rights and non-legal factors to make their IPOs attractive for investors.
Governance practices in publicly traded LLCs, due to common restrictions and waivers of statutory rules, differ from the traditional governance models of listed corporations. Board entrenchment and control-enhancing mechanisms are common. LLC members, unlike corporate stockholders, are free to contract around fiduciary duties of members and managers and they do so. The frequent purpose of restricting fiduciary duties or limiting liability for the breach of these duties is nonetheless to create contractual equivalents of two rules applicable to corporations:
- the business judgment rule—by excluding liability for the breach of the duty of care as long as managers do not act in a manner that is grossly negligent, and
- the statutory safe harbor provisions for reviewing interested transactions with fiduciaries—by defining standards to be met or special procedures to be followed in order to exclude fiduciary liability or shift the burden to prove unfairness to the plaintiffs.
Contractual safeguards is not the only means of protecting outside investors’ rights and interests. The following factors, which, to distinguish them from the contractual rights of investors, I conditionally grouped under the term “non-legal,” play an important role as well. First, ownership and capital structures serve both as substitutes for and complements to the legal protection mechanisms of the operating agreements of listed LLCs. These structures are not selected randomly; rather, they aim to align the interests of different groups of LLC constituencies. In the majority of the sample, the controlling members had to hold significant ownership interests to get control rights. In cases where the controlling member’s economic interest was small, outside investors received additional guarantees in the form of the limitation of the company’s scope of activities and the discretion of its managers.
Second, publicly traded LLCs do not differ much from listed corporations concerning the structure, composition, and practices of the boards of directors. Even LLCs that were eligible for exemptions from the corporate governance requirements of stock exchanges opted for voluntary compliance. The boards of the listed LLCs mostly had a majority of independent directors; they established audit, compensation, and other committees composed of independent directors; and they regularly held board and committee meetings. Consequently, if corporate boards are considered active actors in dealing with governance problems, LLC boards deserve similar credit.
Third, publicly traded LLCs distribute a significant part of their earnings and cash flows among the unitholders. The small amount of the retained cash reduces the discretion of the insiders and, hence, the agency problems within LLCs. The annual dividend yield of the listed LLCs was usually more than triple the dividend yield of S&P 500 corporations. Large cash payments also compensate outside investors for weak legal rights.
Regular distributions of available cash among LLC members lead to the fourth factor. The practice of paying large dividends does not allow publicly traded LLCs to retain earnings and accumulate cash similar to corporations. To keep going as a business, LLCs have to turn frequently to the markets through SPOs and the issuance of debt notes. Establishing an investor-friendly reputation is thus crucial. For this reason, the effect of market disciplining is stronger on listed LLCs than on corporations.
And finally, the evidence shows that the public offerings of LLC interests are clustered around several standardized governance structures. A limited number of investment banks act as lead underwriters of LLC IPOs; besides, there is a specialization among the banks depending on the industry. This standardization establishes confidence among outside investors—who can make investment decisions based on prior experience with the offered governance structures—and reduces investor costs in interpreting the organizational structure of an offering company.
One aspect that remained outside the scope of this study is the possibility of an upfront discounting for weak investor rights. It is reasonable to expect rational investors to be able to offer a certain price for investor rights. Therefore, LLCs with weaker rights and unfamiliar governance structures will be valued lower.
The preceding post comes to us from Suren Gomtsian, PhD Researcher at Tilburg University, Department of Business Law; Tilburg Law and Economics Center (TILEC). The post is based on his recent article, which is entitled “The Governance of Publicly Traded Limited Liability Companies” and available here.