Investor Rights in Non-Listed LLCs

In an earlier blog post, I argued that a combination of contractual rights and non-legal factors balances the interests of the controlling insiders and outside investors in publicly-traded limited liability companies (LLCs). Since most of these non-legal factors—the firm’s ownership structure, dividend policies, board composition and board practices, market forces, and the standardization of the governance structures—are specific for listed LLCs, the situation is different in non-listed LLCs. The members of private LLCs have only legal rights and, perhaps, a promise of continued cooperation to rely upon. At the same time, given the default nature of almost all provisions of the LLC statutes, the founders can choose to either replicate traditional governance structures of corporations or modify and waive any or all long-established investor protection rights. This flexibility permits users of the LLC form to draft customized rules governing their business relationships. Yet, it can also be abused. Not surprisingly, the controversy focuses on the question of imposing some mandatory rules that will protect LLC members. In a new article, I describe contracting practices in non-listed Delaware LLCs. The study is based on 289 agreements filed with the SEC by the parent firms of LLCs.

The results support the argument that contractual rights play more important role in non-listed LLCs than in publicly-traded LLCs. In cases of changing default statutory rules, the parties of LLC agreements adopted contractual substitutes that ensure equivalent protection. Furthermore, contractual choices were strategic: they tended to differ depending on the number of company members and underlying conflicts of interests. The members of non-listed LLCs also reduce formalities in decision-making which makes the organization of a business via an LLC cheaper.

The freedom to contract out of fiduciary duties is one of the principal differences between Delaware LLCs and corporations. And agreements modifying or completely waiving these duties were indeed at the center of contractual planning. The duties of care and loyalty were waived or modified in less than one-quarter of the firms. Where these alterations affected the duties of LLC members, their discretion was trimmed by contractual constraints: (1) large transaction rules requiring special approval procedures, such as member consent, for transaction above a certain amount and (2) conflict-of-interest rules requiring the consent or vote of non-interested members to approve transactions in which a member or manager is interested. The duties of care and loyalty of managers were altered in firms where boards replaced member meetings. In such cases, members intend that directors will advance the interests of the members who appointed them and thus need alterations of standard fiduciary duties to allow directors to fetter their discretion to make independent judgments as company directors. Finally, similar to listed LLCs, many contracts exculpated the liability of managers for the breach of the duty of care with the purpose of creating a standard of liability similar to the standard that results from the application of the corporate business judgment rule.

Another commonly-used contracting tool is interest transfer restrictions. In firms with a small number of members, interest-transfer clauses and minority-put rights played an important role. They ensure stability among the parties, secure special relations between them, and provide minority members with exit opportunities where the potential for oppression—either by incumbent insiders or the acquirers of control—is strong. These provisions acted as a remedy where other investor protection rights were weak, thereby encouraging minority investments and making capital accumulation possible in the first place. Minority member exit opportunities were also achieved by the right to dissolve an LLC conditioned upon decision-making deadlock or breach of an agreement by the other member.

The importance of dissolution rights and transfer restrictions—with the apparent exception of a tag-along right—decreases with the increase of the number of LLC members. Tag-along rights—a minority right to sell its interest along with the controlling seller on the same terms in change-of-control transactions—were used in these firms more often, perhaps because the larger the number of minority members and the weaker their vote in opposing control transactions, the stronger the need is to have exit rights.

One last thing that needs to be addressed here is that the sample companies were large firms rather than small corner shops. Accordingly, their members were likely to have access to the services of qualified professional advisors. Contracting practices can be different in small LLCs and in cases where there is bargaining inequality between different groups of LLC members. Nevertheless, the evidence from large private LLCs can shed some light on the reality and inform the debates by improving our understanding of contracting preferences of the users of the LLC form.

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 article, which is entitled “Contractual Mechanisms of Investor Protection in Non-Listed Limited Liability Companies” and available here.