How Do LLC Owners Contract Around Default Statutory Protections?

Limited liability companies, or LLCs, have quickly become the form of choice for new businesses.  Companies ranging from the well known, like Chrysler, to the more experimental, such as French fry vending machine makers, to local flooring installers all organize as LLCs.  One attraction is LLCs’ ability to replicate S-corporations’ robust limited liability protection and potential for single taxation of company profits.  Another attraction is the wide contractual freedom permitted among owners and managers to divide up ownership and management rights and responsibilities.  Most states impose few mandatory rules on this relationship.  For instance, Delaware, the leader in out of state LLC formations, requires that owners and managers have only an implied covenant of good faith and fair dealing, leaving substantial space to tailor individualized terms to individual circumstances.  Yet remarkably little is known about how, or even whether, LLCs exercise this discretion.  Do parties fail to wield LLCs’ contractual flexibility, choosing to operate passively under unaltered default protections?  Do they instead engage in robust bargaining for efficient terms?  Or do they do something else entirely?

In a new paper, How Do LLCs Owners Contract Around Default Statutory Protections, I analyze a sample of 233 Delaware and 50 New York private LLC operating agreements to answer these questions.  These agreements were obtained from exhibits attached to private litigation, offering a rare glimpse into the rules governing the inner workings of private companies spanning a range of sophistication, industry, and size.  The analysis reveals several findings.

First, we can easily dismiss the hypothesis that LLCs fail to exercise contractual flexibility granted by state statutes. LLCs displayed remarkable variation of owner/manager contractual terms.  For instance, two in five LLCs reduced or eliminated the corporate opportunity doctrine; two-thirds waived, exculpated, or indemnified managers’ violations of the duty of loyalty; and almost half did the same for the duty of care.  Twenty percent of companies explicitly cut back the duty of good faith.  And ten percent required owners to waive their right to seek judicial dissolution, often seen as a fundamental backstop for oppressed owners when all else fails.  The variations are not confined to these dimensions; the paper considers several more. [1] It appears, therefore, that LLCs do not form merely for tax reasons and passively adopt default protections.  Instead, they regularly employ contractual flexibility to vary owner/manager relations, often in ways not replicable by other organizational forms.

But how do LLCs use this flexibility?  We might hope that they do so in pursuit of efficient agreements, as advocates of contractual flexibility argue, rather than to appropriate gains from less sophisticated owners, as feared recently by Delaware jurists Strine and Laster, among others. [2] The former justifies adherence to contractual freedom; the latter would suggest mandatory protections might be necessary.

My paper tests one aspect of this debate.  If parties bargain for efficient terms, we might expect that as traditional protections are given up, more countervailing protections will be demanded in return.  If, instead, managers or owners use LLCs’ contractual freedom to sow the seeds for later opportunism, such as by unexpectedly seizing a corporate opportunity or changing the company’s line of business, we might expect no such relationship, or perhaps even an inverse one.

The Delaware agreements show little support for the efficient bargaining hypothesis.  Indeed, the strength of safeguards that LLCs affirmatively adopt appears wholly unrelated to parties’ willingness to waive any individual default protection.  The results do not appreciably vary when controlling for industry, time, or owners’ bargaining power (using owners’ investment amount as a proxy for their vulnerability, under an assumption that low-dollar investors are less likely to be represented by sophisticated legal counsel or have the requisite expertise on their own).  On the other hand, I find that LLCs with sizeable shares held by more vulnerable owners have significantly fewer affirmative safeguards than their less vulnerable counterparts, suggesting a situation more in line with the fears of mandatory protection advocates.

However, before discarding contractual freedom in favor of mandatory protections, two points are worth making.  First, I test only that aspect of the efficiency bargaining story predicting that parties respond to weakened contractual protections by adopting others.  This is not the exclusive way efficient parties might respond; they could, for instance, instead demand to pay a lower price for their ownership stake to compensate for their weaker position, or rely on (or bargain for) non-contractual safeguards, neither of which would show up in an analysis of operating agreements.  In other words, even though I find evidence inconsistent with vigorous bargaining for efficient terms, this process could still play out in unobserved ways.

Second, while these findings show that contractual conditions may be ripe for potential opportunism of minority owners, they do not indicate how often owners actually capitalize on this potential.  Cases from Delaware and other jurisdictions suggest the rate is more than zero.  Yet the extent of opportunism that actually occurs because of an operating agreement’s permissiveness, the harm from that opportunism, and the extent that intervention could solve these problems are important variables that remain elusive.  Before implementing a reform that restricts parties’ bargaining freedom – one of the key potential advantages of the LLC form versus its competitors – these magnitudes must be known to ensure that addressing them is worth incurring reform’s concomitant costs.  Further research into these issues will help determine when and how to protect more vulnerable owners without sacrificing the distinguishing contractual flexibility of LLCs.

ENDNOTES

[1] LLCs also engage in substantial modification of default terms applying to the dispute resolution process.  This analysis forms the basis of a separate paper with Professor Verity Winship of the University of Illinois, LLCs and the Private Ordering of Dispute Resolution, available here.

[2] Leo E. Strine, Jr. & J. Travis Laster, The Siren Song of Unlimited Contractual Freedom, available here.

The preceding post comes to us from Peter Molk, Assistant Professor at Willamette University, College of Law.  The post is based on his paper, which is entitled “How Do LLC Owners Contract Around Default Statutory Protections?” and available here.  A similar post was earlier made available on the Oxford Business Law blog here.