Protecting LLC Owners While Preserving LLC Flexibility

Limited liability companies, or LLCs, have emerged as the entity of choice for new businesses.  The form attracts many everyday owners and entrepreneurs as an easy way to combine corporation-style limited liability protection with partnership-style tax treatment. LLCs also offer an appealing means for sophisticated players to craft more flexible internal governance arrangements without fiduciary duties and other governance terms required of other organizational forms.  LLCs thus cater to two very different groups: average investors, and very sophisticated parties.  Unfortunately, as LLCs have grown in popularity, so too have the stress fractures that result from satisfying these two divergent groups.  In a new paper, Protecting LLC Owners While Preserving LLC Flexibility, I identify this problem and show how it could be addressed by bifurcating LLC law, using principles from federal securities law to create a separating equilibrium, tailoring statutory rules to different owners’ varying needs.

LLC law’s divergent goals stem from the two types of owners they attract.  On the one hand, very sophisticated players use LLCs to jettison mandatory protections required of corporations. Many states’ statutes, most notably Delaware’s, give LLCs the utmost flexibility to craft personalized governance agreements, imposing no mandatory terms other than an implied obligation of good faith and fair dealing.  The lack of mandatory provisions gives LLCs the freedom to dispense with legal protections that aren’t appropriate for their circumstances, replacing them with individualized substitutes such as incentive pay, repeated interactions, or other mechanisms for aligning the incentives of managers and owners that better fit their situations.  On the other hand, LLCs’ rising popularity has made them likely to be used by comparatively less sophisticated parties that focus on a simple means to obtain limited liability and tax treatment, with little regard for the governance freedom the form provides.

The problem with subjecting these two groups to the same statutory rules is that sophisticated and less sophisticated owners have markedly different needs.  Sophisticated parties benefit from maximal governance freedom.  They are presumed to have the wherewithal to protect themselves and bargain for individualized terms instead of needing to rely on clunky mandatory legal protections.  But less sophisticated parties, who are less likely to protect themselves in a bargain for governance terms, derive more benefit from mandatory legal protections.

A single set of LLC rules consequently must prioritize one group of owners at the expense of the other.  Protecting less sophisticated owners by requiring mandatory legal protections reduces LLCs’ attractiveness to sophisticated parties, while supporting sophisticated parties by requiring few mandatory protections leaves less sophisticated owners at risk.  There are a variety of ways we might grapple with this problem.  I explore several possibilities in a companion paper, More Ways to Protect LLC Owners While Preserving LLC Flexibility. These possibilities include, among others, self-regulation, private certification systems, investor-led market forces, relying on lawyers as gatekeepers, and “smart” disclosure systems.  Ultimately, I conclude that a system borrowing from federal securities law’s accredited investor standard has the most promise to satisfy LLC owners’ differing needs.

In securities law, the accredited investor standard is used to identify investors who have the sophistication to protect themselves when buying risky investments, or who at least have the wealth to deal with losses from those risky investments.  It does so primarily by looking at investor wealth.  My proposal would apply the same principles to LLCs.  LLCs with exclusively sophisticated investors who are likely to protect or accurately value their governance interests, as measured by an LLC analogue of the accredited investor standard, could opt into a set of legal rules that resemble Delaware’s current method of maximizing owners’ flexibility with few mandatory protections.  LLCs with investors who don’t satisfy the standard or who don’t take action would be subject to a more robust set of mandatory protections, providing owners with fundamental governance rights.  These more robust protections could still leave considerable space to adjust to individual circumstances while offering meaningful safeguards.  As a starting point, they might resemble the rights of corporation owners, who enjoy mandatory fiduciary duties, the right to seek judicial dissolution, and takeover protections, all of which can be modified or waived with respect to any LLC in states like Delaware.

One of the trickiest design issues would be choosing the mechanism that screens owners for projected sophistication and separates them into groups.  Since the system is designed to vary rules based on owners’ likelihood of protecting or correctly valuing their governance rights, it should employ a separation mechanism that also does so in a way that is predictable and easy to implement.  One possibility is wealth, which is currently used in federal securities law.  Of course, wealth is at best a noisy proxy for owner sophistication, and there are other possibilities, ranging from the objective to the subjective.  The optimal mechanism would accurately classify LLC owners while imposing low burdens on companies and providing predictability to investors.  Since owner characteristics vary by state, the optimal mechanism might, too.

In the end, a system like this relieves the pressure that has been building as a single set of rules tries to satisfy two increasingly opposing interests.  By adjusting the rules to cater to these interests’ divergent needs, we ensure that LLCs continue as a simple way to satisfy owners’ limited liability and tax treatment preferences while still offering sophisticated players the means for customized agreements without mandatory provisions.

This post comes to us from Professor Peter Molk at Willamette University College of law. It is based on his recent articles, “Protecting LLC Owners While Preserving LLC Flexibility,” available here, and “More Ways to Protect LLC Owners and Preserve LLC Flexibility,” available here

1 Comment

  1. jesus alfaro

    Did you mesure the value of allowing complete freedom of contract for sofisticated parties? What if there are no advantages for investors but only opportunism on the side of insiders?

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