Ownership Piercing

In a new article, I build upon the paradox of ownership. My central thesis is that those who own are not always in control; therefore, those who control should be held accountable like the owners would if they were in control.

I am inspired by the theory of the firm, particularly, the model created by professors Sanford Grossman and Oliver Hart in their path-breaking article, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration. Grossman and Hart posit that “we do not distinguish between ownership and control and virtually define ownership as the power to exercise control.” I also build upon Stephen Bainbridge’s construction of the business judgment rule as an abstention doctrine to outline the circumstances that would lead to the shift of the burden of proof in the business judgment rule and make courts intervene.

In a manager-managed limited liability company (LLC), where the managers alone act as the company’s management, there is very little real ownership or control exercised by members. The company’s contractual framework consists of the operating agreement and other hidden contracts that may set forth pre-emptive rights and other restrictions that cause a de facto lack of marketability of the members’ units.

In my article, I deal with situations where standard contractual terms give the managers exclusive decision-making power. In light of the company’s contractual framework, members are peculiarly vulnerable because  they cannot remove the managers or easily sell their units. I suggest that, under these circumstances, courts may be less willing to give managers the benefit of the doubt than is called for under the business judgment rule. Instead, courts should ownership pierce.

Ownership piercing is a mechanism of evaluative reasoning by which a court will intervene to clarify who owns property rights and substantively controls the LLC. The doctrine of piercing the LLC veil inspires the idea of ownership piercing. Both expressions appeal to the idea of an alter ego that affects the company’s business. However, while the former disregards the shield of limited liability and determines the member to be liable for the company’s debts and obligations, I use the latter to suggest courts intervene to clarify who owns property rights and substantively controls the LLC. I suggest that courts should intervene to clarify who substantively controls the company when:

  1. Managers indirectly hinder members’ exercise of property rights, and a clear definition of the members’ property rights is needed to establish the foundations for efficient bargaining.
  2. Members, despite having the right to participate in the company’s decision-making, become dependent on the managers to the point that the property rights members hold in their units are unclear, and they lose the ability to overcome ill-managing decisions.
  3. Members cannot comply with their obligations vis-à-vis third parties (e.g., creditors) due to agency problems, bargaining failures, and hold-ups in the company.
  4. Managers act as trustees of third parties, which hinders the members’ exercise of property rights in the company.
  5. The control over decision-making is manipulated by managers who act in a self-interested manner and, therefore, hinder the business judgment rule’s advantages.

These situations have in common the fact that managers control or substantively own the company and, as a result, the exercise of the members’ property rights is curtailed. When this happens, I suggest that managers should be held to a higher standard that shifts the burden of proof in the business judgment rule. The idea that there may be situations in which courts must ownership pierce rests on the principle of substance over form: That the economic substance of transactions rather than their legal form be disclosed.

If ownership means to control, however, why are the members not in control? The ownership paradox my article builds on is rooted in the concept of legal pleiotropy, which refers to the expression of different ownership traits caused by the LLC’s contractual features. In biology, pleiotropy is a well-established phenomenon of a single gene affecting multiple traits. I configure the LLC’s operating agreement and the nexus of contracts informing the LLC as that one single gene. Legal pleiotropy means that the way constituencies and stakeholders interplay in the LLC generates unintended contractual consequences that affect members’ property rights and the concept of ownership in this business entity at various levels.

Who de facto controls the company when, in a manager-managed LLC, the members – “owners” of the company – cannot freely decide what to do with their investment in the LLC’s units and do not fully control the company due to their ownership?

I use Metro Storage International LLC v. Harron to frame my analysis and provide answers. In this case, the Delaware Chancery Court had to decide whether a Delaware court had personal jurisdiction under Section 18-109(a) of the Delaware Code, which implies consent to jurisdiction on the part of the jury and de facto managers of an LLC. However, in order to decide those issues, the court had to define “de facto manager” and what it meant to own and control the LLC. Acting managers participate materially in the management of the company but what that means is an open question.

Whenever faced with this question, I suggest that courts analyze the company’s contractual framework and scrutinize the acting manager’s fiduciary duties in light of that contractual framework. Suppose the acting manager, even if not formally designated as such in the company’s operating agreement, yields an indisputable proprietary interest deriving from the company’s management. In that case, the manager participates materially in the management of the company and is in control.

In response to Professor Bainbridge, if the court will ownership pierce, it must apply a three-pronged test to unveil the company’s real owners: the managers. This test boils down to the following questions and sub-set of questions.

  1. Does the de facto manager control the company?
    • Are the de facto manager’s duties defined in contracts other than the operating agreement?
    • Does the de facto manager have a proprietary interest in the company’s business deriving from contract?
    • Is the de facto manager subject to fiduciary duties deriving from contract?
  2. Would not treating the de facto manager as a controller lead to inequitable results?
  3. Given the individual’s position in the company, does the business judgment rule apply? There can only be a shift in the burden of proof in the business judgment rule if it applies.

If the court’s findings are positive, then ownership piercing’s three-pronged test is met, which means the court will shift the burden of proof in the business judgment rule. In other words, once the court engages in ownership piercing to determine the extent of the managers’ control of the company and their actual ownership, the managers-defendants are the ones who carry the burden of proving that they did not breach fiduciary duties.

My article explores multiple expressions of ownership controlled by contract (legal pleiotropy) in the LLC. However, the expressions that ownership controlled by contract may assume in this and other business entities such as closely-held corporations are countless. It will all depend on the company’s contractual design and the scope and depth of the applicable contractual provisions.

This post comes to us from Lécia Vicente, the Henry Plauché Dart Endowed Assistant Professor of Law at Louisiana State University’s Paul M. Hebert Law Center. It is based on her recent article, “Ownership Piercing,” available here.

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