How Do LLC Owners Contract Around Default Statutory
Protections?
PETER MOLK
*
Limited liability companies are built on the idea of contractual freedom. Unlike with
other business organization forms, most owner protections apply only by default to LLCs,
which are free to waive or modify them as desired. This freedom promises economic
efficiency if parties are sophisticated but raises the potential for opportunism by
relatively more sophisticated managers and majority owners. While companies ranging
from small landscape firms to Chrysler and Fidelity organize as LLCs, remarkably little
is known about whether or how LLCs use this contractual flexibility.
I analyze the operating agreements of 283 privately owned LLCs organized under
Delaware and New York law to determine when and how parties alter default provisions.
I find widespread use of LLC statutes’ flexibility to decrease default owner protections,
as well as widespread adoption of owner protections that do not apply by default. There
is little evidence, however, that the contractual freedom is used to craft systematically
more efficient contractual owner protections. Instead, using a proxy for owner
vulnerability, I find that LLCs with more vulnerable owners adopt significantly fewer
owner safeguards, suggesting that contractual freedom may be used more often for
opportunism and not for efficiency.
I. INTRODUCTION ............................................................................................................ 504
II. THE LAW OF LLCS ..................................................................................................... 508
III. PRIOR STUDIES .......................................................................................................... 513
IV. EMPIRICAL EXAMINATION OF LLC OPERATING AGREEMENTS: METHODOLOGY ...... 515
V. EMPIRICAL EXAMINATION OF LLC OPERATING AGREEMENTS: RESULTS .................. 521
A. Weakening Protections .......................................................................................... 522
1. Authorizing Competition ................................................................................... 522
2. Waiving the Business Opportunity Doctrine ..................................................... 523
3. Modifications of Traditional Fiduciary Duties.................................................. 524
a. Drag-Along Rights ....................................................................................... 531
b. Judicial Dissolution ...................................................................................... 533
B. Strengthening Protections ..................................................................................... 535
1. Amending the Operating Agreement ................................................................. 535
2. Transferability ................................................................................................... 537
3. Withdrawal Rights ............................................................................................. 538
*
Assistant Professor, Willamette University College of Law. Thanks to Amitai Aviram, Larry
Hamermesh, Mohsen Manesh, Peter Moldave, John Morley, Zenichi Shishido, Melissa Wasserman, Joe
Yockey, and participants at the Iowa Innovation and Business Law colloquium, the Corporate and Securities
Litigation workshop, and the Law and Entrepreneurship, American Law and Economics Association, and
National Bussiness Law Scholars annual meetings for comments and suggestions. Alicia Leduc and Matthew
Sabbah provided excellent research assistance.
504 The Journal of Corporation Law [Vol. 42:3
4. Tag-Along Rights ............................................................................................... 540
5. Limitation of LLC’s Purposes ........................................................................... 542
6. Required Distributions ...................................................................................... 543
7. Limited Life ....................................................................................................... 544
8. Ownership Stakes Held by Management ........................................................... 546
C. Summary................................................................................................................ 549
VI. WHAT MOTIVATES CONTRACTING AROUND DEFAULTS? ......................................... 551
A. Testing for Efficiency ............................................................................................. 551
B. Other Explanations................................................................................................ 555
C. Protecting Vulnerable Owners .............................................................................. 556
VII. CONCLUSION ........................................................................................................... 557
I. INTRODUCTION
Since the first enabling statute was passed in 1977, limited liability companies, or
LLCs, have exploded in popularity. There are now over 2.2 million LLCs, dwarfing the
number of traditional corporations by almost 40% while continuing to grow at a rapid
pace.
1
Companies ranging from the neighborhood lawn care service provider to Chrysler
1. Ron DeCarlo & Nina Shumofsky, Partnership Returns, 2012, IRS, fig. G (2015),
http://www.irs.gov/pub/irs-soi/soi-a-pa-id1504.pdf (2.2 million LLCs); Statistics of Income, Corporation
Income Tax Returns, IRS, fig. I (2011), http://www.irs.gov/pub/irs-soi/11coccr.pdf (1.6 million active
corporations); Rodney D. Chrisman, LLCs Are the New King of the Hill: An Empirical Study of the Number of
2017] How Do LLC Owners Contract Around Default Statutory Protections? 505
and Fidelity organize as LLCs.
2
Publicly traded companies as well as the exchanges they
trade on are LLCs.
3
Several of the largest privately held companies in the world similarly
choose the LLC business form.
4
A common reason to adopt the LLC structure is to achieve limited liability
protection with only single taxation of profits. This advantage, however, has long been
attainable through competing partnership and corporation forms.
5
But LLCs combine this
limited liability with almost complete contractual flexibility. Practically every corporate
law mandatory rule aimed at protecting owners, such as manager fiduciary duties, is only
a default for LLCs. The protections apply by default, but LLCs are free to waive or
modify them as desired. The contractual freedom “contractarian” approach is built on the
expectation that sophisticated LLC owners are capable of crafting optimal governance
provisions that may or may not include traditional protections. Because traditional
corporate protections impose costs on the firm and its owners, waiving them can be
desirable when parties adequately protect themselves through other, more efficient
means. Eliminating fiduciary duties, for example, may reduce what managers charge to
run the firm, and the elimination could be entirely appropriate if manager opportunism is
constrained through other means.
Not everyone thinks that traditional protections should be merely defaults for LLCs,
however. Eliminating owners’ standard protections can be problematic if those owners
are not sophisticated and underestimate the protections’ value. Because mandatory
corporate law rules exist to align manager and owner interests, waiving that protection
opens the door to value-reducing opportunism. For example, unsophisticated owners who
waive managers’ fiduciary duties without adopting substitute protections may later be
surprised to have no recourse when managers engage in self-dealing. The results are
undesirable from both efficiency and equity grounds. For this reason, traditional owner
protections are mandatory for corporations and cannot be waived even if the parties wish
to do so. The need to protect vulnerable owners of corporations is deemed superior to the
efficiency gains that might result through sophisticated bargaining.
The desirability of treating mandatory corporate protections as only default
provisions for LLCs therefore boils down to an issue of how LLCs’ contractual freedom
is used. Are sophisticated owners using LLC statutes’ flexibility to construct more
efficient arrangements than are permissible under corporate law? Are unsophisticated
owners induced to waive protections, giving rise to the potential for opportunism that
motivates mandatory protections for corporations? Or are LLCs neglecting to take
New LLCs, Corporations, and LPs Formed in the United States between 2004–2007 and How LLCs were Taxed
for Tax Years 2002–2006, 15 FORDHAM J. CORP. & FIN. L. 459, 460 (2010) (estimating new LLCs outpacing
new corporations by a two-to-one margin).
2. About Us, FCA, http://www.fcanorthamerica.com/company/AboutUs/Pages/AboutUs.aspx (last
visited Mar. 8, 2017); Our Heritage, FIDELITY, https://www.fidelity.com/about-fidelity/our-heritage (last visited
Mar. 8, 2017).
3. E.g., TRAVELCENTERS OF AM. LLC, 2014 ANNUAL REPORT 8, http://www.ta-
petro.com/assets/ce/Documents/2014Annual%20Report.pdf (2014); In the Matter of NYSE LLC et al.,
Exchange Act Release No. 72,065, 2014 WL 1712113, at *1 (May 1, 2014) (identifying the New York Stock
Exchange and the former American Stock Exchange as LLCs).
4. For example, 2 of the 14 largest, privately held American companies are LLCs (Albertsons and Pilot
Flying J), accounting for almost $82 billion in annual revenue in 2016. America’s Largest Private Companies,
FORBES, http://www.forbes.com/largest-private-companies (last visited Mar. 8, 2017).
5. S corporations in particular often compete with the LLC form for these advantages.
506 The Journal of Corporation Law [Vol. 42:3
advantage of contractual freedom and instead choosing the LLC form solely for tax
reasons? Despite the importance of these questions in light of LLCs’ emerging
dominance, little systematic effort has been spent in understanding whether and to what
extent LLCs use their contractual freedom to allocate owner rights and responsibilities.
6
For example, Professor Larry Ribstein, in several influential pieces, argued forcefully in
favor of LLC contractual freedom because of its superior potential for crafting efficient
owner protections.
7
LLCs must actually avail themselves of the flexibility for this
situation to be the case, yet Ribstein never conducted a systematic analysis of LLCs’
operations to determine if or how his theory played out in practice. On the opposite side
of the debate, Leo Strine and J. Travis Laster, Delaware Supreme Court Chief Justice and
Delaware Court of Chancery Vice Chancellor, respectively, recommend sacrificing
contractual flexibility in favor of mandatory LLC owner protections because of a
perceived need to help vulnerable owners. Such a recommendation again requires
knowing how LLCs actually use contractual flexibility to draft their governance
provisions.
8
Others have similarly argued for and against reining in LLCs’ contractual
freedom based on behavior reported in a handful of prominent cases.
9
I address this disconnect through an in-depth analysis of privately owned LLCs’
operating agreements—the LLC analog of corporate charters and bylaws that allocate
rights, responsibilities, and protections among owners and managers.
10
I analyze a set of
283 operating agreements to determine when and how default terms are modified. I find
that parties regularly use LLCs’ contractual flexibility to reduce or eliminate traditional
owner safeguards in ways not replicable under corporate law. For instance, LLCs often
eliminate fiduciary duties; authorize owners and managers to compete directly with their
6. Notable exceptions have been contributed by Mohsen Manesh, Michelle Harner, Jamie Marincic, and
Suren Gomtsian. Their studies’ contributions and their limitations are discussed infra Part III.
7. LARRY E. RIBSTEIN, THE RISE OF THE UNCORPORATION (2010); Larry E. Ribstein, Fencing Fiduciay
Duties, 91 B.U. L. REV. 899 (2011); Larry E. Ribstein, The Uncorporation and Corporate Indeterminacy, 2009
U. ILL. L. REV. 131; Larry E. Ribstein, Limited Liability Unlimited, 24 DEL. J. CORP. L. 407 (1999).
8. The Justice and Judge extrapolate from their sizeable yet anecdotal experience on the bench. Leo E.
Strine, Jr. & J. Travis Laster, The Siren Song of Unlimited Contractual Freedom, in RESEARCH HANDBOOK ON
PARTNERSHIPS, LLCS AND ALTERNATIVE FORMS OF BUSINESS ORGANIZATIONS 11 (Mark Lowenstein &
Robert Hillman eds., 2015).
9. For examples of those in favor of limiting LLCs’ contractual flexibility, see Benjamin Means,
Contractual Freedom and Family Business, in RESEARCH HANDBOOK ON PARTNERSHIPS, LLCS AND
ALTERNATIVE FORMS OF BUSINESS ORGANIZATIONS 40 (Mark Lowenstein & Robert Hillman eds., 2015)
(arguing for a particular need for default and mandatory rules for family businesses); Daniel S. Kleinberger,
Two Decades of “Alternative Entities”: From Tax Rationalization Through Alphabet Soup to Contract Deity,
14 FORDHAM J. CORP. & FIN. L. 445, 465–71 (2009); see generally SANDRA K. MILLER, LIMITED LIABILITY
COMPANIES: A COMMON CORE MODEL OF FIDUCIARY DUTIES (2015); Sandra K. Miller, What Fiduciary Duties
Should Apply to the LLC Manager After More than a Decade of Experimentation?, 32 J. CORP. L. 565 (2007);
Sandra K. Miller, The Role of the Court in Balancing Contractual Freedom with the Need for Mandatory
Constraints on Opportunistic and Abusive Conduct in the LLC, 152 U. PA. L. REV. 1609 (2004). For examples
of those against limiting LLCs’ contractual flexibility, see Myron T. Steele, Freedom of Contract and Default
Contractual Duties in Delaware Limited Liability Partnerships and Limited Liability Companies, 46 AM. BUS.
L.J. 221 (2009); Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnership and
Limited Liability Companies, 32 DEL. J. CORP. L. 1 (2007); Andrew S. Gold, On the Elimination of Fiduciary
Duties: A Theory of Good Faith for Unincorporated Firms, 41 WAKE FOREST L. REV. 123 (2006).
10. While LLCs file a certificate of formation that formally is analogous to the corporate charter, LLCs’
certificates of formation are surprisingly devoid of substance, specifying the company name, the registered
office, the registered agent, and typically little else.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 507
companies; waive the corporate opportunity doctrine; and even eliminate owners’ right to
seek judicial dissolution. These actions significantly cut back the protections enjoyed by
owners of traditional corporations and other organizations. For many, therefore, the
decision to organize as an LLC involves more than just achieving single tax treatment of
profits.
But LLCs also add various protections to their operating agreements that are neither
required nor apply by default, filling some of the void from reducing default protections.
These include a regular dividend distribution; a specified business purpose; a limited
lifetime; a restriction on majority owners’ ability to sell their ownership stake; and
aligning owner and management interests by compensating LLC management with
significant profit shares.
Many LLCs therefore are discarding default judicial and statutory protections that
are mandatory for corporations, and employing substitute safeguards. This more finely
tailored approach has the potential to maximize entity value and create efficient
governance relationships in ways not replicable through traditional corporate law. If
parties were contracting around default terms in pursuit of efficiency, one prediction of
the contractarian approach is that we would expect an inverse relationship between
reductions and additions: as traditional corporate protections are circumscribed, other
protections would be written in to fill the void. However, I find no significant relationship
between the subtraction of and addition to owner protections, either among LLCs as a
whole or among those LLCs identified as likely to have more sophisticated parties. This
finding suggests that when LLCs wield their contractual freedom, they do not
systematically do so to trade off traditional corporate protection for better substitute
contractual terms as envisioned by contractarian proponents.
On the other hand, I find that LLCs identified as likely to have more vulnerable
minority owners—those owners who invest little in the LLC and are less likely to seek
sophisticated legal counsel—adopt significantly fewer owner safeguards than LLCs with
less vulnerable owners. This result suggests that LLCs may instead be using their
contractual freedom to set up later opportunism by managers and majority owners.
These findings have several implications. First, they shine a light into the dark space
of LLC operations. Despite their significance as a form of doing business, LLCs remain
understudied because privately held companies are not subject to disclosure
requirements. This Article shows what LLCs are actually doing, which is useful for
studying a wide variety of questions in this increasingly important field.
The results also provide concrete evidence for the evolving debate on whether LLCs
require mandatory owner protections. Much of the discussion has suffered from a lack of
knowledge about how LLCs use their contractual flexibility. Because I find little
evidence for sophisticated bargaining and instead evidence of opportunism, the results
suggest both a greater need for minority owner protections and that the cost to
sophisticated LLCs of implementing protections may be small. However, because LLCs
currently modify protections in such diverse ways, implementing new protections must
be done carefully, and imposing mandatory rules could bring significant costs.
Part II provides the basics of the LLC organizational form. I describe LLC
fundamentals, including relevant judicial and statutory safeguards, and compare these to
the law of competing types of business organizations. I also introduce the debate
surrounding the need for mandatory LLC owner safeguards and show how it revolves
around largely untested assumptions about how LLCs behave in the real world.
508 The Journal of Corporation Law [Vol. 42:3
Part III summarizes the existing empirical literature on LLC operating agreements
and shows the continued need to understand what motivates LLCs’ decision to modify
default protection provisions. Parts IV and V provide the results of my study of private
LLC operating agreements. I show the diverse ways that parties both augment and detract
from default owner protections. The study is based primarily on a sample of 233
Delaware LLCs, but to assess the representativeness of these results, I compare them to a
sample of 50 LLCs organized under New York law. The New York sample shows
roughly similar use of LLCs’ contractual flexibility to waive and modify traditional
corporate protections.
Part VI synthesizes the preceding results by testing the motivations behind
modifying the default protections that apply to LLCs. I find little relationship between the
prevalence of strengthening and weakening owner protections, either for the sample as a
whole or for the subset of LLCs with exclusively less vulnerable owners. However, I find
significantly lower levels of owner protection for those LLCs with less sophisticated and
more vulnerable minority owners. While this test of one component of the contractarian
approach does not necessarily imply a complete lack of efficiency bargaining, the results
suggest a need for devising new measures to protect minority owners, and I offer some
thoughts on the relative tradeoffs of doing so through statutory and other means.
II. THE LAW OF LLCS
LLC statutes were developed with the twin goals of providing comprehensive
limited liability protection to owners while avoiding the double taxation on earnings
incurred by corporations. Until LLCs, entrepreneurs were faced with choosing either
weakened liability protection through a partnership entity, gaining strong liability
protection at the cost of double taxation via C corporations, or mixing the advantages of
both but restricting the available types of owners and equity via an S corporation.
11
LLCs
combined the best of all possible worlds, importing the limited liability protection of a
corporation and achieving partnership-like single tax treatment.
12
Most states graft onto this original motivation a commitment to freedom of
contract.
13
This contractual freedom stands in contrast to the mandatory rules of
corporations and partnership entities. Corporations, the typical alternative to an LLC, are
governed by a set of required statutory and judicial rules that restrict manager and owner
behavior.
14
These rules primarily address costs that arise when a firm’s decision maker
11. See Kleinberger, supra note 9, at 451–56 (discussing the history of LLCs). S corporations, while
coupling the limited liability of a corporation with the single taxation of a partnership, restrict ownership to at
most 100 shareholders comprised solely of domestic individuals, exempt nonprofits, or trusts (thereby ruling out
foreign investors and domestic partnership or corporation investors). S corporations are also allowed to issue
only a single class of stock. IRS, Instructions for Form 2553 (2013), http://www.irs.gov/pub/irs-pdf/i2553.pdf.
12. IRS, IRS Form 8832 (2013), http://www.irs.gov/pub/irs-pdf/f8832.pdf. Such entities will later be
subject to corporation-like double taxation if they are deemed by the IRS to be “publicly traded.” 26 U.S.C. §
7704 (2008).
13. See, e.g., LARRY E. RIBSTEIN & ROBERT R. KEATINGE, RIBSTEIN AND KEATINGE ON LIMITED
LIABILITY COMPANIES App. 9:6 (2016) (summarizing state LLC law fiduciary waiver provisions).
14. The discussion at this stage shifts to comparing LLCs’ contractual flexibility to that of (S and C)
corporations, which provide limited liability comparable to that of LLCs. Partnerships, even those with
“limited” in their name, typically only roughly approximate the all-important limited liability protection offered
by LLCs and corporations or are available only for professional services firms. See NICHOLAS MURRAY
2017] How Do LLC Owners Contract Around Default Statutory Protections? 509
does not bear the full consequences of her actions, leading her to profit at the firm’s
expense. For instance, when a firm’s manager receives less than all of the firm’s profits—
as is necessarily the case for firms with more than one owner—she has the financial
incentive to expropriate firm value through reduced effort, obtaining perquisites,
tunneling profits into related entities, and the like because she gains the entire upside of
the self-interested behavior while suffering only a portion of the firm’s decreased
profitability. Similarly, a controlling owner may opportunistically sell her control stake to
a less desirable owner or pressure management to benefit herself at the firm’s expense.
The mandatory rules familiar in corporation and partnership law seek to minimize this
opportunism by aligning managers’ and owners’ interests with the firm’s.
One way this alignment is achieved in corporate law is through restricting the
available decisions that can be made, trying to ensure that discretion is exercised in the
best interests of the firm rather than in the decision maker’s self-interest. Business law
accomplishes this goal by imposing fiduciary duties, a topic quite familiar to scholars and
students of business associations. Managers of corporations and certain partnerships owe
duties of loyalty, good faith, and care to their firms. While these requirements have
retreated from the pinnacle enunciated by Justice Cardozo’s colorful Meinhard v. Salmon
language,
15
the concept of protecting owners through fiduciary duties remains strong.
Corporate managers must put the firm’s interests above their own, must avoid fraud or
illegal conduct, and must act without gross negligence in carrying out their
responsibilities.
16
These basic fiduciary duties have extended into additional freestanding
doctrines to restrict managers from competing with their firms or from seizing business
opportunities for themselves.
17
The principles also can extend beyond managers and
apply to particular owners, as with the duties that controlling owners owe to minority
owners.
18
The second way that business law aligns manager and owner interests is to proscribe
management from unilaterally making certain fundamental decisions without the
additional consent of owners. These decisions, including merging or disposing of
substantially all of the firm’s assets,
19
voluntary dissolution,
20
amending the corporate
BUTLER, WHY SHOULD WE CHANGE OUR FORM OF GOVERNMENT?: STUDIES IN PRACTICAL POLITICS 82
(1912) (“[L]imited liability [of a] corporation is the greatest single discovery of modern times . . . . Even steam
and electricity are far less important . . . and they would be reduced to comparative impotence without it.”);
Kleinberger, supra note 9, at 449, 455–56 (describing limited effectiveness of attempts to replicate LLC and
corporate limited liability through partnership forms). Much of the comparison between LLCs and corporations
can also be made between LLCs and partnerships, the latter of which also limit parties’ contractual freedom in
various ways. See, e.g., REVISED UNIFORM P’SHIP ACT § 103 (UNIF. LAW COMM’N 1997) (listing mandatory
rules for partnerships).
15. Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928); cf. Ind. Civil Rights Comm’n v. Kightliner &
Gray, 567 N.E.2d 125 (Ind. Ct. App. 1991) (enforcing prenegotiated contractual language over a principle of
utter selflessness).
16. See, e.g., MODEL BUS. CORP. ACT §§ 8.30(a), (b), 8.42 (COMM. CORP. LAWS 2008).
17. On non-competition, see id. § 8.31 cmt. (g); Sci. Accessories Corp. v. Summagraphics Corp., 425
A.2d 957, 965 (Del. 1980) (citing several cases). On the partnership and corporate opportunity doctrines, see
generally Broz v. Cellular Info. Sys., 673 A.2d 148 (Del. 1996) (corporate opportunity doctrine); Kahn v. Icahn,
No. Civ. A. 15916, 1998 WL 832629 (Del. Ch. Nov. 12, 1998) (partnership opportunity doctrine); Eric Talley,
Turning Servile Opportunities to Gold: A Strategic Analysis of the Corporate Opportunities Doctrine, 108
YALE L.J. 277 (1998) (analyzing the corporate opportunity doctrine).
18. E.g., Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971).
19. See, e.g., DEL. CODE ANN. tit. 8, §§ 251(c), 271 (2016, 2012).
510 The Journal of Corporation Law [Vol. 42:3
charter,
21
and electing directors,
22
all require owner approval before they can be
implemented by a corporation’s management. As with fiduciary duties, these rules
require that certain activities vulnerable to value-reducing, self-interested behavior can be
made only with owners’ explicit consent.
For most organizational forms, these owner protections are mandatory, meaning that
they apply even if the owners prefer to eliminate them. Mandatory rules provide
paternalistic protection to unsophisticated parties who might underestimate the
protections’ value or mistakenly waive them.
23
But because these mandatory protections
also have costs, requiring them as mandatory is less compelling when owners are
sophisticated and able to protect themselves and curb opportunism through monitoring,
contracting, or other means.
24
If a particular behavior is proscribed or a right cannot be
waived, situations when it would be mutually profitable to engage in that behavior or
waive a right are lost. For instance, managers might accept lower management fees if
they could engage in limited competing activities independently, and the direct savings
from lower management fees could more than compensate owners for the waived
protection—a trait often observed in private equity and venture capital.
25
Less obvious,
but still important, can be the costs saved by avoiding litigation over alleged violations of
traditional corporate protections.
26
Aligning owners’ and management’s incentives
through sophisticated bargaining can therefore be superior to imposing mandatory
corporate law protections, ultimately enhancing the value of the firm. But when
conducting their business via a corporation or certain partnership forms, owners’ freedom
to substitute these alternatives for corporate protections is limited or eliminated entirely.
LLC statutes like Delaware’s take a more permissive approach. These statutes
embrace contractual flexibility, assuming that sophisticated parties can craft the
agreements that best achieve their goals without imposing mandatory protections.
27
Traditional mandatory protections apply, if at all, only by default, allowing parties to
20. DEL. CODE ANN. tit. 8, § 242 (2014); MODEL BUS. CORP. ACT § 14.02 (COMM. CORP. LAWS 2010).
21. DEL. CODE ANN. tit. 8, § 275; MODEL BUS. CORP. ACT § 10.03.
22. DEL. CODE ANN. tit. 8, § 211(b); MODEL BUS. CORP. ACT § 8.03.
23. Cf. FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE
LAW 25 (1991) (justifying mandatory terms where, because of market failures, those terms are not priced). Less
commonly, the mandatory approach is justified as correcting for negative externalities if their waiver
undermines business norms that facilitate trust and good governance. See, e.g., Margaret M. Blair & Lynn A.
Stout, Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law, 149 U. PA. L. REV. 1735
(2001) (recognizing the feedback among duties, management behavior, and social norms).
24. See Ribstein, Fencing Fiduciary Duties, supra note 7, at 905–08 (identifying the costs arising from
mandatory fiduciary duties).
25. See generally Larry E. Ribstein, Fiduciary Duties and Limited Partnership Agreements, 37 SUFFOLK
U. L. REV. 927 (2004) (analyzing fiduciary duty waivers in limited partnerships, including venture capital
firms); Terence Woolf, Note, The Venture Capitalist’s Corporate Opportunity Problem, 2001 COLUM. BUS. L.
REV. 473 (discussing conflicts between the corporate opportunity doctrine and venture capital investing); Larry
E. Ribstein, Univ. of Ill. College of Law, Wall Street and Fiduciary Duties: Hearing Before the S. Comm. on
the Judiciary, 111th Cong. (arguing that fiduciary duties are inappropriate in the investment banking industry).
26. Litigation expenses encompass not just the expenditures with defending non-meritorious suits, but
also the costs associated with having a court’s judgment substituted for a business expert’s. Kelli A. Alces,
Debunking the Corporate Fiduciary Myth, 35 J. CORP. L. 239, 241 (2009) (noting the necessity of deferring to
management and the “potentially harmful” effects of shareholder interference).
27. E.g., Zimmerman v. Crothall, 62 A.3d 676, 691 (Del. Ch. 2013) (“The LLC Act provides contracting
parties with flexibility to craft an agreement that is tailored to their needs.”).
2017] How Do LLC Owners Contract Around Default Statutory Protections? 511
modify or eliminate them if desired through terms in the LLC’s operating agreement. If
LLC owners do not want the mandatory protections offered under corporate law, they
may affirmatively waive them in the operating agreement or just refrain from adopting
them, depending on whether the terms apply by default or not at all.
28
While LLCs’ contractual approach promises efficiency gains if parties are
sophisticated, problems arise if some of the owners waive traditional protections without
bargaining for substitute safeguards. Doing so can set the stage for later value-destroying
opportunism by managers or majority owners. As a consequence, states vary in their
willingness to allow LLC waivers of traditional business law protections, based on
assumptions about how sophisticated parties are and how contractual freedom is used.
29
States like California, while permitting contractual flexibility for LLCs beyond that
available to corporations, nevertheless proscribe owners’ and managers’ ability to cut
back protections. California requires broad fiduciary duties, allowing parties to reduce
them only by specifying specific exempt actions and only as long as those actions are not
manifestly unreasonable.
30
The Uniform Law Commission’s Revised Uniform Limited
Liability Company Act, adopted in sixteen states, mandates that LLCs include fiduciary
duties of loyalty, care, good faith, a contractual obligation of good faith and fair dealing,
and a provision for judicial dissolution of LLCs.
31
Other states allow more contractual flexibility. New York permits LLC waivers of
all fiduciary duties while retaining managers’ liability for acts or omissions taken in bad
faith or that gave a manager a financial profit to which she is not entitled.
32
Delaware
goes further, facilitating almost limitless contractual freedom in the belief that, on
28. Note that no states allow LLCs to waive by operating agreement the terms designed to protect third
parties, such as creditors’ abilities to force involuntary bankruptcy or pierce the limited liability veil because
these third parties are not parties to the operating agreement. See generally RIBSTEIN & KEATINGE, supra note
13, §§ 3:3, 12:3, 14:4 (discussing third party protections that are either entirely non-waivable or not waivable
without the separate consent of third parties). Similarly, federal and state securities laws apply to protect holders
of those LLC interests deemed securities, and these securities laws are also not waivable. See generally United
States v. Leonard, 529 F.3d 83 (2d Cir. 2008) (sustaining a jury’s finding LLC ownership interests constitute a
security for federal securities laws); CAL. CORP. CODE § 25019 (2001) (explicitly including non-passive LLC
interests within state securities laws’ purview). But see IDAHO CODE § 28-8-103 (2004) (exempting LLC
interests from state securities laws).
29. A second important balance that should be kept in mind for LLC statutes is between deciding whether
particular terms should even be default terms or instead should not apply unless affirmatively adopted. If the
contracting process is relatively costless, then it does not matter whether terms apply by default or must be
affirmatively adopted—parties will adopt the appropriate mix. If, on the other hand, the contracting process is
not costless, then it becomes an important issue of whether to include various terms by default or instead require
parties to adopt them affirmatively, because default terms begin to acquire the characteristics of mandatory
ones. See Henry Hansmann, Corporation and Contract, 8 AM. L. & ECON. REV. 1, 3 (2006) (analyzing the
mandatory-like attributes of default rules for large corporations); Sandra K. Miller, The Best of Both Worlds:
Default Fiduciary Duties and Contractual Freedom in Alternative Business Entities, 39 J. CORP. L. 295, 319–24
(2014) (suggesting that bargaining over LLC contract terms is not costless).
30. CAL. CORP. CODE § 17701.10 (c)–(g) (2014).
31. REVISED UNIF. LTD. LIAB. CO. ACT § 110(c) (UNIF. LAW COMM’N 2006) [hereinafter Uniform Act];
Revised Uniform Limited Liability Company Act Gains Momentum, LLC ADVISOR (CCH), Dec. 22, 2014
(listing adopting jurisdictions).
32. N.Y. LTD. LIAB. CO. LAW § 417 (2016). The statutory language authorizes waiving only personal
liability for fiduciary duty breach, but cases have extended the language to authorize a complete waiver of the
fiduciary duty. Pappas v. Tzolis, 982 N.E.2d 576, 599 (N.Y. 2012); Centro Empresarial Cempresa S.A. v.
América Móvil, S.A.B. de C.V., 952 N.E.2d 995, 1001 (N.Y. 2011).
512 The Journal of Corporation Law [Vol. 42:3
balance, the costs of mandatory rules outweigh their benefits. Like other states, Delaware
has a host of default protections that apply if the parties to an LLC agreement do not
specify otherwise, but the only mandatory term is an implied contractual covenant of
good faith and fair dealing, whose purpose is only to ensure the terms of the operating
agreement are interpreted as a reasonable person would.
33
Beyond this implied covenant,
Delaware allows LLCs to waive protections seemingly without limit, allowing for
complete elimination of fiduciary duties, exit rights, and voting rights, for example.
34
Employing this permissive approach, Delaware has taken the lead in LLC
formations as it has with corporate charters.
35
Even though it has been successful in
attracting LLC formations, whether Delaware’s approach is the optimal one is an open
question. For instance, if most LLC agreements attract minority owners that misprice the
value of protections, then Delaware’s contractual freedom may be used primarily by
those looking to opportunistically appropriate gains from uninformed owners. In that
case, LLC statutes’ reliance on default rather than mandatory protections, exemplified in
Delaware’s approach, would be problematic as it leads to inefficient governance
arrangements and suboptimal firm value. However, if most LLC agreements are the
product of bargaining among sophisticated parties who trade over inclusive traditional
protections for more finely tuned substitute measures, then LLC statutes’ default
approach leads to greater efficiency that cannot be replicated with alternative
organizational forms. Or finally, if most LLC agreements are governed by the default
protections with little modification, then the mandatory/default distinction may matter
little.
Whether LLCs use the offered contractual freedom for efficiency, for opportunism,
or not at all determines whether relying on merely default rather than mandatory
protections is warranted. Unfortunately, because research has yet to show how parties
bargain around default provisions, the debate over contractual freedom continues. Before
33. DEL. CODE ANN. tit. 6, § 18-1101(c), (e) (2013); Uniform Act § 409 cmt. (d); Bay Ctr. Apartments
Owner, LLC v. Emery Bay PKI, LLC, No. C.A. 3658, 2009 WL 1124451, at *7 (Del. Ch. Apr. 20, 2009)
(“Delaware courts rightly employ the implied covenant sparingly when parties have crafted detailed, complex
agreements, lest parties be stuck by judicial error with duties they never voluntarily accepted.”). The Uniform
Model Act goes on to explain that “[t]he obligation of good faith and fair dealing is not a fiduciary duty, does
not command altruism or self-abnegation, and does not prevent a partner from acting in the partner’s own self-
interest. Courts should not use the obligation to change ex post facto the parties’ or this Act’s allocation of risk
and power. . . . [T]he obligation should be used only to protect agreed-upon arrangements from conduct that is
manifestly beyond what a reasonable person could have contemplated when the arrangements were made . . . .
In sum, the purpose of the obligation of good faith and fair dealing is to protect the arrangement the partners
have chosen for themselves, not to restructure that arrangement under the guise of safeguarding it.” Uniform
Act § 409 cmt. (d). But see Douglas M. Branson, Alternative Entities in Delaware – Reintroduction of
Fiduciary Concepts by the Backdoor?, in ELGAR HANDBOOK ON ALTERNATIVE ENTITIES 55 (Mark
Loewenstein & Robert Hillman eds., 2015) (arguing that the good faith and fair dealing requirement may be
used to reintroduce fiduciary duty concepts in certain circumstances).
34. See infra Part IV (providing examples of these waivers).
35. CARTER G. BISHOP & DANIEL S. KLEINBERGER, LIMITED LIABILITY COMPANIES: TAX AND BUSINESS
LAW ¶ 14.01[2] (Warren Gorham & Lamont/RIA eds., 1994) (noting the “almost gravitational pull” that
Delaware exerts on LLC law); Jens Dammann & Matthias Schündeln, Where Are Limited Liability Companies
Formed? An Empirical Analysis, 55 J.L. & ECON. 741 (2012) (finding that large LLCs overwhelmingly choose
Delaware when choosing to form outside their home state); Bruce H. Kobayashi & Larry E. Ribstein, Delaware
for Small Fry: Jurisdictional Competition for Limited Liability Companies, 2011 U. ILL. L. REV. 91 (finding
that most LLCs forming outside their domiciliary state choose Delaware).
2017] How Do LLC Owners Contract Around Default Statutory Protections? 513
turning to my analysis of LLC operating agreements that addresses these issues, I first
summarize the existing empirical literature on LLC operating agreement terms and show
how they leave unaddressed this central question over default versus mandatory
protections.
III. PRIOR STUDIES
Two sets of prior studies have examined the terms in LLC operating agreements.
While each advanced the understanding of what a particular type of LLC is doing, neither
provides comprehensive evidence for resolving the mandatory/default debate for LLC
protections.
The first, initiated by Mohsen Manesh and later expanded upon by Suren Gomtsian,
is based on a sample of operating agreements from 12 publicly traded Delaware LLCs.
36
Manesh coded these entities’ operating agreements for waivers or liability exculpations
of traditional fiduciary duties.
37
He also included mandatory distribution requirements,
limited company lifespans, or a right to elect management, each of which is a substitute
protection mechanism that can align managers’ and owners’ incentives.
38
Manesh found
routine waivers or exculpations of fiduciary duties,
39
which decrease owner protections,
but these were rarely accompanied by significant management-owner alignment via
mandatory asset distributions, limited company lifespans, or a right to elect management,
let alone all three.
40
While these findings have helped inform the discussion on LLC regulation and
governance, they leave several unresolved issues. For instance, LLCs may compensate
for diminished owner protection by adopting substitutes beyond the mandatory
distributions, finite lifespans, and the right to elect management that Manesh studied. On
the other side of the coin, waiving or eliminating personal liability for fiduciary duties is
not the only traditional mandatory owner protection that LLCs are free to eliminate. They
might, for instance, do away with the right to seek judicial dissolution, allow
opportunistic sales of control by majority owners, or authorize managers to compete
directly with the LLC.
Perhaps the greatest limitation of Manesh’s work in terms of understanding the
typical LLC’s operating agreement is that his sample consisted entirely of publicly traded
firms whose activities, primarily due to tax considerations, involved almost exclusively
passive investments in mineral and natural resource extraction.
41
It is unlikely that the
operating agreements of such an unrepresentative sample mirror those of LLCs at large,
36. Mohsen Manesh, Contractual Freedom Under Delaware Alternative Entity Law: Evidence From
Publicly Traded LPs and LLCs, 37 J. CORP. L. 555 (2012). In the same study, Manesh also examined 73
publicly traded Delaware limited partnerships, which are governed by a related but distinct set of statutes.
Manesh’s work was later replicated for the set of publicly traded LLCs using an expanded set of coding
variables. Suren Gomtsian, The Governance of Publicly Traded Limited Liability Companies, 40 DEL. J. CORP.
L. 207 (2015).
37. Manesh, supra note 36, at 567–69.
38. Id. at 569–71.
39. Id. at 575–77.
40. Id. at 579–81.
41. Id. at app. A.
514 The Journal of Corporation Law [Vol. 42:3
limiting the generalizability of Manesh’s work.
42
As examples of just a few reasons to be
concerned: managers of publicly traded firms may be more sophisticated than the typical
LLC manager, and therefore bargain for relatively lower owner rights; publicly traded
firms have difficulty escaping the limelight that may make owner opportunism more
difficult;
43
publicly traded firms face takeover threats that constrain the amount of
feasible opportunism;
44
publicly traded firms, unlike others, are subjected to investor
protections imposed by both stock exchanges
45
and federal securities laws
46
that can
substitute for traditional mandatory owner protections; and the operations of firms in
mineral and natural resource extraction industries may carry unrepresentative
expectations regarding owners’ and managers’ rights.
47
Finally, publicly traded firms are
emblematic of a situation with vulnerable minority owners.
48
Studying solely these firms
sheds little light on whether firms with sophisticated owners wield contractual freedom to
craft efficient operating agreements, which is essential for fully understanding the
mandatory/default debate. From this work, therefore, we cannot reliably discern whether
corporate protection reductions are done in the name of efficiency or opportunism.
The second set of studies, originated by Michelle Harner and Jamie Marincic and
later expanded by Suren Gomtsian, focused on examining LLC operating agreements
available from public SEC filings.
49
Like Manesh’s initial study, these studies found
widespread use of fiduciary duty waivers and personal liability limitation through
exculpation and indemnification clauses, cutting back some of the mandatory corporate
owner protections that apply by default to LLCs.
50
Like Manesh’s study, however, these
conclusions may not be easily generalizable to LLCs at large because of a potentially
unrepresentative sample. Operating agreements obtained from SEC filings consist of
LLCs where publicly traded companies are an owner (making the operating agreement
subject to public SEC filing), leading to larger than average LLCs that had at least one
large publicly traded company as an owner.
51
As just discussed, the presence of a
42. Note that Manesh correctly recognizes these generalizability limitations of his sample and does not
seek to extend the utility of his findings beyond their proper scope. Manesh, supra note 36, at 571–72.
43. Public companies will not only be more likely to attract the attention of financial analysts and news
outlets, but they also are subject to various shareholder-rights watchdogs such as the Institutional Shareholder
Services organization.
44. E.g., EASTERBROOK & FISCHEL, supra note 23, at 231.
45. For example, in addition to minimum listing requirements, the New York Stock Exchange requires
that listed companies comply with particular investor safeguards, such as that a majority of the board be
comprised of independent directors. NEW YORK STOCK EXCHANGE LISTED COMPANY MANUAL §§ 303A.00–
.13.
46. Public firms must file various disclosures about their operations, which both provides information
about management’s performance—making it more likely that opportunism will be discovered—as well as
exposes them to antifraud liability. 15 U.S.C. § 78m (2016) (disclosure requirements); id. § 78j (general
antifraud liability); id. § 78r (liability for fraud in filed documents).
47. This final point is particularly likely with respect to the corporate opportunity doctrine, as these
passive firms often have professional managers that manage several related organizations and that do not want
to be liable to sharing profits among them.
48. See EASTERBROOK & FISCHEL, supra note 23, at 25.
49. Michelle M. Harner & Jamie Marincic, The Naked Fiduciary, 54 ARIZ. L. REV. 879, 898 (2012);
Suren Gomtsian, Contractual Mechanisms of Investor Protection in Non-Listed Limited Liability Companies, 60
VILL. L. REV. 955, 960 (2015).
50. Harner & Marincic, supra note 49, at 907.
51. Id. at 898.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 515
publicly traded company as an owner might be expected to skew behavior away from
opportunism, so that contractual protections in the operating agreement are less
important.
52
These studies also did not incorporate the full set of protections that can be
waived—such as the right to seek judicial dissolution—or the full set of protections that
can be added, such as tying management’s compensation to the success of the firm.
53
From this analysis, therefore, it is impossible to discern whether the observed reduction
in a restricted set of traditional corporate protections is done for efficiency reasons (in
which case one might expect substitute protections to be adopted), or whether the
reductions were done with an eye towards later opportunism (in which case one would
expect no substitute protections to appear).
Therefore, this second study, too, leaves open the question of whether LLC
protections should apply only by default or instead should be mandatory. Although the
two studies taken together show that specific LLCs regularly modify traditional corporate
protections, that fact on its own provides little insight into whether the typical LLC uses
contractual flexibility for efficiency or other means. In Part V, I provide the results from
my analysis of a new, more complete sample of LLC operating agreements and terms to
address this issue.
IV. EMPIRICAL EXAMINATION OF LLC OPERATING AGREEMENTS: METHODOLOGY
This Part begins the empirical study of LLC operating agreements. I describe the
methodology behind the selection and analysis process. Part V then provides the results
of the study.
To draw conclusions about how LLCs as a whole are operating, it is important to
begin with as wide and representative a set of LLCs as possible. Because the key to
determining how LLCs balance owner and management rights is to study their operating
agreements, this key translates into obtaining a broad cross-section of LLC operating
agreements. Unfortunately for researchers, these agreements need not be filed with any
state agency in the ordinary course of business. Operating agreements are therefore not
subject to public inspection through state corporate office records or FOIA requests, nor
are they aggregated into useful collections.
In two situations, however, operating agreements are available to the public. The
first is when the operating agreement is subject to the public filing requirements of the
federal Securities Exchange Act of 1934, either because the LLC itself is a public
company or because a public company is a party to the LLC operating agreement.
54
These disclosure requirements are triggered once a company lists on a public securities
exchange, engages in a public offering of its securities, or crosses minimum thresholds on
asset size (several hundred million dollars) and number of owners.
55
Operating
52. See supra notes 43–48 and accompanying text.
53. The initial study by Harner and Marincic focused almost exclusively on fiduciary duties, while
Gomtsian later incorporated a more comprehensive set of variables. Harner & Marincic, supra note 49, at 899;
Gomtsian, supra note 49, at 963.
54. 15 U.S.C. § 78m (2016).
55. 15 U.S.C. § 78l(a) (2015) (prohibiting brokers or dealers from trading shares on national exchanges
unless issuer complies with, among other rules and regulations, 15 U.S.C. § 78m’s disclosure rules); id. §
516 The Journal of Corporation Law [Vol. 42:3
agreements can then be readily isolated and obtained from these disclosures, but these
entities almost certainly paint a biased picture of what typical LLCs are doing.
The second situation when operating agreements become publicly accessible, and
the one utilized in my analysis, arises when parties file them as an exhibit to state or
federal litigation. Drawing from this universe of operating agreements yields a rich
mixture of large and small firms in diverse industries with both sophisticated and
vulnerable owners and managers. However, focusing on these operating agreements
brings its own potential biases. First, this sample could potentially underrepresent
operating agreements for the smallest LLCs, because tiny businesses may not have
enough at stake to make litigating worthwhile. Second, the operating agreements could be
more likely to be poorly drafted, or they may not reflect the understanding of the parties
if ambiguous agreements or agreements without mutual assent are more likely to be
litigated than others. Nevertheless, I decided to use this pool of LLC operating
agreements because of its superiority in representing LLCs as a whole. To address
concerns about disproportionate levels of poor drafting or understanding, I did not
include operating agreements that were incomplete or whose mutual understanding was
contested by the parties.
56
I began by selecting Delaware as the LLC formation state to study. Delaware was
chosen for several reasons. First, most LLCs choosing to organize outside of their
domiciliary state select Delaware, so focusing on Delaware operating agreements
provides a mix of operating agreements from domestic companies as well as more
sophisticated foreign firms located outside Delaware.
57
Second, as already discussed,
Delaware’s LLC law represents the current maximum of contracting freedom. While it
supplies several default rules, Delaware imposes practically no consequential mandatory
rules on the owner-manager relationship. Examining the agreements that parties strike in
this accommodating environment will therefore both provide the best evidence about how
traditional corporate owner protections can be traded for substitute safeguards—since the
parties are largely free to do whatever they want—as well as provide the most vigorous
test of whether sophisticated managers and owners opportunistically induce elimination
of minority owner protections by more vulnerable minority owners.
I identified Delaware operating agreements by searching Bloomberg’s database of
Delaware cases, as well as its database of Delaware dockets for iterations of the phrase
“operating agreement” combined with a party name including iterations of the term
“LLC.” While the results included many false positives, they struck what I felt was an
appropriate balance of identifying close to the full universe of available Delaware
operating agreements while excluding many spurious results. Research assistants and I
then combed through each result’s docket to obtain available operating agreements.
These agreements were screened for disputes about their validity or mutual
78o(d) (issuers must comply with disclosure rules after a public offering); id. § 78l(g) (requiring large issuers to
file registration statement, in turn subjecting it to disclosure rules).
56. As it turned out, very few operating agreements were excluded because of ambiguity or asserted lack
of mutual assent. In fact, most of the operating agreements were not themselves the subject of the litigation.
Because there is no overall baseline distribution of LLC size, I could neither identify nor correct for potential
undersampling of small LLCs.
57. Kobayashi & Ribstein, supra note 35, at 93–94.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 517
understanding, irreconcilable ambiguities, or LLCs with only a single owner.
58
Agreements were also screened so that if substantially identical agreements were
included for the same case, as when the same lawyer drafts similar agreements for a
series of related entities, only one agreement was included to avoid oversampling of the
same effective agreement. Finally, agreements were included only if they were effective
in 1997 or later. Significant tax reform that took effect on January 1, 1997 eliminated
restrictive requirements for LLCs seeking single taxation of profits, and agreements
before the reform could have owner protection terms that were written solely to achieve
desirable tax treatment rather than for their protection function.
59
This process produced an analytical sample of 233 Delaware operating agreements.
All were in some way connected to litigation, raising concerns that the sample could be
biased in favor of more litigious owners and potentially unrepresentative contracting
behavior. However, many operating agreements were only tangentially connected to the
underlying dispute, such as when an agreement was attached to a creditor’s action to
collect on a member’s economic interest in the LLC, reducing the bias from any selection
effects.
Next, to assess how representative the operating agreements of Delaware LLCs are
relative to those formed in other states, I repeated this process with the most recent New
York state case dockets to arrive at a sample of 50 LLCs formed within New York. New
York served as a useful foil for Delaware, because while its LLC statutory rules are close
to Delaware’s,
60
the firms choosing to form under New York law are far more likely to be
domestic firms, providing a meaningfully different sample to examine.
61
The resulting LLCs operated in diverse industries, ranging from smaller examples
such as local lawn care services and real estate rentals, to large entities like the Quiznos
restaurant chain, to publicly traded companies like TravelCenters of America, to obscure
58. Single-owner LLCs do not present the same owner opportunism risk as multi-owner LLCs because
the owner and manager are one and the same so that the manager fully internalizes the consequences of owner
opportunism. Consequently, the operating agreements for these LLCs have no reason to include any owner
protections as with multi-owner LLCs.
59. Under the older “corporate characteristics” regime, LLCs were subjected to corporate double taxation
if they had at least three of the four corporate characteristics: continuity of life; centralized management; limited
liability; and free transferability of ownership interests. Consequently, LLCs desiring to avoid double taxation
would adopt at most two of the above attributes. Effective January 1, 1997, IRS “check the box” regulations
allow LLCs to choose whether to be taxed as corporations or partnerships without regard to corporate-like
attributes. IRS, Internal Revenue Manual § 4.61.5 (May 1, 2006), http://www.irs.gov/irm/part4/irm_04-061-
005.html.
60. The two most meaningful differences are that New York does not allow waiving liability for
violations of the duty of good faith, and it may not allow waiving the right for owners to seek judicial
dissolution. N.Y. LTD. LIAB. CO. LAW § 417 (1996) (prohibiting waivers of liability for good faith); Zulawski v.
Taylor, 11 Misc. 3d 1058(A), 2005 WL 3823584, at *10 (N.Y. Sup. Ct. July 1, 2005) (refusing to dismiss a
petition for judicial dissolution even though the operating agreement waived the right); see generally
Youngwall v. Youngwall Realty, LLC, No. 2266-07, 2008 WL 827916 (N.Y. Sup. Ct. Mar. 14, 2008) (refusing
to enforce waiver of right to seek judicial dissolution as against public policy). As will be seen, few Delaware
LLCs take advantage of this contractual freedom to either exculpate duty of good faith violations or to waive
owners’ right to petition for judicial dissolution.
61. Kobayashi & Ribstein, supra note 35, at 101. In the Delaware sample, only 14% of the firms were
domestic, while 100% of the New York firms were domestic (the latter of which likely results from the lack of
diversity jurisdiction needed to retain litigation over New York-formed LLCs within New York state court).
518 The Journal of Corporation Law [Vol. 42:3
firms that made french fry vending machines. I categorized the companies according to
the North American Industry Classification System.
62
Table 1 presents the distribution.
62. North American Industry Classification System, U.S. CENSUS BUREAU (2012),
http://www.census.gov/cgi-bin/sssd/naics/naicsrch?chart=2012.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 519
NAICS
Del.
N.Y.
Code
Description
n = 233
n = 50
1%
0%
n = 2
n = 0
2%
0%
n = 5
n = 0
3%
0%
n = 7
n = 0
7%
0%
n = 17
n = 0
3%
0%
n = 7
n = 0
9%
6%
n = 21
n = 3
2%
4%
n = 4
n = 2
3%
6%
n = 8
n = 3
14%
4%
n = 33
n = 2
23%
50%
n = 54
n = 25
9%
4%
n = 21
n = 2
6%
2%
n = 15
n = 1
4%
6%
n = 10
n = 3
3%
0%
n = 8
n = 0
4%
4%
n = 9
n = 2
4%
12%
n = 10
n = 6
1%
0%
n = 2
n = 0
71 Arts, Entertainment, and Recreation
721 Accomodation
Finance and Insurance
62 Health Care and Social Assistance
Professional, Scientific, and
Technical Services
56
Admin., Support, Waste Mgm't, and
Remediation Services
Wholesale Trade
Personal and Laundry Services
44–45 Retail Trade
48–49 Transportation and Warehousing
51 Information
53 Real Estate and Rental and Leasing
42
812
54
722 Food Services and Drinking Places
52
Table 1
Industry Distribution of Sample
11
21
22
31–33
Agriculture, Forestry, Fishing and
Hunting
Mining, Quarrying, and Oil and Gas
Extraction
Utilities
Manufacturing
520 The Journal of Corporation Law [Vol. 42:3
The LLCs covered a wide range of number of owners. Most had relatively few
owners, but several had quite large ownership bases, exceeding 1000 owners. Table 2
presents the distribution.
I then examined each of these operating agreements individually, coding them for
various terms coincident with expanding or diminishing owner protections both directly
and indirectly.
63
When possible, I also coded the Delaware operating agreements for
whether it appeared minority owners were more likely to have been unsophisticated or
vulnerable in the operating agreement bargaining context. One can think of several
potential ways to differentiate. For example, we could look at the apparent sophistication
of the operating agreement itself to determine whether it was likely drafted by specialized
legal counsel. The problem with assessing parties’ sophistication based on the operating
agreement’s terms is that sophisticated parties could easily draft what looks like an
unsophisticated operating agreement—or unsophisticated parties might nevertheless hire
expert legal counsel.
64
Or we might decide that owners who held investments directly
63. Contractual terms related to the dispute resolution process are discussed separately. See Peter Molk &
Verity Winship, LLCs and the Private Ordering of Dispute Resolution, 41 J. CORP. L. 795 (2016).
64. Sophisticated parties may do so if they can rely on non-contractual safeguards to avoid opportunism,
such as a repeat relationship or identifiable reputation among the parties. See, e.g., Lisa Bernstein, Beyond
Relational Contracts: Social Capital and Network Governance in Procurement Contracts, 7 J. LEGAL
Range
Delaware
New York
34%
38%
n = 80
n = 18
44%
45%
n = 101
n = 21
9%
9%
n = 101
n = 21
6%
4%
n = 14
n = 2
4%
4%
n = 9
n = 2
3%
0%
n = 8
n = 0
Table 2
Number of Members
2
11–20
51+
3–5
6–10
21–50
2017] How Do LLC Owners Contract Around Default Statutory Protections? 521
through a limited liability investment vehicle rather than directly in their individual
capacity might be less likely to seek sophisticated legal representation.
65
The problem
with this approach is that it tells us little about those agreements whose owners are pure
firms, rather than individuals investing through personal investment entities. It may not
even be a reliable indicator for sophistication in those cases where the investing firm is an
investing vehicle for an individual because it implies only that that individual likely had
sophisticated advice at one time, rather than with respect to the operating agreement at
issue.
Ultimately, I based the decision on the amount of capital invested into the firm.
Minority owners with less money at risk were assumed to have sought correspondingly
less sophisticated counsel (perhaps no counsel at all) and, therefore, would have received
less vigorous protection of their owners’ interests and allowed for greater potential
opportunism by managers or majority owners.
66
However, the presence of one such
owner might not result in weak minority owner protections; other minority owners with
more capital at risk might nevertheless bargain for sufficient safeguards. I therefore
tailored the standard to identify when potentially vulnerable owners held enough assets to
make opportunism by majority owners worthwhile. An LLC was deemed to involve more
vulnerable owners if, based on my analysis, it had owners who invested less than
$100,000 each but collectively held greater than a 10% share, which results in a
substantial collective stake held by minority owners such that the rewards to majority
opportunism are relatively large. Additionally, LLCs were coded as having more
vulnerable owners if a single owner held more than a 90% share, with remaining owners
investing under $100,000 each, which identifies a situation where rewards to majority
opportunism are relatively lower but minority rights are particularly unlikely to be
protected.
67
These criteria resulted in 159 LLCs being deemed to have less vulnerable
owners, 50 having more vulnerable owners, and 24 that could not be classified. While
adopting this particular threshold was the product of experience and discussion with
various practitioners in this area, the principal findings were robust to other financial
specifications ranging from 1% to 20% owners investing $10,000 to $250,000.
V. EMPIRICAL EXAMINATION OF LLC OPERATING AGREEMENTS: RESULTS
This Part provides the analysis of Delaware and New York operating agreements. I
begin by looking at provisions that weaken owners’ protections and then turn to
provisions that strengthen these protections.
ANALYSIS 561, 563 (2015) (examining non-contractual devices used by sophisticated parties to avoid
opportunism).
65. Investors would invest through corporate investment vehicles to shield their investments from their
personal creditors. See generally Henry Hansmann et al., Law and the Rise of the Firm, 119 HARV. L. REV.
1333 (2006) (focusing on the importance of this entity shielding).
66. Sandra Miller has found variation in legal cognizance of basic LLC issues, suggesting that hiring
more novice or cut-rate representation could produce significantly weaker owner protection in the realm of
LLCs. See generally Sandra K. Miller et al., An Empirical Glimpse into Limited Liability Companies: Assessing
the Need to Protect Minority Investors, 43 AM. BUS. L.J. 609 (2006); Sandra K. Miller, A New Direction for
LLC Research in a Contractarian Legal Environment, 76 S. CAL. L. REV. 351 (2003).
67. For these criteria, I also included investments of cash equivalent, such as sweat equity. Four firms
that were set up for the benefit of minors and other family relatives were treated as unclassified because of the
presumed initial non-adversarial relationship that could affect the bargaining process.
522 The Journal of Corporation Law [Vol. 42:3
A. Weakening Protections
Several protections from corporate law have been imported into the law of LLCs. In
Delaware and New York, these protections generally apply to LLCs by default and can
be waived by the parties if desired; in other states, they may apply by default or may be
mandatory, non-waivable rules. This Section examines the prevalence of weakening or
completely dispensing with these protections in LLC operating agreements. While
seemingly an unintuitive action to take, it could be to the benefit of the LLC as a whole,
and, therefore, to its owners, to cut back these protections if owners are able to protect
themselves in other ways. The worry, of course, is that rollbacks of owner protections
may be merely a means for sophisticated managers or controlling owners to expropriate
welfare from the less informed.
1. Authorizing Competition
LLC managers are precluded by default from engaging in external activities that
compete with the LLC’s business.
68
The requirement for managers not to compete with
the LLC comes out of the fiduciary duty of loyalty, discussed more fully in Section 3.
Consonant with the belief in contractual freedom, parties to Delaware and New
York LLC operating agreements are able to waive this protection.
69
Doing so clearly
undermines owners’ protection against potential opportunism by managers, but the
waiver could be desirable if owners are otherwise protected and the waiver authorizes a
mutually beneficial bargain. For example, investment managers often manage a series of
funds organized as separate entities, and a prohibition against their engaging in
competing activities could greatly increase the costs they would charge in management
fees. Waiving this protection could collectively save owners more than the protection is
worth to them.
Table 3 collects the results on waiving managers’ prohibition against competition.
The results aggregate full and partial waivers together; only six agreements contained a
partial waiver of the prohibition against competition. As can be seen, waivers are not
uncommon, occurring in 40% of Delaware LLCs. The rate is insignificantly lower among
New York LLCs, occurring in 38% of the operating agreements. Within Delaware, the
difference was largely invariant to whether parties were likely to have been represented
by sophisticated counsel. Thirty-nine percent of LLCs with less vulnerable owners
waived managers’ duty not to compete, while 40% of LLCs with more vulnerable
minority owners less likely to hire sophisticated representation did so.
68. E.g., UNIF. LTD. LIAB. CO. ACT § 409(a), (g) (UNIF. LAW COMM’N 2006) (applying to member-
managed and manager-managed LLCs, respectively).
69. N.Y. LTD. LIAB. CO. LAW § 417 (2006) (authorizing waivers of the duty of loyalty and thus the
subsumed duty not to compete); see, e.g., Cantor Fitzgerald L.P. v. Cantor, No. C.A. 16297, 1998 WL 326686
(Del. Ch. June 16, 1998); Centro Empresarial Cempresa S.A. v. America Móvil, S.A.B. de C.V., 952 N.E.2d
995, 1001–02 (N.Y. 2011) (enforcing waivers).
2017] How Do LLC Owners Contract Around Default Statutory Protections? 523
2. Waiving the Business Opportunity Doctrine
Related to managers’ duty not to compete is the business opportunity doctrine,
which bars managers and controlling shareholders from seizing projects for themselves
that would benefit the LLC. Like the prohibition against competition, the business
opportunity doctrine (or the corporate opportunity doctrine counterpart in corporate
law)
70
is a particular manifestation of the duty of loyalty, which is discussed more fully in
the next Section.
Whether a project constitutes a business opportunity is measured by balancing
several factors—including whether the firm is financially able to undertake the
opportunity, whether the opportunity is in the firm’s line of business, whether the firm
has a reasonable expectancy in the opportunity, and whether the manager would have a
conflict between her self-interest and her duty to the LLC as a result of seizing the
opportunity.
71
Patently, a waiver of the business opportunity doctrine undermines the protection of
LLC owners. Legally, managers would be free to capture all profitable investments for
their own account rather than share them with the LLC, leaving the LLC an empty shell
that earns no profit. Of course, just because conduct has no legal sanction does not mean
managers will engage in it; social norms, shaming, not being fired, and the desire to
maintain a good reputation also deter behavior. And if these deterrents are sufficient,
waiving the business opportunity doctrine may make sense. With poorly defined
contours, the doctrine generates legal uncertainty that could overdeter (or underdeter)
desirable behavior by managers, not to mention produce sizable litigation expense.
72
In
other words, the protection offered by the business opportunity doctrine comes with
costs.
70. For comparisons between the business opportunity doctrine and its corporate analogue, see RIBSTEIN
& KEATINGE, supra note 13, at § 9:3.
71. Broz v. Cellular Info. Sys., 673 A.2d 148, 154–55 (Del. 1996).
72. Talley, supra note 17, at 279 (describing the doctrine as “provid[ing] little guidance either to
theorists or to practitioners”).
40%
n = 94
39%
n = 62
40%
n = 20
38%
n = 19
Table 3
Waiver of Duty Not to Compete
…less vulnerable, n = 158
…more vulnerable, n = 50
New York (total sample), n = 50
Delaware (total sample), n = 233
524 The Journal of Corporation Law [Vol. 42:3
Consequently, as they do with the duty not to compete, Delaware and New York
authorize waivers of the business opportunity doctrine for LLCs.
73
As Table 4 shows,
40% of Delaware LLCs take advantage of the contractual freedom to do so, with no
significant difference between LLCs with and without vulnerable minority owners.
Among the sample of New York LLCs, 42% waive the business opportunity doctrine.
3. Modifications of Traditional Fiduciary Duties
The concept of fiduciary duties pervades all areas of business organization law.
Agents owe fiduciary duties to their principals. Partners owe fiduciary duties to their
partnership and one another. Directors and officers owe fiduciary duties to their
corporation. For LLCs, managers, and potentially members, may owe fiduciary duties to
the LLC.
Fiduciary duties act as a judicial backstop for when legal rules, contractual terms,
and market discipline are insufficient to deter destructive behavior.
74
Delaware, New
York, and most other jurisdictions recognize three fiduciary duties: loyalty, care, and
good faith.
75
Under the duty of loyalty, the fiduciary must avoid self-dealing; she cannot
benefit to the detriment of the organization.
76
In addition, to a general bar on self-dealing,
the duty of loyalty has expanded to include a prohibition on competing with the firm via
one’s other activities as well as a prohibition against claiming corporate opportunities for
oneself.
77
The duty of care requires that the fiduciary carry out her responsibilities in a
manner that avoids gross negligence or worse.
78
This obligation means that, among other
things, the fiduciary must make business decisions in an informed manner and not ignore
73. See generally Broz, 673 A.2d 148; Pappas v. Tzolis, 982 N.E.2d 576 (N.Y. 2012).
74. E.g., D. Gordon Smith, Doctrines of Last Resort, in REVISITING THE CONTRACTS SCHOLARSHIP OF
STEWART MACAULAY: ON THE EMPIRICAL AND THE LYRICAL 426, 427 (Jean Braucher et al. 2013) (referring to
fiduciary duties as a “doctrine of last resort” once contractual and other explicit safeguards fail).
75. TAMAR FRANKEL, FIDUCIARY LAW 101–07 (2011).
76. E.g., RIBSTEIN, Fencing Fiduciary Duties, supra note 7, at 908.
77. See supra note 17 and accompanying text.
78. In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 53 (Del. 2006).
41%
n = 95
41%
n = 65
34%
n = 17
42%
n = 21
New York (total sample), n = 50
Table 4
Waiver of Business Opportunity Doctrine
Delaware (total sample), n = 233
…less vulnerable, n = 158
…more vulnerable, n = 50
2017] How Do LLC Owners Contract Around Default Statutory Protections? 525
her responsibilities as a fiduciary.
79
Finally, the duty of good faith, as its name would
suggest, requires that fiduciaries carry out their responsibilities honestly and in good
faith. The legal indicators of conduct that violates the duty of good faith are bad faith,
willful or intentional misconduct, or knowing violations of the law.
80
Recognizing the overlap among these protections and the fact that sophisticated
parties may be better off eliminating fiduciary duties, Delaware and New York allow
LLC parties to waive them, although fiduciary duties apply by default.
81
If parties want to
soften some of a fiduciary duties’ bite but not go as far as a complete waiver, another
option is to exculpate owners’ and managers’ personal liability for violating specified
fiduciary duties. Exculpating personal liability without waiving fiduciary duties leaves
fiduciary duties intact but restricts the remedies that aggrieved parties can seek to non-
monetary options.
82
These options include “injunctive relief, a decree of specific
performance, recission, the imposition of a constructive trust, and a myriad of other non-
liability-based remedies.”
83
Taking monetary damages off the table, however, decreases
the chances that fiduciary duty suits will be brought because the typical motivator—
money damages—is not available when confronted with an exculpation clause. Both
Delaware and New York authorize exculpating breaches of fiduciary duty.
84
Finally, parties seeking a third option can indemnify breaches of fiduciary duties,
which commits the LLC to reimbursing managers’ costs associated with a breach. Under
an indemnification agreement, while the manager remains personally liable for the costs
of a fiduciary duty breach, the manager is entitled to be reimbursed from the LLC for this
personal liability.
85
79. See generally Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985); Francis v. United Jersey Bank, 432
A.2d 814 (N.J. 1981).
80. E.g., Disney, 906 A.2d at 67. Delaware has subsumed this duty within the duties of loyalty and care,
using it to brand particularly egregious examples of duty of loyalty violations; it is unclear whether other
jurisdictions similarly treat the duty of good faith as an independent fiduciary duty. See generally Stone v.
Ritter, 911 A.2d 362 (Del. 2006).
81. N.Y. LTD. LIAB. CO. LAW § 409 (1994); DEL. CODE ANN. tit. 6, §§18-1101(c)–1104 (2013). Section
1104, amended in 2013 to say that fiduciary duties apply by default, made clear what the Chancery Court had
previously held and what litigants took for granted. See Mohsen Manesh, Damning Dictum: The Default Duty
Debate in Delaware, 39 J. CORP. L. 35, 37, 41–46 (2013) (describing a variety of sources reflecting the same
understanding); see generally Auriga Capital Corp. v. Gatz Properties, 40 A.3d 839 (Del. Ch. 2012) (holding
fiduciary duties apply to LLCs by default); William Penn P’ship v. Saliba, 13 A.3d 749 (Del. 2011) (mentioning
that parties agree that managers of LLCs owe traditional corporate fiduciary duties unless expressly modified or
waived); Feeley v. NHAOCG, LLC, 62 A.3d 649 (Del. Ch. 2012). Like Delaware, New York allows fiduciary
duty waivers and exculpation absent a final judgment of bad faith or obtaining an illegal financial profit or
entitlement. See supra note 32 and accompanying text. Fiduciary duties apply by default. E.g., In re Die
Fliedermaus LLC, 323 B.R. 101, 110 (Bankr. S.D.N.Y. 2005); Melcher v. Apollo Med. Fund Mgmt. LLC, 923
N.Y.S.2d 92, 93 (N.Y. App. Div. 2011).
82. E.g., Feeley, 62 A.3d at 664.
83. Id.
84. DEL. CODE ANN. tit. 6, § 18-1101(e); supra note 81 and accompanying text. New York’s statute
requires that bad faith not be exculpated, although as discussed above, the precise contours of the duty of good
faith outside Delaware are not clearly defined. N.Y. LTD. LIAB. CO. LAW § 417 (1995); supra note 80 and
accompanying text.
85. Indemnification agreements can also advance expenses to managers, which alters the timing but not
the substance of the indemnification agreement.
526 The Journal of Corporation Law [Vol. 42:3
If the company is solvent and has no insurance to cover managers’ liability,
86
then
an indemnification clause acts like a species of exculpation: managers pay damages to the
LLC for the fiduciary duty breach, and the LLC in turn pays this back to managers as a
reimbursement. Indemnification then goes a step beyond exculpation by also covering
managers’ litigation expenses. But if the company is insolvent, indemnification can be a
stronger deterrent to managers than exculpation by not being available to reimburse
managers.
87
And to be indemnified, managers must first incur legal expenses, meaning
they must proceed through the litigation process. Having to defend oneself in the public
courtroom to later be indemnified can be less attractive than exculpation, which closes
the door on lawsuits much earlier in the process if those suits seek financial damages
from the manager.
Delaware authorizes LLCs to indemnify managers without limit. New York permits
operating agreements to authorize indemnification absent a final adjudication that the
manager acted in bad faith or gained an advantage or profit to which she was not legally
entitled.
88
Waiving, exculpating, or indemnifying breaches of fiduciary duties clearly
undermines the protection that LLC owners have against managers and the actions of
other owners. Table 5 shows that these waivers, exculpations, and indemnifications are
common among LLCs with either more or less vulnerable owners, with modifications to
the duty of loyalty significantly more common among Delaware LLCs with less
vulnerable owners.
89
Both the Delaware and New York samples followed similar
patterns. Table 6 provides information about solely indemnification, showing that the
86. Directors and officers insurance is sold to cover precisely these circumstances, but these policies may
have exclusions rendering them unavailable—as, for instance, an exclusion in the corporation context that
excludes insurance coverage for actions brought by current or former directors. Of course, insurance would also
be unavailable if it were never purchased.
87. When the LLC is insolvent, it cannot reimburse managers’ expenses so that managers bear the
financial costs of a fiduciary duty breach. While this situation will not produce a net recovery to owners, it will
deter fiduciary duty breaches—perhaps at a time when those breaches are most likely, as being in the zone of
insolvency increases managers’ incentives to take risks, including expropriating LLC assets from owners who
have nothing to lose. See, e.g., Credit Lyonnais Bank Nederland v. Pathe Commc’ns Corp., C.A. No. 12150,
1991 WL 277613, at *34 n.55 (Del. Ch. Dec. 30, 1991) (recognizing the incentive for managers to gamble with
creditors’ money when near insolvency). As managers are answerable to owners and as owners’ claims have no
value when the LLC is insolvent, it is not unreasonable to suppose that managers will likewise be more inclined
to breach fiduciary duties when near insolvency and for owners to remain relatively indifferent to this breach.
See WILLIAM C. POWERS, JR. ET AL., REPORT OF INVESTIGATION BY THE SPECIAL INVESTIGATIVE COMMITTEE
OF THE BOARD OF DIRECTORS OF ENRON CORP. 3–4 (Feb. 1, 2002) (describing members of Enron tunneling
money in a series of transactions while Enron was near insolvency).
88. DEL. CODE ANN. tit. 6, § 18-108; N.Y. LTD. LIAB. CO. LAW § 420.
89. The operating agreement was deemed to modify the duty of loyalty if it referred to the duty of loyalty
explicitly, required managers to act in a way she reasonably believed to be in (or at least not opposed to) the
LLC’s interests, prohibited improper takings, or used similar formulations. See Leo E. Strine Jr. et al., Loyalty’s
Core Demand: The Defining Role of Good Faith in Corporation Law, 98 GEO. L.J. 629, 658–59 (2010)
(associating this latter language with the duty of loyalty under Delaware law); see generally OH. REV. CODE
ANN. § 1701.59(D)(1) (associating the duty of loyalty with this standard). The duty of good faith was deemed
modified if the operating agreement modified the duty of good faith explicitly or any of that duty’s hallmarks:
bad faith, willful or intentional misconduct, or intentional violations of the law. See supra note 80 and
accompanying text. Finally, I determined that operating agreements modified the duty of care if they explicitly
referenced the duty of care or its typical judicial counterpart, gross negligence or recklessness. See supra note
78 and accompanying text.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 527
prevalence of indemnifying fiduciary duty breaches generally follows the same pattern as
waiving, exculpating, or indemnifying them.
528 The Journal of Corporation Law [Vol. 42:3
Loyalty*
Good Faith
Care
4%
3%
3%
n = 9
n = 7
n = 8
4%
4%
4%
n = 7
n = 6
n = 7
4%
2%
2%
n = 2
n = 1
n = 1
37%
5%
23%
n = 87
n = 12
n = 53
39%
4%
21%
n = 62
n = 7
n = 33
26%
6%
24%
n = 13
n = 3
n = 12
22%
10%
19%
n = 52
n = 23
n = 45
23%
10%
17%
n = 37
n = 16
n = 27
20%
8%
26%
n = 10
n = 4
n = 13
64%
18%
45%
n = 148
n = 42
n = 106
67%
18%
42%
n = 106
n = 29
n = 67
50%
16%
52%
n = 25
n = 8
n = 26
6%
2%
2%
n = 3
n = 1
n = 1
34%
0%
16%
n = 17
n = 0
n = 8
26%
22%
28%
n = 13
n = 11
n = 14
66%
24%
46%
n = 33
n = 12
n = 23
*References to the duty of loyalty do not include modifications of solely the duty not to compete
or of the business opportunity doctrine. While both fall within the duty of loyalty, they are
broken out separately in the prior subparts.
…less vulnerable
…more vulnerable
New York (complete waiver)
…not waived; exculpated
…not waived or excul.;
indemnified
Total (waived, exculpated,
or indemnified)
Total (waived, exculpated,
or indemnified)
Table 5
Fiduciary Duty Modification
Delaware (complete waiver)
…less vulnerable
…more vulnerable
…not waived; exculpated
…less vulnerable
…more vulnerable
…not waived or excul.;
indemnified
…less vulnerable
…more vulnerable
2017] How Do LLC Owners Contract Around Default Statutory Protections? 529
Tables 7 and 8 provide information on conditional probabilities—the chance that
one or more other fiduciary duties will be waived, exculpated, or indemnified given that a
fiduciary duty has already been modified. The conditional probabilities vary substantially
by fiduciary duty. Two generalized conclusions immediately emerge: first, if at least two
fiduciary duties are modified, it is almost a guarantee that the third fiduciary duty will
also be modified. Second, operating agreements that modify the duty of good faith are
extremely likely to modify both other fiduciary duties—although modifications to the
duty of good faith are relatively rare in the first instance.
90
90. Supra tbl. 5.
530 The Journal of Corporation Law [Vol. 42:3
L
GF
C
L & GF
L & C
GF & C
26% 52% 26%
n = 38 n = 77 n = 38
90% 93% 90%
n = 38 n = 39 n = 38
73% 37% 36%
n = 77 n = 39 n = 38
100%
n = 38
100%
n = 38
97%
n = 38
Conditional on This Duty(ies) Being Modified
…
Table 7
Conditional Duty Modification (Delaware)
*References to the duty of loyalty do not include waivers of either the duty not to compete or of
the business opportunity doctrine. While both fall within the duty of loyalty, they are broken out
separately in the prior subparts.
Is This Duty(ies) Modified?
Loyalty (L)*
Good Faith (GF)
Care (C)
Loyalty & Good
Faith
Loyalty & Care
Good Faith &
Care
2017] How Do LLC Owners Contract Around Default Statutory Protections? 531
a. Drag-Along Rights
Drag-along rights allow a particular owner, typically the holder of a majority
ownership stake, to force other owners to proceed with a sale of the company on the same
terms received by the majority owner and, thereby, eliminate minority owners’ power to
hold up deals.
91
Drag-along rights are a common fixture among venture capital deals,
appearing in approximately three quarters of major deals.
92
Owners’ valuations of their ownership stakes can vary for a variety of reasons.
Some may have higher discount rates or shorter time horizons than others.
93
They may
91. For an example of a drag-along right, see Nat’l Venture Cap. Ass’n, Amended and Restated Voting
Agreement 5–10 (Mar. 2014), http://nvca.org/?ddownload=387. Statutes typically require at least supermajority
consent to mergers. See, e.g., Uniform Act § 1003 (requiring unanimous owner consent to merger). One can see
that drag-along rights therefore effectively alter this rule to one that authorizes mergers and acquisitions solely
with the consent of the owner holding the drag-along rights.
92. Cooley LLP, 2014 Venture Financing in Review, COOLEY VENTURE FINANCING REPORT 6 (2015),
https://www.cooley.com/~/media/cooley/pdf/venture-financing-reports/cooley-vf2014q4.ashx?la=en.
93. This difference was particularly dramatic in the recent Delaware Chancery Court case In re Trados
Inc. S’holder Litig., 73 A.3d 17 (Del. Ch. 2013) (applying the entire fairness standard to a change of control
transaction that benefited venture capital preferred shareholders but not common shareholders); see generally
L
GF
C
L & GF
L & C
GF & C
36% 61% 36%
n = 12 n = 20 n = 12
100% 100% 100%
n = 12 n = 12 n = 12
87% 52% 52%
n = 20 n = 12 n = 12
100%
n = 12
100%
n = 12
100%
n = 12
*References to the duty of loyalty do not include waivers of either the duty not to compete or of
the business opportunity doctrine. While both fall within the duty of loyalty, they are broken out
separately in the prior subparts.
Table 8
Conditional Duty Modification (New York)
Is This Duty(ies) Modified?
Conditional on This Duty(ies) Being Modified
…
Loyalty (L)*
Good Faith (GF)
Care (C)
Loyalty & Good
Faith
Loyalty & Care
Good Faith &
Care
532 The Journal of Corporation Law [Vol. 42:3
differ about the firm’s future prospects. Founders and owner-employees of the company
may have idiosyncratic or employment-related reasons to resist sales. Sellers of majority
stakes may be receiving a side deal whose value cannot be captured by other selling
owners, such as the promise of a lucrative employment deal. Because sales of the
company require the approval of ownership interests, sales can get held up or even
scuttled when owners disagree over the value of the firm.
94
Drag-along rights solve this
issue by having the parties agree upfront to follow the desires of the rights’ holders.
However, committing to follow the wishes of the drag-along rights’ holders can
involve a loss of protection for the remaining owners. In circumstances when the rights
holders are selling on terms the other owners want anyway, the rights are effectively
close to worthless; the transaction would have happened even without issuing the rights.
When at least some minority owners disagree with the selling terms, such as for the
reasons discussed above, drag-along rights represent a loss of protection for these
minority owners.
95
Drag-along rights are not unique to large venture capital-backed deals. Table 9
shows their prevalence in LLC operating agreements. While the rights are less common
than in large deals, they still feature in a quarter of all LLC operating agreements. The
rights were significantly more prevalent among Delaware LLCs with less vulnerable
owners and among Delaware LLCs compared to New York LLCs.
Abraham J.B. Cable, Opportunity-Cost Conflicts in Corporate Law, 66 CASE W. L. REV. 51 (2015) (analyzing
the implications from investors with conflicting time horizons).
94. For discussions of these and other reasons for including drag-along rights, see Brian Broughman &
Jesse M. Fried, Carrots and Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups, 98 CORNELL L.
REV. 1319, 1331–35 (2013).
95. Even if the votes by the holders and non-holders would be sufficient to approve a sale, the
requirement that dissenting owners also vote for the deal could still be valuable, as it forecloses their appraisal
rights. Id. at 1330–31.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 533
b. Judicial Dissolution
LLC statutes provide owners of problematic LLCs the option to seek a remedial
order of judicial dissolution, which dissolves the LLC and distributes its assets to owners.
Obtaining an order of dissolution requires showing that it is no longer “reasonably
practicable” to carry on the LLC’s business along the terms indicated in its operating
agreement—as, for instance, if management is deadlocked or minority owners are
suffering systematic exploitation.
96
Seeking an order of judicial decree therefore acts as a
nuclear option available to LLC owners when other options fail.
Judicial dissolution can provide a valuable safeguard to owners. By default, owners’
interests are neither transferable nor withdrawable, tethering owners to the LLC for good
or for bad, giving rise to potential opportunism familiar to those who study closely held
organizations. With no exit rights for minority owners, majority owners have entrenched
themselves as managers; paid themselves excessive salaries; both refused to distribute
accrued earnings or distributed too much earnings; refused potential takeovers or buyouts
preferred by the other owners; and engaged in a host of other behavior to transfer money
from other owners to themselves.
97
The potential opportunism may be even more severe
with LLCs. Owners are not only prohibited from withdrawing their ownership stake by
default but also are prohibited from withdrawing at all from the LLC, even if they are
willing to sacrifice any accrued ownership value.
98
Furthermore, as we have seen,
minority owner protections can be significantly weaker for LLC owners than owners of
other business organizations, given LLCs’ unique freedom to waive traditional owner
96. DEL. CODE ANN. tit. 6, § 18-802 (1992); N.Y. LTD. LIAB. CO. LAW § 702 (McKinney 1994); Uniform
Act § 701(a)(4); RIBSTEIN & KEATINGE, supra note 13, § 11.5.
97. E.g., Douglas K. Moll, Minority Oppression & The Limited Liability Company: Learning (or not)
from Close Corporation History, 40 WAKE FOREST L. REV. 883 (2005) (analyzing these problems).
98. Reasons to withdraw, even if doing so forfeits accumulated value, include the desire to avoid being
held personally liable for the LLCs debts via piercing the corporate veil, as well as the desire to remove any
fiduciary responsibilities to the LLC, particularly the corporate opportunity doctrine’s requirement that
opportunities be shared with the LLC if appropriate. See supra Section IV.A.2 (discussing the corporate
opportunity doctrine and associated waivers and modifications).
24%
n = 57
28%
n = 44
12%
n = 6
10%
n = 5
New York (total sample), n = 50
Table 9
Prevalence of Drag Along Rights
Delaware (total sample), n = 233
…less vulnerable, n = 158
…more vulnerable, n = 50
534 The Journal of Corporation Law [Vol. 42:3
protections. A last ditch judicial dissolution effort can be extremely valuable in these
circumstances.
Nevertheless, there are legitimate reasons why LLC parties may be better off by
waiving the right to seek judicial dissolution. First, doing so increases the credibility of
the parties’ commitment to the LLC, its operating agreement, and one another; judicial
dissolution no longer provides relief when things get difficult. Such a commitment can
send a mutual signal of trust and encourage a good working relationship.
99
Second,
judicial dissolution can be harmful to the business as a whole; for example, loan
agreements commonly have covenants under which judicial dissolution triggers a
noncurable event of default.
100
In the right circumstances, then, a waiver of the right to seek judicial dissolution can
enhance the LLC’s value, but the ramifications of a waiver can be severe if less
sophisticated owners are involved. Consequently, the Model Act and several states view
the right to seek judicial dissolution as a mandatory right that cannot be waived.
101
Lower
courts in New York have followed suit and held judicial dissolution to be a nonwaivable
right.
102
Delaware, however, authorizes waivers of judicial dissolution, taking the view
that benefits to sophisticated parties outweigh costs to the less sophisticated.
103
Table 10 collects the results on the prevalence of waivers of the right to seek judicial
dissolution. Overall, waivers of the right to seek judicial dissolution are uncommon,
reflecting the fundamental value that parties place in it. Waivers occur in 12% of all
Delaware LLCs, with small variation between those firms with and without vulnerable
owners. Interestingly, the right to seek judicial dissolution was waived in 8% of New
York LLCs, despite its demonstrated lack of enforceability there.
104
99. See generally Blair & Stout, supra note 23, at 1774–75.
100. R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, C.A. No. 3803-CC, 2008 WL
3846318, at *7 (Del. Ch. Aug. 19, 2008); RIBSTEIN & KEATINGE, supra note 13, § 11:5.
101. Uniform Act § 110 (c)(7); RIBSTEIN & KEATINGE, supra note 13, § 11:5 (listing other states where
the right to seek judicial dissolution cannot be waived).
102. Youngwall v. Youngwall Realty, No. 2266-07, 2008 WL 827916 (N.Y. Sup. Ct. Mar. 14, 2008).
103. DEL. CODE ANN. tit. 6, § 18-1101(c) (2013) (promoting contractual freedom); R & R Capital, 2008
WL 3846318, at *8 (enforcing waiver of right to seek judicial dissolution). The Delaware judiciary has shown
some reluctance to allow complete waivers of judicial dissolution, enforcing waivers while at the same time
expressing a desire to preserve judicial dissolution as an equitable source of last resort. See In re Carlisle
Etcetera LLC, 114 A.3d 592 (Del. Ch. 2015); Huatuco v. Satellite Healthcare & Satellite Dialysis of Tracy,
LLC, C.A. No. 8465-VCG, 2013 WL 6460898 (Del. Ch. Dec. 9, 2013).
104. The point of including the waiver in these New York operating agreements is presumably to
implement waivers automatically should New York courts decide to recognize them or to decrease the
attractiveness of seeking judicial dissolution in the first place as judges could always recognize the right upon
suit being brought with a contractual waiver.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 535
B. Strengthening Protections
The preceding Sections show the ways that LLCs reduce standard protections
offered to owners, giving more power to managers and majority owners. As discussed
before, this reduction in standard owner protections is not necessarily disconcerting if it is
accompanied by the adoption of substitute owner protection mechanisms. The following
Sections examine these protections. The first four protections examined directly provide
additional rights to owners, while the remaining four indirectly provide owner protections
by reducing managerial discretion and aligning management interests with owners’.
1. Amending the Operating Agreement
The rights and protections initially given to LLC owners would not be very effective
if they could later be taken away without those owners’ input. Consequently, I examined
operating agreements to determine whether owners’ approval was required to amend the
agreements.
Under basic contract law principles, because an operating agreement is a contract
among parties, those parties should not be bound to amendments unless they have agreed
to them. Extending this reasoning to operating agreements suggests that amendments
would require unanimous owner consent. Unanimous consent means that owners’ rights
are not modified without those owners’ consent and would protect minority owners from
an opportunistic majority that might otherwise try to eliminate minority protections. Yet
achieving unanimous owner approval may involve practical difficulties, particularly for
those LLCs with more than a handful of owners, giving legitimate business reasons to
allow amendment by less than unanimity. Recognizing this difficulty, Delaware, New
York, and the Uniform Act allow LLCs to amend their operating agreements with less
than unanimous owner consent.
12%
n = 29
14%
n = 22
10%
n = 5
8%
n = 4
New York (total sample), n = 50
Table 10
Waivers of Judicial Dissolution Right
Delaware (total sample), n = 233
…less vulnerable, n = 158
…more vulnerable, n = 50
536 The Journal of Corporation Law [Vol. 42:3
Delaware and the Uniform Act enforce the amendment procedures that appear in the
operating agreements—no statutory default procedure is provided.
105
New York also
enforces operating agreement amendment procedures against a background default of
consent by every adversely affected owner.
106
Almost every operating agreement in my
sample explicitly addressed how it could be amended. Table 11 shows the cumulative
distribution of the ownership vote necessary to make substantive amendments to the
operating agreement.
107
Most common by far was a provision requiring unanimous owner
vote, but amendment by less than unanimous owner approval occurred in one-third of
Delaware operating agreements and one-quarter of New York operating agreements. One
operating agreement even provided for amendment without owner approval of any
sort.
108
105. Uniform Act § 18-110(a). The Delaware statute includes no provision for how the operating
agreement must be amended. Because no default procedure is provided, for the analysis I assumed that those
Delaware operating agreements not specifying an amendment procedure required unanimous owner consent for
amendment, consistent with basic contract law principles. Cf. DEL. CODE ANN. tit. 6, § 17-302(f) (2016)
(unanimous consent default rule for amending limited partnership operating agreements).
106. N.Y. LTD. LIAB. CO. LAW § 417(b) (1994).
107. Operating agreements commonly allow management to make unilateral amendments to the operating
agreements as long as these amendments are not substantive in nature, such as amendments to reflect changes to
the identity of owners, or amendments necessary for compliance with securities laws. See, e.g., Amended and
Restated Limited Liability Company Agreement of Seminole Night Club LLC (Sept. 22, 2004), § 12.4. For
those operating agreements requiring just the consent of managers without owner approval, I “looked through”
the management clause to see the ownership share, if any, that managers held. For example, an operating
agreement requiring the majority consent.
108. Amended and Restated Operating Agreement of PJM Interconnection, LLC (July 14, 2011), § 8.1
(allowing amendment with approval of management and owner committee comprised of representatives of the
hundreds of owners). Because PJM is subject to federal oversight and substantial regulation by the Federal
Energy Regulatory Commission, the requisite owner protection may be supplied by these alternative means.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 537
2. Transferability
In closely held organizations, the identity of owners can be extremely important.
This importance can be because the owners also have a role in managing the firm,
because owners were specifically selected to share a common vision with management,
because the firm is a family business, or for a myriad of other reasons. Because of the
importance of owner identity to these closely held organizations, they commonly do not
provide for free transferability of shares, which instead is found in large corporations
where the particular identity of owners is unimportant.
109
Transfer restrictions also serve as a minority protection device for both closely held
and large firms. When transfers can be blocked by minority owners, controlling owners
are prohibited from opportunistically selling their control stakes to a new group that may
expropriate welfare from minority shareholders. Of course, broad transfer restrictions
also mean that minority owners will not be able to sell their position if they find
themselves systematically abused by the majority, but the right to sell in these
circumstances is not particularly valuable anyway—minority shares will trade at a
discount if minority owners find themselves in such an unfortunate position.
LLC statutes, built on the closely held firm framework, provide a default rule that
restricts transfers to rights to receive economic distributions only. Transferring the full
rights of ownership, including voting rights, requires the approval of nontransferring
109. E.g., Hansmann et al., supra note 65, at 1350.
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
Cumulative Percent of Operating
Agreements
Membership Share Required for Approval
Figure 11
Amendment of Operating Agreements
Delaware
New York
538 The Journal of Corporation Law [Vol. 42:3
owners.
110
Because of the value from liquidity arising with free transferability, however,
both Delaware and New York allow the default rule to be overridden, trading off owner
protections against other potential benefits.
Most firms follow the default provision to restrict free transferability. Table 12
summarizes the percent of firms that restrict transfers beyond bare economic interests by
at least the majority owners.
111
Fully three–quarters of Delaware operating agreements
include such a provision; the prevalence did not vary between firms with and without
vulnerable owners. The rate of restrictions was even higher among New York LLCs, with
86% including a restriction. Additionally, even for those firms that included a right to
transfer, the operating agreement typically provided either the firm or the non-
transferring owners (or both) with a first refusal right to purchase any shares that would
be transferred, further protecting the stability of owners’ identity.
112
3. Withdrawal Rights
A potentially powerful weapon owners have against the threat of opportunism is to
withdraw the value of their ownership stake and exit the firm—assuming they are
allowed to exit.
113
Rational owners and managers who require assets to conduct the firm’s
operations may therefore refrain from mistreating owners to avoid capital exit. However,
110. Uniform Act §§ 502, 401(d) (requiring unanimous owner approval); DEL. CODE ANN. tit. 6, § 18-702
(2016) (requiring unanimous owner approval); N.Y. LTD. LIAB. CO. LAW § 604 (1994) (requiring majority
approval of the non-transferring owners); Larry E. Ribstein, Litigating in LLCs, 64 BUS. LAW. 739, 741 (2009)
(noting many LLC statute terms were designed for closely held firms).
111. Not included is the right to transfer to one’s immediate family, an irrevocable trust, an affiliate
organization, an existing owner, and the like, which effectively keeps the ownership of the LLC relatively
constant.
112. See, e.g., Amended and Restated Limited Liability Company Agreement of PetroAlgae, LLC, § 7.5
(Feb. 16, 2007).
113. See generally ALBERT O. HIRSCHMAN, EXIT, VOICE, AND LOYALTY: RESPONSES TO DECLINE IN
FIRMS, ORGANIZATIONS, AND STATES (1970) (broadly discussing exit, or the prospect of exit, as a deterrent to
abuse by management); Henry Hansmann & Reinier Kraakman, Exit, Voice, and Liability: Legal Dimensions
of Organizational Structure (June 2008) (unpublished manuscript) (on file with author).
75%
n = 174
76%
n = 120
78%
n = 39
86%
n = 43
New York (total sample), n = 50
Table 12
Restrictions on Transfers by Majority
Delaware (total sample), n = 233
…less vulnerable, n = 158
…more vulnerable, n = 50
2017] How Do LLC Owners Contract Around Default Statutory Protections? 539
while this threat of exit imposes constraints on management, it also makes the firm’s
capital structure fragile—particularly if the firm invests in illiquid assets—or it can
perversely provide owners with the power to extract welfare gains from other owners and
managers by threatening to take the firm’s capital lifeblood with them. Consequently, the
default rule for LLCs is that owners have no exit rights. Unless an operating agreement
explicitly grants the right, owners can neither withdraw as owners of the LLC nor
demand return of their capital contributions or accrued ownership value.
114
I examined operating agreements to determine when members had the right to
withdraw unilaterally and receive the value of their ownership stake.
115
Table 13 collects
the results. As expected, withdrawal rights are rare but not nonexistent, occurring in 9%
of Delaware LLCs and 6% of New York LLCs. Withdrawal rights were more common
among LLCs with more vulnerable minority owners, where the rights would be more
valuable. Surprisingly, the withdrawal rights were not confined to those firms with liquid
assets or low capital requirements. Firms granting withdrawal rights ranged from low-
capital service industries to developing illiquid real estate to operating a car dealership.
116
The withdrawal rights were more likely to appear in LLCs with a vulnerable minority.
114. DEL. CODE ANN. tit. 6, § 18-603 (2015); N.Y. LTD. LIAB. CO. LAW § 606 (1999). Not all
commentators agree with the wisdom of this rule, precisely because of the benefits offered by liberal
withdrawal rights. See RIBSTEIN, THE RISE OF THE UNCORPORATION, supra note 7, at 180. In fact, until
amendments in 1999, New York allowed owners a unilateral withdrawal right upon giving six months’ notice.
115. Such a right arises if the operating agreement affirmatively grants the right to withdraw and receive
the value of one’s ownership interest or if the operating agreement merely grants the right to withdraw, in which
case the Delaware and New York LLC statutes provide a default right to receive the value of the withdrawer’s
ownership stake. DEL. CODE ANN. tit. 6, § 18-604 (1999); N.Y. LTD. LIAB. CO. LAW § 509 (1994). Operating
agreements that gave a unilateral right to withdraw but barred paying the accrued ownership value or that gave a
right to withdraw contingent on a vote by managers or other owners were not included.
116. Operating Agreement of Launchpad Healthcare Solutions, LLC (Jan. 1, 2012), § 7.1; Operating
Agreement of North Park, LLC, § 4.6 (Oct. 26, 2005); Limited Liability Company Agreement of Annapolis
Motor Cars, LLC, § 6.2 (Aug. 2002).
540 The Journal of Corporation Law [Vol. 42:3
4. Tag-Along Rights
Tag-along rights provide that when an owner has negotiated a sale of her ownership
stake to an outside party, rights holders can participate in the sale on the same terms.
117
If
the purchaser is unwilling or unable to purchase the additional owners’ interests, the
original negotiating seller’s sale stake is reduced so that all owners participate on a pro-
rata basis.
Tag-along rights reverse the traditional American business law rule that allows
selling owners to capture control premiums when selling shares without sharing these
premiums with other owners.
118
The rights protect minority owners by ensuring they are
at least partially compensated if a controlling shareholder sells to someone who later
harms the firm.
119
Tag-along rights also make inefficient transfers—as well as transfers of
control generally—less likely to happen because much of the surplus paid to divest a
controlling owner of her stake must be shared with other LLC owners.
The downside of tag-along rights is that they make being a controlling owner less
attractive because the rights eliminate one potential method that controlling stakeholders
are compensated for their particular burden.
120
Controlling stakeholders bear monitoring
and management costs that inure to the benefit of all owners; compensating them for
these costs, such as via tag-along rights, provides the inducement needed to gain
117. E.g., John C. Coffee, Jr., Racing Towards the Top?: The Impact of Cross-Listings and Stock Market
Competition on International Corporate Governance, 102 COLUM. L. REV. 1757, 1799 (2002).
118. See Zetlin v. Hanson Holdings, Inc., 397 N.E.2d 387, 389 (N.Y. 1979) (announcing the typical
American rule).
119. This could be direct harm, when the new controlling owner expropriates gains from other
shareholders, or more indirect harm, as when the new owner is a less effective manager or monitor of managers.
120. It is often argued that tag-along rights also make it less likely that firm-enhancing transfers in control
will occur. E.g., George W. Dent, Jr., Venture Capital and the Future of Corporate Finance, 70 WASH. U. L.Q.
1029, 1066 (1992). However, the holders of these rights are not required to exercise them, so assuming owners
are able to coordinate—which is more likely in closely held firms—the rights will not have this additional
downside.
9%
n = 22
6%
n = 10
18%
n = 9
6%
n = 3
New York (total sample), n = 50
Table 13
Unilateral Withdrawal Rights
Delaware (total sample), n = 233
…less vulnerable, n = 158
…more vulnerable, n = 50
2017] How Do LLC Owners Contract Around Default Statutory Protections? 541
controlling owners in the first place.
121
Further, while tag-along rights reduce the
likelihood of inefficient transfers of control, they also reduce the likelihood of efficient
control transfers, requiring that buyers of control stakes be willing to pay a higher
premium to convince the existing controlling owner to leave.
122
It is worthwhile to note the similarity between the protections and drawbacks of tag-
along rights and transfer restrictions, discussed previously. Both methods provide
minority owners with protection against opportunistic sales by majority owners. Both
also give minority owners the power to hold up efficient ownership transfers. We would
expect to see tag-along rights more often in those operating agreements without the direct
substitute of transfer restrictions, and Table 14 shows this expectation to be the case. Tag-
along rights appear in 27% of the Delaware operating agreements, but they are
significantly more common when unaccompanied by transfer restrictions, occurring in
40% of Delaware agreements without transfer restrictions and 22% of agreements with
transfer restrictions. The rights were also found significantly less often among LLCs with
more vulnerable minority owners and among New York LLCs.
121. Ronald J. Gilson & Alan Schwartz, Constraints on Private Benefits of Control: Ex Ante Control
Mechanisms Versus Ex Post Transaction Review, 169 J. INSTITUTIONAL & THEORETICAL ECON. 160, 162
(2013).
122. Although it might be argued that efficient transfers of control would not be deterred by tag-along
rights, since it would be in the minority’s interest to facilitate the transfer by not exercising their right, a simple
game theory analysis shows that to be unlikely. While it may be in all minority owners’ interests to facilitate
such a transfer and the ideal situation would have all minority owners committing to refrain from exercising
their right, the rational action would be for each individual minority owner to exercise the right so that both
efficient and inefficient control transfers are deterred by tag-along rights.
27%
n = 63
22%
n = 39
41%
n = 24
32%
n = 51
12%
n = 6
10%
n = 5
New York (total sample), n = 50
Table 14
Operating Agreements with Tag Along Rights
Delaware (total sample), n = 233
…w/ transfer restrictions, n = 174
…w/o transfer restrictions, n = 59
…less vulnerable, n = 158
…vulnerable, n = 50
542 The Journal of Corporation Law [Vol. 42:3
5. Limitation of LLC’s Purposes
We now move from direct to indirect ways that operating agreements protect
minority owners and align managers’ and owners’ incentives. The first of these, limiting
the LLC’s business purpose, restricts the company’s ability to surprise minority owners
with new projects. Traditional corporate purposes and powers are exceptionally broad,
and LLC statutes follow in the same vein. Although LLCs must be organized to
accomplish a purpose, this purpose can be simply “any legal act.”
123
Broad purposes
provide LLCs with flexibility to seize diverse profit-making opportunities they come
across. However, wide latitude can allow the LLC to stray from its core competencies,
giving rise to greater potential agency costs or opportunism. This scenario can leave
owners without recourse when the type of projects they believed they were investing in
have changed, especially as there is no owner right to vote on fundamental changes in the
LLC’s line of business if the LLC purpose is specified broadly.
124
Alternatively, the LLC can sacrifice some flexibility by specifying a narrower
purpose. The narrower the purpose, the more protection that is provided to owners, but
the more potential profit-making opportunities are forfeited if they fall outside the LLC’s
purpose. Although the LLC’s purpose can always be broadened by amending the
operating agreement, achieving the necessary consensus becomes difficult once the
number of owners expands past a handful. As with all the provisions that we have seen so
far, therefore, there are both costs and benefits from specifying a broad or narrow
business purpose in the LLC operating agreement.
Table 15 shows the prevalence of narrowing the LLC’s business purpose.
125
Narrowing occurs in just over half the operating agreements for both Delaware and New
York LLCs, but it is far more common among LLCs with less vulnerable owners
compared to LLCs with more vulnerable owners.
123. Uniform Act § 104; DEL. CODE ANN. tit. 6, § 18-106 (2016); N.Y. LTD. LIAB. CO. LAW § 201
(1994).
124. In re Seneca Invs. LLC, 970 A.2d 259, 264 (Del. Ch. 2008) (fundamental business change is not
prohibited if operating agreement specifies purposes of any lawful act); Rosan v. Chi. Milwaukee Corp., C.A.
No. 10526, 1990 WL 13482 (Del. Ch. Feb. 6, 1990).
125. Operating agreements were deemed to narrow the LLC’s business purpose if they explicitly
restricted the LLC’s purpose to pursuing specified activities or else specified the LLC’s purpose as a derivate of
“any legal act” but conditioned management’s decision to pursue new activities on a vote by the owners.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 543
6. Required Distributions
Requiring regular distributions constrains managers’ opportunism by restricting the
pool of money that managers have at their discretion. Without a distribution requirement,
managers may self-interestedly accumulate cash even if that cash could be put to better
use by owners. This cash hoarding has allowed managers to inefficiently engage in
empire building, minimize insolvency risk during an unexpected business downturn, or
take other actions that benefit themselves at owners’ expense. This problem afflicts all
types of organizations, from Apple to nonprofit firms.
126
A distribution requirement acts
as a disciplinary device that deters management opportunism by requiring that excess
funds be either distributed or else retained only after justification to owners.
127
Distribution requirements can be draconian disciplinary devices, however. If the
requirement is specified as a minimum dollar amount per period, coming up with the cash
requires selling illiquid assets at a discount or otherwise could destroy firm value.
Weaker distribution requirements that disburse excess cash lose some of the deterrence,
as determining what constitutes excess cash necessarily requires some manager discretion
and makes it difficult for the firm to finance large projects that require asset
accumulation. Consequently, good business reasons may exist for owners who trust
managers to dispense with a distribution requirement entirely.
I examined operating agreements for distribution requirements. Delaware’s and New
York’s LLC statutes provide no requirement for firms to make distributions prior to
dissolution, leaving it to the parties to affirmatively adopt such a rule if desired.
128
Table
126. Henry Hansmann, Why Do Universities Have Endowments?, 19 J. LEGAL STUD. 3, 35–36 (1990);
Tim Worstall, Apple Puts Carl Icahn’s $150 Billion Buyback Proposal to Shareholders, FORBES (Dec. 28,
2013), http://www.forbes.com/sites/timworstall/2013/12/28/apple-puts-carl-icahns-150-billion-buyback-
proposal-to-shareholders/.
127. RIBSTEIN, THE RISE OF THE UNCORPORATION, supra note 7, at 209–10.
128. DEL. CODE ANN. tit. 6, § 18-601 (1995); N.Y. LTD. LIAB. CO. LAW § 507 (1994).
52%
n = 120
59%
n = 93
34%
n = 17
58%
n = 29
New York (total sample), n = 50
Table 15
Narrowing the LLC's Business Purpose
Delaware (total sample), n = 233
…less vulnerable, n = 158
…more vulnerable, n = 50
544 The Journal of Corporation Law [Vol. 42:3
16 collects the results of those firms requiring distributions at predetermined intervals.
129
Most, although not all, operating agreements including a distribution requirement adopted
a weaker form, requiring a distribution of some derivative of available cash after taking
out necessary reserves, rather than mandatory distributions of a minimum amount.
130
As
the Table shows, half the Delaware firms required mandatory distributions; the
prevalence was lower among New York LLCs.
7. Limited Life
By default, LLCs have perpetual lifetimes. Absent the firm’s insolvency, an
affirmative decision by the owners to dissolve the organization, or the entry of an order of
judicial dissolution, LLCs continue to exist indefinitely.
131
Perpetual existence provides
the firm a stable capital base useful for financing illiquid assets and firm-specific
investments. These projects, even if they promise positive expected returns, might not be
feasible to undertake if the firm faced imminent deadlines upon which its assets must be
liquidated and distributed.
The downside of perpetual existence, however, is that it locks owners’ capital into
the firm. As we have seen, owners rarely have the right to either transfer or withdraw the
value of their ownership stake, so their investment is largely at the mercy of the firm’s
129. Those LLCs whose operating agreements required distributions but gave management complete
discretion over when, if ever, to make those distributions prior to dissolution were not counted as requiring
distributions.
130. E.g., Amended and Restated Limited Liability Company Agreement of Kahuku Holdings, LLC
(Apr. 7, 2011), § 4.4 (requiring annual distributions of net cash). This finding mirrors that found by Manesh,
supra note 36, at 579–80. Most of the operating agreements requiring minimum defined distributions specified
that distributions must be at least sufficient to cover owners’ imputed tax liability on the LLC’s earnings at a
predetermined marginal tax rate, although some provided for pre-specified dollar distributions. E.g., Schedule II
to Amended and Restated Limited Liability Agreement of Saladworks, LLC (Mar. 9, 2008), § 2.3 (tax
distributions); Plan of Conversion and Operating Agreement of Shorenstein Hays-Nederlander Theatres LLC
(Nov. 6, 2000), § 6.1 (mandatory $8,333.33 per month distribution per member).
131. Uniform Act § 104(c); DEL. CODE ANN. tit. 6, § 18-801(a)(1) (2016); N.Y. LTD. LIAB. CO. LAW §
701(a)(1) (1999).
58%
n = 136
61%
n = 97
50%
n = 25
42%
n = 21
New York (total sample), n = 50
Table 16
Required Distributions
Delaware (total sample), n = 233
…less vulnerable, n = 158
…more vulnerable, n = 50
2017] How Do LLC Owners Contract Around Default Statutory Protections? 545
management. As with the situations discussed above, this state provides a breeding
ground for potential opportunism.
Providing for a limited LLC duration can reduce this potential for opportunism.
Once the firm has a finite lifespan, managers are no longer perpetual stewards of the
capital pool. Instead, they must periodically go to the well of owners’ pocketbooks to
raise money for new projects. Since there are few worse signals that a management team
could send to future investors than a track record of prior unhappy owners, these forced
repeat interactions with the capital markets deter management opportunism.
132
I analyzed operating agreements for limitations on perpetual existence. As Table 17
and Figure 18 show, 17% of Delaware and 20% of New York LLCs had a finite
existence, with the limitation most likely to be found among Delaware LLCs with less
vulnerable minority owners. No firms limited their existence to the completion of a
specific project; instead, all LLCs that chose to restrict their lifetimes did so by
specifying a predetermined number of years, ranging from as few as 3 years to as many
as 99.
132. E.g., RIBSTEIN, THE RISE OF THE UNCORPORATION, supra note 7, at 212.
17%
n = 39
22%
n = 35
6%
n = 3
20%
n = 10
New York (total sample), n = 50
Table 17
Limited Lifetime
Delaware (total sample), n = 233
…less vulnerable, n = 158
…more vulnerable, n = 50
546 The Journal of Corporation Law [Vol. 42:3
8. Ownership Stakes Held by Management
The final technique of aligning owners’ and managers’ interests I examined was to
determine the percentage of ownership shares that were held by the firm’s managers.
Although in theory managers run the firm to maximize the welfare of its owners,
133
the
agency cost examples discussed throughout this Article have shown this is rarely the
case. When managers are not the sole residual claimants, they gain the entire benefit that
decreased profitability through increasing manager perquisites provides, while sharing
with others the cost of decreased profitability. The larger a stake that managers have in
the firm’s success, the greater share of the costs they bear and the less likely it is that
managers will put their personal interests over the firm’s.
Of course, it is not always feasible to pay managers of the firm with a sizable
ownership stake. Managers may not be keen on taking the undiversified position that a
sizable ownership position brings.
134
Moreover, firms often find that the readiest and
cheapest access to capital comes from combining several different owners who may not
133. HENRY HANSMANN, THE OWNERSHIP OF ENTERPRISE 20–22 (1996); Peter Molk, The Puzzling Lack
of Cooperatives, 88 TUL. L. REV. 899, 905–10 (2014); Peter Molk, The Ownership of Health Insurers, 2016 U.
ILL. L. REV. 873, 887 (examining how the identity of a firm’s owners affects operations in the specific context
of health insurance).
134. The lack of diversification from having both the manager’s job and investment tied to the success of
the same firm implies an increase in the compensation necessary to attract managers or inefficient attempts by
management to reduce the firm’s riskiness. See RIBSTEIN, THE RISE OF THE UNCORPORATION, supra note 7, at
209 (discussing this problem).
0%
20%
40%
60%
80%
100%
0 25 50 75 100 125
Cumulative Percent of Operating
Agreements
Lifetime (Years)
Figure 18
LLC Term
Per
Delaware
New York
2017] How Do LLC Owners Contract Around Default Statutory Protections? 547
be qualified for or have no desire to manage the firm. As the percent of equity held by
these non-managing owners grows, the percent of profits paid to managers decreases. At
the extreme case, in large publicly traded firms, managers have diminishingly small
ownership stakes, routinely under a fraction of 1%.
135
The 1% stake of diminished
profitability would hardly deter these managers from capturing perquisites.
Publicly traded corporations nevertheless succeed with a diffuse and diversified
ownership base because of the increased scrutiny that analysts and the financial limelight
bring to these firms’ management. The exchanges on which these firms’ stock is traded
also impose various owner protections.
136
Finally, since most publicly traded firms are
corporations, they come with the mandatory rules of corporate law that are aimed at
protecting owners. Privately held LLCs might feature none of these protections. Even
large privately held firms may not be regular fixtures of the financial press; because these
firms are not subject to SEC disclosure requirements, it is harder to figure out what
managers are doing and, therefore, for the news media to hold them accountable.
137
Furthermore, these firms do not trade on public exchanges and so need not comply with
those exchanges’ owner protection rules. Finally, as LLCs, these firms are allowed to—
and, as we have seen, often do—waive the mandatory owner protections of corporate
law. We might therefore expect LLC managers to hold comparatively large ownership
stakes to deter the management opportunism that might otherwise result.
I analyzed the operating agreements and other available documents to determine the
size of ownership stakes held by management. Interests were attributed to managers if the
manager was an individual and held an ownership stake, if the manager was a firm but
that same firm held an ownership stake, or if the manager was an individual and that
individual, although holding no ownership stake in her individual capacity, signed the
operating agreement on behalf of a firm holding an ownership stake (for instance, if an
individual formed a separate firm within which to own a stake of the LLC). With this
method, the ownership percentage could be calculated for 91% of the LLCs. Figure 19
presents the results. As can be seen, most LLCs had management holding sizable
ownership stakes. Two–thirds of Delaware LLCs and one-half of New York LLCs had
management holding at least two-thirds of the ownership interests ownership stakes; 45%
of Delaware LLCs and 35% of New York LLCs had managers cumulatively owning the
entire LLC.
138
Only three LLCs had management with no ownership interest.
135. Although management of publicly traded corporations are often compensated with some form of
incentive based compensation, this compensation generally insulates management from downside risk so that
agency costs are deterred only if the firm would otherwise have made a profit. See id. at 218.
136. See supra note 45 and accompanying text (noting the NYSE requires companies to comply with
investor safeguards).
137. Moreover, because these firms are privately held, their number of owners is necessarily restricted so
that financial investigation of these firms would not interest the general investing public in the same way that
stories about a widely held company would. 15 U.S.C. § 78l(g)(1) (2015) (requiring registration for firms with
2000 equity shareholders of record or 500 non-accredited investors).
138. Note that, because of sampling issues, the cumulative percentages may be somewhat inflated.
Management’s ownership share could not be calculated for 18 of the 219 LLCs, but it was obtainable for every
one of the LLCs that had 100% management ownership, so the sample was biased toward higher total
ownership numbers.
548 The Journal of Corporation Law [Vol. 42:3
Of course, while the collective size of the ownership stake held by management is
important, the stake held by each manager also influences the incentive to engage in self-
interested behavior. A single manager owning 90% of the firm would be expected to have
lower agency costs than nine managers who each own 10% stake, even if the aggregate
90% stake is the same. To capture this component, Figure 20 presents the average
ownership share per manager. When considered on a per-manager basis, the holdings are
markedly lower. Half of the Delaware LLCs have management with less than 33%
ownership stake per manager; under 10% have management owning more than 50% per
manager. New York LLCs followed a similar distribution.
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
Cumulative Percent of Operating
Agreements
Management's Share of Residual Earnings
Figure 19
Total Ownership Stake Held by Management
Delaware
New York
2017] How Do LLC Owners Contract Around Default Statutory Protections? 549
C. Summary
We can see that LLCs routinely take advantage of LLC statutes’ flexibility to adopt
and waive protections that are mandatory for other business organizations. Moreover, on
a sample-wide comparison, the two types of Delaware LLCs, as well as the Delaware and
New York LLCs, adopt roughly similar protections, as summarized in Table 21. While
the samples from the two states show different patterns for particular terms, the overall
picture is one of substantial modification to traditional corporate protections and suggests
that Delaware-formed LLCs are not outliers in their tendency to modify default operating
agreement provisions.
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
Cumulative Percent of Operating
Agreements
Management's Share of Residual Earnings
Figure 20
Average Ownership Stake Held Per Manager
Delaware
New York
550 The Journal of Corporation Law [Vol. 42:3
Modification
DE (Total
Sample)
Delaware vs. New York (Total
Samples)
Authorizing
Competition
40% No statistical difference
Business Opp.
Waiver
40% No statistical difference
Duty of Loyalty
Modification
64%
b
No statistical difference
Duty of Good Faith
Modification
18% No statistical difference
Duty of Care
Modification
45% No statistical difference
Drag-Along Rights
24%
c
Delaware significantly higher***
Judicial Diss.
Waived
12% No statistical difference
Average Share to
Amend
85% New York significantly higher**
Transfer
Restriction
75% New York significantly higher**
Withdrawal Right
9%
y
No statistical difference
Tag-Along Right
27%
c
Delaware significantly higher***
Limited LLC
Purpose
52%
c
No statistical difference
Required
Distributions
58% Delaware significantly higher**
Defined Lifetime
17%
c
No statistical difference
Avg. Management
Stake
74% No statistical difference
Avg. Stake Per
Manager
36% No statistical difference
Table 21
Modification by Firm Type
a
signifies more vulnerable lower, p-value less than 0.10;
b
0.05;
c
0.01.
x
signifies more vulnerable higher, p-values less than 0.10;
y
0.05;
z
0.01.
* signifies p-value less than 0.10; ** 0.05; *** 0.01.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 551
The descriptive results, while useful in understanding LLCs’ propensity to waive
traditional owner protections, do not answer whether this behavior is occurring in socially
efficient ways. If, for example, LLCs’ contractual flexibility to weaken protections for
less sophisticated minority owners without adopting countervailing measures, LLC
statutes’ flexibility could be highly troubling. Part VI takes up this issue.
VI. WHAT MOTIVATES CONTRACTING AROUND DEFAULTS?
Part V revealed that LLC operating agreements weaken owner protections in a
variety of ways, but they also adopt assorted substitute owner protections. One specific
prediction from the contractarian approach is that among sophisticated parties with
relatively equal bargaining power, reducing and adding protections would have an
inverse relationship: the more standard protections that are cut back, the more additional
protections owners would demand to mitigate the risk of opportunism by managers or
other owners.
On the other hand, if minority owners lack bargaining power or sophistication, we
might expect little relationship between cutting back and adding to owner protections, at
least for those organizations with these weak minority owners. In a worst case scenario,
we might even see a positive relationship: firms with comparatively more elimination of
standard protections may also have comparatively fewer substitute safeguards in an
attempt to maximize the potential for later opportunism by managers or majority owners.
Finally, operating agreements might reflect minimal strategic drafting of any sort.
Instead, operating agreements might reflect an effectively random assignment of
protections and waivers. For example, perhaps operating agreements are determined by
whatever form the drafting attorneys habitually use, with little or no negotiation among
the owners and managers for specific protections.
139
In that case, we would expect to see
no relationship between waivers and additional protections on a sample-wide basis with
no meaningful difference for the sophisticated and vulnerable minority subsamples.
I used the Delaware operating agreement data to determine both the existence of any
relationship between reducing and strengthening owner protections as well as whether
this relationship varies with the presence of vulnerable minority owners. The next two
Sections analyze this issue.
A. Testing for Efficiency
I started by constructing an owner protection index to capture the strength of
affirmatively adopted owner protections in the operating agreements. Although many
owner protections apply by default to LLCs, five particular protections do not apply by
default but were affirmatively adopted at a meaningful rate. These were the right to
withdraw one’s ownership stake from the LLC, a business purpose restriction, required
distributions, a limited lifetime, and transfer restrictions through either tag-along rights or
requirement that minority owners consent to a transfer. Formally, the index equals the
sum of the following:
139. Miller, supra note 29, at 321–23.
552 The Journal of Corporation Law [Vol. 42:3
𝐼𝑛𝑑𝑒𝑥 = 𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙 + 𝑃𝑢𝑟𝑝𝑜𝑠𝑒 𝐿𝑖𝑚𝑖𝑡𝑎𝑡𝑖𝑜𝑛 + 𝑅𝑒𝑞
′
𝑑 𝐷𝑖𝑠𝑡 + 𝐹𝑖𝑛𝑖𝑡𝑒 𝐿𝑖𝑓𝑒 +
𝑀𝑎𝑥(𝑇𝑟𝑎𝑛𝑠, 𝑇𝑎𝑔)
Higher values of the index correspond to operating agreements that adopted more
minority owner protections.
I then ran Poisson regressions to determine the relationship between waiving or
reducing default owner protections and affirmatively adding owner protections. With the
owner protection index as the dependent variable, I included as explanatory variables the
indicator variables for affirmative weakening default owner protections (authorizing
competition, waiving the corporate opportunity doctrine, modifying fiduciary duties,
drag-along rights, and waiving the right to seek judicial dissolution), the number of
members, the total ownership stake held by management, the ownership share per
manager, and the presence of vulnerable minority owners as dependent variables. The
model was estimated separately for the entire pooled sample and for the subsets that did
and did not have vulnerable minority shareholders.
Table 22 contains the results. As the Table shows, when looking at the pooled
sample, most of the explanatory variables are not significantly associated with any
meaningful impact on those owner protections constituting the index. Several of the
explanatory variables even have impacts in an unexpected direction. When looking at the
aggregate sample, therefore, there is very little evidence that supports the efficiency
bargaining envisioned by LLC contractarian enthusiasts.
2017] How Do LLC Owners Contract Around Default Statutory Protections? 553
Little changes when we consider the subsamples with vulnerable minority owners
and with exclusively less vulnerable owners. Again, many of the estimates are either
insignificant, or significant in the opposite direction expected by the efficiency
bargaining theory. Moreover, the most statistically significant findings emerge with the
subsample of LLCs with more vulnerable owners, rather than the portion with
Table 22: Relationship Between Protections and Waivers
-0.115* -0.181*** -0.132 -0.128 -0.187*** -2.069*** -2.471***
(0.07) (0.07) (0.10) (0.10) (0.06) (0.34) (0.52)
0.073 0.120 0.054 0.070 0.114 2.914*** 3.262***
(0.05) (0.08) (0.13) (0.11) (0.09) (0.62) (0.56)
0.168*** 0.185*** 0.087 0.035 0.024 -0.734*** -0.911***
(0.06) (0.05) (0.07) (0.07) (0.07) (0.23) (0.23)
0.009 0.010 -0.026 -0.109 -0.132 -1.085** -1.072***
(0.10) (0.12) (0.12) (0.08) (0.09) (0.48) (0.24)
-0.166* -0.164 -0.088 -0.092 -0.071 0.456*** 0.577*
(0.09) (0.10) (0.09) (0.10) (0.09) (0.18) (0.32)
0.219* 0.229* 0.176 0.186* 0.196* 1.526*** 1.459***
(0.12) (0.12) (0.11) (0.10) (0.10) (0.34) (0.34)
0.167** 0.116 0.085 0.164* 0.091 -0.445** -0.768***
(0.07) (0.07) (0.09) (0.09) (0.06) (0.22) (0.28)
0.355** 0.352** 0.380*** 0.232 0.144 2.310*** 2.856***
(0.14) (0.17) (0.14) (0.17) (0.15) (0.51) (0.96)
-0.052 -0.074* -0.069* -0.071 -0.097** -0.207*** -0.313***
(0.03) (0.04) (0.04) (0.05) (0.05) (0.06) (0.08)
0.166 0.130 0.223* 0.004
(0.13) (0.09) (0.12) (0.46)
-0.056 0.061 0.073 0.163
(0.11) (0.15) (0.14) (0.92)
-0.322***
(0.09)
0.883*** 0.803*** 0.546** 1.429*** 1.322*** -5.351*** -5.599***
(0.22) (0.28) (0.26) (0.17) (0.27) (1.17) (0.80)
N 231 211 194 158 145 50 49
More Vulnerable Members
Ownership Share Per Manager
Ownership Share Held by
Management
* signifies p-value less than 0.10; ** 0.05; *** 0.01. Estimated coefficients measure the impact on log-counts. All regressions include year and industry fixed effects.
Robust standard errors in parentheses and are clustered at the NAICS industry code level to correct for autocorrelation by industry.
Pooled Sample
Less Vulnerable Only
More Vulnerable Only
Drag Along Right Included
Competition Allowed
Business Opportunity Doctrine
Waived
Duty of Loyalty
Waived/Exculpated/Indemnified
Duty of Good Faith
Waived/Exculpated/Indemnified
Duty of Care
Waived/Exculpated/Indemnified
Constant
Members Waive Right to Seek
Judicial Dissolution
Ownership Share Required to
Amend Operating Agreement
Number of Members (Log)
554 The Journal of Corporation Law [Vol. 42:3
exclusively less vulnerable, more sophisticated members. This result is particularly
surprising because the bargaining theory predicts the strongest relationships to emerge
when examining LLCs with less vulnerable, more sophisticated owners, as sophisticated
owners are the ones more likely to extract protections through aggressive bargaining and
representation.
140
The almost complete lack of that evidence in the subsample of less
vulnerable, sophisticated owners suggests that seeking more efficient arrangements is not
the primary motivating factor behind drafting operating agreement terms. Instead, the
apparent randomness of LLC terms indicates that in large part, the initial forms supplied
by lawyers rather than bargaining for efficient protections could be what explains the
protections included in operating agreements.
141
However, returning to the aggregate sample, Table 22 shows that LLCs with more
vulnerable owners affirmatively adopt significantly fewer owner protections than those
LLCs with less vulnerable owners, irrespective of whether other traditional corporate
protections are modified. Indeed, this result is one of the strongest statistical findings
from the study. In one sense, this result may not be surprising. When minority owners
have less money at stake and are therefore less likely to be represented by sophisticated
legal counsel or be able to represent themselves, we would expect that they would extract
weaker legal protections. But the data show little evidence of the bargaining for efficient
terms envisioned by contractual freedom enthusiasts. It appears that less vulnerable, more
sophisticated LLC minorities bargain for relatively more protection, but the additional
protection they seek does not vary systematically by the aggressiveness of waiving or
modifying traditional corporate protections. In this way, there is evidence of limited
bargaining among the parties to LLC operating agreements, but not in the way envisioned
by contractarians.
While there is limited evidence of bargaining, combining Tables 21 and 22 shows
worrisome results for more vulnerable LLC owners. Vulnerable parties give up most
traditional protections at the same rate as less vulnerable parties, but they extract
significantly lower affirmative protection. While it is true that LLCs with less vulnerable
owners more often include minority-unfriendly duty of loyalty modifications and drag-
along rights, this factor is not a compelling explanation for their adoption of significantly
more minority protections, as neither term corresponds on its own to an increase in
protections for any of the samples.
Vulnerable minority owners are already more likely to suffer opportunism even if
they have the same legal rights as other owners. Their small ownership stake implies less
attention to the LLC’s affairs and more leeway for unnoticed opportunism by managers
and majority owners.
142
The results show that LLCs exacerbate vulnerable minority
owners’ position by adopting weaker legal protections for them, widening the space for
potential opportunism. Although operating agreements cannot show whether LLCs
actually take advantage of vulnerable owners’ position, the groundwork for this
opportunism has been laid.
140. See e.g., RIBSTEIN, THE RISE OF THE UNCORPORATION, supra note 7, at 194–222 (describing the
traditional corporate protections and substitute safeguards over which LLC owners would bargain).
141. For an example of this argument, see Miller, supra note 29.
142. E.g., EASTERBROOK & FISCHEL, supra note 23, at 25, 231 (noting the similar plight of minority
owners in publicly traded corporations).
2017] How Do LLC Owners Contract Around Default Statutory Protections? 555
B. Other Explanations
In addition to the interpretation discussed above, complementary or competing
explanations could also be consistent with the findings. Foremost among them is the
possibility of omitted variables, in which case the included variables could paint a
misleading picture. Although I coded the important terms that appeared with any degree
of frequency, some terms defy coding and by necessity could not be included, which is a
necessary limitation of the study. However, the fact that all key contractual terms
identified by LLC contractarians (plus additional terms) were included in the study
without finding strong evidence of efficiency bargaining suggests that, in practice, LLCs
are failing to attain the ideal heights envisioned by default rule supporters.
Nevertheless, it is worthwhile to consider how omitted variables might factor into
the pictures. Non-contractual dynamics can provide significant owner protections yet
would not appear in the LLC operating agreement. Consider, for instance, the value of
reputation. Regardless of contractual terms, managers may wish to cultivate a reputation
for success and fair dealing that could facilitate their moving to higher prestige and
higher paying positions.
143
For example, several LLCs in my sample featured repeat
relationships among owners who had successfully backed the same manager repeatedly
over time. Owners may benefit from developing a reputation for honesty that could
reduce their cost of raising capital for future projects. When developing a good reputation
is costly, managers and majority owners may refrain from opportunism even when they
are contractually permitted to do so. Owners may consequently buy into LLCs headed by
owners and managers with good reputations regardless of terms in the operating
agreement. In that case, because this value of reputation cannot be captured in the
regression models, the estimates would be skewed towards insignificance, with the
degree of skew depending on the proportion of the sample for which reputation is
important. Note this explanation implies that weakening and strengthening owner
protections has a less meaningful inverse relationship only for those LLCs where
reputation is a key substitute protection; for those LLCs lacking a good reputation
protection mechanism, contractual terms would maintain their importance.
Similarly, social relationships could provide a deterrent against opportunism.
Owners who all belong to the same family, for example, might confidently assume that
the manager will be unlikely to expropriate earnings at their expense when she must sit
next to them at the annual Thanksgiving dinner.
144
And the manager of a local LLC might
be less inclined to expropriate gains from owners belonging to the same community—
unlike the faceless owners of more widely dispersed ownership, it can be far more
difficult to profit at another’s expense when you know who that other is.
145
When social
norms depress opportunistic tendencies, parties may be willing to join an operating
agreement even if contractual terms provide little minority owner protection.
Again, as with the value of reputation, the impact of social norms is not captured in
my models and would dampen the significance of the model’s estimates. Just as with
143. For recent work on the interaction between reputation and corporate behavior, see generally Roy
Shapira, A Reputational Theory of Corporate Law, 26 STAN. L. & POL’Y REV. 1 (2015).
144. For evidence of some of the power of social norms, see ROBERT C. ELLICKSON, ORDER WITHOUT
LAW: HOW NEIGHBORS SETTLE DISPUTES 123–264 (Harvard University Press 1994).
145. Id.; Amitai Aviram, A Paradox of Spontaneous Formation: The Evolution of Private Legal Systems,
22 YALE L. & POL’Y REV. 1, 63–67 (2004) (discussing the frameworks necessary for norm enforcement).
556 The Journal of Corporation Law [Vol. 42:3
reputation, however, the impact of social norms implies only that the
weakening/strengthening tradeoff matters less for some LLCs, not that it is nonexistent.
Finally, I reiterate that this model tests only one prediction from the contractarian
economic efficiency model: that as traditional protections are cut back or eliminated,
parties will bargain for more optimal substitute contractual safeguards. It could be that
some terms are so objectionable to all parties, even minority owners, that reducing or
eliminating them makes all parties better off even without adopting substitute protections.
Because the test in this Part assumes that parties bargain for substitute contractual
safeguards, it will underestimate the degree of efficiency bargaining to the extent of this
situation. Moreover, efficiency bargaining need not occur exclusively along the
dimension of contractual terms. Some parties could instead bargain for a mixture of
contractual protections and price. For example, minority owners might respond to
reductions in contractual protections not by seeking additional contractual protection
elsewhere, but instead by reducing the price they will pay for their ownership interest.
Testing this response would require comparing the prices that owners paid for interests in
similar LLCs with varying contractual provisions. Because data limitations make such a
comparison impossible, it again means the test in this Part may underestimate the degree
of efficiency bargaining that occurs.
Unless these alternative explanations disproportionately affect LLCs with more
vulnerable minority owners, the troubling finding persists that as a whole, LLCs with
vulnerable minority owners adopt fewer contractual safeguards. While this does not
conclusively mean that no efficiency bargaining takes place, the results suggest a stronger
need to ensure less sophisticated owners are adequately protected when default rules
prove insufficient. I take up this issue next.
C. Protecting Vulnerable Owners
The results suggest that modifying default LLC owner protections may more often
be done with an eye to potential opportunism rather than for efficiency reasons. If
relatively few LLCs are engaging in nuanced bargaining in pursuit of efficiency, then the
costs of importing mandatory owner protections to LLCs decrease, and the benefits from
protecting parties who apparently do not protect themselves increase, making a stronger
case for proposals that restrict contractual freedom. Layered on top of this is the finding
that LLCs with vulnerable minority owners—already most at risk for manager and
majority owner opportunism—adopt fewer owner safeguards, again buttressing the case
for increasing owner protections. On the other hand, undoubtedly some sophisticated
parties are bargaining for efficient operating agreements, and the only way this bargain
can be accomplished is through a system of default, but not mandatory, protections.
There is thus a tension between protecting more vulnerable owners and allowing
sophisticated parties the contractual space to achieve efficient governance agreements.
Unfortunately, therefore, there is no clear answer for how owner protections should be
increased without unduly burdening sophisticated owners. While some experts have
recommended imposing mandatory owner protections akin to those found for
corporations,
146
this Article raises caution against such a significant step. Sophisticated
parties are modifying all traditional corporate protections that are merely defaults for
146. See, e.g., supra notes 8–9 (discussing LLCs’ contractual freedom).
2017] How Do LLC Owners Contract Around Default Statutory Protections? 557
LLCs. Switching default protections to mandatory ones could not only have significant
disruptive effects for these already-extant LLCs, but also impact the terms contained in
new operating agreements in unexpected ways—perhaps by promoting additional
undermining of other non-mandatory protections or suppressing the affirmative adoption
of owner protections, any of which would reduce the potential efficiency of LLC
governance.
147
The extent of efficiency loss from imposing mandatory rules ultimately
depends on how many LLCs actually bargain to modify those terms in their operating
agreement. The above analysis suggests that comparatively few LLCs may actually do
so; instead, the particular terms included in operating agreements may be better explained
by the terms their lawyers happen to use in their form operating agreement documents or
for some other reason. Nevertheless, telling those comparatively few LLCs that do
carefully bargain for governance terms that they cannot operate as intended undoubtedly
increases their cost of doing business.
Requiring mandatory owner protections for LLCs is of course not the only way to
protect minority owners. Relying on judicial oversight to prevent actual cases of
opportunism, which may be the current trend in Delaware,
148
has the benefit of permitting
contractual freedom while deterring undesirable behavior when it actually occurs, rather
than the overinclusive solution that seeks to prevent the necessary, but not sufficient,
conditions for expropriation created by waivers and modifications. This approach too has
its drawbacks, namely that the judiciary may provide an imperfect screen for behavior
that constitutes expropriation. Above all, it is apparent that there is no easy way to uphold
contractual freedom while protecting vulnerable owners.
VII. CONCLUSION
This Article has shown the ways that LLCs use LLC statutes’ contracting flexibility
to allocate rights in ways impossible to replicate with other organizational forms. LLCs
regularly jettison rights that are mandatory for other business entities and employ a
number of alternative measures that align manager and owner interests. However, for
both LLCs as a whole and for LLCs with less vulnerable, more sophisticated owners,
there is little relation between detracting from and adding to owner protections, implying
a lack of systematic bargaining for efficient contractual terms. On the contrary, I find
significantly fewer owner protections for those LLCs with weaker, more vulnerable
minority owners, which suggests that when LLCs modify default owner protections, it
may on average be more with an eye to potential undesirable opportunism, rather than in
pursuit of economic efficiency.
147. See Verity Winship, Shareholder Litigation by Contract, 96 B.U. L. REV. 485, 528 (2016)
(discussing recent corporate efforts to limit shareholder litigation rights through terms in corporate charters and
bylaws).
148. See Mohsen Manesh, Equity in LLC Law?, 44 FLA. ST. U. L. REV. (forthcoming 2017) (discussing
courts’ willingness to override LLC contractual terms in the name of equity).
