Limited liability companies (‘LLCs’) now outnumber corporations and continue to grow at a rapid rate. The form is remarkably flexible, attracting firms ranging from small local businesses to bastions of the modern economy. States impose few requirements on how LLCs are governed, instead leaving owners and managers the option to contract around a series of terms that apply by default. This contractual freedom has the prospect of more efficient governance than can be obtained by corporate one-size-fits-all mandatory rules, but it comes at the cost of potential opportunism if owners mistakenly or irrationally waive valuable rights that apply only by default. Despite recent arguments supporting both sides of this position, little is known about how LLCs actually craft their governing documents.
In my recent paper, available here, I assemble and analyse 283 operating agreements for private LLCs organised in Delaware and New York, two leading states that follow the contractual freedom approach and require almost no mandatory protections, to determine whether and how parties alter default governance rights and responsibilities. The operating agreements were obtained from exhibits attached to private litigation, providing an opportunity to learn how non-public companies respond in an environment of contractual permissiveness. My analysis reveals several findings of note.
First, LLCs actively modify default protections by eliminating standard protections that apply by default or, more rarely, by adopting affirmative owner safeguards that are neither mandatory nor default terms. Many of these modifications cannot be achieved by corporations or other organisational forms. For example, 40% of both Delaware and New York LLCs jettison the corporate opportunity doctrine, while violations of the fiduciary duties of care, loyalty, and good faith are modified by 60%, 20%, and 50% of LLCs, respectively. Contractual flexibility appears to be a key component driving LLC governing documents. By and large, LLCs do not remain passively subject to the set of default protections.
Knowing that LLCs regularly alter owner protections, we might next wonder whether there is any predictability for how they do so. In particular, do parties adopt stronger affirmative protections when traditional safeguards are whittled away, as efficient bargaining might predict? Analysing the operating agreements reveals the answer to this question as ‘no’. The strength of contractual protections appears wholly unrelated to weakening default protections, even after controlling for time, industry, and expected sophistication of owners (using investment amount as a proxy). However, LLCs with significant stakes held by more vulnerable owners –determined by low investment amounts that signify a lower chance of their seeking robust legal representation, or having the requisite expertise themselves – adopt significantly fewer contractual safeguards. This story is more consistent with policy advocates who recommend mandatory protections.
Before initiating reform and requiring mandatory safeguards, however, we must recognise two remaining issues. First, although the paper finds that operating agreements set the contractual groundwork for potential opportunism by managers or majority owners, we cannot conclude how often this opportunism actually occurs, assess the costs of this opportunism, or know how much of this opportunism could be prevented by mandatory protections. In other words, it is difficult to assess the benefits of legal intervention from current information. Second, while I find little evidence of efficient bargaining for contract terms, this bargaining could play out in other, unobservable ways, such as by adjusting the company’s valuation to account for the strength of owner protections, or extracting non-contractual concessions from managers or majority owners. If these actions exist on a significant level, there could be real costs from constraining LLCs’ distinguishing feature of contractual flexibility. Further research into this issue, and an understanding of the concomitant costs and benefits of reform, will determine when and how intervention is required.
Peter Molk is an Assistant Professor of Law at Willamette University.