NY's Top Court Hears Argument on LLC Promoter Liability
On November 15, 2011, the spectacular Albany courtroom pictured at left was the setting for oral argument before the New York Court of Appeals in Roni LLC v. Arfa, No. 228, in which the court is poised to decide whether pre-formation limited liability company "promoters" have a fiduciary duty of disclosure to potential investors. The outcome could have a significant impact on investment structure and investor solicitation, especially in the real estate industry where the LLC, for tax and other reasons, is the preferred form of business organization.
The case involves claims by a group of Israeli real estate investors who purchased membership interests in a series of LLCs formed to acquire, renovate, manage and eventually re-sell multi-family residential properties in New York City. The complaint's gravamen is that the defendants, who identified the properties, solicited investors, organized the LLCs, negotiated the acquisitions and obtained mortgage financing, concealed from the plaintiffs certain "brokerage" fees of up to 15% that the defendants were to receive from the property sellers and mortgage brokers, eventually exceeding $6.5 million. The plaintiffs alleged that the defendants as "promoters" of the to-be-formed LLCs had a fiduciary duty to disclose the brokerage arrangement to the plaintiffs as prospective investors, and that the fees inflated the purchase prices paid for the properties to plaintiffs' financial detriment.
The trial court denied defendants' motion to dismiss the complaint. In a June 2010 decision which I reported on here, the intermediate appellate court held that the complaint's allegations did not state a traditional claim for breach of fiduciary duty based on a business or personal relationship of trust and confidence, superior expertise and knowledge. The court nonetheless upheld the denial of the defendants' dismissal motion based on the defendants' "status as the organizers of the business venture", explaining as follows:
[P]laintiffs' allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them are sufficient to establish a fiduciary relationship. It is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders. By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members. The fiduciary duty includes the obligation to disclose fully any interests of the promoter that might affect the company and its members, including profits that the promoter makes from organizing the company. Accordingly, plaintiffs stated a cause of action for breach of fiduciary duty by alleging that the promoter defendants failed to reveal that they would receive commissions from sellers and mortgage brokers in addition to their other, disclosed, profit from the venture. [Citations omitted.]
The Briefs
In September 2010, the intermediate appellate court granted the defendants' motion for leave to appeal to the state's highest court, the New York Court of Appeals.
The defendants' brief filed in the Court of Appeals (read here) argues:
- the 19th century case authorities relied on by the lower court, involving promoters of corporations, did not establish a per se rule that promoters were fiduciaries as a matter of law;
- those authorities require a relationship of trust and confidence which the lower court expressly found lacking in Roni; and
- even if the old authorities did create a status-based rule for corporation promoters, it should not be applied to persons who organize LLCs.
The last point contrasts the discretion and control exercised by corporation organizers in creating the initial governance structures (i.e., articles of incorporation and bylaws) and deciding how to use investor money, with the contract-based LLC form in which governance and capital structures are set forth in written, fully integrated operating agreements executed by the investors.
The plaintiffs' opposing brief (read here) argues:
- the defendants' control of the investors' funds and management of the enterprise in the period prior to formation of the LLCs give rise to a fiduciary duty of disclosure of "hidden commissions";
- the common law rules governing corporation promoters as a matter of legal theory and policy should extend to LLC promoters; and
- in the alternative, the intermediate appellate court erred in holding that the complaint failed to allege a fiduciary relationship based on the defendants' special knowledge and real estate expertise coupled with the defendants' solicitation of overseas investors through personal relationships and "cultural affinity".
Professor Larry Ribstein, a leading authority on LLC and partnership law, filed an amicus brief in support of the defendants' position (read here), in which he argues:
- the intermediate appellate court's holding in favor of fiduciary duty of disclosure of organizers of LLCs is unprecedented in the law of LLCs;
- the NY LLC Law's provisions governing organizers and managers do not support a status-based fiduciary obligation for the former; and
- the old corporate promoter cases, even if not made "dead letter" by federal and state securities laws, should not be applied to establish pre-formation duties in LLCs, among other reasons, because unlike corporations, LLCs are "creatures of contract" that do not present "a potential for abuse comparable to that of large business entities seeking capital from hundreds or thousands of small investors."
The Oral Argument
If you click here, you can view a video webcast of the oral argument in Roni held on November 15, 2011. But first, you'll need some navigational aid.
The Court of Appeals combined oral argument in Roni with a second case, Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., No. 227, due to the circumstance that both cases raise issues involving a preemption defense under the anti-fraud provisions of New York's Martin Act governing the sale of publicly offered securities. The entire argument lasts an hour. If you'd like to view the Roni portion of the webcast, click on the first entry on the November 15 calendar and, once the video opens, advance to the 27 minute mark for argument by defendants' counsel immediately followed by plaintiffs' counsel until the 45 minute mark. Defendants' counsel's rebuttal argument picks up at the 58 minute mark and goes just a few minutes to the end of the session. In the summary that follows, numbers in parentheses refer to the minute and second marks in the video.
Four of the six judges who heard the argument (Judge Smith recused himself) questioned the attorneys in Roni, with Chief Judge Lippman being the most active inquisitor. Early in defense counsel's argument (28:20), Judge Lippman set a somewhat skeptical tone with the questions, "What is the fact that it's an LLC have to do with the fiduciary duty issue?" and "Why should LLCs be treated differently?" to which defense counsel answered, LLCs are based on contractual relations established by the parties in the operating agreement and, therefore, at the pre-formation stage there is no point at which one can say the fiduciary relationship begins and ends.
Judge Graffeo queried (29:15) if the intermediate appellate court "went too far" in drawing such a close comparison between the corporate realm and LLCs, with which defense counsel readily agreed, stating that absent allegations of a relationship of trust and confidence, superior skill and knowledge, there can be no fiduciary obligation imposed on a promoter of a corporation or an LLC, and if there's no fiduciary relationship, the promoter has no duty to disclose a pre-formation commission arrangement like the one in Roni.
Judges Graffeo (31:50) and Pigott (32:40) asked several questions focused on the adequacy of the complaint, and whether the plaintiffs in Roni sufficiently alleged for pleading purposes a fiduciary relationship based on the plaintiffs' foreign residence and their dependence on the real estate expertise of the defendants, to which defense counsel replied that, in an interlocutory appeal (as opposed to an appeal from a final judgment), the Court of Appeals lacks jurisdiction to review the intermediate appellate court's ruling that the complaint fails to plead the traditional badges of a fiduciary relationship.
Plaintiffs' counsel was met by questions from Judge Lippman (35:05) as to the basis for the alleged fiduciary relationship and if it matters "whether you're an LLC or not?" Plaintiffs' counsel replied that the business form does not matter ("not at the starting gate yet") and that the "control and domination" exercised by defendants over the pre-formation enterprise imposes fiduciary duties of disclosure.
Judge Ciparick asked (37:20) whether the purchase prices of the real properties were inflated by the secret commissions, to which plaintiffs' counsel answered "Yes, absolutely" and that the plaintiffs consequently suffered a direct, out-of-pocket loss.
Judge Graffeo then asked (39:30) whether an undisclosed commission, standing alone, creates a fiduciary relationship and, if other factors must be pleaded, whether the Court of Appeals has jurisdiction to review the finding below that the complaint did not adequately allege the traditional fiduciary badges. Plaintiffs' counsel responded that a claim based on undisclosed commission is stated where the promoters solicited investors, controlled the funds and controlled the properties, and that the Court of Appeals has jurisdiction to affirm the decision below on an alternative ground.
Judge Pigott next asked (41:50), "Is there any limit to this?" and "Can you bring a case similar to this on almost any set of facts in which someone is dissatisfied with the amount of the return they got?" Plaintiffs' counsel suggested in reply that such cases are limited to ones where the promoter sells the investment, controls the investment funds pre-formation, and where the alleged non-disclosure -- here, the $6.5 million in commissions -- is material to the decision to invest.
Judge Pigott then pressed counsel (43:25) to identify the source of the alleged fiduciary duty in Roni, to which plaintiffs' counsel replied that it stems from the defendant promoters' soliciting the investment, taking the investors' money, controlling the expenditure of the monies, hiring counsel for the enterprise, arranging financing for the acquisitions, and managing the properties, to which Judge Pigott responded (44:00), "That's kind of where I'm looking for the line drawing because if you have a situation where each one of those is a fiduciary obligation, each one could be a cause of action for breach of fiduciary duty."
In his rebuttal argument (58:00), defendants' counsel contended that his clients did not exercise control and domination over the investments, and that they were required to use investor funds in the manner specified in the written promotional materials provided to the plaintiffs. Judge Lippman asked (59:25), "What about the concealment of the 15% fee?" to which defendants' counsel replied that the defendants were not disputing concealment for purposes of the dismissal motion but that, without an independent basis for imposing a fiduciary duty, the concealed fees could not give rise to liability.
Will New York be the first state to adopt a status-based rule holding LLC promoters to a fiduciary standard? If not, will the Court of Appeals nonetheless affirm on the ground that the complaint adequately pleads a fiduciary relationship based on control and domination or, contrariwise, will it dismiss the fiduciary breach claim on the basis it has no jurisdiction to review the intermediate appellate court's conclusion that the complaint does not plead a fiduciary relationship other than based on the defendants' status as promoters?
We'll likely have to wait until the early months of next year for the answer, though that may also depend on how long the Court takes to decide the related appeal in the Assured Guaranty case. Indeed, if the Court in that case and in Roni holds that the Martin Act preempts the plaintiffs' common law claims, the LLC promoter liability issue in Roni likely will be mooted.
Avoiding the Pain of Achaian, or How Not to Draft LLC Membership Transfer Provisions
Under Section 603 of New York's LLC Law, unless the operating agreement says otherwise, membership interests in limited liability companies (LLCs) are freely transferable but the transferee only gets the transferor's economic rights to distributions and allocation of profits and losses. Under Section 604's default rule, the transferee becomes a full-fledged "member" with voting and management rights only upon the consent of a majority in interest of the existing members (other than the transferor). The default rules in Sections 18-702 and 704 of Delaware's LLC Act essentially are the same.
The typical, closely held LLC has relatively few members, most if not all of whom are active in the business. In my experience, the bulk of operating agreements deal with membership interest transfers in one of two ways, either by prohibiting all transfers of any kind except as specifically allowed by the agreement, or by including provisions that track the statutory default rules. The primary aim and practical effect of both versions is to prevent membership interest transfers to outsiders in furtherance of the members' all-important right to choose their own business partners.
But what about insider transfers, that is, from one existing member to another existing member? Does the default rule (and operating agreements that track the default rule) requiring member approval to bestow voting rights on new members apply to an existing member acquiring an incremental interest? For example, in an LLC with three co-equal members A, B and C, if A assigns his entire one-third membership interest to C, does C end up with a two-thirds economic interest and 50% voting interest (B holding the other one-third economic interest and 50% voting interest) or does C end up with two-thirds economic interest and two-thirds voting interest?
The question came to the fore in Achaian, Inc. v. Leemon Family, LLC, C.A. No. 6261-CS (Del Ch Aug. 9, 2011), decided earlier this month by Chancellor Leo Strine of Delaware Chancery Court (HT: Pileggi). In Achaian, involving a three-member LLC, Chancellor Strine construed the operating agreement's transfer provisions, which generally tracked the Delaware statute's default provisions, as allowing one 30% member to transfer both its economic and voting rights to another 20% member without obtaining the third, 50% member's consent, based on the agreement's definition of a member's interest as "the entire ownership interest of the member." The ruling created a 50/50 deadlock between the two remaining members and laid the basis for the court's order granting judicial dissolution of the LLC.
The subject company in Achaian, called Omniglow, LLC, manufactures chemiluminescent novelty items such as glowsticks. Omniglow's operating agreement authorized a member to "transfer all or any portion of its Interest in [Omniglow] to any Person at any time" but also provided that "no Person shall be admitted as a Member of [Omniglow] . . . without the written consent of the Member[s]." The agreement defined "Interest" as "the entire ownership interest of the Member in Omniglow."
The existing 50% member, in his opposition to dissolution, argued that these provisions do not vary the statutory default rule limiting the assignment to economic rights absent member consent, and that the assignee-member did not acquire any voting rights associated with the assigned 30% interest. Chancellor Strine disagreed, writing:
When read as a whole, as it must be, the LLC Agreement provides that all of the rights accompanying the Interest--including voting rights--in Omniglow may be transferred to an already existing Member of Omniglow without the written consent of the other Members. Read in complete context, the LLC Agreement makes Interests in Omniglow freely transferable subject only to a limited proviso that requires the written consent of the existing Members in order for a transfer to confer the status of Member on a Person, who at the time of the transfer was not already a Member. Because Achaian was already a Member at the time of the Purchase Agreement and nothing in the LLC Agreement requires that it be readmitted as a Member with respect to each additional Interest it acquires in Omniglow, it was entitled to receive the "entire ownership interest" owned by Holland [the assignor], including the Interest's corresponding voting rights. [Footnotes omitted.]
Professor Larry Ribstein commenting on Achaian concludes that the decision "reaches the wrong result." In his view, the operating agreement does not vary the default rule primarily because the Delaware statute (Section 18-101[8]) defines "interest" as including only economic rights, therefore the agreement's use of the modifier "entire" in the phrase "entire ownership interest" only modifies economic rights. Since the other pertinent provisions do not address the situation in which an existing member acquires additional voting rights, he reasons, "the statute fills in the gaps by providing that a member can get shares with voting rights only by member consent."
Section 18-101[8] has its analog in Section 102(r) of the New York LLC Law which defines "membership interest" as including economic and voting rights. It's doubtful, however, that the New York statute brings any greater clarity to an Achaian-like situation in view of the explicit language found in LLC Law Section 603[3] providing that "the only effect of an assignment of a membership interest is to entitle the assignee to receive, to the extent assigned, the distributions and allocations of profits and losses to which the assignor would be entitled."
Any shift of voting power among existing members can be just as consequential--and sometimes more consequential--as the addition of a new member. A shift in control from inter-member transfers can occur when no single member has a 51% interest (as in Achaian) or, even if there is a member with 51% voting power, when the operating agreement requires a super-majority vote to approve certain major decisions.
There's no single drafting solution.
Sometimes the parties to the operating agreement collectively will prefer explicit prohibition on transfer of membership interests--both economic rights and voting rights--to any person inside or outside the LLC, absent the unanimous agreement of the other members or otherwise subject to express rights of first refusal that temper any realignment of voting power among the remaining members.
Sometimes the parties will want the right freely to assign economic rights, in which case the operating agreement should address explicitly whether the assignor can or cannot also freely convey voting rights to an insider or an outsider.
And, of course, in the push and pull of negotiations between members with disparate interests, and depending on the specific voting percentages at inception and the presence or absence of super-majority voting requirements, one or another party may desire (or resist) a provision allowing inter-member assignments of membership interests inclusive of voting rights.
In all events, the fact that the top judge on the Delaware Chancery Court and the top expert on LLC law disagree on the outcome in Achaian should serve as a red alert for lawyers drafting operating agreements for any LLC with three or more members, not to overlook prospective scenarios involving transfers of membership interests between existing members.
Larry Ribstein on the Evolution of the Closely Held Firm and Judicial Dissolution Remedies
"The earliest small firms were partnerships, which began as intimate, usually family, relationships. They were referred to as 'compagnia,' which means those sharing bread, reflecting their origins in households. Kinship ties were an important mechanism for controlling agency costs. As Kerim told James Bond in From Russia with Love, 'all of my key employees are my sons. Blood is the best security in this business.'"
So begins Part I of Professor Larry Ribstein's terrific, new research paper entitled Close Corporation Remedies and the Evolution of the Closely Held Firm, in which he traces the development of the private business association from its partnership infancy to its close corporation adolescence to its recent passage into adulthood as the limited liability company (LLC). The paper, prepared for a recent conference at Western New England College School of Law marking the 35th anniversary of the Massachusetts Supreme Court's landmark ruling in Wilkes v. Springside Nursing Home, Inc., traces changes in business form to tax policy and constraints on the availability of limited liability, and then relates those changes to judicial remedies in dissolution cases. The paper concludes that the growing dominance of the LLC form makes it "easier . . . for parties to reach agreements that approximate their ex ante expectations" and allows courts to "fill in the gaps using the contract and statute as general guidelines" rather than, as in Wilkes and other close corporation dissolution cases, applying a "reasonable expectations" dissolution standard that "invites courts to make up contracts for the parties."
Regular readers of this blog may remember my interview last year of the prolific Professor Ribstein on the subject of his new book, The Rise of the Uncorporation. The book and his latest paper share some of the same themes, such as characterizing the close corporation as an "evolutionary dead end" built on a statutory framework that secured the necessary protective shield of limited liability but that otherwise has ill served the partnership characteristics of small firms, particularly when it comes to dispute resolution among co-owners.
In Professor Ribstein's view, the enactment and judicial enforcement of statutory minority shareholder oppression laws, designed to deal with the twin problems of majority shareholder opportunism and minority shareholder lock-in, have mired judges in the difficult and uncertainty-generating task of determining ex post the intentions of parties who failed to memorialize their agreement or who, because of the costs and inherent limitations of contracting, have agreements "that did not fully anticipate the problems that arose on breakup or exit." The oppression remedy, Professor Ribstein writes, "does not quite alleviate the essential indeterminacy inherent in firms that are neither quite corporations nor partnerships," and effectively requires the courts to divine the parties' reasonable expectations based on a host of ambiguities and untethered judicial assumptions. In the famous Wilkes case, where the court invoked the majority shareholders' fiduciary duty as a basis for ordering restoration of a frozen-out minority shareholder's salary, in Professor Ribstein's words "the court spins a contract out of gossamer expectations."
The LLC revolution over the last 30 years has altered dramatically the small firm landscape. The great majority of new entities being formed in the U.S. are LLCs. (Read here my prior post on a recent statistical study of new entity formations.) Professor Ribstein explains that the IRS's classification in 1988 of LLCs as tax partnerships, and its subsequent adoption of the "check-the-box" rule, enabled the separation of tax structure from governance structure and thereby allowed LLCs via private contracting to "evolve into the flexible mix of corporate and partnership features small firms had always wanted instead of having to choose between the intimate general partnership and the unwieldy corporation." In other words, "[c]losely held firms now can choose statutes that accommodate their contracting needs without having to compromise these objectives to get limited liability and favorable tax treatment."
The LLC revolution has not obviated the need for flexible judicial remedies in cases of abuse by controlling members, especially since many states (including New York) have LLC statutes that do not provide a member with a default right to withdraw and get bought out. Professor Ribstein's paper makes the case that courts in LLC dissolution disputes
increasingly have focused on what parties actually put in their contracts, interpreted in light of the statutory standard form they used as a basis for their business agreement. Instead of asking what reasonable parties would want if they could contract cheaply, courts now tend to ask what the specific parties actually wanted given what they contracted for.
Professor Ribstein cites a number of Delaware and New York court decisions as evidence of "the enhanced role of the agreement" under the statutory LLC dissolution standard, including the Appellate Division, Second Department's important decision earlier this year in Matter of 1545 Ocean Avenue, LLC where the court took a contract-oriented approach in denying dissolution based on deadlock (read here my post on the case). Professor Ribstein's paper also argues that, consistent with this new approach, courts should rely more on the implied duty of good faith and fair dealing in fashioning appropriate, non-dissolution remedies for manager misconduct rather than using problematic fiduciary-duty analysis to arrive at a dissolution remedy tantamount to "giv[ing] a weapon to an opportunistic minority shareholder."
In the last section of his paper, entitled "The Future of Closely Held Firms," Professor Ribstein sketches out "challenges and opportunities" for the still-evolving closely held firm. These include:
- resisting enactment of corporation-style dissolution laws for LLCs based on oppressive or fraudulent conduct;
- encouraging and judicially enforcing LLC agreements that provide dissolution opt-outs under specified circumstances, including waiver and buyout;
- increasing the number of available standard LLC forms, e.g., for professional firms, very small general partnership-type firms and startups considering eventually going public;
- better lawyering in advising choice of law and form, and crafting customized agreements; and
- broader use of arbitration and other private dispute resolution mechanisms.
Understanding the roots, development and differences between the several forms of closely held business entities is essential for any lawyer whose practice includes judicial dissolution and related disputes. Professor Ribstein's paper is an excellent place to start.
Delaware Supreme Court Upholds Application of Statute of Frauds to Oral LLC Operating Agreements
Around a year ago I wrote about Delaware Chancery Court's ruling in Olson v. Halvorsen, in which it held that the statute of frauds applies to oral LLC operating agreements. I pointed out that Delaware's LLC law expressly permits oral operating agreements, whereas New York's LLC law defines the operating agreement as a written agreement. To my knowledge, no New York court has yet grappled with the issue.
The Olson ruling was appealed to the Delaware Supreme Court, which yesterday affirmed Chancery Court's ruling (read decision here). In a posting today on his Ideoblog, Professor Ribstein quotes at length from the decision and offers his always-incisive analysis, including his take on how the Olson ruling might play out in a jurisdiction like New York that requires written operating agreements.
It's an important issue for practicing attorneys who help form and give counsel to LLCs, so if you fall into that category -- or even if you don't -- I recommend you read the Professor's post.
Update June 22, 2010: Over at the Unincorporated Business Entities Law blog, Gary Rosin reports that the Delaware legislature has enacted an amendment to the definition of "limited liability company agreement" in § 18-101(7) of the Delaware LLC Act which overrules the Supreme Court's Olson ruling by explicitly stating that "[a] limited liability company agreement is not subject to any statute of frauds." How's that for plain-English drafting?
Interview with Law Professor Larry Ribstein on his New Book, "The Rise of the Uncorporation"
If you've ever studied partnerships or limited liability companines, chances are you know of Professor Larry Ribstein, the Mildred Van Voorhis Jones Chair in Law at the University of Illinois College of Law. In fact, the same can be said for securities law, choice of law, jurisdictional competition, the portrayal of business in film, the law business, and a host of other topics that come under his penetrating analysis. Professor Ribstein is co-author of the leading treatises on LLCs and partnerships along with two business associations casebooks, and he has written or co-authored about 140 articles. His ABA Top-100 blog (Ideoblog.org) addresses legal and economic issues of interest to lawyers and the business world on a daily basis. His books include The Sarbanes-Oxley Debacle and The Constitution and the Corporation (both with Henry Butler), The Law Market (with Erin O'Hara) and The Economics of Federalism (with Kobayashi).
To this vast ouevre Professor Ribstein now adds his latest book published by the Oxford University Press, entitled The Rise of the Uncorporation. The book covers the history, law and finance of unincorporated firms which, since LLC enabling statutes swept the country in the early 1990's, have become the dominant business form for non-publicly traded companies, and are poised to enter the large-firm realm of private equity, hedge funds and publicly traded partnerships (e.g., Chrysler LLC). Professor Ribstein's book identifies competition between the states and among business forms to constrain regulatory excesses as one of many reasons for the growing dominance of the "uncorporation." For anyone interested in this area of law, it is must reading.
I'm fortunate that Professor Ribstein agreed to answer some questions about his book and related topics for this blog. The Q&A follows. Enjoy.
Mahler: Congratulations on your new book, The Rise of the Uncorporation, which you describe in your introduction as "the first general theoretical and practical overview of alternatives to incorporation." Since my practice deals mostly with closely held business firms, my first questions are whether the issues and themes you develop in the book divide into two separate universes, one for the large, publicly owned firm and another for the smaller, owner-managed companies, and whether the problems engendered by the corporate form are greater for one than the other?
Ribstein: The fundamental distinction I make in the book is between corporations and what I call "uncorporations" -- that is, partnerships and other business forms such as the limited liability company that are based on the partnership. So, no, I do not think that publicly held firms are in a separate "universe." However, large uncorporations, such as publicly traded partnerships and private equity and hedge funds, raise separate issues. I deal with those issues in Chapter 8, as discussed below in answer to your question about the "architecture of corporate law." The corporate form can raise significant problems for both types of firms.
Mahler: Your book points out that, prior to the Industrial Revolution, when the need for centralized management, limited liability and large pools of capital spurred the rise of the corporation, business associations in the United States were dominated by the partnership and joint stock company, whose management structure and flexibility are more akin to the modern limited liability company. Why, over 100 years after its triumph, is the pendulum swinging away from the rigid corporation and back to a contract-based form?
Ribstein: There are separate stories for small and large firms. Partnership-type forms always were appropriate for closely held firms. However, small firms that wanted limited liability were confined by tax and other laws to the close corporation form during the second half of the 20th century. I discuss in Chapter 6 how the "LLC revolution" broke down these barriers. The corporate form was arguably appropriate for larger firms, though the joint stock company also could have been adapted to this use as it was in England. Chapter 8 discusses how a variety of factors, including the development of new governance technologies (particularly private equity), regulation (particularly Sarbanes-Oxley), and a reduced demand for corporate features, have led to increased use of the uncorporation by large firms in the U.S. over the last quarter century.
Mahler: Last time I checked, new LLC filings are outpacing corporation filings everywhere except four of the biggest states accounting for a disproportionately large number of new filings, namely, New York, California, Illinois and Florida. In your book and in your other writings you highlight the importance of state law competition in formation choices. What do you think explains the disparity, and do you see the larger states eventually stepping in line with the rest?
Ribstein: Each state imposes different burdens on different business forms. A few years ago I studied the choice between the LLC and limited liability partnership forms (Ribstein & Kobayashi, Choice of Form and Network Externalities, 43 William & Mary Law Review 79 (2001)) and determined that the LLC dominated except in states where the LLP was tax-favored. I haven't done detailed research on the latest state filing data on LLCs and corporations. However, I believe that the two forms are running fairly close in Florida, and that higher LLC fees likely explain the corporation's lead in New York and Illinois. State competition for business location and formation plays an important long-run role in ensuring that states offer firms an efficient menu of business forms.
Mahler: A 2008 empirical study by Professors Dammann and Schundeln (Where are Limited Liability Companies Formed? An Empirical Analysis, Research Paper (2008) examined the state of formation choices for limited liability companies and reached the conclusion, among others, that LLC's are migrating away from states that offer lower levels of protection for minority investors, which struck me as counter-intuitive because the majority owners presumably have more say in the matter. Your reaction?
Ribstein: My recent paper with Kobayashi, Jurisdictional Competition for Limited Liability Companies, analyzes Dammann and Schundeln's results and tests the role of other factors and comes to very different conclusions. Specifically, we find that the larger LLCs that form outside their home jurisdiction basically are choosing whether to form at home or to form in Delaware. Only a couple of other states host substantial numbers of out-of-state LLCs, and they don't come close to Delaware. We conclude that firms form in Delaware because they want their litigation handled in Delaware's high-quality business courts, not because they are seeking stricter or laxer laws. This is probably the same factor that explains publicly held corporations' jurisdictional choice.
Mahler: In your book you suggest that the "architecture of corporate law" may have contributed to the recent financial meltdown. What do you mean, and are you suggesting that Bear Stearns and Lehman Brothers might still be with us today if they had adopted the uncorporate form?
Ribstein: Chapter 8 of the book discusses how elements of the partnership structure can do a better job in some situations than the corporate form of ensuring that managers act in the owners' interest. These elements include uncorporate managers' significant ownership stake in the firm and the owners' greater access to the firm's cash through distributions and the firm's limited life. I do think that Bear and Lehman's adoption of corporate structures contributed to their downfalls. I also note that the investment banking firm that came through the subprime crash in the best shape -- Goldman Sachs -- had the most partnership-like structure. I don't conclude that investment banking firms necessarily should have remained partnerships, but rather that they should have retained some partnership-like features rather than going all the way from partnership to the standard corporate form.
Mahler: You have a chapter in your book on the problems of the close corporation which you characterize as an "evolutionary dead end" because, as you put it, "the corporate form could not be a satisfactory vehicle for closely held firms." Why is that so, and does the LLC experience over the last 20 years suggest that the problems of closely held firms, particularly the problem of owner lock-in, are any less difficult with that entity form?
Ribstein: The corporate form is designed for large, centrally managed, publicly traded firms. These are the default rules that apply when the parties neglect to make specific contracts, as they often do in closely held firms. Of course the problems of closely held firms do not simply disappear when the firms become LLCs. The owners and courts must balance, among other things, the owners' need to be able to withdraw from the firm to escape majority oppression, the firm's need for permanence, and a variety of tax and regulatory concerns. Although statutory default rules do not always meet a firm's idiosyncratic needs, the LLC does a better job than the corporate form because it is better designed for modern closely held firms, its flexibility better enables firms to tailor the form to their needs, and the continual process of judicial decisions and legislative change, is gradually producing better results than the "evolutionary dead end" of the close corporation.
Mahler: In that same chapter you critique Gardstein v. Kemp & Beatley, 64 NY2d 63 (1984), the iconic New York decision adopting the reasonable expectations test for minority shareholder oppression, which you cite as an example of a court providing ad hoc a contract for the parties who have not made one for themselves. Others would argue that the judicial function entails exactly that kind of ad hoc decision-making based on the specific facts of each case, necessarily at the expense of some degree of predictability. How would you respond to that argument?
Ribstein: I don't necessarily fault the Gardstein court, but rather the statute the court had to deal with. When parties form a firm that looks like a partnership but yet is organized as a corporation and do not agree over exit, what do they "expect" -- to be treated like the partnership they looked like or the corporation they were? This problem is forced on the courts and the parties by the fact that at the time of Gardstein closely held firms essentially had to incorporate in order to get limited liability. While courts also have to fill gaps in LLCs on a case by case basis, at least closely held firms now can make the court's task easier by choosing more suitable default rules.
Mahler: You also question the fair value standard used in many of the buyout statutes adopted by the states (including New York) as a counterbalance to the minority shareholder's right to seek judicial dissolution of closely held corporations. At the same time you point out that corporation shareholders implicitly opt into the dissolution/buyout statutes when they chose the corporate form for their business. Doesn't that latter point obviate the arguable lopsidedness of the fair value standard, given that the shareholders are always free to contract their own rules, e.g., deeming a dissolution proceeding to be an offer to redeem shares at a predetermined price or formula?
Ribstein: To return to my previous answer, the parties generally can fashion their contracts as they choose, even as close corporations. The problem is that closely held firms do not always engage in elaborate contracting. The best response to this problem is to give the parties the most suitable default rules. As I have said, that means partnership-type rules for closely held firms.
Mahler: I recently posted on this blog an interview with Professor Douglas Moll in which he summarized his view, articulated in his 2005 article in the Wake Forest Law Review, that minority members of LLC's are subject to the same types of abuse as minority shareholders in close corporations and therefore ought to have comparable statutory protection akin to the minority shareholder oppression laws in most states. Do you agree?
Ribstein: I agree with Professor Moll that LLC members may be subject to majority abuse. That can occur whenever there is a penalty associated with exiting the firm, including in general partnerships. LLC statutes are not perfect in this regard. For example, I am uncomfortable with LLC default rules that bar members from dissociating at will, which to some extent were a response to family limited partnership tax rules. But the LLC form, which is very flexible and not hobbled by corporate type default rules, is a better basis for productive evolution of statutory provisions that fit closely held firms than is the close corporation
Mahler: In one of your Ideoblog postings you refer to the "impenetrable murk of NY LLC law" created by cases such as Tzolis v. Wolff (recognizing LLC member's common law right to bring derivative action) and Gottlieb v. Northriver Trading Co. (recognizing LLC member's common law right to equitable accounting). Is your criticism based on separation of powers (which animated the dissenters in Tzolis), or because these common remedies are particularly unsuited to the LLC form, or because they're unsuited to closely held firms in general, or all or none of the above?
Ribstein: I do think that the NY courts have tried to legislate and that this has led to costly unpredictability. The courts need to recognize that even if statute is flawed, commercial dealings have to be based on a solid legal foundation, and that means respecting the court's role vis a vis the legislature. The Delaware courts have done a much better job in this respect, and as I suggested above that has arguably been a factor in Delaware's attracting so many formations of out-of-state LLCs.
Mahler: Thank you, Professor, for taking the time to answer my questions.
