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.