"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.