Peter Molk, an Assistant Professor of Law at Willamette University College of Law and a rising young star in legal academia, has written a groundbreaking article entitled How Do LLC Owners Contract Around Default Statutory Protections? slated for publication in the University of Iowa College of Law’s Journal of Corporation Law and currently available here on SSRN.
The article also is the subject of my podcast interview of Professor Molk embedded at the bottom of this post.
Professor Molk’s article deserves attention because it asks and attempts to answer based on empirical evidence a vital question: Is the freedom of contract promoted by the LLC statutes’ default rules being used as theory would predict, to promote economic efficiency and to craft more efficient owner protections? In fact, his study finds that LLCs with more vulnerable owners adopt fewer owner safeguards, suggesting that contractual freedom may be used by LLC controllers opportunistically rather than to achieve efficiencies.
Professor Molk’s first-of-its-kind study tests theory with the reality of what is actually happening in the world of LLC operating agreements. He does this by carefully examining almost 300 operating agreements of LLCs involved in litigated cases mostly in Delaware but also in New York, looking for provisions that either weaken or strengthen owner protections granted by the statutory default rules. The patterns his study finds have a direct impact on business divorce practitioners and also should influence choice of entity decisions and the drafting of agreements by practitioners involved in entity formation.
In his own words, here’s the abstract of Professor Molk’s article:
Limited liability companies are built on the idea of contractual freedom. Unlike 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 substitute owner protections that do not apply by default. There is little evidence, however, that the contractual freedom is used to craft more efficient 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 for opportunism, not efficiency.
Professor Molk has much, much more to say on the subject in my podcast interview which I hope you’ll listen to and enjoy.