Contractual Mechanisms of Investor Protection in Non-Listed Limited Liability Companies
58 Pages Posted: 5 Jan 2016
Date Written: January 4, 2016
Limited liability companies (LLCs), although introduced only in early 1990s, are the second most popular organizational form of business in the United States. Their rise is changing the traditional governance structures and investor protection mechanisms used in firms. Given the default nature of almost all provisions of the LLC statutes, the founders can form LLCs that either replicate typical governance structures of corporations or waive any or all long-established investor protection rights, including fiduciary duties of members and managers. In the absence of minimum corporate governance requirements of disclosure and monitoring, strong market disciplining, and liquid markets for LLC units, contractual mechanisms of investor protection are expected to play important role in non-listed LLCs. This study analyzes the operating agreements of almost 300 non-listed LLCs with two and more members formed in Delaware to establish the demand for freedom of contract in LLC governance and examine the practice of investor rights in closely-held LLCs. An LLC operating agreement contains provisions typically found in corporate bylaws and shareholders’ agreements. All agreements in the sample were coded based on a scorecard containing 84 questions affecting investor rights. The results confirm the main hypothesis that in the case of changing default statutory rules the parties used contractual substitutes which ensured equivalent protection and, in many cases, increased clarity and reduced incentives for ex post speculative litigation. Furthermore, the choices of governance structures and investor rights were strategic as they tended to differ depending on the underlying conflicts of interests. Thus, the strong contractual freedom of LLCs, at least in large companies, brings more benefits than risks for the firm members. The results of the study provide drafting reference points for the members of smaller firms and can be informative for courts and legislatures in the ongoing debate on the nature of fiduciary duties in non-corporate business organizations.
Keywords: Partnerships, limited liability companies, closely-held business forms, voting rights, fiduciary duties, options, corporate governance, principal-agent, capital and ownership structure
JEL Classification: K220, G340
Suggested Citation: Suggested Citation