Thursday, November 19, 2015

Exalting the Distinct Nature of the LLC (Contract Is King Micro-Symposium)

Regular readers of this blog know that I am fervent that the distinction between entities matters, particularly when it comes to LLCs and corporation.  I’m happy to be a part of this micro-symposium, and I have enjoyed the input from the other participants. 

My comments relate primarily to the role of contract in LLCs and how that is different that corporations. Underlying my comments is my thesis that LLCs and corporations are meaningfully distinct. This view is in contrast to Jeff Lipshaw, who argued in his post:

[I]f uncorporations differ from corporations, it’s more a matter of degree than of any real difference.  Both are textual artifacts.  We have created or assumed obligations pursuant to the text at certain points in time, and we use the artifacts and their associated legal baggage opportunistically when we can.  I am not convinced that organizing in the form or corporations or uncorporations makes much difference on that score.

I tend to be more of a Larry Ribstein disciple on this, and I wish I had the ability to articulate the issues as eloquently and intelligently as he could.  Alas, you’re stuck with me. (Editor's note: As Jeff Lipshaw says in his comment below, he did not say the forms of LLCs and corporations are not distinct. He is, of course, correct, and I know very well he knows the difference between the forms. In fact, a good portion of what I understand of the practical implications of the LLC comes from him. I do believe that the choice of form matters, and at least should matter in how courts review the different entities, as I explain below. And I do think the LLC is better, or should be (if courts will allow it), because of what the form allows interested parties to do with it. The flexibility of the LLC form creates opportunity for highly focused, nimble, and more specific entities that can be vehicles that facilitate creativity in investment in a way that corporations and partnerships, in my estimation, do not.]

In his book, The Rise of the Uncorporation, Ribstein stated, “Uncorporations [his term for noncorporate entities] come in all shapes and sizes, and are increasingly encroaching on traditionally ‘corporate’ domain.  The thesis is that form matters.” He goes on to explain that the differences between corporations and noncorporate entities have practical implications for those in business (and their lawyers).  I think he was right. 

It seems that some view the limited liability protection that comes with both an LLC and a corporation as the main, if not sole, defining function of the firm. If that were true, then it would be accurate that LLCs and corporation are functionally the same. I think the evolution and purposes of the limited partnership, the LLC, and the corporation suggest that these entities at least should (if they don’t in fact) serve different purposes and roles for those who create them.

The LLC Revolution helped facilitate formation of entities with pass-through taxation and limited liability protection. And it is true, that limited liability one chief benefit of the corporation, and the rise of the corporation can be tracked to that benefit.  But, entity choice is more that just liability and taxation, too, at least where there are real entity choices that provide options. 

Corporations are far more off-the-rack in nature, and they have a tremendous number of default rules. These rules facilitate start up, and help skip a number of conversations that promoters and initial investors might otherwise need to have. (Of course, they probably should have these conversations, but if they don’t, there are more significant gap fillers than for other entities.) 

Ribstein observed, “Uncorporations not only explicitly permit, but also indirectly facilitate contracts.  A firm’s contractual freedom should be evaluated not only in terms of the flexibility permitted by a given business association statute, but in light of the alternative available standard forms.”  As such, the clearer and more distinct the terms of the various entity-form statutes are, the more significant a firm’s choice of form can be.  And if the choice is an LLC, that choice should be respected.

As my countless posts lamenting the fact that courts can’t seem to get the distinction between LLCs and corporations clear, there’s evidence that Lipshaw is right as to the current state of the law, or some meaningful portion of it. But that doesn’t make it right.

The LLC Revolution allowed firms to move away from the limitation of the corporate form that were deemed acceptable when limited liability was practically only available via the corporation. If an LLC weren’t different in some significant way, the LLC would not have been so popular.

In my first legal job, which was not that long ago, many practitioners were still advising against the LLC because of the uncertainty the form created. Choose the corporation or the LLP, many advised. Despite those admonitions, the form took off, which suggests the LLC filled a real and valuable need. 

And this is where contract is king.  Those who form LLCs have freedom to create the relationships they seek.  Delaware is the prime example, of course. Take, for instance, In re Atlas Energy Resources, LLC Unitholder Litigation, C.A. No. 4589-VCN (Del. Ch. 2010),  

“Limited Liability Companies are creatures of contract, designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved. One aspect of this flexibility is that parties to a limited liability agreement can contractually expand, restrict, modify, or fully eliminate the fiduciary duties owed by the company or its members, subject to certain limitations. By contrast, in the absence of explicit provisions in a limited liability company agreement to the contrary, the traditional fiduciary duties owed by corporate directors and controlling shareholders apply in the limited liability company context.”

In choosing the LLC, the firm has chosen the right to define more broadly (or narrowly) the rights and obligations by and among the firm and its members. It is the existence, and not the exercise, of this freedom that makes the LLCs unique. As such, we should look at LLCs in a separate and distinct manner from corporations. Where the firm and its members show that they have chosen to have a corporate-like relationship, that should be respected, but it should not be assumed. And where the firm chooses a more partnership-like relationship, that should be respected. 

But, most importantly, we should respect the fact that a firm may choose to combine separate and distinct attributes from traditional corporate law and partnership law, in a way that makes that particular LLC unique. Beyond that, members may even choose to include terms that were not traditionally permissible for corporations or partnerships. And that’s okay. We should not be trying to make the entity into a pseudo partnership or pseudo corporation.  It’s an LLC.  And that’s just fine.

Business Associations, Corporations, Delaware, Joshua P. Fershee, LLCs, Partnership | Permalink


Ah, Josh, I never argued that "uncorporations" weren't distinct forms. In that regard, I have as little patience as you for those cannot fathom the difference.

What I said was that I couldn't generate any normative fervor, as Larry could, that they were BETTER. The forms are indeed different kinds of abstract artifacts, and we use them as we need to achieve our purposes. In that regard (and that one only, as least as to my first post in this micro-symposium) was my point.

Posted by: Jeff Lipshaw | Nov 19, 2015 2:29:15 PM

Fair point, Jeff. I'll amend my critique. As I said, you're stuck with me.

Posted by: Joshua Fershee | Nov 19, 2015 2:44:59 PM

I think the question is what power King Contract has, and whether there are legitimate usurpers of the throne.

Posted by: Bill Callison | Nov 19, 2015 3:02:41 PM

In my view, if courts will let LLCs be LLCs in the way statutes generally seem to allow, then contract is king for the LLC in a way that other entities cannot be.

Posted by: Joshua Fershee | Nov 19, 2015 3:42:05 PM

Josh, the problem with the online format is that you can't see the twinkle in my eye and the grin when I'm posting comments. I need to do a better job with emoticons.

Seriously, though, I think Greg Day has given a nice example illustrating my point. There's no reason writ in stone why you can't do series of convertible preferred LLC membership interests as the VC investment model, but that's just not the custom, and perhaps for the reasons Greg suggests. Indeed, the only reason to be in the corporate form is to be ready to go public. If your exit were by way of a sale (a liquidation in VC style convertible preferred terms), being an LLC might even be easier.

Posted by: Jeff Lipshaw | Nov 19, 2015 4:59:26 PM

I have a pair of thoughts:

First, while aspects of the laws of other business organizations were utilized as models in drafting certain aspects of the LLC Act, they were simply models. LLCs have certain characteristics because those characteristics are embodied in the governing statute. The point is subtle but important; by way of example:

• LLCs are not similar to partnerships because both embody the rule of in personam delectus, but rather LLCs and partnerships are similar to one another because they both embody the rule of in personam delectus; and

• LLCs are not similar to corporations because both afford limited liability to the owners (members and shareholders), but rather LLCs and corporations are similar to one another because they both provide limited liability to the equity owners.

Second, the LLC is entirely a construct. All of the partnership, the limited partnership and the corporation predate the law governing each being reduced to statute. LLCs are entire strangers to the common law; there was no LLC before there was an LLC Act. The Kentucky Supreme Court, in Pannell v. Shannon, 425 S.W.3d 58, 79, 80, 2014 WL 1101472, *7 (Ky. 2014), observed:

In fact, ‘“limited liability companies are creatures of statute,”’ controlled by Kentucky Revised Statutes (KRS) Chapter 275,” Turner v. Andrew, 413 S.W.3d 272, 275 (Ky. 2013) (quoting Spurlock v. Begley, 308 S.W.3d 657, 659 (Ky. 2010), not primarily by the common law. To the extent that common law doctrines could arguably govern limited liability companies, the Kentucky Limited Liability Company Act “is in derogation of common law,” KRS 275.003(1), and the traditional rule of statutory construction that “require[s] strict construction of statutes that are in derogation of common law shall not apply to its provision.” Id. Thus, to the extent the statutes conflict with common law, the common law is displaced.
This Court must therefore look first to the controlling of statutory law.

I submit that (a) the perspective from which we make comparisons matters and (b) the historical model versus the legal construct nature of the LLC versus other forms matters.
These factors go to understanding the "tools" provided to us.

Posted by: Tom Rutledge | Nov 20, 2015 6:13:50 AM

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