Archives For close corporations

LLCs vs. corporations: explaining state variations in formations

Larry Ribstein —  17 July 2011

The literature on the state “market” for LLC law is growing.  Bruce Kobayashi and I published what I would modestly call the leading study (K & R) on jurisdictional competition for LLCs.  There is also an unpublished study to which our article is in part a response by Dammann & Schündeln (D & S). Now there’s a third study, Hausermann, For a Few Dollars Less: Explaining State to State Variation in Limited Liability Company Popularity.  Here’s the abstract:

The limited liability company (LLC) is a much more popular business entity in some U.S. states than in others. This empirical study provides the first detailed analysis of this phenomenon, using a partly original set of cross-sectional state-level data. I find that formation fees, rather than taxes or substantive rules or anything else, explain the variation in LLC popularity best. Differentials between the fees for organizing an LLC and the fees for organizing a corporation explain 17% to 28% of the state-to-state variation in LLC popularity. These formation fee differentials are not very big, but they are highly visible at the moment the business entity is formed. In contrast, the data show no relationship between LLC popularity and differentials in annual fees and state entity-level taxes. I find only weak evidence that the popularity of the LLC is associated with different substantive rules contained in state LLC statutes. However, LLCs are more popular in those states whose LLC statutes expressly uphold the principle of contractual freedom and thus reassure LLC members that courts will not rewrite their contract in the event of a lawsuit. Finally, I found no evidence that LLC popularity is related to different levels of uniformity of LLC statutes, the age of LLC statutes, and other factors.

Note that while K & R and D & S focus on state competition for out-of-state formations, Hausermann looks at the “popularity” of the LLC vs. the corporate form within each state.  Kobayashi and I found that Delaware has won the national competition, the most likely explanation being the quality of its courts.  This contrasts with D & S’s findings “that substantive law matters to the formation state choices of closely held limited liability companies” and that LLCs “appear to be migrating away from states that offer lax norms on minority investor protection.”

Hausermann mostly confirms K & R’s conclusion that the substance of the statutes is not determining parties’ formation choices.  His corporation/LLC comparison finds that the important variable is the difference in each state between the fees for forming an LLC and those for forming a corporation.

A few points to note about Hausermann’s study:

  • Although the author emphasizes K & R and D & S re state competition for LLCs, the closer comparison is with Kobayashi and my study of the state-by-state relative popularity of LLCs and LLPs, which Hausermann also discusses. We found that LLCs beat LLPs despite the expectation from the “network externalities” literature that the LLP’s connection to the “network” of partnership cases and forms would give it an advantage over the LLC.  Similar to Hausermann, we found that the costs of forming the two types of business associations (specifically, entity-level taxes) affected state-to-state differences in their relative popularity.
  • Hausermann finds that even tiny fee differences between corporations and LLCs make a difference in popularity of the two forms and that the parties ignore continuing fees and focus on upfront fees.  This rightly puzzles the author and calls for more theory and data.  I speculate that this reflects incomplete information on the part of many people who are forming LLCs.  This is clearly the case for ignoring continuing fees.  Moreover, since the vast majority of small firms should be LLCs rather than corporations (for more on this, see my Rise of the Uncorporation), making the choice based on tiny differences in upfront fees and ignoring continuing fees likely reflects bad advice and poor information.  In other words, Hausermann’s study arguably suggests the legal services industry is failing small firms.  Perhaps law’s information revolution will fix this.
  • Hausermann shows that freedom of contract regarding fiduciary duties matters to the corporation/LLC choice. This, coupled with the fact that the sheer number of mandatory rules in a statute doesn’t matter, indicates the importance to small firms of certainty that their contract will be enforced by its terms (see Hausermann at p. 36).  The importance of legal certainty is discussed in my and Kobayashi’s recently posted draft on private lawmaking (to be discussed here shortly).

Note what Hausermann finds doesn’t matter to parties’ choice between corporation and LLC:

  • Protection of third-party creditors.  This suggests creditors think they can protect themselves, and that the rise in LLCs vs. corporations is not about avoiding debts.
  • Default rules that members can easily vary by contract.  This is not surprising.  But perhaps default rules would matter if parties had a better and more varied menu of private forms from which to choose. This also relates to Kobayashi and my work on the potential role of private lawmaking.
  • Uniformity in general, and adoption of NCCUSL-promulgated uniform laws in particular.  This casts more doubt on the value of NCCUSL.  My most recent uniform laws article with Kobayashi helps explain why parties aren’t attracted to NCCUSL-drafted laws.

Hausermann rightly suggests the need for further research, including on the effect of overall formation costs, and the role of lawyers in guiding parties to particular forms.

More generally, I would suggest the need not only for more data but also more theory to guide both what kinds of data to get and how to interpret the data that is gotten.  In other words, Rise of the Uncorporation should be required reading for scholars seeking to mine the potentially rich data produced by the leading business law phenomenon of our time — the rapid rise and evolution of the LLC.

In close corporations, Jurisdictional competition, limited liability companies, uncorporations, Unincorporated business entities
permalink

Close corporation remedies and the evolution of the closely held firm

Larry Ribstein —  16 November 2010

As previously discussed,  I attended and presented a paper at an interesting symposium on the famous close corporation case, Wilkes v. Springside.  Now the paper is available.  Here’s the abstract:

Close Corporation Remedies and the Evolution of the Closely Held Firm

This paper examines the law of closely held firms from an evolutionary perspective. The corporate tax and constraints on the availability of limited liability forced closely held firms to compromise their planning objectives and choose standard forms that did not fully reflect their needs. This forced courts to construct duties and remedies that did not relate to the parties’ contracts. The famous close corporation case of Wilkes v. Springside Nursing Home, Inc. classically illustrates this problem. The advent and spread of the limited liability company significantly increased the availability of suitable standard forms for closely held firms. As a result, courts now can focus on fully effectuating the parties’ contracts rather than creating remedies the parties may not have wanted. This analysis has implications for potential improvements in contracting for closely held firms.

In close corporations, limited liability companies
permalink

Terrorism Finance Meets Business Associations

J.W. Verret —  17 August 2010

Now that TOTM blog traffic is hitting all-time highs, I thought it would be a good time to share a link to my most recently published paper, Terrorism Finance, Business Associations, and the “Incorporation Transparency Act.” It is highly critical of Senator Levin’s “Incorporation Transparency and Law Enforcement Assistance Act,” over which Senator Levin, Senator Lieberman, and the Obama Treasury Department are currently haggling.

I got the idea to write an article about this Act from reading posts from colleague Ribstein and blog neighbor Bainbridge some time ago.  Senator Carl Levin has been pushing to mandate that states keep open registeries listing the names of all owners of business entities they form.  There are a number of problems with this proposal.  First, it is sold as an anti-terrorism measure.  During the first two rounds of hearings on the bill, officials from the various law enforcement agencies made vague references to the war on terror, which…don’t get me wrong, I support wholeheartedly.

They did not, however, provide any meaningful analysis for why alternative entities stand at the heart of terrorism finance.  To the extent that terrorism has involved intricate finance in the past, it has been through the Hawala system of underground Asian and Middle Eastern bankers.  But hawaladars don’t form alternative entities…they have no reason to.  Why would they need the protection of limited liability when the very nature of their business is, in both the United States and abroad, centrally an illicit enterprise?

Moreover, hawaladars function within a system of cultural and family bonds, with reputational costs as paramount, allowing them to transfer money outside of a sophisticated wire transfer system.  To a hawaladar, protection from personal liability for entity obligations is entirely useless.  But more importantly, the 9/11 Report describes how most international terrorists have been self-financing their activity, both from legal employment and illicit credit card fraud and drug distribution.  Also remember that the 9/11 hijackers did not use LLCs or LLPs in their activities either, and to the extent terrorists continue to use the banking system the Patriot Act already provides an extensive surveillance mechanism that the Levin Bill does precious little to supplement.  Even more ridiculously, the Levin Bill anticipates owners filing their identification with the relevant state of formation, thus we would rely on terrorists to accurately report their ownership information!

The Levin Bill fails to achieve its stated objective.  The truly pernicious part of the bill is the cost that would accompany its implementation.  Business privacy is an important element of business entity use.  Imagine if, instead of acquiring tracts of land in Florida through acquiring shell entities, Roy Disney had to acquire tracts through the Disney company directly?  Making beneficial ownership information public can potentially result in reapportionment of bargaining leverage because it potentially reveals insight about one party’s walk-away point.

The Levin Bill reporting obligations are triggered by ownership.  But what is an owner?  If I am the only creditor of an LLC, and I have all of the LLC’s assets secured as collateral, and the debt covenants provide me with veto power over all LLC decisions, am I an owner?  This part could get very tricky.  The Levin Bill ties in the definition of “ownership” to “control.”  That will get even trickier.  Furthermore, the Bill harms the entire enabling purpose of alternative entities.  One important advantage of using alternative entities is the freedom to design governance structures appropriate for a particular venture.  But where governance structures are arranged to avoid Levin Reporting obligations, rather than to create governance structures appropriate for a particular venture, that benefit of the alternative entity form is lost.

All in all, a very bad bill.  TOTM readers, be sure to write your Congressman.

UPDATE: One reader comments “If you’ve ever done due diligence for fraud, you would support this bill.”  Not true.  I agree completely that due diligence is a vital element of business relationships, so important in fact that I think its a bad idea for due diligence to be managed by the federal government in this context.

In close corporations, corporate governance, LLCs
permalink

A corporation is not a partnership

Larry Ribstein —  2 August 2010

Peter Mahler discusses a recent NY close corporation case, Pappas v. Fotinas
which he describes as “a thoughtful, well-reasoned decision that sets forth the competing factual narratives and operative legal principles.” I defer to Mr. Mahler’s overall assessment of the opinion, and refer the reader to his detailed discussion of the case. But in one respect I disagree with the court’s reasoning.

In brief, the court declines to condition dissolution on giving defendants the right to buy out plaintiff as required under the NY statute. This might have been ok given that the parties had stipulated they weren’t seeking a buyout. The problem is that the court went further:

Dissolution here, where one of the three shareholders has died, and another has retired because of injury, is consistent with the real-world similarity between closely-held corporations and partnerships. Indeed, the Court noted in its January 2009 Decision After Hearing that, at the time 577 Baltic Street was purchased and the three shareholders commenced business from the property, Mr. Fotinos and Mr. Pappas described the enterprise to third parties as a partnership. Had Messrs. Pappas, Kalogiannis, and Fotinos chosen to conduct business as a partnership, the result would be clear.

It is “elemental” * * * [citing case] that, in the absence of agreement to the contrary, the death or withdrawal of a partner dissolves the partnership by operation of law, and a right to an accounting accrues to any partner or the partner’s personal representative in connection with the winding up of the partnership’s affairs. * * * That the same result obtains here would not offend the purpose or policies of Business Corporation Law § 1104-a.

Repeat after me: A CORPORATION IS NOT A PARTNERSHIP.

Is that clear? If not, let’s do it again:

A CORPORATION IS NOT A PARTNERSHIP.

Got it now?

At one time parties intending partnership nevertheless had to incorporate in order to get limited liability. The courts then had some basis for accommodating what they thought were the parties’ real intentions. Now uncorporations, and particularly the LLC, let the parties to closely held firms choose the business form they want. Indeed, more firms now are organizing as LLCs than as corporations. (For a history of these developments see my Rise of the Uncorporation.)

The upshot is that courts should now respect firms’ choice of form. So if the parties choose to incorporate, a court should not assume that they actually wanted to be anything other than a corporation.

Again, the court may have reached the result in Pappas given the parties’ no-buyout stipulation. But the court’s reasoning perpetuates the “incorporated partnership” confusion that has long infected the close corporation cases.

True, this may hurt some older firms that initially organized as close corporations during the bygone close corporation era and never switched. But ignoring the terms of the applicable statute creates costly unpredictability, particularly in the present age of the LLC.

I soon will be posting a paper that lays all this out. In the meantime, just remember:

A CORPORATION IS NOT A PARTNERSHIP.

Got it?

In close corporations, Unincorporated business entities
permalink