Simply by forming LLCs, entrepreneurs now unwittingly lock themselves in to perpetual entities that offer them no liquidity and present them with costly procedural obstacles to enforcing both their agreement among themselves and their statutory rights. Even in at-will LLCs that are member-managed, recent LLC acts deny members both a right to dissolve and a right to be bought out. While thus locking members in, these acts deny them standing to bring many if not most of their claims among themselves or against the firm. In swinging so dramatically toward a corporate model, recent acts have failed to consider the presumptive intent of small groups of entrepreneurs who operate informally and expect to have a direct role in management. At least in the case of member-managed LLCs, legislatures should reinstate more appropriate default rules and courts should be receptive to claims that members never intended their relationships to have such harsh consequences.
In the mid- to late-1990s, there was unprecedented legislative activity to offer unincorporated business owners liability shields protecting them from personal liability for the obligations of the firm. In 1994, the Uniform Law Commission (“ULC”) approved the first major overhaul of partnership law in eighty years.1 Only three years later, the ULC added to it the option to become a limited liability partnership (“LLP”) with a protective shield. This combined package, which the ULC refers to as the Uniform Partnership Act (1997)2 but is popularly known as “RUPA,” is the law in most states. At about the same time the ULC finalized RUPA, it also finalized the Uniform Limited Liability Company Act (1996) (“1996 Act”),3 with its shield for members of limited liability companies (“LLCs”).
The LLP and LLC shields were virtually identical, and the two acts were also extremely similar on the two key issues that are the subject of this article: they provided members with significant liquidity rights and with easy access to judicial remedies. In just ten years, the ULC promulgated the 2006 Uniform LLC Act (“RULLCA”),4 which reversed course on both these key issues. It declared LLCs to be perpetual entities, and it denied dissociated members both the right to dissolve and the right to be bought out. It also took away their easy access to judicial remedies by importing the direct versus derivative distinction from corporate law. This rapid and dramatic change between these two uniform acts reflects the national shift that has taken place on these two key issues. The purpose of this article is to explain and critique this shift, which leaves LLPs and LLCs with very different default rules.
Part I of this article explains that RUPA’s default rules were primarily designed to reflect the presumed intent of small groups of entrepreneurs who form without representation and expect to operate their business informally. These rules included significant liquidity rights and gave partners easy access to judicial remedies, although the buyout rules included corporate-style procedural requirements the target groups probably do not intend. Part II discusses how and why the uniform LLC acts first embraced, then eliminated, the liquidity rights of partners. The default rules were redirected away from small LLCs formed without the benefit of counsel in order to protect family LLCs engaged in sophisticated estate planning. This elimination of liquidity rights made LLCs more like corporations. Part III critiques how and why the uniform LLC acts first embraced, then eliminated, easy access of members to judicial remedies, adopting instead the corporate approach that denies members standing to bring claims RULLCA now classifies as derivative. In addition to noting the usual arguments that the derivative limitation typically serves no policy in the context of closely held firms, Part III argues that the limitations on judicial remedies are costly obstacles that are contrary to the presumed intent of most small groups of entrepreneurs. In particular, the default rules on special litigation committees are both cumbersome and inconsistent with broader national law that disfavors pre-dispute binding arbitration in the absence of clear agreement. Part IV concludes that, by forming LLCs, entrepreneurs across the nation are now unwittingly locking themselves in to perpetual entities that offer them no liquidity and present them with costly procedural obstacles to enforcing both their agreement among themselves and their statutory rights. It further concludes that, at least in the case of member-managed LLCs, the statutory default rules ought to be brought closer to those that apply to LLPs, which more accurately reflect the presumed intent of small groups of entrepreneurs who form businesses without the benefit of counsel. If LLC acts are not liberalized to restore greater liquidity rights or other member remedies, courts should be attentive to claims made by members that they are protected by oral operating agreements, by the terms of an overarching partnership, or by historic principles of law and equity.
The RUPA Drafting Committee considered the choice of default rules to be informed by the number and character of the target group, their presumed intention, and a particular conception of the entity.
RUPA’s primary target for default rules is small groups of entrepreneurs who organize their business without the benefit of counsel. The drafters assumed that, whatever the mix of services and capital the members contribute, they all expect to have some role in the management of the business, which they expect to operate informally. The Committee thought that the members are often heavily invested in the firm, perhaps with little or no diversification, and so might be looking to the firm for income, through either distributions or salaries to themselves or their family members.5 They are also likely to engage in other third-party transactions, such as selling or leasing property to the partnership or lending it money.
These small, informal groups of entrepreneurs are in greatest need of appropriate statutory default rules because, unlike large firms or syndications of investment interests, they typically have little or no written partnership agreement.6 They tend to avoid or minimize a written agreement for any one of a number of reasons. They may rely on the glue of their pre-existing relationships, either as friends, family members, or business associates. They may underestimate the problems that are likely to arise over the life of the business, or want to avoid lawyers, either on aesthetic grounds, to save costs, or to avoid facing difficult issues lawyers might call to their attention. The task of the Drafting Committee, in a sense, was a very modest one. Throughout the Committee’s deliberations on RUPA, the recurring hypothetical involved two or three people who owned and worked in a business that used a truck.
The RUPA default rules were based on the Committee’s determination of the presumptive intention of the target group. In drafting an “off the rack” partnership agreement for these small groups of entrepreneurs, the Committee asked two separate questions about their presumptive intent. One, what are the terms that the parties would probably have in mind but fail to express? Two, what are the terms that the parties probably would not have in mind, but would agree to if the matter were brought to their attention? These two questions of presumptive intent are essentially empirical questions. To the extent the Committee could not with any confidence determine presumptive intent as an empirical matter, it chose a default rule it thought was most likely to be fair.
It is especially important to avoid inappropriate default rules for a target group that has little or no written agreement. For this group, the cost of an inappropriate default rule is not the cost of drafting around it. For this group, there is no practical difference between a default rule and a mandatory rule. A person who finds herself on the wrong side of a default rule will be forced either to accept it or to incur what might be considerable cost to try to establish a contrary agreement, either through negotiation, mediation, arbitration, or litigation before a court.
The Committee had no empirical studies to answer the two questions of presumptive intent. The best evidence of presumptive intent was the experience of the members of the Committee and the statements of numerous other attorneys involved in the RUPA process. The ULC often appoints drafting committees of generalists, on the assumption that generalists in the legislatures enact the ULC products and on the further assumption that the statutes need to be accessible by generalists. Generalists on the Drafting Committee, and more broadly among the membership of the ULC, often defer to others, especially American Bar Association (“ABA”) Advisors, who often have considerable additional experience across a wide range of industries. ABA Advisors are also important because the ULC is aware that ABA support or opposition can make or break uniform adoption by the states, which is a primary goal of the ULC.
On occasion, the Committee added default rules that reflected language that appeared in agreements drafted and negotiated by some of the sophisticated business counsel involved in the drafting process, precisely the sort of expertise we assumed our target group would not have at its side. Particularly in the case of a partner’s right to be bought out, the result was longer and more technical default rules.7 Unfortunately, the details went beyond what we could have assumed was the intent of our target group of unrepresented entrepreneurs.8 Instead, the rules reflected what the Committee felt were fair provisions similar to those that had been included in agreements that had been fully negotiated with the assistance of counsel.
RUPA was drafted to replace the venerable Uniform Partnership Act of 1914. Without belaboring here the UPA’s well-documented history, the UPA began with an emphasis on an entity theory and ended with an emphasis on an aggregate theory. In the end, the UPA represented a blend of both approaches. In terms of partnership property, for example, an entity-type of result was reached but stated in aggregate terms. The UPA declared each partner a co-owner of partnership property,9 but then removed the normal incidents of co-ownership.10
RUPA declared for the first time that a “partnership is an entity distinct from its partners.”11 First, declaring partnerships as entities reflected the reality that third parties treat partnerships as entities. Second, the entity theory was consistent with the intent to give stability to partnerships that had contracted for it. Third, the entity theory was adopted for the sake of simplicity.12 For example, the rules reflecting partnership property are much more cleanly and simply stated in terms of an entity theory. Finally, RUPA partnerships become even more entity-like if they register as LLPs to qualify for the “shield” against personal liability for partnership obligations.13 The RUPA rules for limited liability partners are very different from the new rules for limited liability company members. Entrepreneurs seeking the shield of an unincorporated form should carefully consider their choice between an LLP and an LLC.
RUPA made no attempt to adopt a theoretically pure entity model. The Committee adopted an entity theory only to reach and clearly state the substantive results it wanted, not the reverse. As was the case in the UPA, it adopted a blended approach. RUPA includes aggregate features, particularly on issues affecting the relationships among the members themselves. It adopted an aggregate approach to look “inside” the partnership to identify and enforce the partners’ expectations of one another and of the firm. Most importantly, for example, a partner has fiduciary duties both to the partnership and to the other partners.14 As noted commentator Bob Keatinge so aptly summarized, the transition from the UPA to RUPA represents “going from a partnership’s being an aggregate which is sometimes an entity to an entity that is sometimes an aggregate.”15
RUPA’s blended approach to the entity is similar to the blended approach the federal income tax law takes to partnerships and LLCs. While overall, the partnership is a tax-computing and reporting entity, the partnership rules, now also the LLC rules, still possess many aggregate features. In some cases, the parties are free to choose whether to adopt an aggregate approach or an entity approach. For example, assume a taxpayer purchases an interest in a partnership or LLC that has highly appreciated depreciable assets. The taxpayer can be treated simply as purchasing an interest in the entity, which will compute and allocate to the purchaser its share of the entity’s depreciation deductions. Or, the entity and the purchaser can elect to look inside the entity,16 and recognize that the price the purchaser is paying for a membership interest reflects the purchaser’s share in the entity’s highly appreciated, depreciable assets.17 The result is that the purchaser can claim more depreciation deductions than if it had simply been allocated its share of the deductions computed and reported by the entity.
The RUPA Drafting Committee ultimately dismissed concerns that the statute could get too long. The prevailing view was that the Committee should include all the rules it thought appropriate, and not concern itself with the risk that the statute was getting too long. On occasion, the prevailing view was that the Committee should answer, in the statute, every significant question that was raised. The more questions addressed and answered in the statute, the longer it got.
A statute ought to be short enough and clear enough to state a readily accessible philosophy of the business organization. The statute ought to be easily readable, certainly by lawyers and judges, and ideally by the parties themselves. The longer statutes get, the more difficult they are to read, especially by generalists. In addition, the longer and more detailed the default rules, the greater the likelihood of error in determining presumptive intent.
The tax rules for allocations in partnerships and LLCs illustrate the pitfall.18 Those rules, traditionally addressed to small business, were revised in the 1980s to comprehensively address tax shelter allocations, and in the process became unreadable by small businesspeople, their accountants, and their attorneys. Unlike state statutes defining business associations, the federal income tax rules are divided between the statute and the regulations under it. That is, to some extent, the statute can serve as a shorter conceptual overview and leave it to regulations to get into the weeds. On the state law side, however, everything is in the business statute, weeds and all. That means that the business statute is much longer than it would be if some of the details could be diverted to regulations.
There is no reason the statutory reform of the law of any business organization should reinvent the wheel. It can be efficient to borrow from successful provisions of other statutes. For example, it makes sense for a partnership or LLC drafting committee to borrow from other statutes defining when a firm is imputed with the knowledge or notice of its owners. Borrowing successful provisions in existing law not only makes the drafting process less costly, it also lowers the information costs to the ultimate readers of the statutes. The reader has to spend less time parsing the partnership knowledge and notice rules if she recognizes them from the Uniform Commercial Code or from LLC law.
It was therefore expected and perhaps commendable that real estate and law firm experts wanted the best of partnership law continued, estate planners and investment groups wanted the best of limited partnership law reflected, and corporate lawyers wanted their favorite corporate law reflected. A major problem with this borrowing is that rules from other business forms do not always fit.
RUPA provides that a partner who dissociates from a term partnership has the right to be bought out for a statutorily defined buyout price. The partnership must tender either cash or a promise to pay it at the end of the term. However, RUPA went further and imported from corporate law certain procedural rules about how the buyout right is to be exercised. Those rules require a partnership to give its estimate of the buyout price and either pay the amount, or tender a promise to pay it,19 “within 120 days after a written demand20 for payment.”21 A dissociated partner who wants to sue the partnership to determine the buyout price must do so “within 120 days22 after the partnership has tendered payment or an offer to pay or within one year after written demand for payment if no payment or offer to pay is tendered.”23
These procedural provisions, and the statutes of limitations within them, were drawn from “the dissenter’s rights provisions” of the Revised Model Business Corporation Act.24 There are two basic reasons they do not quite fit in RUPA. First, they are inconsistent with the fundamental rule that a partnership can be formed and operated without the need for a writing. Indeed, no writing is required to dissociate from a partnership. These procedural rules, however, make writings particularly important. Second, the 120-day statute of limitations, for example, is inconsistent with the fundamental rule of RUPA section 405 that general law determines the limitation periods on actions between a partner and the partnership. RUPA intended the partnership agreement to be treated as a normal commercial contract, and as such be subject to normal limitation periods.
A more fundamental problem with inserting these corporate rules25 is that even attorneys with a deep expertise in all other areas of partnership law—indeed, with every other provision of RUPA—could be completely blindsided by these dissonant procedural rules and their statutes of limitations. These rules are also likely to serve as a trap for unwary members of our target group, both dissociating partners and the continuing partners.26 Dissociating partners may not be aware that they need to make a written demand for payment. The continuing partners may not be aware that they have only 120 days to respond. Indeed, even if the continuing partners know of the 120-day period, they may find the deadline difficult to meet. Partnerships without counsel or sophisticated accountants may find it difficult to mark assets up or down to market, estimate known and unknown liabilities against which they are required to indemnify the dissociating partner, and estimate any damages from wrongful dissociation, all within 120 days. Finally, the dissociating partner may then not realize she has only 120 days to respond to the partnership’s tender or be barred from suing the partnership to determine the buyout price. The only people who will not be surprised are the very sophisticated corporate lawyers whom we assume our target group does not have at its disposal.
A partner’s liquidity rights under RUPA vary depending upon whether the partnership is at-will or for a term. If there is no agreement “to remain partners until the expiration of a definite term or the completion of a particular undertaking,”27 the partnership is classified as “at-will” and each partner has a right to dissociate and cause a winding up of the business and be paid a share of the surplus after creditors are satisfied.28 On the other hand, if a partnership is for a term or particular undertaking, each partner has the power to dissociate, but is denied the right to trigger a business windup. Instead, the other partners have the right to continue the business, provided they buy out the dissociating partner for a statutorily defined buyout price,29 which is determined at the date of the dissociation.30
The buyout price generally does not have to be paid until the end of the term.31 If a partner were allowed to exit prematurely and force the continuing partners to pay the buyout price in cash, the continuing partners could be hurt in any number of ways. In order to pay the buyout price, they might be forced to sell or mortgage firm assets. Therefore, the default rule allows the continuing partners merely to promise to pay the buyout price in the future—at the end of the term—provided they secure their promise to pay.32 However, a dissociating partner may demand earlier payment if she “establishes . . . that earlier payment will not cause undue hardship to the business of the partnership.”33
The liquidity rights of members under the 1996 Uniform LLC Act are very similar to RUPA’s liquidity rights of partners because the drafters had the same target group in mind. They “maintained a single policy vision—to draft a flexible act with a comprehensive set of default rules designed to substitute as the essence of the bargain for small entrepreneurs.”34 They “recognized that small entrepreneurs without the benefit of counsel should also have access to the Act. To that end, the great bulk of the Act sets forth default rules designed to operate [an LLC] without sophisticated agreements and to recognize that members may also modify the default rules by oral agreements defined in part by their own conduct.”35
As under RUPA, the liquidity rules of the 1996 Act were based upon the fundamental distinction between at-will firms versus those for a term or particular undertaking. It also continued the default rule that LLCs are at-will.36 The at-will versus term designation was one of two “key designations” under the 1996 Act. The other was whether the LLC is member-managed or manager-managed. According to the Prefatory Note, “[a]ll default rules under the Act flow from one of these two designations.”37 The liquidity rules in particular flowed from the at-will versus term designation.
Unlike RUPA, the 1996 Act does not give a dissociating member in an at-will LLC the right to force a business windup. The drafters eliminated the windup right in part because of criticism that said that the right to “blow up” an at-will partnership gives the dissociating partner too much leverage over the partners who wish to continue the business.38 The drafters also wanted to take advantage of new tax rules providing that LLCs could be taxed as partnerships even if they more nearly resembled corporations.39 Instead of a windup right, members of an at-will LLC “may demand a payment of the fair value of their interests at any time,”40 with fair value41 “determined as of the date of the member’s dissociation.42 Because valuation is set at dissociation, a dissociated member in an at-will company “receives the fair value of their interest sooner than in a term company and does not bear the risk of valuation changes for the remainder of the specified term.”43
If, on the other hand, the LLC is for a term, a dissociating member “must generally await the expiration of the agreed term.”44 However, unlike the buyout from a term partnership, the fair value of the interest is not determined at the time of dissociation. Instead, it is determined as of “the date of the expiration of the term.”45 Thus, a member who dissociates from a term LLC bears the risk of further declines in value between the time of her dissociation and the end of the term. If the LLC extends its term after the member dissociates, the term that matters is the term “at the time of the member’s dissociation.”46
Like the 1996 Act, RULLCA denies dissociating members the right to trigger a windup. However, RULLCA also denies dissociating members a right to be bought out, either in an at-will LLC or in a term LLC. Indeed, the labels “term” and “at-will” no longer appear in the statute. Instead, LLCs are declared to be entities that have “perpetual duration,”47 just like corporations and, more recently, limited partnerships. A member’s liquidity right is simply the right to share in distributions of any surplus whenever, if ever, the perpetual entity is wound up.48 While awaiting a liquidating distribution, a member still has the right to her share of any current distributions. If she dissociates, her interest is “degraded” to that of a mere transferee.49
It is remarkable that there is virtually no explanation in the Prefatory Note or Official Comments about the elimination of all buyout rights. The only mention of their elimination is in a statement in the Prefatory Note that, because members are being denied the right to be bought out from entities now deemed to be perpetual, it is “necessary” to give them a right to seek judicial dissolution in the event of oppressive conduct.50 There are three responses to this language, which at a minimum supports the inference that the remedy for oppressive conduct is being added because members are now being locked in. First, the 1996 Act, which included two buyout rights, already gave members and dissociated members a right to judicial dissolution in the event of oppressive conduct.51 Second, RULLCA actually reduces access to the oppression remedy by taking it away from dissociated members.52 Third, not all states that adopted RULLCA included its oppression remedy. Florida, for example, eliminated the buyout rights but rejected its “necessary” protective remedy in the event of oppression.53
Commentators were of course quick to point out that minority members of LLCs were being “locked in” and made as vulnerable to abuse as minority shareholders in closely held corporations.54 Some defenders of the new regime have suggested that the LLC “lock in” is not as bad as the corporate lock in. The minority shareholder is typically locked in to a corporate regime that is governed by majority rule. Hence, the minority shareholder is vulnerable to changes made by the majority. By contrast, in the typical LLC, the minority member has some protection because the operating agreement cannot be changed without unanimous consent.55 Despite this difference, there is no question that the elimination of liquidity rights still leaves minority members vulnerable to the majority, for example on important issues such as employment, compensation, and fringe benefits.56
The obvious question is why RULLCA reversed course on the issue of member liquidity. Either the target group changed, its presumptive intent had been reevaluated and determined to be different than what was originally thought, or the tail of the entity theory came to wag the dog of the substantive default rules. The answer appears to be primarily twofold: a new target group came to the fore and there was a desire to create a more corporate entity.
The first thing that happened, well before RULLCA, is that the target group for setting LLC default rules, at least the default rules on liquidity rights, shifted to family businesses engaged in sophisticated estate planning.
Tax planners for family businesses had become used to contracting away liquidation rights in order to reduce the value of ownership interests in businesses for estate tax purposes.57 In 1990, Congress adopted a provision58 that disregarded contractual restrictions on liquidation rights “that are more restrictive than the limitations that would apply as a default rule under the state law generally applicable to the organization in the absence of the restriction.”59 In short, restrictions in statutory default rules could result in valuation discounts whereas restrictions in operating agreements could not. This change created “a tax incentive to create restrictive state law provisions regarding the ability to sell, redeem, or otherwise liquidate an ownership interest in a business entity.”60 Practitioners started “lobbying their state legislatures to eliminate all dissociation rights,” both in LLC acts61 and in limited partnership acts. Their lobbying was successful, and by the time RULLCA was promulgated, the target group for the liquidity rules had shifted from small groups of entrepreneurs unrepresented by counsel to affluent families engaging in sophisticated estate planning. To protect the represented few, RULLCA denied liquidity rights to the unrepresented many.62
The second and related thing that happened was an increased demand for a more corporate entity. As the 1996 Act was being finalized, the Internal Revenue Service issued its now-famous “check the box” regulations, which allowed LLCs to elect to be taxed as partnerships even if they possessed a preponderance of corporate characteristics.63 There was, of course, no tax requirement to make LLCs more like corporations. Nevertheless, it is clear that the drafters of RULLCA intended to take advantage of the newfound freedom to make LLCs more like corporations.
Like RUPA and the 1996 Act, RULLCA states that an LLC “is an entity distinct from its . . . members.”64 However, RULLCA goes further and also provides that an LLC “has perpetual duration,”65 conforming LLC law to corporate law66 and to recent limited partnership acts.67 Despite this unqualified statement of perpetuity, the Official Comments are equivocal: “The word ‘perpetual’ is a misnomer, albeit one commonplace in LLC statutes. In this context, ‘perpetual’ means that the act: (i) does not require a definite term; and (ii) creates no nexus between the dissociation of a member and the dissolution of the entity.”68
The question is obvious: why say in the statute that the LLC is perpetual and then say in the Official Comments that you don’t really mean it? By embracing the corporate “perpetual entity” model, the drafters appear to be providing a theoretical foundation for eliminating both the present buyout right in an at-will LLC and the deferred buyout right in a term LLC. At the same time, the perpetual entity model provides a rationale for importing corporate restrictions on member access to judicial remedies.69 For whatever mix of reasons, it is clear that the RULLCA drafters sought to make a more perfect entity. For further example, section 105(c)(2) states the very modest mandatory rule that an operating agreement may not “vary a limited liability company’s capacity under Section 109 to sue and be sued in its own name.” By contrast, the Official Comment to that relatively narrow provision is much broader. It states that the now-perpetual LLC “is emphatically an entity, and the members lack the power to alter that characteristic.”70
Despite the intent to give LLCs more entity features than partnerships or early LLCs, it is an overstatement to say that members “lack the power to alter” the entity characteristic. Indeed, RULLCA itself continues to treat the association of members in an LLC as an aggregation to the extent it provides that a member of a member-managed LLC “owes to the company and, subject to Section 801, the other members the duties of loyalty and care.”71 The monkey-wrench in this statement is, of course, the reference to section 801, which imposes a distinction from corporate law that limits a member’s remedies for contractual and statutory breaches by classifying many member claims as derivative rather than direct. Like almost all the rules in RULLCA, this limitation on the right to bring a direct action can be contracted away in the operating agreement.72 Just as shareholders in a corporation, members can add aggregate features to their relationship. For example, they may agree to be personally liable for third-party claims against the entity or to one another if they breach the operating agreement. Whether such contractual stipulations make an LLC or a corporation less of an entity is in the eye of the beholder.
Members who do not wish to be locked-in to a perpetual entity can, of course, contract for windup or buyout rights. Perpetual entity status is not mandatory under RULLCA. Neither Section 108(a)’s rule that an LLC is an entity distinct from its members nor section 108(c)’s rule that the entity “has perpetual duration” is on the exclusive list of mandatory rules.73 Therefore, those rules can be varied or even eliminated by the operating agreement, except that there can be no limit on the entity’s ability to sue and be sued.74 Indeed, the Official Comments to section 108(c) expressly confirm that, under section 701(a)(1), the operating agreement may determine when dissolutions occur.75
The problem, of course, is that the original target group, by definition, is not represented by counsel and has little, if any, written agreement.76 If there is a bare-bones agreement, it may not address resolving disagreements or liquidity rights. After dissension arises, dissatisfied members are likely to resort to the rule that the operating agreement can be oral, written, or established by conduct.77 If they are resisting changes in policy, including decisions affecting them in particular, such as their employment or compensation, they may also rely on the rule that unanimous consent is necessary either to amend the operating agreement or to act outside the ordinary course.78
If dissatisfied members want to go further and establish liquidity rights, particularly the right to be bought out, courts should and can be expected to be attentive to their claims. To many members, the default rule of a perpetual lock-in will come as a harsh surprise. Under partnership law, courts have strained to avoid default rules they find too harsh. For example, they have found continuation agreements or other workarounds to avoid the at-will liquidation right they consider harsh.79 Courts can be expected to do the same under LLC law. They should be prepared to find liquidity rights, particularly in small, informal, member-managed LLCs formed without the benefit of counsel.80 Many of these involve heavily invested members who are not broadly diversified81 and who thus are dependent upon income either from the LLC or from a return on capital they can invest elsewhere.82
A major question is the level of specificity of proof courts will require to find a liquidity agreement. In some cases, members may be able to prove a specific oral agreement either to a buyout or to a business windup. In other cases, it may only be possible to establish a more general proposition. For example, it may only be possible to prove that the members agreed either that the association was at-will or that it was limited to a term or particular undertaking. In either of these situations, the members should be seen as having contracted out of the default rule of perpetual existence and its attendant lack of liquidity. Whether a buyout or a business windup would result could be determined either by analogy to partnership or other LLC law or by resort to the statutory mandate to supplement the statute with the principles of law and equity,83 particularly the laws of contract and agency.84 In either situation, courts should keep in mind that a business windup is an extreme remedy. In yet another class of cases, it may only be possible to prove an even more general proposition, for example, that the members agreed either to operate the LLC as a partnership85 or to use the LLC as simply an instrumentality of an overarching partnership.86
As we have seen, RULLCA continued to give members an action for oppression, which became “necessary” when it declared their LLCs to be perpetual.87 At the same time, however, and perhaps more significantly, it also took away their easy access to remedies in many more garden-variety situations.
One of RUPA’s major policy changes was to provide partners easier access to remedies, both in suits against one another and in suits against the partnership. The UPA had made a first step in this direction by giving partners a limited right to an accounting88 before dissolution.89 RUPA section 405 went “far beyond” the UPA rule and provided that a partner may sue the partnership or another partner at any time, for legal or equitable relief, to enforce the partner’s rights under the partnership agreement or under RUPA.90 Section 405 “reflects a new policy choice that partners should have access to the courts during the term of the partnership to resolve claims against the partnership and the other partners, leaving broad judicial discretion to fashion appropriate remedies.”91
In short, RUPA treated the partnership agreement like a normal commercial contract. RUPA made the partnership entity sufficiently stable to withstand a partner’s claim against it or against another partner. There is neither a dissociation nor a dissolution if a member takes her contractual or statutory claims to court. The Official Comment states that “no purpose of justice is served” by delaying the resolution of partner claims “on empty procedural grounds.”92 RUPA intended to eliminate “present procedural barriers to suits between partners,” and explicitly provided for “direct actions” against other partners or the partnership “for almost any cause of action arising out of the partnership business.”93 Stale claims are cut off by normal statutes of limitation,94 and time-barred claims are not revived by an accounting on winding up.95 To emphasize: no provision in RUPA restricts these direct actions.96 Nothing denies or delays any of a partner’s claims on the ground that they are derivative rather than direct.97
Like RUPA, the 1996 Act intended to provide “the essence of the bargain” for “small entrepreneurs without the benefit of counsel.”98 Its default rules were “designed to operate an LLC without sophisticated agreements and to recognize that members may also modify the default rules by oral agreements designed in part by their own conduct.” Accordingly, section 410 of the 1996 Act echoed RUPA’s broad authorization of member suits against the LLC or another member for breach of the operating agreement, statute, or other member rights.99 Like RUPA, it clearly intended “broad judicial discretion to fashion appropriate legal remedies.”100 Finally, like RUPA, it provided that statutes of limitation are governed by other law and that a time-barred claim is not revived by a right to an accounting on winding up.101
Unlike RUPA, the 1996 Act authorized derivative suits by members.102 Section 1101 provided that a member “may maintain an action in the right of the company if the members or managers having authority to do so have refused to commence the action or an effort to cause those members or managers to commence the action is not likely to succeed.”103 These derivative action provisions, however, are merely enabling, not mandatory. Like RUPA, the 1996 Act does not delay or deny a member’s claims on the ground that they are derivative rather than direct.
RULLCA reversed course on the issue of easy access to judicial remedies. It diverts a member’s claims to the derivative track unless the member can “plead and prove an actual or threatened injury that is not solely the result of an injury suffered or threatened to be suffered by the limited liability company.”104 In short, RULLCA adopts the “direct versus derivative” distinction from corporate and limited partnership law.105
The theory is that a derivative claim is the firm’s claim, not the member’s claim, and the firm can decide what to do with it.106 Before a member can bring a claim on behalf of the firm, it must give the firm a chance to decide what to do with it. To provide that chance, the member must demand that the firm pursue the claim, unless a demand would be futile.107 For example, it might be futile to make a demand if, in effect, the demand is that the firm sue all its controlling members.
If demand is made or forgiven and the member moves forward with a derivative suit, the LLC has the right to respond by appointing a special litigation committee (“SLC”) “to investigate the claims asserted . . . and determine whether pursuing the action is in the best interests of the company.”108 The SLC “must be composed of one or more disinterested and independent individuals, who may be members.”109 After “appropriate investigation,” the SLC may determine that it is in “the best interests” of the LLC that the proceeding continue under the control of the plaintiff, continue under the control of the SLC, settle on terms approved by the SLC, or be dismissed.110 The SLC must then file with the court a statement of its determination along with a supporting report.111 If the court concludes that the committee members “were disinterested and independent and that the committee acted in good faith, independently, and with reasonable care, the court shall enforce the determination of the committee.”112
In the context of publicly held corporations, direct actions are denied, and derivative actions are required, for any one of a number of policy reasons. Perhaps most importantly, recognizing that the claim belongs to the firm and not to a shareholder may preserve the role of the firm and its managers in resolving or disregarding a claim according to their best business judgment.113 Denying direct actions may also prevent multiple suits over the same cause of action, assure there is a fair distribution of any recovery among all interested shareholders, and avoid prejudice to firm creditors.114
Denying members standing and diverting them to a derivative track has long been criticized as inappropriate in the context of closely held corporations and LLCs.115 Distinguishing direct from derivative claims can be difficult, and the distinction has become one of the most litigated issues in LLCs.116 Numerous cases have denied members standing on the ground that their claims are derivative, even though no policy goals appear to be served by the denial.117 For example, there are many cases denying standing to one or more members of three- or four-member LLCs, even though all members are represented in the proceeding.118 These cases presented no risk of a multiplicity of suits by members and no risk of uneven recovery among members. Instead, they would have provided all members a chance to assert their claims, including any claims about the appropriate exercise of business judgment. They did not appear to impair the rights of creditors.119
Instead of the easy access to remedies they would have as partners or under the 1996 Act, members now face a daunting gauntlet of procedural obstacles.120 First, litigation may be necessary to accomplish what may be the difficult task of distinguishing direct claims from derivative claims. Second, if a claim is denied on the ground that it is derivative rather than direct, members must determine whether they must make a formal demand on the firm, and how that demand should be made, before filing a derivative proceeding. Third, if they proceed with derivative litigation on the theory that making a demand on the firm would be futile, they must then determine how to respond to any SLC the firm appoints in response. Indeed, a separate proceeding may be necessary to appoint the SLC or to challenge the disinterest and independence of any SLC the firm has appointed. Finally, depending upon the particular LLC act, there may be further litigation to challenge the work of the SLC or its recommendation. This procedural gauntlet is similar to the one that has been criticized as inappropriate in the context of closely held corporations.121 It is at least equally inappropriate in the context of closely held, member-managed LLCs, whose members may operate with even less formality and with no reason to expect the imposition of formalities normally associated with public corporations.122
There is nothing in the Official Comments to RULLCA suggesting that members intend to impose these procedural obstacles upon themselves. To the contrary, these obstacles seem inconsistent with their presumptive intent to operate informally123 and treat their agreement as a normal commercial contract. There is no fundamental policy in favor of the obstacles, as evidenced by the fact that they are default rules, not mandatory rules. Members who want to contract for easy access to judicial remedies may do so. A member’s right to maintain a derivative action is a mandatory rule only to the extent that the operating agreement may not “unreasonably restrict the right of a member to maintain” a derivative action.124 There is no restriction on the ability of the operating agreement to expand the right to bring direct actions.
The Official Comments do not explain why it is now necessary to prove a special contract to opt out of the procedural obstacles of derivative actions, even in the smallest of member-managed LLCs. At least in those LLCs, the default setting seems contrary to the presumed intent of members. It certainly was not necessary to restrict access to remedies to implement the elimination of buyout rights.125 Indeed, locking members in to perpetual entities calls for additional remedies, not fewer, as admitted by the Prefatory Note describing the inclusion of a “necessary” cause of action for oppression.126 On the other hand, the two changes fit together in the sense that they are both features of corporate law. So the question is, if it was not to effect presumptive intent, why did drafters import this remedy-restricting feature of corporate law?
The Prefatory Note and Official Comments are extremely brief. The Prefatory Note understates the significance of the change by stating only: “The new Act contains modern provisions addressing derivative litigation, including a provision authorizing special litigation committees, and subjecting their composition and conduct to judicial review.” By contrast, the Prefatory Note contains much more extensive discussion of the much less significant elimination of statutory apparent authority. The Official Comments add only that this “rule of standing [restricting direct actions] . . . predominates in entity law.”127 This Comment ignores the fact that the new rule of standing is in direct conflict with the easy access to remedies in partnership entities and under earlier LLC law. Unless the target group has changed, the imposition of the obstacles of derivative litigation cannot be explained on the basis of presumed intent.
The drafters of RULLCA sought to prevent the operating agreement from being treated like a normal commercial contract. The Official Comments admit that, “in ordinary contractual situations it is axiomatic that each party to a contract has standing to sue for breach of that contract.”128 However, the Comments then state that, “within a limited liability company different circumstances typically exist.”129 Without explaining why or how the “different circumstances typically exist,” the Comments conclude, oddly and without further explanation, that the distinction between direct and derivative claims “protects the operating agreement.” There is no indication how an agreement is “protected” by raising procedural barriers to its enforcement. At best, the Official Comment simply begs the conclusion:
A member does not have a direct claim against a manager or another member merely because the manager or other member has breached the operating agreement. Likewise, a member’s violation of this act does not automatically create a direct claim for every other member. To be able to have standing in his, her, or its own right, a member plaintiff must be able to show a harm that occurs independently of the harm caused or threatened to be caused to the limited liability company.130
In so stating, the Official Comment is revealing, if not explaining clearly, that the rule is not based on the presumptive intent of the target group. There is no indication that the drafters decided that members forming an LLC intend, or would intend if they thought about it, to deny themselves the remedies they would have under partnership law. Rather, the Comment can only mean that the drafters refused to treat the operating agreement as an ordinary commercial contract because of their intent to restrict member standing.131
Co-Reporter Daniel Kleinberger made this point more clearly in a subsequent article, in which he stated that “the distinction between direct and derivative claims follows necessarily from the concept of a legal person being separate and distinct from its owners.”132 However, both partnership law and early LLC law establish that it is incorrect to state that the direct/derivative distinction follows “necessarily” from the concept of an entity distinct from its owners. Rather, it only follows from the particular versions of business entity developed in the corporate and limited partnership contexts. Nevertheless, his fundamental claim is correct: the direct versus derivative distinction has no vitality unless you eliminate the expansive and easy access to member remedies of partnership law and early LLC law. He admits that the distinction occasionally “helps shelter a miscreant majority owner who has managed to harm a fellow owner indirectly,” conceding that in some states, “a plaintiff who makes a demand creates almost insurmountable obstacles to bringing a derivative claim if (typically when) the managers reject the demand.”133
There is no suggestion that the imposition of these “insurmountable obstacles” as default rules reflects the presumptive intent of our target group of entrepreneurs. Instead, adopting the default rules from corporate law presents a complex trap for unwary entrepreneurs. The members of our target group are unlikely to be aware of the need to contract away the machinery of corporate derivative litigation. They are likely to consider the issue only after a controversy has arisen. At that time, they will be put to the burden of establishing a contrary agreement, as they now must to establish liquidation or buyout rights.134 Here again, the question will be the necessary level of proof. It should not be necessary to show that the parties addressed and specifically set aside the rules of corporate derivative litigation. It should suffice to show that, either orally or by conduct, that they have agreed135 to treat their agreement as a normal commercial contract, to resolve their disputes as if they were partners136 or to treat the LLC as an instrument of an overarching partnership.137 In the process of resolving their claims, a court can rely on the statutory directive to consider principles of contract, agency, and equity to protect members from harsh, unintended consequences.138 Courts sympathetic to their plight should also use their authority to award lesser remedies in response to dissolution claims, including claims for dissolution in the event of oppression.139
The same factors that make derivative suits inappropriate in closely held LLCs also cut against the imposition of the extra machinery of an SLC. No policy goal is being served by the procedural obstacle140 and its imposition, even as a default rule, is contrary to the presumptive intent of the parties. However, there is an additional and even more specific critique of the imposition of an SLC as a default rule. RULLCA Official Comments refer to the SLC as an “ADR mechanism.” The SLC provisions effectively impose on the parties a pre-dispute binding arbitration agreement. Outside the corporate derivative action arena, the law is hostile to binding arbitration agreements unless there is informed consent.
Across a wide variety of disputes, courts, including the U.S. Supreme Court itself, are extremely divided on the validity of pre-dispute binding arbitration agreements.141 Even courts generally supportive of arbitration closely consider whether particular pre-dispute agreements should be enforceable. They look to see whether there was a knowing waiver of rights, especially the Seventh Amendment right to a trial by jury and the right to an appeal. Courts explore agreements to see whether they sufficiently inform the signatories of the practical differences between arbitration and litigation before a court. Depending upon the context, courts or regulators may require that a signatory’s attention be specifically drawn to the arbitration agreement, that it be in a separate document, and that a signatory be advised of the right to seek independent counsel about it. At the extreme, law firms with pre-dispute binding arbitration provisions in client retention agreements may be ethically obligated to put the arbitration agreement into a separate document and explain in writing to their clients that they should seek the advice of independent counsel because they are contracting away their constitutional right to a trial by jury, that only limited discovery may be available to them, that they will be required to pay up-front the fees of the arbitrator(s), and that they will have very little opportunity to appeal an adverse decision.142
Against this backdrop of controversy about the enforceability of pre-dispute agreements that are actually signed, it is surprising that RULLCA imposes such an agreement, as a default rule, on small groups of unwitting entrepreneurs who have not signed anything. To some extent, an SLC has even more discretion than an arbitrator. The SLC is empowered, if not primarily tasked, to apply its business judgment, and not just the law.143 The Official Comments state that “an SLC is intended to function as a surrogate decision-maker, allowing the [LLC] to make what is fundamentally a business decision.”144 It is true that the business judgment rule is part of the law arbitrators should apply. However, arbitrators generally apply the law to decisions others have made, not make the decision in the first instance.
It could be argued that the SLC is nevertheless an appropriate mechanism because courts have greater discretion to review the decisions of an SLC than they have to review the decisions of an arbitrator. Under the Federal Arbitration Act, there is extremely limited review of the decisions of arbitrators.145 Great deference is given to the arbitrator’s process regulation, finding of facts, and application of law, with the burden on the party challenging the arbitrator’s decision. By contrast, the Official Comments to RULLCA state that “a good deal of judicial oversight is necessary in each case” reviewing the work of an SLC, although “courts must be careful not to usurp the committee’s valuable role in exercising business judgment.”146 A court must consider not only whether the SLC members were “disinterested and independent,” but also “whether the committee conducted its investigation and made its recommendation in good faith, independently, and with reasonable care, with the committee having the burden of proof.”147 If these tests are satisfied, “it makes no sense to substitute the court’s legal judgment for the business judgment of the LLC.”148
RULLCA states that an SLC “must be composed of one or more disinterested and independent individuals, who may be members.”149 To this extent, greater disinterest and independence is required than in the case of arbitrations, in which there may be some opportunity for parties to directly appoint a non-neutral, if they agree in writing.150 In the corporate area, there has been considerable concern, and litigation, about whether a member of an LLC is sufficiently independent. In the famous case of In re Oracle Corp. Derivative Litigation,151 the court rejected the argument that members of an SLC are sufficiently independent if they are free from the “dominion and control” of the interested parties. It set a much higher bar for independence by requiring consideration of a much broader range of personal and social relationships:
Delaware law should not be based on a reductionist view of human nature that simplifies human motivations on the lines of the least sophisticated notions of the law and economics movement. Homo sapiens is not merely homo economicus. We may be thankful that an array of other motivations exist that influence human behavior; not all are any better than greed or avarice, think of envy, to name just one. But also think of motives like love, friendship, and collegiality, think of those among us who direct their behavior as best they can on a guiding creed or set of moral values.152
Social institutions have norms and expectations that “explicitly and implicitly, influence and channel the behavior of those who participate in their operation.”153 The law cannot assume that corporate directors who serve on SLCs “are, as a general matter, persons of unusual social bravery, who operate heedless to the inhibitions that social norms generate for ordinary folk.”154 These same considerations also apply to closely held LLCs, which are so often organized among family members, friends, or other business or social relationships.
There is a threshold question about the disinterest and independence of SLC members that is particularly problematic in the case of closely held LLCs. To what extent must those who appoint the SLC be disinterested and independent? RULLCA itself says very little on this point. In the case of a member-managed LLC, an SLC may be appointed by “a majority of the members not named as parties in the proceeding,” or, if all members are named as parties, by “a majority of the members named as defendants.”155 In the case of a manager-managed LLC, an LLC may be appointed by a “majority of the managers not named as parties,” or, if all managers are named, “by a majority of the managers named as defendants.”156 To the extent that majorities of defendants may appoint SLCs, the statute has virtually no disinterest and independence standard on who may appoint.
Especially in the case of closely held LLCs, it is difficult to understand how majorities of defendants can appoint “disinterested and independent” individuals. Recent cases have expressed skepticism about the ability to appoint disinterested individuals in the context of small firms.157 Co-Reporter Daniel Kleinberger reports there is reason to be skeptical. He states that, “as a matter of fact, almost all SLCs decide in favor of dismissal (sometimes conditioned on changes in the entity’s policies or practices) and so recommend to the court.”158 In the broader world of arbitration, it is considered critical to have arbitrators who are considered impartial and independent. For this reason, providers of arbitration services have special rules for selecting arbitrators when the parties cannot agree.159 Here again, the statutory law of the SLC as a “dispute resolution” mechanism falls short of arbitration rules exogenous to RULLCA, although careful judicial review should bring it closer.
The default rules of LLC law have dramatically turned away from partnership law and much more fully embraced corporate law. RULLCA declared LLCs to be “perpetual entities” and denied members any right to liquidate or be bought out. While this change facilitated sophisticated estate planning for family businesses, it immediately raised concern among those who saw minority members in closely held LLCs being made as vulnerable to abuse as minority members in closely held corporations. Although RULLCA gave minority members the “necessary” concession of a cause of action for dissolution in the event of oppression, not every state has followed suit.160 More importantly, the grant of a cause of action for oppression was more than offset by the act’s imposition of the direct/derivative distinction from corporate law. Minority members are now denied standing to bring many of their claims, whether based on the operating agreement or based on the statute. Instead, those claims are diverted to a derivative track that promises high dispute resolution costs with little chance of success.
Most fundamentally, the new LLC default rules are contrary to the presumptive intent of the target group that was the primary concern of RUPA and of the first wave of LLC acts: small groups of entrepreneurs who, without the benefit of counsel, form businesses in which they invest significant personal and financial resources and which they manage informally. It seems unlikely that these groups, by filing a certificate of organization, intend to lock themselves into perpetual entities with no right to liquidate or be bought out. It further seems unlikely that they would intend to deny themselves the right to sue one another for breach of their agreement. The current LLC default rules are more suitable for sophisticated investors and for members of affluent families engaged in sophisticated estate planning. These individuals are, of course, equally worthy of rules that reflect their intent. However, because they are much more likely to form and operate with the benefit of counsel who will draft bespoke agreements for them, they should not displace our target group as the primary concern of the default rules.
The presumptive intent of our target group was better reflected in the liquidity and remedial rules that existed in the 1996 Act. If it is unrealistic for the pendulum of LLC law to swing back to all of the liquidity and remedial rules of the 1996 Act, its default rules could be reinstated at least for member-managed LLCs. In these situations, different buyout rights could be given in both at-will and term LLCs. Even if the buyout rights continue to be eliminated, there is no further need to deny the easy access to judicial relief available both in the case of partnerships and under the 1996 Act. No public policy is being served by imposing upon our target group the procedural obstacles of derivative litigation. The presence of a shield is not an adequate explanation. Easy member access to judicial relief is provided in the default rules for LLPs. It is the default rules of the LLC that miss the mark of the presumed intent of the owners, not the default rules for LLPs.
Until there is statutory reform to bring the default rules of LLCs closer to the presumptive intent of the parties, courts should identify and enforce the reasonable expectations that members have agreed upon among themselves. As they have in other areas of the law, courts will tend to avoid default rules they deem unfair. One statutory basis for relief is the new cause of action for dissolution or other relief in the event of oppression. Another statutory basis is the definition of the operating agreement, which can be written, oral, or inferred from conduct. The third statutory basis is the rule that the principles of law and equity apply, unless specifically displaced. The common law principles of agency and contract are the most important supplemental principles. At the level of the greatest generality, courts might find that members intend to treat their agreement as a normal commercial contract, operate their LLC as a partnership, or use the LLC as an instrumentality of an overarching partnership.
A Remedy for Oppressive Conduct. Reflecting case law developments around the country, the new Act permits a member (but not a transferee) to seek a court order “dissolving the company on the grounds that the managers or those members in control of the company . . . have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the [member].” Section [701(a)(4)(C)(II)]. This provision is necessary given the perpetual duration of an LLC formed under this Act, Section [108(c)], and this Act’s elimination of the “put right” provided in ULLCA § 701.
R.U.L.L.C.A., Prefatory Note at 2.
[W]hen the personal relationship among the participants in a close corporation breaks down, the minority shareholder has neither the power to dissolve the business unit at will, as does a partner in a partnership, nor does he have the “way out” which is open to a shareholder in a publicly held corporation, the opportunity to sell his shares on the open market. Thus, the illiquidity of a minority shareholder’s interest in a close corporation renders him vulnerable to exploitation by the majority shareholders (citations omitted).
(1) the member first makes a demand on the other members in a member-managed limited liability company, or the managers of a manager-managed limited liability company, requesting that they cause the company to bring an action to enforce the right, and the managers or other members do bring the action within a reasonable time; or
(2) a demand under paragraph (1) would be futile.
R.U.L.L.C.A. § 802(1), (2) (emphasis added).
(1) special litigation committees decide to pursue or settle claims much more frequently than heretofore recognized; (2) special litigation committees do not otherwise let defendants off the hook when pursuing or settling claims, in view of the financial recovery to the company in either scenario; (3) most shareholder claims subject to the authority of special litigation committees end up settled, not dismissed; and (4) claims subject to the authority of a special litigation committee are resolved faster than standard derivative claims, indicating that the special litigation committee may serve as a form of alternative dispute resolution.
Minor Myers, The Decisions of The Corporate Special Litigation Committees: An Empirical Investigation, 84 Ind. L.J. 1309, 1309 (2009).