The Two Worlds of LLCs: A Conversation With Professor Peter Molk (Part One)

December 16, 2019

After three decades during which it rose from obscurity to become the entity of choice, the limited liability company remains an experiment in progress.

This is especially true when it comes to the internal relations of LLC members and managers, caught in the cross currents of the LLC’s freedom-of-contract foundation, oftentimes fuzzy statutory default rules, and the courts’ resort to traditional powers of equity to resolve the particular disputes that come before them.

In my experience advising LLC owners, litigating their disputes with co-owners, and keeping up with legislative and case law developments nationwide, I see two very different worlds of LLCs.

In the one are highly capitalized enterprises, usually manager-managed with any number of sophisticated non-managing members/investors, all of whom are represented by or have access to competent legal and financial advisors. For these LLCs, optimal efficiencies and allocation of capital can be achieved via negotiated operating agreements without need of mandatory statutory rules and judicial intervention on the side of equity.

In the other world are more thinly capitalized (at least at the start) owner operated and managed LLCs populated by relatively unsophisticated members, by which I mean without knowledge of the rules governing business organizations (or even know what an LLC is), without bargaining power, and without access to, or financial ability and motivation to hire, competent legal and financial advisors. Often these LLCs have no operating agreement, or a cookie-cutter agreement purchased online or prepared by an attorney without deep knowledge of LLC law. Many also involve family-owned businesses. For these LLCs, the argument is stronger for certain mandatory protections against opportunistic behavior by fellow members.

Which brings me to my latest podcast guest, Peter Molk, an Associate Professor of Law at the University of Florida Levin College of Law, who has established himself as one of the foremost thinkers in the field of LLC law. Longtime readers of this blog may recall a podcast interview I did with Professor Molk in 2016 concerning his groundbreaking study of how LLC owners contract around default statutory protections.

I reached out again to Professor Molk after reading his latest article on LLCs published in the U.C. Davis Law Review, entitled Protecting LLC Owners While Preserving LLC Flexibility. In his article, Professor Molk draws a line resonant with my “two worlds of LLCs” by proposing an accredited investor qualification borrowed from securities law to separate sophisticated and unsophisticated LLC owners, subjecting only the latter to a set of mandatory statutory protections. From the article’s abstract:

LLC statutes allow owners to restrict or completely waive standard governance protections required of other business forms. Corporate law mandatory stalwarts like fiduciary duties can be entirely eliminated in an LLC. This flexible approach has the potential to generate the most efficient governance relationships: tailored negotiation among LLC investors can produce an optimal set of governance terms that corporate law’s mandatory protections cannot. Yet when owners lack sophistication or bargaining power, contractual freedom allows for opportunistic terms that misprice capital, reduce investment, and inefficiently allocate capital across LLCs.

A series of cases involving opportunistic conduct have brought this problem to the fore. Recommendations for reform have focused on doing nothing, imposing mandatory protections, or relying on ad-hoc judicial interventions, but these solutions are each ultimately unsatisfying. I ultimately show how a model inspired by securities law’s accredited investor concept has the most promise to ensure LLCs’ continued viability as a distinct organizational form, with favorable liability and tax treatment to everyday investors and the freedom to craft unique governance relationships for sophisticated ones.

The article can be downloaded on SSRN here.

I had the pleasure of interviewing Professor Molk once again for the Business Divorce Roundtable podcast. In Part One of a two-part podcast, which you can hear by clicking on the below link, we talk mostly about the pros and cons of the freedom-of-contract paradigm for LLCs and its different impact on the two worlds of LLCs. In Part Two, which should be available in early 2020, the discussion focuses mainly on Professor Molk’s accredited investor proposal.