Having spent the better part of my career litigating disputes between minority and majority owners of closely-held businesses, I can comfortably say that all else equal, I would prefer to be a minority shareholder of a New York corporation than a minority member of a New York LLC.
With share ownership comes the protections specifically enumerated in the Business Corporation Law and a rich body of caselaw concerning shareholders’ rights and the need for courts to protect shareholders from majority overreach.
LLCs, by contrast, we often describe as “creatures of contract,” and courts tend to focus less on protection of the minority members and more on determining and enforcing the parties’ intent at the outset of their relationship. That focus sometimes puts too much faith in the belief that members enter into a thoughtful, ex ante agreement governing their relationship and any potential fallout. It takes minutes to create an LLC and execute a fill-in-the-blank operating agreement, and that is exactly what many business owners do. Then when a dispute arises, a court’s first instinct is to scrutinize the same document that the owners may not even have read when the LLC was formed.
Those observations explain why I thoroughly enjoyed reading Professor Megan Wischmeier Shaner’s recent article in the Columbia Business Law Review, Corporate Resiliency and Relevancy in the Private Ordering Era (available on SSRN here). Professor Shaner, the Arch B. & Jo Anne Gilbert Professor of Law at University of Oklahoma College of Law, presents her compelling observations that the contract-based focus often associated with LLCs is migrating to corporations, producing unintended consequences.
Private Ordering and Corporations
It all started, Professor Shaner writes, in response to a resurgence in shareholders’ rights. Market reforms in the early 2000s and following the 2008 financial crisis gave new muscle to shareholders—increasing their rights to sue derivatively, access information, and approve board decisions. Corporations responded by focusing on “private ordering,” or contractually imposing certain limitations on shareholders’ rights in the corporation’s bylaws.
The subjects of “private ordering” in corporate bylaws were arguably modest at first: corporations hemmed the risk of activist shareholder litigation by adopting forum selection clauses or litigation fee-shifting provisions into their bylaws. Those changes met Court approval in Boilermakers Local 154 Retirement Fund v Chevron Corp., 73 A3d 934 [Del Ch 2013], and ATP Tour, Inc. v Deutscher Tennis Bund, 91 A3d 554 [Del 2014]. Both cases pinned their reasoning on the freedom of the corporation to contract with its shareholders as its sees fit.
So corporations and boards leaned harder into contract-based private ordering: they began including in their bylaws provisions expressly renouncing any interest in future corporate opportunities—freeing directors and officers to pursue opportunities independently without exposing themselves to a claim of usurpation of opportunity. Those measures also met court (and ultimately, legislative) approval under a contract-based analysis (see Del. Gen. Corp. Law § 122).
Further fueling the trend, Professor Shaner writes, is the contractarian influence that closely-held corporations have on public corporations. Private ordering in close corporations is nothing new: owners have always been keen to impose a contractual layer onto their shareholder relationship with things like buy-sell agreements, employment agreements, and restrictive covenants. And that willingness increasingly extends to fundamental shareholders’ rights:
Aggressive contracting efforts in this space . . . have moved beyond traditional matters, such as voting and board composition, to alter bedrock governance rights, such as appraisal, books and records inspection rights, and fiduciary duties. To date, courts have upheld these efforts based on principles of contract, not corporate, law. This recent shareholder agreement jurisprudence . . . has been described as ‘reconfigur[ing] Delaware’s longstanding defaults along each of exit, voice, and liability.’ ”
All told, Professor Shaner writes,
The private ordering era has revealed the dominance of contractarianism in corporate law—statutory amendments endorse, and courts have embraced, private ordering consistent with the contract theory of the firm.”
Approaching Singularity of the Business Form
The expansion in “private ordering,” Shaner argues, results in a blurring of the line between the corporation and LLC, where contractual freedom reigns supreme. Taken to its logical end, the trend brings about a fusing of the corporation and the LLC: “The ultimate convergence point, some scholars assert, will be one of maximum freedom of contract and zero mandatory regulation (i.e., the LLC).”
This convergence comes with often unconsidered costs, highlights Professor Shaner. It deprives business owners of a meaningful choice among different corporate forms—corporate form selection should mean something (and signal something to regulators, investors, and the public). It results in a lack of standardization; heavily bespoke bylaws and shareholders agreements means that a shareholder of corporation A could be in a very different position than a shareholder in corporation B. And it creates increased transaction and litigation costs—someone needs to pay for all the private ordering, after all.
Takeaways for New York Closely-Held Corporations
Professor Shaner’s article focuses mostly on public corporations, but contractarianism and private ordering have an even greater place in closely-held corporations. Unlike shareholders of public corporations, who can exit the corporation on a moment’s notice thanks to a robust market, shareholders of closely-held corporations are expected to have given greater consideration to the terms under which they became shareholders. That expectation makes the tendency to treat the shareholder-corporation relationship as contract-based more natural.
For these reasons, and as contractarianism continues its advance into corporate law, shareholders of closely-held corporations can expect courts—wittingly or not—to treat disputes among shareholders as contractual disputes over the bylaws or shareholders agreements. Close corporations should reexamine their governing documents with that in mind.
Even if we are headed toward a convergence of the corporation and the LLC, under today’s rules, I’d still rather be a minority shareholder in a New York corporation than a minority owner of a New York LLC. Here’s why:
More Dissolution Leverage. BCL § 1104-a allows the holders of shares representing at least 20% of all voting shares to petition for dissolution when, inter alia: (i) the directors or those in control of the corporation have been guilty of illegal, fraudulent or oppressive actions toward the complaining shareholders; or (ii) the property or assets of the corporation are being looted, wasted, or diverted for non-corporate purposes by its directors, officers or those in control of the corporation. A minority shareholder holding less than 20% of the shares entitled to vote can also petition for common law dissolution.
Those standards are generally friendlier to minority shareholders than the involuntary dissolution standard for LLCs, which requires showing that “it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement,” particularly where many operating agreements state that the LLC is formed for “any valid business purpose” (LLC Law § 702; Matter of 1545 Ocean Avenue, LLC, 72 AD3d 121 [2d Dept Jan. 26, 2010] [discussed here]).
Better Transferability. Shares held by a corporation are freely transferrable: they can be sold, traded, bequeathed, and inherited. That transferability can be a valuable asset for minority owners: it gives them a means to exit the corporation or pass on their shares. Membership in an LLC, by contrast, is not freely assignable. Under LLC Law § 603, a member may assign her interest in an LLC, but the assignee of a member’s interest does not become a member in the LLC; they become an “economic interest holder,” permitted to receive distributions, but not permitted to participate in the management of the LLC, sue derivatively, or petition for dissolution of the LLC (although, perhaps—as this post considers—the heirs to a deceased member may petition for dissolution after all).
Cleaner Management Roles. Unless otherwise set forth in the shareholders agreement, minority shareholders have limited management rights. They can vote to elect the Board of Directors (BCL § 614), vote on a merger or consolidation of the corporation (BCL § 903), vote on an amendment to the Certificate of Incorporation (BCL § 803), and vote on items requiring shareholder approval in the shareholders’ agreement. Beyond that, however, day-to-day management of the corporation falls to the directors and officers.
Default management rights in a New York LLC are greater, but also much . . . murkier. In a member-managed LLC (the default under New York Law), majority rules for major decisions, and each member has the independent authority to manage the day-to-day affairs of the company. In the event of a dispute between managing members, it is easy to wind up in a situation where feuding members are independently (or antagonistically) managing the business, with the business and its employees caught in the middle.