Uncorporate Governance

Although this blog uses the name Harvard Law School Corporate Governance Blog, I want to introduce a new but closely related topic – uncorporate governance.

By uncorporate I mean partnership-type business associations (i.e., general partnerships, limited liability companies and limited partnerships) and the default rules and norms that are associated with these business forms.

One might say that looking at uncorporations moves away from this blog’s focus on publicly held firms. But as I show in my Uncorporating the Large Firm, uncorporations are increasingly important in governing large, publicly held firms. Examples include not only publicly traded partnerships, limited liability companies and real estate investment trusts, but also private equity, venture capital and hedge funds that exercise critical control powers in firms that are large, publicly traded, or both.

All of these firms are characterized by their substitution of discipline and incentives for corporate-type monitoring as ways to control managerial agency costs. Specifically, uncorporations (1) loosen managers’ grip on the firm’s cash through distributions and liquidation rights; and (2) give managers high-powered owner-like incentives. The trade-off is that uncorporations rely much less on high-cost but often ineffective monitoring devices such as fiduciary duties, owner voting and the market for control.

Corporate scholars and practitioners have been complaining for generations about the inadequacy of corporate monitoring devices in controlling agency costs. Tweaks of conventional corporate governance, such as majority voting for directors, are more band-aids than solutions. Defenders of the corporate status quo argue that the benefits of strong managerial power are worth the costs. But whether that is true depends on whether there are cheaper and more effective alternatives. My paper shows that there are, and that market forces have been substituting these alternatives for traditional corporate governance.

So research on corporate governance needs to start paying more attention to uncorporate governance. This means, among other things, more focus on the distinct role of uncorporate structures in producing value. For example, many articles discuss activist hedge funds’ role in unlocking corporate value, but not why they produce these results. My work suggests that hedge funds’ uncorporate structure – that is, use of typical limited partnership and LLC governance devices – is a big part of the answer. Similarly, many attribute the success of private equity to factors such as the escape from securities regulation and the use of debt. Again, I suggest that private equity’s uncorporate structure plays a critical role. The public policy implication is that disabling critical private equity features through tax or regulation may have significant costs.

The role of uncorporations in large firms may increase as new uses are found for these devices. For example, I’ve tried to make the case for publicly traded law firms (which, of course, would involve changes in current ethical rules). See MacEwen, Regan & Ribstein, Law Firms, Ethics and Equity Capital: A Conversation. I show in my “Uncorporating” paper that uncorporate structures are the likely vehicles for such firms.

The future of the uncorporation in large firms depends critically on the courts and Congress. The courts need to enforce contracts in uncorporations, particularly including fiduciary duty waivers, in order to effectuate the uncorporate substitution of discipline and incentives for monitoring. I show in The Uncorporation and Corporate Indeterminacy that the Delaware courts are, indeed, doing that. Francis Pileggi wrote about one recent such case on this Blog, Chancery Gives Victory to Freedom of Contract, May 23, 2008.

As for Congress, we can expect calls by interest groups to stunt the expansion of private equity and other uncorporate governance devices. These devices increase managers’ incentives to respond to owners’ interests and eliminate the shareholder meeting as a mechanism for non-owner interest groups to be heard. As I’ve discussed on my blog (The SEIU and Private Equity, June 4, 2008) the unions are aware of this and fighting back. The political question boils down to the appropriate balance between managerial accountability and managers’ power to allocate some of the corporate pie to non-owner groups. Congress could try to stunt the growth of the uncorporation through tax and regulation. On the other hand, such moves as eliminating the corporate tax or relaxing publicly traded firms’ ability to be taxed as partnerships could pave the way to really significant changes in the way corporations are governed.

In short, managers’ agency costs in large corporations has for a long time been a lot like the weather. Politicians and interest groups talk about it a lot, but the results, like umbrellas and galoshes, don’t change the basic scenery. The uncorporation could make a basic change if we’re willing to unleash its potential.