Corporate Research E-Letter No. 27, September 2002
THE BUCK DOESN’T STOP HERE:
THE SPREAD OF LIMITED LIABILITY COMPANIES
by Philip Mattera
Will the LLP hold up against the impact of the LLCs? That’s a shorthand way of expressing one of the key questions surrounding the future of the Enron-Arthur Andersen business crime scandal.
LLP stands for limited liability partnership, the business form that Arthur Andersen, along with other large accounting firms as well as many law firms, adopted to protect partners from the legal consequences of misdeeds by their colleagues. LLCs, short for limited liability companies, are a comparable organizational type that has grown increasingly popular in the business world, in part because of the tax advantages it provides. Many of the off-balance-sheet entities created by Enron executives to hide debt – the discovery of which led to the undoing of the company and its accounting firm, Andersen – were formed as LLCs.
The efficacy of the LLP shield is about to be put to the test. Following its conviction on federal obstruction of justice charges in June, Andersen is all but defunct. Yet its partners are still defendants in huge civil suits brought by Enron shareholders and are the targets of bankruptcy court actions by Enron creditors. Also among the defendants are several of Enron’s law firms, one of which, Houston-based Vinson & Elkins, is organized as an LLP. The plaintiffs in these cases are trying to attach liability to all of the firms’ accounting and law partners, not just the ones that may have been directly involved in criminal matters. Legal experts are divided on how the dispute, for which there are no real precedents, will turn out.
LLCs are also being discussed as a way for corrupt executives to avoid giving up all of their ill-gotten gains. Business Week recently speculated that CEOs facing indictment could stash assets in LLCs, as well as in children’s trusts and offshore investments, to prevent their confiscation after a conviction.
SEEKING THE BEST OF BOTH WORLDS
So what exactly are these LLCs and LLPs that are popping up in the news? Limited liability companies first emerged in the late 1970s, when a Colorado energy firm called Hamilton Brothers Oil began lobbying state legislatures to approve a new form of business organization similar to the Panamanian “limitadas” that Hamilton had used in some of its foreign operations. Legislators in Wyoming were amenable to the idea, and in 1977 that state was the first to sanction LLCs.
The appeal of LLCs was that they provided what accountants and business lawyers called “the best of both worlds.” Those worlds were the two predominant forms of business organization: corporations and partnerships.
Corporations embody the principle of limited liability: the idea that someone can invest in a profit-making enterprise without putting all of his or her personal assets at risk in the event of litigation. Corporations can have large numbers of shareholders and can remain in existence indefinitely. The drawback, from a business owner’s point is view, is that corporate earnings are subject to double taxation. First, the company pays taxes on its earnings. Then, shareholders pay levies on the portion of those earnings they receive in the forms of dividends. Corporations, especially those whose shares are publicly traded, are also forced to be somewhat transparent in their operations by holding annual meetings and producing annual reports.
Partnerships have much less protection from liability. In general partnerships, each of the partners is putting at risk both personal assets as well as funds invested in the business. A major adverse legal judgment can render a partner penniless. In limited partnerships, most participants (the limited partners) do not expose their personal assets, but they are not allowed to be active in the management of the business, which is run by one or more general partners whose personal assets are not shielded. Partnerships, however, are not subject to double taxation. Each partner’s share of earnings is reported on his or her personal tax return, while the partnership serves as a pass-through entity and thus is not itself levied.
For much of the history of American capitalism, business owners had to decide between establishing a corporation or a partnership, confronting the tradeoffs between the two forms. In 1958 Congress allowed smaller businesses to gain the advantages of limited liability without taking on all the burdens of conventional corporations. This was done through the creation of Subchapter S corporations, which were treated as partnerships for tax purposes. S corporations, however, were subject to rigid rules—such as a maximum of 35 shareholders—that restricted their appeal.
THE LLC STAMPEDE
Hamilton Oil wanted to have its cake and eat it, too, without any limits on the size of the portion. The entities that Hamilton got Wyoming legislators to create combined limited liability with partnership-type tax advantages. An LLC did not have a ceiling on the number of shareholders, and its investors (who were called members) were allowed to be active in the management of the company.
Wyoming did not immediately set off a rush to LLCs in the rest of the country. Five years later, Florida took a similar step, but most states were reluctant to act until the tax status of this new form of business organization was clarified. That clarification came in 1988, when the Internal Revenue Service affirmed that LLCs would be treated like partnerships for federal tax purposes.
The IRS ruling set off what has been described as a stampede. In a matter of a few years, one state after another passed legislation authorizing LLCs. Many legislators were apparently motivated by concerns that failing to take such a step would put their state at a disadvantage in attracting new business investment. In doing so, little attention was paid to the implications of the move for state tax revenues. While it is difficult to quantify, the availability of the LLC option means that business owners can avoid setting up corporations and paying corporate income taxes on their profits. In this sense, the sanctioning of LLCs amounts to a kind of tax subsidy for the private sector.
By 1996, all 50 states and the District of Columbia had endorsed the creation of a new category of business organization that did not exist in the country two decades earlier. Entrepreneurs wasted no time taking advantage of this appealing new legal structure. The number of LLCs reached 100,000 in 1995, and two years later it surpassed the number of limited partnerships. In 1999 (the most recent data available), there were some 589,000 LLCs with total assets of about $1.7 trillion.
In the early 1990s, LLCs got a dubious reputation when scam artists used them as a device for attracting investments in fly-by-night telecommunications ventures that circumvented state securities laws. The Securities and Exchange Commission cracked down on these schemes, and LLCs seemed to gain respectability. That was until their use by the likes of Enron came to light.
PUTTING PRUDENCE BEFORE SOLIDARITY
The desire to limit liability while retaining the advantages of a partnership was not limited to entrepreneurs. A similar yearning emerged among the professional class. During the savings and loan scandals of the 1980s, a number of accounting and law firms were hauled into court because of their failure to blow the whistle on fraudulent activities by their S&L clients. Traditionally, all of the members of a partnership could be held liable for the misdeeds of one of their number. The S&L experience persuaded law and accounting firms that they needed to put prudence before solidarity. So they began to push for a new form of organization--a limited liability partnership, or LLP--that would not put everyone’s personal assets at risk.
Texas, the epicenter of the S&L scandals, was the first state to respond to the call of the lawyers and accountants. In 1991 it enacted a statute allowing for the creation of LLPs that protected partners from liability arising out of malpractice by other firm members. From there the trajectory was even steeper than that of LLC legislation. One state after another joined the bandwagon, and by 1997 all but one state permitted the LLP form. Ironically, the laggard was Wyoming, which pioneered LLCs; the Equality State later joined the rest of the country in embracing LLPs.
While the LLC revolution involved mostly smaller corporations, the LLP phenomenon took in many large and well-known professional firms, including the Big Six accounting firms and many of the country’s leading law firms. Investment bank Goldman Sachs turned itself into an LLP for a few years before deciding to go public.
Arthur Andersen LLP’s legal woes stemming from its involvement in Enron are the first major test of the limited liability partnership arrangement. That arrangement clearly affords protection of assets in the event of normal commercial litigation, but the Andersen situation is far from normal. What lawyers for Enron’s shareholders will presumably argue is that the limitations of liability should not apply when criminal conduct is involved. This principle, known as “piercing the veil,” is frequently used to get around liability limits in cases involving corporations. If corporate officers can be held responsible for their company’s misdeeds in certain circumstances, it seems likely that LLP partners will be treated the same way.
LLCs AND NUKES
Beyond the outcome of the Andersen-Enron litigation, there are larger questions about the spread of LLCs and LLPs. In retrospect, it is puzzling and dismaying that these quite significant changes in business law were enacted with virtually no opposition. Now that these new forms of limited liability are with us, we are left to wonder what the consequences will be.
One area in which this issue is already being addressed is with regard to nuclear power plants. In recent years, utility companies have put more than 25 such plants under the ownership of subsidiaries set up as LLCs. The potential consequences of this move are beginning to be analyzed. Last month, Synapse Energy Economics released a report on the subject (available online at <http://www.synapse-energy.com/publications.htm>) that was commissioned by the STAR Foundation and Riverkeeper Inc. Entitled “Financial Insecurity,” the report warns that in the event of a serious nuclear accident, the LLC owning the plant could declare bankruptcy, and its parent company could avoid liability for damages. Given that the federal Price-Anderson Act already limits the industry’s liability, the report notes, the ultimate cost of an accident could be borne by taxpayers.
The conversion of nuclear power plants to LLC ownership may be only the first of many situations in which dangerous or litigation-prone industries seek to limit their liability at the expense of potential plaintiffs or, ultimately, the general public. While it is too late to prevent the universal adoption of LLCs and LLPs within the United States, it may be just the right time to raise questions about these business forms that, from the public’s point of view, combine the worst of both worlds.