The Fable of the B.A.’s:

Network Externalities and the Choice of Business Form*

Bruce H. Kobayashi Associate Professor of Law

George Mason University School of Law 3401 N. Fairfax Drive Arlington, VA 22201

bkobayas@gmu.edu

Larry E. Ribstein Foundation Professor of Law

George Mason University School of Law 3401 N. Fairfax Drive Arlington, VA 22201

lribstei@gmu.edu

Abstract

Recent papers have asserted the applicability of the "network externalities" literature to the choice of business form. This paper critically examines these claims. We show why network externalities theoretically should be expected to have only a minimal effect on the choice of business form. We then directly examine the empirical significance of network externalities by comparing recent formation data on limited liability companies (LLCs) and limited liability partnerships (LLPs). The two forms are close substitutes, the main exception being that the LLP is explicitly linked to the "network" of partnership law, while the LLC is not. The network externalities hypothesis predicts that LLPs would be adopted at a much greater rate than LLCs. This hypothesis is rejected, as we find that the non-linked form, the LLC, has far outperformed the LLP in terms of new formations in every state. The limited empirical relevance of network externalities is further demonstrated by the fact that the relative LLP adoption rate is significantly greater in states that tax LLCs as corporations than in states that tax LLCs and LLPs equally.

* Very helpful comments were provided by Michael Klausner, Stan Liebowitz, and participants at a session of the Canadian Law and Economics 1999 Annual Meeting and at a workshop at the Center for Study of Public Choice at George Mason University. Errors remain ours.

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I. THE NETWORK EXTERNALITIES HYPOTHESIS 4

II. THE PROBLEMS OF PROVING NETWORK EXTERNALITIES 7

A. DETERMINING NETWORK EXTERNALITIES 8

B. WHEN DO NETWORK BENEFITS INVOLVE "EXTERNALITIES"? 9

C. LOCK-IN OTHER THAN BY NETWORK EXTERNALITIES 10

III. A LINKED PRODUCT APPROACH TO NETWORK EXTERNALTIES 11

A. IS THERE LOCK-IN OF CLOSELY HELD BUSINESS FORMS? 12

B. LINKED FORMS AS A TEST OF NETWORK EXTERNALITIES: THE LLP 16

C. DATA ON ADOPTION OF THE LLC AND LLP FORMS 19

IV. CONCLUSIONS 23

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Scholars have asserted that "network externalities" or "lock-in" can impede the development of new products or services.1 As the story goes, users flock to the product or service because of the value added by other users. The user network becomes so valuable that, without such a network, even a superior competitor may be unable to dislodge the market leader. The importance of the theory has been asserted in recent legal cases involving the antitrust and copyright laws.2 As computers and the Internet create new opportunities for the formation of networks, the theory is likely to gain in prominence in the absence of a serious challenge.

The problem with the lock-in hypothesis is that it is a kind of fable. As in Kipling's "Just So" stories the story plausibly explains the outcome, such as the elephant's trunk or the giraffe's neck. The recent rise of the lock-in theory in the economics literature started with a "just so" fable of how, in the face of network externalities, the QWERTY typewriter keyboard was able to lock out the superior Dvorak alternative.3 But the story broke down upon a closer examination of the factual background. Liebowitz and Margolis demonstrated that the evidence for Dvorak's superiority was weak, and that QWERTY won only after proving itself against competing standards.4

A general problem with challenging the lock-in hypothesis is that convincing data is hard to find. Unless the winning product is shown to be superior to the loser, as in the case of QWERTY and Dvorak, lock-in is a possible explanation of the outcome. While there may be competing explanations, their role in the outcome may be difficult to establish. This article contributes to the network externalities literature by stating the theory in the form of a testable hypothesis and then bringing data to test the hypothesis. We find convincing data in the area of business association statutes. Commentators have asserted that network externalities can impede the development of business associations5

1 For general discussions of network externalities and lock-in see e.g., Joseph Farrell & Garth Saloner, Standardization, Compatibility, and Innovation, 16 RAND J. Econ. 70, 71-72 (1985) (characterizing the problem as one of excess inertia); Michael L. Katz & Carl Shapiro, Systems Competition and Network Effects, 8 J. Econ. Persp. 93 (1996).

2 The most prominent recent example is the use of the theory in the government's antitrust case against Microsoft. See, e.g., S. J. Liebowitz & Stephen E. Margolis, Winners, Losers, and Microsoft: Competition And Antitrust In High Technology (1999) ("Microsoft"); John E. Lopatka and William H. Page, “Antitrust on Internet Time: Microsoft and the Law and Economics of Exclusion,” 7 Sup. Ct. Econ. Rev. 157, 168-71 (1999). For a discussion of this issue in the copyright context, see Lotus v. Borland, 49 F.3d. 807, (1st Cir, 1995), 516 U.S. 233 (1996) (summary affirmance by equally divided Supreme Court). See also Kenneth W. Dam, “Some Economic Considerations in the Intellectual Property Protection of Computer Software,” 24 J. Leg. Stud. 321, 351-6 (1995).

3 See Paul A. David, Clio and the Economics of QWERTY, 75 Am. Econ. Rev. 332 (May 1985).

4 See S. J. Liebowitz & Stephen E. Margolis, The Fable of the Keys, 33 J. L. & Econ. 1 (1990) ("Liebowitz & Margolis"). See also Liebowitz and Margolis, supra note 2 (showing evidence that Microsoft's victory in software markets is due to the superiority of their products rather than network externalities); S. J. Liebowitz & Stephen E. Margolis, Network Externality: An Uncommon Tragedy, 8 J. Econ. Persp. 133 (1994).

5 See Marcel Kahan & Michael Klausner, Standardization and Innovation in Corporate Contracting (Or, "The Economics of Boilerplate"), 83 Va. L. Rev. 713 (1997); Marcel Kahan & Michael

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just as they can new products and services. The network externalities theory has potentially significant implications for the law of business associations. If there is a market failure, unfettered state competition cannot be assumed to produce efficient results. It arguably follows that academics, uniform lawmakers and others should intercede to help the law along.

The recent history of firms' rapidly embracing new business entities immediately on removal of federal and state tax impediments provides a laboratory for testing this theory. Most important, recent history has provided a competition between two types of business associations, the new and distinct limited liability company (LLC) and the limited liability partnership (LLP), which is similar to the LLC except that it links with the existing general partnership form. The two business forms differ mainly in that one (the LLP) allows those who adopt it to benefit from existing network effects while the other, (the LLC) does not. The network externalities theory essentially asserts that the winner of the competition would be the business association that minimized network externalities even if this characteristic made it inferior to the competing form. Thus, the network externality theory predicts that the LLP would win the competition because firms would not have to give up the large established "network" of general partnership cases and private forms. However, our evidence shows that most firms have preferred the LLC. This suggests that network effects have had minimal importance as a barrier to the adoption of new business forms.

The article proceeds as follows. Part I briefly reviews the general theory of network externalities. Part II then critically analyzes the lock-in theory as applied to business associations. We examine the theory's specific assumptions with a view to determining whether these assumptions are accurate. Part III presents both anecdotal and more systematic data that bears on the existence of network externalities in business association statutes. We discuss aspects of the recent history of closely held firms that, taken together, either refute or fail to support the lock-in theory. Part IV discusses our conclusions and implications from our study.

I. THE NETWORK EXTERNALITIES HYPOTHESIS

A network benefit occurs when the advantages of a particular product or standard increases with the number of users. For example, the private benefit of a telephone increases with the number of persons it can reach. Network benefits can become "externalities" because new adopters of the standard or service consider only their own benefits and not those of other users. Because of risk and the time value of money, future network benefits are worth less to early adopters than they are to later ones.6 People therefore may not buy a new product or adopt a new standard even if it is inherently better than the old one. Accordingly, a new product or standard might not emerge even if Klausner, Antitakeover Provisions in Bonds: Bondholder Protection or Management Entrenchment?, 40 UCLA L. Rev. 931 (1993); Marcel Kahan & Michael Klausner, Path Dependence in Corporate Contracting: Increasing Returns, Herd Behavior, and Cognitive Biases, 74 Wash. U. L. Q. 347 (1996) ("Path Dependence"); Michael Klausner, Corporations, Corporate Law, and Networks of Contracts, 81 VA. L. REV. 757 (1995); Note, Tara Wortman, Unlocking Lock-In: Limited Liability Companies and the Key to Underutilization of Close Corporation Statutes, 70 N.Y.U. L. Rev. 1362 (1995); Lucian Arye Bebchuk and Mark J. Roe, A Theory of Path Dependence in Corporate Ownership and Governance, 52 Stan. L. Rev. 127 (1999). For writings critical of this application of network externalities theory, see Clayton P. Gillette, Lock-In Effects in Law and Norms, 78 B.U. L. Rev. 813 (1998); Mark A. Lemley and David McGowan, Legal Implications of Network Economic Effects, 86 Cal. L. Rev. 479, 562-86 (1998).

6 See Klausner, supra note 5 at 790.

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it might have given rise to a superior network but for externalities.

Business associations, like products and standards, exhibit some network characteristics that appear only after other people decide to use them. First, courts interpret ambiguous terms in all similar contracts.7 Second, common practices such as investment banker fairness opinions emerge that implement contract terms.8 Third, legal services may be standardized and their cost reduced after parties gain experience in drafting and books and continuing legal education materials explain contractual terms.9 These benefits help reduce errors of ambiguity, inconsistency and incompleteness in contract terms.10 Fourth, wide use of the term may help the firm in capital markets because of pricing and signaling effects.11 The existence of these benefits may lock in an existing form.

The literature concerning products and standards suggests that these characteristics may involve externalities that may lead to sub-optimal outcomes. New users might discount possible future network benefits and not take into account the benefits they confer on others by joining the network. They may therefore select an existing form that has already generated network benefits over even an inherently superior alternative that might generate such benefits if more people used it. This may either deter firms from moving to a new standard12 or cause them to adopt an existing standard even if an alternative standard form would better suit their needs.13 An example might be large corporations' long-term use of Delaware law in order to take advantage of judicial and legal expertise and other benefits they expect the Delaware legal "network" to continue to produce.14

It is helpful to set up a model to clarify the network externalities theory in general and as applied to business associations. Suppose a firm is considering the benefits of adopting a set of standard terms or forms (which could be either statutes or form contracts). The private value to a firm i of adopting a Statute J at time T equals:

IJ equals the "inherent" benefits of Statute J, which, for simplicity, are assumed

7 Id. at 774. See also id. at 776 (noting that the case law interpretation of a contract "embeds that interpretation of all firms that use the same term").

8 Id. at 780.

9 Id. at 782 .

10 See Charles J. Goetz & Robert E. Scott, The Limits of Expanded Choice: An Analysis of Express and Implied Contract Terms, 73 Cal. L. Rev. 261, 286-89 (1985).

11 See Klausner, supra note 5 at 785-86.

12 Id. at 814-15.

13 See id. at 807.

14 Id. at 844-47.

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not to vary over time. The second term, BTJ(NT

J) expresses the existing benefits of Statute J that have already accrued from the network of users, at time T, or what has been termed "learning" benefits.15 These benefits increase with the number of users NT

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Figure 1 illustrates the problem. Consider the choice of two alternative statutes A and B. The function VA represents the aggregate value of Statute A over time under the assumption that all new formations occur under statute A. The function VB represents the aggregate value of Statute B under the assumption that all new formations are under statute B. That is,

In this example Statute A has lower inherent benefits than Statute B but larger accrued network benefits. Because of diminishing returns, the same increase in formations under Statute A causes a smaller increase in future network benefits than would the equivalent number of formations under Statute B.

One might suppose that network externalities occur when firms adopt A at T even if VA < VB at T'. However, this would not be correct. To be sure, there is no inefficiency unless VA < VB at some point T'. But firms might still efficiently choose statute A at time T if the present value of statute A net of the litigation and other costs of producing the additional network benefits is greater than the equivalent present value of statute B. That is:

Figure 2A illustrates this case. High discount rates or large costs of producing precedents tip the scale in favor of A, even though VA < VB after time T*. The present value of Statute A, equal to area X + Y in Figure 2A is therefore greater than the present value of Statute B, equal to Y + Z in the Figure.

Figure 2B illustrates the opposite case where:

Under these conditions, Area X < Area Z, and it is not necessarily efficient for all firms to choose Statute A.

The above analysis assumes that all firms choose either Statute A or Statute B. The sub-optimal equilibrium may also involve too much or too little uniformity. Statutes

15 See Klausner, supra note 5 at 786-89.

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may have different inherent or network benefits for different firms so that the optimal equilibrium may involve something other than the same choice of statute by all firms. It is also possible, of course, for firms to adopt the optimal equilibrium at T.16

This analysis has several possible normative implications for the law of business associations. First, the fact that parties cannot necessarily choose the standard form they want means that courts might interpret existing contracts, including parties' adoption of standard forms, based on what the parties seemed to want rather than what they actually selected.17 Second, if diverse firms are likely to gravitate toward uniform standards perhaps legislatures should draft open-ended default provisions that judges can tailor to individual cases18 or offer menus of alternative rules in order to promote optimal diversity.19 Third, the law might respond to the problem of sub-optimal diversity by promoting uniform laws. This suggests a role for institutions such as the American Law Institute and the National Conference of Commissioners of Uniform State Laws. Rules promulgated by these organizations could overcome network externalities by serving as a "focal" provision that new users will adopt because they expect others to gravitate toward it.20 The wisdom of these alternatives as solutions to network externalities depends, of course, on whether there is a problem to be solved. This is addressed in the next Part.

II. THE PROBLEMS OF PROVING NETWORK EXTERNALITIES

The problem with drawing policy prescriptions for network externalities is that it may be difficult to determine when they exist. This Part indicates the difficulty of finding reliable data on network externalities. The next Part shows that using the "linked form" approach is a way to solve this problem.

16 As Michael Klausner notes, "the point here is not that a sub-optimal equilibrium will prevail, but that such an equilibrium may prevail." He notes that this may be hard or impossible to determine. See id. at 810-814.

17 Id. at 814. For example, in Nixon v. Blackwell, 626 A.2d 1366, 1379-81 (Del. 1993), the Delaware supreme court declined to adopt a special rule for close corporation shareholders, partly because the parties failed to opt for treatment under the Delaware close corporation provisions. However, since the standard-form corporation has a much larger user network than the little-used statutory close corporation, there is a question whether network concerns effectively foreclosed the close corporation form as a realistic option, and therefore whether users should be penalized by their choice.

18 See Klausner, supra note 5 at 831-32.

19 Id. at 837. For evidence on uniformity in LLC statutes, see Bruce H. Kobayashi and Larry E. Ribstein, Evolution and Spontaneous Uniformity: Evidence from the Evolution of the Limited Liability Company, 34 Econ. Inquiry 464 (1996).

20 Id. at 800, 804 (noting importance to network externalities of a term's focal nature). See generally Eric Rasmusen, GAMES AND INFORMATION: AN INTRODUCTION TO GAME THEORY 36 (1989) (noting that a focal point is an example of a Nash equilibrium in which no player will deviate from cooperation as long as the other players do not deviate); Thomas C. Schelling, THE STRATEGY OF CONFLICT 54-58 (1980) (discussing focal points). For discussions of uniform laws as focal points see Lea Brilmayer, Conflict Of Laws: Foundations & Future Directions, 155-85 (4th ed. 1995); Larry E. Ribstein & Bruce H. Kobayashi, An Economic Analysis of Uniform State Laws 25 J. Leg. Stud. 131, 139-40 (1996).

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A. DETERMINING NETWORK EXTERNALITIES

Network externalities might not be a problem at all, and the inherent benefits of the alternative forms might determine the existing equilibrium. In order to determine whether this is the case, it is necessary first to determine the extent of network and inherent benefits. As discussed above, network benefits in the case of business associations include materials that help clarify and implement the terms of standard forms: interpretive judicial rulings, common practices such as investment banker fairness opinions, standardized services and pricing and signaling effects. These materials would be most important where terms are open-ended or complex enough to require clarification, and an interpretation has value for many users in the network. Yet there may not be many such terms because courts often tailor open-ended terms such as fiduciary duties for specific applications so that an interpretation in one case has little value for others.21 Moreover, any network benefits that exist may not increase with the number of users.22 With respect to clarification provided by case law, litigation may occur too infrequently to provide much clarification irrespective of the number of users,23 and in any event more cases do not necessarily provide more clarity because courts may reach inconsistent results.

Even if network benefits are clear, for the theory to yield testable hypotheses it is necessary to be able to determine whether adoption of a standard is attributable to network externalities or to the inherent benefits of the adopted standard.24 Liebowitz & Margolis demonstrated the difficulties here by showing that, contrary to Paul David's assumptions,25 Dvorak typing might not really have been better than QWERTY irrespective of how many people used each method.26 In other words, the eventual equilibrium was attributable to QWERTY's higher inherent benefits rather than to the high discount applied to Dvorak's network benefits. Similarly, Liebowitz & Margolis have attributed Microsoft's dominance in the software market to the superiority of their products, which weakens the argument for network externalities in this context as well.27

These problems are evident in the examples proposed by Michael Klausner, the leading proponent of the network externalities theory in the context of business associations. Klausner argues that Silicon Valley entrepreneurs' apparent reluctance to use the partnership form despite the evident tax advantages because of their unfamiliarity with partnership equivalents to stock options28 shows the importance of network

21 See Lemley & McGowan, supra note 5 at 571-72.

22 Klausner supra note 5 at 793, note 119 assumes both that network benefits grow in a linear fashion over time as more users are added, and that these increases occur indefinitely.

23 See Lemley & McGowan, supra note 5 at 573.

24 See Klausner, supra note 5 at 813-14.

25 See articles cited in supra note 3.

26 See Liebowitz & Margolis, supra note 4.

27 See Liebowitz & Margolis, Microsoft, supra note 2.

28 See Joseph Bankman, The Structure of Silicon Valley Start-ups, 42 UCLA L. Rev. 1737 (1994).

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marketing benefits because employees would be more comfortable with the partnership form as its use grew.29 But these firms might have used the standard corporate form for other reasons. They may have wanted the assurance of limited liability, particularly given the risk inherent in a start-up. Although they could incorporate under Subchapter S and obtain partnership-type taxation, they would then be barred from complex financial structures by the one-class-of-stock limitation.30 Or the parties might have been concerned that the greater impermanence of the partnership form exposes the members to the risk of opportunistic withdrawal of capital.31 In short, use of the corporate form might reflect the higher inherent benefits of that form rather than network externalities.

B. WHEN DO NETWORK BENEFITS INVOLVE "EXTERNALITIES"?

Even if network externalities might arise if a move to a new network depended solely on individual users, others such as the seller might internalize the benefits of creating a new standard.32 Entrepreneurs can help shape users' expectations by convincing potential users that a new form is likely to become a standard. These expectations, in turn, determine whether users will adopt or shun a new form.33 With respect to business associations, academics and practitioners can earn reputational and other benefits by encouraging the development of network benefits relating to standard forms.34 These efforts can lead to active competition among standards, just as QWERTY emerged victorious from an active competition with Dvorak.35 Thus, lawyers might promote LLCs to have a new product to sell. They can hold continuing legal education programs on the use of a new standard form, which states in effect subsidize by requiring or encouraging lawyers to participate. Lawyers also can write books and articles that help in the interpretation and use of new forms. Private groups such as the state bar may internalize the benefits of promoting these statutes.36 Lawyers also earn reputational

29 See Klausner, supra note 5 at 821-22.

30 See infra note 50 and accompanying text.

31As to opportunistic withdrawal, see Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure Of Corporate Law, 239-40 (1991); Charles R. O'Kelley, Jr., Filling Gaps in the Close Corporation Contract: A Transaction Cost Analysis, 87 N. W. U. L. Rev. 216 (1992); Larry E. Ribstein, A Statutory Approach to Partner Dissociation, 65 Wash.U. L. Q. 357 (1987); Edward Rock & Michael L. Wachter, Waiting for the Omelet to be Finished: Match-Specific Assets and Minority Oppression in the Close Corporation 24 J. Corp. L. 913 (1999). The parties might be able to obtain a kind of limited liability by forming a limited partnership, but this form arguably exacerbates the problems of opportunistic withdrawal by limited liability members who do not bear the possible costs of collapse. See Naomi R. Lamoreaux, Partnerships Corporations and the Theory of The Firm, 88 Am. Econ. Rev. 66 (May 1998).

32 See Liebowitz & Margolis, supra note 4.

33 See Klausner, supra note 5 at 800, 802-03, 805.

34 See Lemley & McGowan supra note 5; Larry E. Ribstein, Statutory Forms For Closely Held Firms: Theories and Evidence from LLCs, 73 Wash. U. L. Q. 369 (1997).

35 See Liebowitz & Margolis, supra note 4.

36 See William J. Carney, The Production of Corporate Law, 71 S. CAL. L. REV. 715 (1998) (describing corporate law as the product of a competition of interest groups, including the organized bar);

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benefits from drafting and lobbying for new legislation.37 Moreover, as discussed more fully in Part III, the move to a new standard can be facilitated by linking or bundling it with an existing standard form in order to utilize case law and other interpretive materials. This is analogous to engineering a new product with convertibility features or bundling it with another product.38

Thus, "network externalities" is an ambiguous concept. Although those who believe network externalities are an important phenomenon might argue that the devices just discussed indicate the presence of a network externalities problem that must be solved, it might be argued with equal force that the easy availability of such solutions indicates that there was never any problem. The existing equilibrium may be sub-optimal only in the sense that human beings, even viewed collectively, lack perfect knowledge and foresight at any given point of time.39

C. LOCK-IN OTHER THAN BY NETWORK EXTERNALITIES

The difficulty of establishing the network externalities hypothesis is compounded by the fact that network externalities may not be the only cause of apparent lock-in of sub-optimal equilibria. Lock-in by other mechanisms may call for different policy responses.

First, lawyers may cause excessive standardization because their incentives differ from those of their clients.40 Lawyers may receive relatively little reward from successful innovation, but suffer significant losses to their non-diversifiable human capital. The market may be imperfectly informed about the quality of the lawyers' efforts and evaluate the lawyer based only on whether her actions, or the outcomes from these actions, diverged from those of other lawyers.41 Thus, the lawyer's best course may be to conform

Klausner, supra note 5 at 841.

37 See Ribstein & Kobayashi, supra note 20; Larry E. Ribstein and Bruce H. Kobayashi, Uniform Laws, Model Laws, and Limited Liability Companies, 66 U. Colo. L. Rev. 947 (1995).

38 See Liebowitz & Margolis, supra note 2 at 125-126 (discussing linkage of upgraded types of VCRs with pre-existing technology); Liebowitz & Margolis, supra note 4 at 5; Gillette, supra note 5 at 820; Lemley & McGowan, supra note 5 at 496.

39 There is a further problem in determining whether network externalities result in a suboptimal equilibrium. A new standard might attract users from an optimal existing standard by offering short-term inherent benefits. A bandwagon attributable to the creation of a new network might then cause a general move to the new standard. Thus, lock-in may be analogous to arguments for the efficiency of entry barriers. See Harold Demsetz, Barriers to Entry, 72 Am. Econ. Rev. 47 (1982); C. C. von Weizsacker, A Welfare Analysis of Barriers to Entry, 11 Bell J. Econ. 399 (1980).

40 See Kahan & Klausner, Path Dependence, supra note 5 at 353-55; Edward L. Rubin, The Phenomenology of Contract: Complex Contracting in the Entertainment Industry, 152 J. Inst. & Theo. Econ. 123, 135 (1996). See also Donald C. Langevoort & Robert K. Rasmussen, Skewing The Results: The Role Of Lawyers In Transmitting Legal Rules, 5 S. Cal. Interdisc. L.J. 375 (1997) (discussing overstatement of risk as a type of agency cost).

41 See Kahan & Klausner, Path Dependence, supra note 5 at 356-8. Note that the lack of information may itself be attributable to network effects, thereby further entangling network externalities with other causes.

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even if this is not best for the client.42 To be sure, this cause of lock-in blends with network externalities because a larger network and more information reduce lawyers' risk. But focusing on lawyers' incentives may point to fixing the lawyer-client relationship rather than the underlying legal rules.

A second source of lock-in may be individual firms' costs of switching from one form to another. For example, Klausner and Kahan note that firms that had already offered bondholders takeover protection based on putting the bonds at par would find it hard to offer a subsequent class more precise protection only from takeover-related interest rate fluctuations.43 This is a form of path dependence in which the equilibrium is an efficient adaptation to initial conditions but is less suited to subsequent conditions than other hypothetical alternatives that are too costly to adopt.44 The past, of course, often determines the future in this sense. But the costs of, for example, putting highways on wheels or making buildings portable, may outweigh the benefits. Thus, the normative implications of these switching costs are unclear.

Third, cognitive biases may cause lock-in. Klausner & Kahan focus on the status quo, anchoring and conformity biases and the endowment effect, which refer to tendencies to favor present states, group judgments and initial "reference points," and to prefer what the actor now owns.45 As with lawyer-client agency costs, cognitive and judgment biases may be hard to separate from network externalities because they may turn out to be learning or network effects.46 Also, even if the problem is identified, the normative prescription may be unclear. Since legislators, courts and regulators are subject to the same biases, the best solution may be to simply let the market minimize the effect of the biases by clarifying the costs of sticking with inferior solutions.

Fourth, government action itself may cause lock-in. For example, as discussed below in Part III, the legal impediments to developing unincorporated business forms may have contributed to lock-in. In this case, deregulation may be the appropriate response.

III. A LINKED PRODUCT APPROACH TO NETWORK EXTERNALTIES

The above discussion demonstrates the difficulty of proving or disproving the hypothesis that an existing equilibrium, including business association standard forms or statutes, is sub-optimal because of network externalities. We address this problem by

42 On the other hand, innovating lawyers may be able to earn sufficient fees to compensate them for the risks of being first movers. Indeed, lawyers' conservatism might counter-balance their incentive to drive up fees through excessive innovation.

43 See Kahan & Klausner, Boilerplate, supra note 5.

44 For discussions of categories of path-dependence based on whether the initial and subsequent equilibria are suboptimal, see S. J. Liebowitz & Stephen Margolis, Path Dependence, Lock-in and History, 11 J. L. Econ. & Org. 205 (1995); Mark Roe, Chaos and Evolution in Law and Economics, 109 Harv. L. Rev. 641, 647-53 (1996).

45 See Kahan & Klausner, Path Dependence, supra note 5 at 359-65 (citing the literature on these phenomena).

46 See id. at 365.

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looking at the recent history of closely held business organizations. In a relatively short time period there have been significant changes in firms' choice of organizational form coinciding with changes in the tax law. This affords an opportunity to examine whether lock-in has impeded a movement to the optimal form. In general, legislatures have developed organizational forms that combine the governance attributes of partnerships with the limited liability of corporations.

One approach to showing or disproving network externalities is to examine the inherent benefits of the various alternatives, as Liebowitz & Margolis have done with respect to software and typewriters.47 This is also possible for business forms, as practitioners and academics review the costs and benefits of various legal approaches. But we take a different tack. The recent history of closely held business forms offers a way to test more directly whether firms' adoption or non-adoption of particular business is attributable to network externalities. In linking limited liability partnership (LLP) provisions to general partnership statutes legislatures employed a device that avoids network externalities by giving the new form the advantage of an existing network.48 Thus, linkage may be a cost-effective way to deal with network externalities if they exist. We show that firms generally have rejected the proffered linkage and embraced distinct standards despite the fact that this would mean forsaking existing networks. This provides direct evidence of the minimal impact of network externalities in the decision to form a close corporation.

A. IS THERE LOCK-IN OF CLOSELY HELD BUSINESS FORMS?

The business association landscape once featured corporations and partnerships. An incorporated firm offers limited liability but is generally subject to "double" taxation on profits at the corporate level and on distributions to the owners. Partners are subject to personal liability for business debts but pay taxes only at the member and not the entity level. This basic relationship is depicted in Table 1.

Against this background, state legislatures developed special close corporation provisions, which eliminated legal ambiguities raised by applying corporate statutory provisions designed for publicly held firms – such as requirements for management by a board of directors – to owner-managed closely held firms. These provisions applied to firms that both elected coverage in their certificates and met certain qualifications intended to bar access by publicly held firms. The federal government also enacted Subchapter S of the Internal Revenue Code, which combines corporate-type limited liability and partnership-type tax for relatively small firms (restricted to 75 owners)49 with a simple capital structure (i.e., one class of stock).50 Such firms generate relatively little entity-level income after salaries to owners, and involve relatively little opportunity for manipulation. Meanwhile, the largest firms -- those that have liquid markets for their shares -- are subject

47 See Liebowitz & Margolis, Microsoft, supra note 2; Liebowitz & Margolis, supra note 4.

48 See supra text accompanying notes 37-38.

49 See I.R.C. §1361(b)(1)(A). The original limit of 35 was raised to 75 by the Small Business Job Protection Act of 1996, PL 104-188, 110 Stat. 1755, §1301.

50 See I.R.C. §1361.

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to the corporate tax regardless of organizational form.51

Although, encouraged by Subchapter S, many closely held firms incorporated, few elected coverage under special close corporation provisions.52 One commentator attributes this to firms' being locked-in to the standard corporate form by its established network of cases and practices.53 But another explanation is that special close corporation provisions might not have been a superior alternative to the standard corporate form because they fit poorly with the rules for publicly held firms provided by the rest of the statute.54 In other words, the advantages of adopting the basic corporate network of cases, illustrated in Table 1, may be negated by the fact that it is the wrong network. Courts might exacerbate the problem by filling gaps with corporate precedents such as standard corporate fiduciary duties more appropriate to publicly held firms.55 These ill-fitting default rules may force close corporation owners to engage in substantial customized planning.56

The rapid rise of the limited liability company (LLC) provides another opportunity for determining the existence of network externalities in connection with closely held firms. The LLC began in Wyoming in 1977.57 In 1988 the IRS approved partnership tax treatment of LLCs.58 Thus, for the first time firms could have full-fledged limited liability without a separate entity-level tax. This triggered the rapid spread of LLC statutes59 and increases in new formations of LLCs beginning in the early 1990's.60 Within eight years of the 1988 tax ruling, all states had adopted LLC statutes that provided for recognition of

51 See I.R.C. §7704 (providing that "publicly traded partnerships" are taxed as corporations).

52 See Wortman, supra note 5.

53 Id. This point has also been made by Dean Robert Clark. See id. at 1379, note 71 (citing Robert C. Clark, Corporate Law §1.3, at 29 (1986)).

54 See Ribstein, supra note 34.

55 See Larry E. Ribstein, The Closely Held Firm: A View from the U.S. 19 Melbourne L. Rev. 950 (1995); Wortman, supra note 5. Because remote managers of publicly held firms are agents in the classic sense of managing other peoples' money they should be subject to a strong duty of unselfishness. The conflicts among the manager/owners of closely held firms who vote their self-interest rather than delegating may require different rules.

56 Special close corporation statutes create potential problems even for closely held firms that do not elect to be covered by the provisions. See Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993), discussed supra note 17.

57 See William J. Carney, Limited Liability Companies: Origins and Antecedents, 66 U. Colo. L. Rev. 855 (1995).

58 See Rev. Rul. 88-76, 1988-2 C.B. 361 (1988).

59 See Larry E. Ribstein, The Emergence of the Limited Liability Company, 51 Bus. Lawyer 1 (1995).

60 See Table 2, infra, for a listing of formations by state. .

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foreign LLCs.61 Unlike the special close corporation statutes, the LLC was a new form, and was not linked to an existing network of cases and practices (see Table 1). Firms therefore embraced the LLC form where they had failed to adopt special close corporation statutes despite the latter's linkage with the existing network of corporate case law, customs and expertise. Moreover, there is significant anecdotal evidence that lawyers pushed hard for LLC statutes in their states,62 thereby supporting the hypothesis that lawyers' groups can internalize the benefits of network creation. This evidence tends to refute the existence of a network externalities problem.

The evolution of the statutes themselves also tends to refute lock-in. If lock-in were significant, one would expect early versions of the LLC to have been adopted, particularly if those versions might be described as "focal." In fact, there has been considerable evolution in LLC provisions.63 For example, the 1977 Wyoming statute, which was essentially a modified limited partnership,64 did not become the model. Nor did the Delaware statute, despite Delaware's "brand name" in corporate law. Dissociation and dissolution provisions illustrate the absence of lock-in. LLCs initially followed the limited partnership model of permitting members to cash out of the firm at any time on appropriate notice, usually six months. Tax classification rules undoubtedly encouraged use of this format since restrictions on dissolution or dissociation were viewed as corporate features that might lead to corporate tax classification.65 Nevertheless, LLC statutes gradually evolved to permit contracting for continuity.66 With the abandonment of tax classification, states rapidly moved toward repealing LLC members' default right to resell their interests back to the firm.67 This accommodated the use of LLCs for family firms by providing a statutory basis for claiming estate tax discounts.68

But network externalities may be playing a role if LLCs emerged too slowly rather than too suddenly. The average number of incorporations per state has remained steady despite the rise of the LLC.69 Thus, all other things equal, LLCs appear to be replacing partnerships but not corporations. The "stickiness" of the corporate form may

61 Statutes are analyzed and tabulated in Larry E. Ribstein & Robert Keatinge, RIBSTEIN & KEATINGE ON LIMITED LIABILITY COMPANIES, (1991 & Supp.), App. 13-1.

62 See Carney, supra note 57; Carol Goforth, The Rise of The Limited Liability Company: Evidence Of A Race Between The States, But Heading Where? 45 Syracuse L. Rev. 1193 (1995).

63 See Ribstein, supra note 34.

64 See Carney, supra note 57.

65 For a discussion of the prior tax rule see Larry E. Ribstein, The Deregulation of Limited Liability and the Death of Partnership, 70 WASH. U. L. Q. 417, 458 (1992).

66 See Ribstein, supra note 34.

67 See Ribstein & Keatinge, supra note 61, App. 11-1 (including table of state provisions).

68 See id. Ch. 18; I.R.C. §2704.

69 See International Association of Corporation Administrators (IACA), Annual Report of the Jurisdictions, 1988 May 2, 1999.

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be attributable to the smaller LLC interpretive network of forms and interpretive cases.70 The LLC's replacement of the partnership form also may be reconciled with the network externalities story. LLCs arguably replaced partnerships only when the inherent benefits of the move increased to the point where they outweighed the network effects. For example, the Tax Reform Act of 1986, which brought down individual tax rates, made the corporate tax shelter less useful and made the search for an unincorporated limited liability business form more imperative.71 Alternatively, the rise of the LLC might be attributed to increased competition in the legal services market, or to LLCs' increased salience in the media, creating expectations that a significant number of firms would move to the new network.

On the other hand, the delay in moving toward LLC statutes might have been attributable to non-network-externalities causes of lock-in. First, even after the IRS' tax recognition of LLCs in 1988, tax classification rules complicated adoption of the LLC form.72 It was not until the beginning of 1997 that the I.R.S. finally eliminated the tax classification rules and permitted non-publicly traded partnerships to choose whether to be taxed as partnerships or corporations.73 One test of the relative significance of taxes and network externalities is to examine the effect of simplification on the LLC/LLP adoption ratio. Consistent with our theory, we observe a significant increase in the LLC/LLP Ratio in 1998.74 Another test is to examine the effect of differences in state tax rules. As discussed below,75 this ratio is lower in states that imposed higher taxes on LLCs than in states that tax LLCs the same as LLPs.

A second non-externalities explanation may be switching costs. In order to convert, the firm would have to redesign its agreements and accounting for the new format. Path-dependence resulting from switching costs is attributable to the inherent benefits of maintaining the status quo rather than network externalities.76

Third, the failure to switch may be attributable to cognitive biases or agency costs. In addition to lawyers' reluctance to experiment with a new form,77 lawyers and

70 On the other hand, the stability of incorporations despite the rise in LLCs, and therefore the growth of attendant learning benefits, arguably indicates that network externalities may never have impeded acceptance of the form.

71 See Susan Hamill, The Origins Behind the Limited Liability Company, 59 Ohio St. L. J. 1459 (1998).

72 See Ribstein, supra note 65.

73 See Simplification of Entity Classification Rules, 26 C.F.R. pt. 1, 301, 602 (December 10, 1996, effective January 1, 1997).

74 See infra text accompanying note 109.

75 See infra text accompanying note 105.

76 Lock-in may be reduced by lawyers' incentive to advise firms to switch in order to earn higher fees. But this effect, in turn, may be offset by lawyers' reluctance to advise switching discussed immediately below.

77 See supra text accompanying notes 40-41.

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accountants might be unwilling to incur the costs of retooling to handle LLC organizational documents and the complex tax issues that arise under Subchapter K as compared with Subchapter S of the Internal Revenue Code. This might be attributed either to the lack of a network of interpretive materials or to path-dependence arising from other causes.78

Fourth, closely held firms might stick with the corporation form because this form is inherently better for them than the LLC form. LLCs have the impermanence of the partnership form and therefore may be more susceptible to hold-up problems than corporations, where owners have no default right to "put" their interests back to the firm.79 The corporate form also offers a clearer centralized default management structure than the "chameleon" LLC form, which offers an election between centralized and decentralized management.80 In other words, the LLC's flexibility may be a drawback for some firms. Or the tax certainty of the Subchapter S form might be attractive for the simplest firms for which the cost of potential tax error exceeds the costs of the one-class-of-stock constraint.81 If the corporate form is advantageous for some firms, the fact that firms are continuing to incorporate not only fails to indicate the presence of network externalities, but arguably indicates the absence of network externalities. If all firms had moved to the LLC form, this might have suggested that the rush to the LLC was a bandwagon to sub-optimal uniformity, or "tipping" to a new standard to avoid being stuck in an abandoned product.82 On the other hand, a relatively smooth move from close corporations to LLCs indicates the absence of new network effects.

Further data concerning LLC formations and incorporations might be illuminating. For example, if state statutory changes such as the recent move toward restricted dissociation83 lead to an increase in the proportion of LLC formations to incorporations, this might indicate that any hypothesized past reluctance to form LLCs was attributable to defects in the statutes rather than to network externalities. But, as discussed in the next section, even without this additional data there is already evidence inconsistent with the network externalities story.

B. LINKED FORMS AS A TEST OF NETWORK EXTERNALITIES: THE LLP

The discussion so far indicates that the existence of network externalities is as hard to prove or disprove in closely held firms as it is for software and typewriters. This subpart discusses data that provides a convincing demonstration of the non-existence of network externalities in this context. The key insight is showing that the market rejected a substitute form -- i.e., the limited liability partnership (LLP) -- that minimized any

78 See supra note 41.

79 See Rock & Wachter, supra note 31.

80 See generally, Ribstein & Keatinge, supra note 61, Ch. 8.

81 Some of this risk comes from the anti-abuse rules added by §1131 of the Taxpayer Relief Act (P.L. 105–34).

82 This would be similar to one that Kahan & Klausner asserted occurred with regard to event risk bond provisions. See Kahan & Klausner, Boilerplate, supra note 5.

83 See supra text accompanying note 68.

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network externalities by "linking" to the existing network.

LLPs closely resemble LLCs except that LLPs are explicitly linked to the existing body of partnership law and practice (see Table 1). LLP statutory provisions are part of the states' partnership laws, and these laws explicitly define an LLP as a partnership.84 A general partnership therefore does not lose the advantages of its existing "network" by becoming an LLP as it might if it became an LLC. Moreover, the LLP is closely equivalent to the LLC in the critical respect of tax treatment. Particularly in the wake of the elimination of the tax classification rules there is no significant difference between LLCs and LLPs regarding federal taxation.85 Thus, firms' acceptance or rejection of the LLP form is a clear referendum on the significance of network externalities.86

LLPs were developed shortly after LLCs started to become popular. The LLP was first invented in Texas in 1991, primarily to help lawyers to escape sudden tort and regulatory liability arising out of savings and loan cases.87 It was adopted in Louisiana in 1992, in three more jurisdictions in 1993 and in 13 additional jurisdictions in 1994. Virtually all states had adopted LLP statutes by early 1998.88 This history suggests that the LLP was designed for professional firms. This is confirmed in many statutes by provisions for supervisory liability required by professional ethics rules.89 Nevertheless, in most states non-professional firms can use the LLP form.90 Accordingly, if the anti-lock-in features of the LLP were important, non-professional firms would have used the LLP as well. This might have caused a relaxation of the professional limitation even in the few states where it was applied.91

84 See Alan R. Bromberg & Larry E. Ribstein, Bromberg & Ribstein on Limited Liability Partnerships And The Revised Uniform Partnership Act, §1.02(a) (2000).

85 See Bromberg & Ribstein, supra note 84, §7.05. There are, however, a few differences with respect to their treatment under state law. See infra note 105 and surrounding text.

86 As discussed supra text accompanying note 38, the advent of such a linkage opportunity might be regarded as a market solution to network externalities. Alternatively, it might indicate that the potential for network externalities is not really a problem because it can be so easily solved in this way. For present purposes, where the purpose is only to demonstrate the existence of non-existence of network externalities, the distinction does not matter.

87 See Robert Hamilton, Registered Limited Liability Partnerships: Present at the Birth (Nearly), 66 Colo. L. Rev. 1065, 1068-74 (1995).

88 The spread of the LLP form is discussed in Bromberg & Ribstein, supra note 84, ch. 1.

89 See Bromberg & Ribstein, supra note 84, §3.04.

90 The exceptions are California, Nevada, New York, and Oregon. See Bromberg & Ribstein, supra note 84, §2.03(a)(3). The states may be price discriminating in their limited liability offerings, reserving the ultimate extension of limited liability only to the specific category of professional firms that lobbied for it.

91 See Bruce H. Kobayashi & Larry E. Ribstein, Contract and Jurisdictional Freedom, in The Fall And Rise Of Freedom Of Contract, F.H. Buckley, ed. (1999) (showing how state competition for closely held firms broke down tax constraints). For a discussion of how competition broke down price discrimination between general-incorporation and special-incorporation statutes, see Henry N. Butler, Nineteenth Century Jurisdictional Competition in the Granting of Corporate Privileges, 14 J. Leg. Stud.

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The rejection of special close corporation statutes discussed above arguably is another example of linkage that minimizes network externalities because these statutes gave closely held firms the advantage of the general corporate "network" of cases, practices and widespread recognition. But for several reasons these statutes do not provide a good test of the network externalities hypothesis. First, the costs and uncertainties of close corporation statutes discussed above may have outweighed any advantages of linkage with the standard form corporate network. Second, rather than being a distinct standard form. Close corporation statutes at most make a few discrete modifications to the general statute. Some, like the Delaware statute, have no special default rules at all, but simply offer close corporations the opportunity to modify corporate default rules in their agreements. Third, close corporation statutes had no alternative "non-networked" competitor comparable to the LLC. The main alternative to close corporation statutes at the time they were adopted was the partnership form, which differed significantly regarding such important matters as tax treatment, management, share transferability, continuity and member liability.

As indicated above, the superiority of the LLP in testing network externalities depends on the equivalence of LLP statutes to their non-linked alternative, LLC statutes. The LLP form does offer non-linkage advantages over the LLC, at least in some states. To the extent that these advantages are important, firms' rejection of the LLP form provides an even stronger challenge to the network externalities hypothesis. First, LLPs may offer professional firms somewhat more certainty regarding whether they may use the form. LLP statutes were originally designed for professional use and many ethics opinions authorize use by accountants and lawyers.92 Second, LLP statutes generally do not restrict on distributions as in other limited liability business associations.93 These restrictions can be particularly burdensome for professional firms, which usually pay out a significant portion of income as compensation to the professional partners. Third, LLPs can avoid entity-level tax some states apply to both corporations and LLCs.94 LLPs also offer somewhat greater assurance that the firm will be able to use the cash method of accounting for tax purposes, which is important for personal service firms.95 Fourth, and perhaps most importantly, firms save some costs of redrafting their agreements when they register as LLPs rather than switch to a wholly new business form.96 This is particularly important for professional firms, which historically have been organized as partnerships, and which usually have more elaborate agreements than typical general partnerships.

A disadvantage inherent in linking business forms, which may cause some firms to reject the LLP form despite network advantages, is that borrowed case law and other

129 (1985).

92See Bromberg & Ribstein, supra note 84, §7.04(a).

93 See id. §4.04(d).

94 See infra note 105 and accompanying text.

95 See Bromberg & Ribstein, supra note 84, §7.05(d). This may be counterbalanced somewhat by the fact that the more pronounced member-management of LLPs means marginally more exposure to self-employment tax. Id. §7.05(e).

96 See supra text accompanying notes 43-44. Some revisions may, however, be desirable to reflect the firm's limited liability. See Bromberg & Ribstein, supra note 84, §1.05.

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interpretive material may not fit the borrowing type of firm.97 General partnership default rules, particularly regarding fiduciary duties, management, transferability and dissociation, suit personal liability firms rather than those in which owners' liability is limited.98 Also, the partners' personal liability may be significant in applying regulatory statutes, and firms must be careful in using form agreements to make adjustments for the partners' limited liability. Although courts and the parties may adjust partnership default rules to suit LLPs, these adjustments would reduce the advantage of sharing the partnership network of cases. This disadvantage may weaken linkage as a test of network externalities. However, it is difficult to assess the significance of this disadvantage and the extent to which it is offset by LLPs' advantages discussed above.

More significant disadvantages of LLPs apply only in some states, thereby allowing state-by-state comparisons that provide further tests of the network externalities hypothesis. First, many of the early LLP statutes were so called "partial-shield," which provided for limited liability for torts but not contracts.99 Most states now have full-shield provisions that substantially mimic the limited liability of LLCs.100 Also, while partnerships, and therefore LLPs, are defined as having two or more members,101 all but a handful of LLC statutes now provide for single-member LLCs.102

C. DATA ON ADOPTION OF THE LLC AND LLP FORMS

The network externalities hypothesis predicts that, all things equal, linking LLPs to the network of partnership law would result in a higher rate of LLP formations than of LLC formations. Under the network externalities hypothesis, the null hypothesis is that LLC formations divided by LLP formations (the LLC/LLP Ratio) will equal some number θ < 1. Table 2 presents LLC and LLP formation data by state for the years 1993-1998.103 Table 3 shows by state the average LLC and LLP formations per year by state,

97 See Larry E. Ribstein, Linking Statutory Forms, 58 J. L. & Contemp. Prob. 187 (1995).

98 See id. Ch. 4; Larry E. Ribstein, Possible Futures for Closely Held Firms, 64 U. Cin. L. Rev. 319 (1996).

99 See Bromberg & Ribstein, supra note 84, §3.02.

100 See id. at 157-60 (chart of types of statutes adopted in each state). It is not clear how much of a disadvantage the partial shield is because firms can avoid personal liability for contracts through the contracts themselves.

101 See U.P.A. §6; R.U.P.A. §101(6).

102 See Ribstein & Keatinge, supra note 61, App. 4-1 (tabulating statutes).

103 The data set forth in Table 2, was obtained from annual reports by the International Association of Corporation Administrators (IACA), which in turn obtains its data from state secretaries of state. The IACA data combines domestic and foreign unincorporated firms. Because we do not know how the reporting states collect their data, we cannot verify the accuracy of these figures. However, it is important to point out that we are interested only in the relative numbers of LLCs and LLPs. Since filings are relatively objective events, it is unlikely that the data is skewed toward one or the other entity, rather than simply reporting too many or two few of both entities.

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the corresponding LLC/LLP Ratio.104 Figure 3 graphically illustrates the relationship between the average LLC and LLP formations. It is significant that the LLC/LLP Ratio is greater than one in every state in every year, and that only seven of forty-nine jurisdictions have a LLC/LLP Ratio of less than 10:1.

In addition, the by state data suggests that that tax and other considerations can alter firms' decisions to adopt the LLC form. As noted above, if the effects of network externalities are strong, we would not expect such tax or other considerations to significantly alter the choice of LLCs over LLPs. An examination of Table 3 suggests otherwise. Of the seven states with LLC/LLP Ratios of less than 10:1, two of these states, Pennsylvania and Texas, imposed corporate income taxes on LLCs but not on LLPs during the relevant period.105 Indeed, the LLPs' invention in Texas may be at least partly attributable to this fact. Additionally, two of the states with the lowest LLC/LLP Ratios -- Minnesota and North Dakota -- have LLC statutes whose unusual corporate-type complexity may have deterred use of the LLC form.106 This explanation would emphasize inherent benefits of the LLP form rather than network externalities.

Table 4 reports the results of a regression analysis of the by state and by year data listed in Table 1. We used a logit model, where the dependent variable is the log of the LLP/LLC ratio.107 The analysis included all observations in which a state had both an LLC and LLP statute in effect for the whole year, or for an equal part of a year, and was estimated using ordinary least squares. We regressed the dependent variable on a constant, a dummy variable denoting whether the state adversely taxed LLCs relative to LLPs (LLC DIFF. TAX), and a dummy variable that proxies for the complexity of a statute (COMPLEX LLC STATUTE).108 Column 1 of Table 4 reports the results of this regression analysis. The coefficient for the constant was positive and statistically significant. The hypothesis that the log(LLC/LLP) = 0 can be rejected at standard

104 The average figures reflect all years in which the state had both an LLP and an LLC statute in effect for the entire year, and years where both the LLC and LLP statues were in effect for a part of the year, but became effective in the same month. For a complete listing, see Table 2.

105 Prior to 1998, Texas, Florida and Pennsylvania levied state taxes on LLC. See Carter G. Bishop and Daniel S. Kleinberger, Limited Liability Companies: Tax And Business Law (1997) at 1.05; State And Local Taxes, Research Inst. Of America (1999) at 222-D. Currently, only Texas has differential income tax treatment of LLCs and LLPs. Florida currently has a differential intangibles tax on LLCs, Pennsylvania has a differential Franchise Tax on LLCs, and Michigan has levies a corporate income tax on both LLPs and LLCs. Id. at 1.08.

106 The complexity test is described in infra note 108.

107 In this model, the probability that a firm in state i during year j chooses to form an LLC is estimated by the observation Pij = LLCij/(LLCij + LLPij). The dependent variable equals log(Pij/(1- Pij)) = log(LLCij/LLPij). See, e.g., Robert Pindyck and Daniel L. Rubinfeld, Econometric Models and Economic Forecasts, 2d ed. New York: McGraw-Hill, 1981, at 289-90.

108 As a proxy for complexity, we coded the COMPLEX LLC STATUTE variable to equal 1 if the state's LLC statute length (in bytes) was more than two standard deviations above the average state's LLC statute length. Under this formulation, Illinois, North Dakota, Minnesota and Tennessee are coded as having complex statutes. The relatively high LLC/LLP ratio for Illinois may result from the fact that LLCs but not LLPs are allowed to practice law. See Ribstein and Keatinge, supra note 61, Section 15.14. Tennessee allows LLCs to practice law but, unlike in many states, there is no explicit rule allowing LLPs to practice law. See Bromberg and Ribstein, supra note 84 at 237-8, n. 93.

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significance levels. A fortiori, the null hypothesis under the network externalities theory, that the log(LLC/LLP) = log θ < 0, can also be rejected at standard significance levels. These comparisons between LLP and LLC formations suggest that "lock-in" is not an inherent impediment to development of new statutory business forms. The adoption of the LLP form by only a small fraction of firms suggests that only the professional firms for which the LLP is most suitable are forming LLPs.

This is confirmed by the fact that LLPs are most successful where the form has the highest relative inherent benefits -- i.e., when it avoids state taxes or avoids a complex LLC statue. Examining Table 4, the coefficients for the differential tax and complexity variable are both negative and statistically significant. Thus, we also can reject the null hypothesis that tax and other considerations do not affect the rate of LLC adoptions. Based on the coefficients, the average LLC/LLP Ratio in a state with equal tax treatment of LLPs and LLCs and with a non-complex LLC statute equals 31.5. In states where there is a differential and adverse tax treatment of LLCs, this ratio falls to 6.3. And in states with complex LLC statutes this ratio falls to 11.9.

Table 4 also reports the results of a regression that included year dummy variables and variables that control for other sources of between state variation in the LLC and LLP statutes. Adding these additional explanatory variables do not materially alter the results for the variables reported in Column 1. Examining the coefficients for the year dummy variables, there is a positive and significant increase in the LLC/LLP ratio in 1998, the second year after the IRS eliminated the complex tax classification rules for LLCs.109 The average LLC/LLP Ratio is 25.5 points higher than the base years of 1993 and 1994. This is consistent with greater use of the LLC form after an increase in the inherent net benefits of using the form.

The data reported above includes single member LLCs, currently allowed by most states.110 Because partnerships must have two or more members, LLPs are not complete substitutes for such single member LLCs, and their inclusion biases the results against the network externalities hypothesis.111 We cannot directly control for this effect because the data does not break out single-member from multiple-member LLCs. Instead, we control for the effect of single member LLCs by including the ONE MEMBER LLC variable, which denotes whether a state allowed one-member LLCs to form under their statue during a given year. A second ONE MEMBER LLC denotes years in which single member LLCs were allowed part of the year. Column 2 of Table 4 reports the results of regressions including these variables. The coefficient on the full year variable is positive, but is small in magnitude and not statistically significant in any of the reported regressions. The coefficient on the part-year variable is negative and not statistically significant. Thus, we reject the hypothesis that the single-member benefits of LLCs over LLPs in some states accounted for relative non-use of the LLP form. Based on the regression coefficients reported in Column 2 of Table 4, the average 1993-4 LLC/LLP Ratio in states that do not allow single member LLCs is 15.3, while the average LLC/LLP ratio is 19.9 in those states that do.

109 See the text surrounding note 73.

110 For a listing of states that allowed single member LLCs by year, see Table 2.

111 Note on LPs included as registered LLPs.

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As with LLC statutes,112 the evolution of LLP statutes provides additional evidence against lock-in. As already noted, many LLP statutes originally provided only for a partial liability shield for torts but not contracts.113 This gave firms the liability protection they needed most while, perhaps, smoothing potential political opposition to expanding limited liability to full-fledged partnerships.114 However, by 1998 most statutes included "full shield" provisions that provided protection for all kinds of liabilities.115 Thus, as with LLCs,116 the early form of statute was not locked in. Column 2 of Table 4 lists the coefficients for a dummy variable of that equals one for a full-shield statute. The full year variable has the expected sign, and is statistically significant. The coefficient on the part-year variable is positive and not statistically significant.

Table 4 also reports regressions that include a dummy variable denoting whether the state's LLP statute was limited to use by professional firms.117 In states with this restriction, the use of LLPs increased relative to LLCs. This may reflect the tailoring of the LLP statute to professional firms. However, this effect is not large in magnitude or statistically significant.

To make sure that outlier observations are not disproportionately influencing the results, Columns 3 and 4 of Table 4 report the coefficients when observations where the LLC/LLP Ratio exceeds 300. This results in deleting the observations from Georgia for all years, and for Delaware for 1996-1998. Deleting these observations do not substantively change the results. The constant is positive and statistically significant, and the differential tax and complexity variables are negative and statistically significant. The results for the other included variables are similar, except that the coefficient on the dummy variable denoting a restricted LLP and the 1997 year fixed effect become statistically significant, and the coefficient on the full year one member dummy variable changes sign, but is not statistically significant.

Similar results were obtained when the sensitivity of the results to dropping data from individual states were examined. Figure 4 depicts the range of the coefficients obtained when the model was re-estimated using the observations from N-1 out of N states. The constant ranges from 2.40 to 2.88, and is statistically significant in all 48 sensitivity regressions. The tax variable ranges from -1.36 to -2.06 and is also statistically significant in all 48 regressions. The complexity variable is sensitive to the exclusion of observations form the states with complex statutes. Deleting the observations from North Dakota or Minnesota results in the coefficient decreasing in absolute value and becoming statistically insignificant. Deleting the observations from Illinois or Tennessee results in a COMPLEX LLC STATUTE coefficient of -1.38 and -

112 See supra text accompanying notes 63-68.

113 See Bromberg & Ribstein, supra note 84, §1.01(a)-(b).

114 See supra note 90.

115 See id. §1.01(c), 3.03 and Table 3-1, also listed in Table 2 of this article, supra.

116 See supra §III(C)(4).

117 See supra text accompanying note 90.

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1.43 respectively. 118

IV. CONCLUSIONS

Network externalities have been hypothesized to alter the market equilibrium in many contexts, including the adoption of efficient forms for closely held businesses. However, closer scrutiny of the theory as applied to this setting casts doubt on the practical importance of these theories. More importantly, we empirically test the network externalities theory by examining the formation rates of LLPs and LLCs. While the two business forms are close substitutes, linking LLPs to the existing "network" of partnership law suggests that firms would prefer the LLP to the LLC form if network externalties mattered. In fact, examination of formations in each state shows that most firms prefer LLCs to the linked LLP form. Further, the relative popularity of the LLP form in states that impose entity taxes on LLCs but not LLPs indicates that tax considerations may matter more than network externalities to the choice of business form.

Our results are significant in terms of the literature on network externalities. Given the ambiguities of the theory and the limited conditions in which network externalities can arise, policymakers should pay careful attention to data rather than using hypothetical network externalities as a basis for regulation. Our conclusions also have broad implications for the law of business associations. The network externalities theory is a potentially significant argument for market failure in the development of business forms. But if, as we show, business associations can be expected to evolve toward efficient equilibria, there is less reason not to enforce the default terms of business associations or to conclude that evolution of business association statutes needs to be supplemented by uniform laws or replaced by federal law.

118 Both coefficients are statistically significant at the ..002 and .000 level. In addition, we also estimated a regression where the COMPLEX LLC VARIABLE was split into a CORPORATE TYPE LLC statute, equal to 1 for Minnesota and North Dakota, and a LLP NO LAW variable, equal to 1 for Illinois and Tennessee. See note 108, supra. The coefficient on the CORPORATE TYPE LLC equaled –2.80, with a p-value of .000, and the coefficient on the LLP NO LAW variable equaled 0.97 with a p-value of .032. The remainder of the estimated coefficients were robust to this alternative specification.

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Table 1 - The Attributes of Business Associations

Unlimited Liability Limited Liability

Double Taxation

Corporation

Partnership Taxation

Partnership

Close Corporation

Limited Liability Company (LLC)

Limited Liability

Partnership (LLP)

Denotes linkage between new form and existing network.

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Table 2 - Formation Data by State

1993 1994 1995 1996 1997 1998AL LLC 114 1208 1800 2548 3430 4624* LLP 269 276 RATIO 12.75 16.75AK LLC 163** 335 534* - LLP 89 - RATIO 6.00 -AZ LLC 2244 3837 5189 6601 8199 10267 LLP - - 115 528 - RATIO - - 57.40 15.53 -AR LLC -** 603 1089 1420 1717 2047 LLP 23** 47 RATIO 43.55CA LLC -** 8373 12151 17979 23190 LLP 171** 530 530 521 RATIO 22.93 33.92 44.51CO LLC 2605.00 4063* 6562 8094 9184 11307 LLP 286** 964 214 570 RATIO 8.40 42.92 19.84CT LLC 2500** * 9730 10086* 13456 LLP 184 198 163 RATIO 52.88 50.94 82.55DE LLC 735 2696 6933* 10888 15967 30793 LLP -** 10 13 21 44* 42 RATIO 269.60 533.31 518.48 362.89 733.17DC LLC 210** - 1245 1245 - LLP -** - 69 78 - RATIO - 18.04 15.96 -FL LLC 474 933 1399 1892 2357 5124 LLP 124 202 207 RATIO 15.26 11.67 24.75GA LLC**** 13** 369 2417 3832 6532* 9239 LLP -** 7 5 16 12 RATIO 345.29 766.40 408.25 769.92HI LLC 768** 1454 LLP 28** 45 RATIO 27.43*** 32.31ID LLC 125** 609 1107 1449 1899 2323 LLP 43** 97 141 141 RATIO 14.94 13.47 16.48IL LLC 1729 2646 3654 4940 7271 LLP 49** 88 75 75 87 RATIO 30.07 48.72 65.87 83.57

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1993 1994 1995 1996 1997 1998IN LLC**** 417** 1692 2465 3152 4022* 5115 LLP 59** 246 253 286 RATIO 12.81 15.90 17.88IA LLC 507 612 1325 1641 2189* 2507 LLP 22** 70 84 60 90 RATIO 18.93 19.54 36.48 27.86KS LLC 499 1096 1658 1867 2397 -* LLP 37** 103 6 74 - RATIO 16.10 311.17 32.39 -KY LLC**** 424** 1505 2190 2647 3955* LLP 36** 103 98 97 90 RATIO 11.78*** 14.61 22.35 27.29 43.94LA LLC 924 1804 2872 3908 5750* 7554 LLP 89 102 115 107 94 90 RATIO 10.38 17.69 24.97 36.52 61.17 83.93ME LLC 293** 434 708* 1054 LLP 14 24 21 RATIO 31.00 29.50 50.19MD LLC 1071 1542 2914 4092 4325* 6884 LLP 0** 100 422 379 - RATIO 29.14 9.70 11.41 -MA LLC 2193 3363 4973 LLP 356 307 246 RATIO 6.16 10.95 20.22MI LLC -** 3921 8868 18579 11053* 17589 LLP 15** 161 108 162 132 RATIO 55.08 172.03 68.23 133.25MN LLC 609 941 1403 1987 2549* 3844 LLP 270** 1033 1129 1241 1270 RATIO 1.36 1.76 2.05 3.03MS LLC**** 14** 859 1188 1876 1463* LLP 20** - 40 31* RATIO - 46.90 47.19MO LLC**** 150** 814 2991 4078 6887* 7043 LLP 109** 127 225 277 RATIO 32.11 30.61 25.43MT LLC -** - - - 1526 1498 LLP -** - - - RATIO - - -NE LLC 61** 375 610 742 1113* - LLP 20** 60 - RATIO 18.55 -

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1993 1994 1995 1996 1997 1998 NV LLC 723 1202 1956 3715 -* - LLP 8** 24 - - RATIO 154.79 - - NH LLC 88* 291 660 861 1495* 2525 LLP 14** 34 34 RATIO 43.97 74.26 NJ LLC 6374* 8442 9998 13609* LLP -** 209 218 RATIO 47.84 62.43 NM LLC 193* 739 1039 1296 - - LLP 20** 26 RATIO - NY LLC 1317** 8431 11170 14454 18101 LLP 294** 1068 815 679 689 RATIO 4.48*** 7.89 13.71 21.29 26.27 NC LLC 2518* 2388 3264 4494 6001* 8162 LLP -** 279 251 258 250 270 RATIO - 8.56 13.00 17.42 24.00 30.23 ND LLC 47** 229 269 304 370 477 LLP 101** 229 251 213 RATIO 1.33 1.47 2.24 OH LLC 1270** 4653 6790 8713* - LLP 137** 238 362 430 - RATIO 9.27*** 19.55 18.76 20.26 - OK LLC 944 1432 2356 2904 3721* - LLP 13** 42* - RATIO 88.60 - OR LLC 0** 1708* 2388 9398 10297 14772 LLP 0** 170 268 351 RATIO 55.28 38.42 42.09 PA*** LLC 491** 723 1498 3519 LLP 176** 370 458 473 RATIO 2.79*** 1.95 3.27 7.44 RI LLC 257 328 510 785 1018* 1448 LLP 19** 26 63* RATIO 39.15 22.98 SC LLC 279** 1270 2143* 3645 4826 LLP 51** 235 267 272 299 RATIO 5.42*** 5.40 8.03 13.40 16.14 SD LLC 83** 297 399 478 550 600* LLP 31** 91 120 145 RATIO 5.25 4.58 4.14

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1993 1994 1995 1996 1997 1998TN LLC 289** 3340 4855 6456 7702 LLP 36** 45 49 48 RATIO 107.89 131.76 160.46TX LLC 3014 4252 5446 6628 8664 11935 LLP 637 520 1457 1664 525 623 RATIO 4.73 8.18 3.74 3.98 16.50 19.16UT LLC 2572 3356 4360 6067* 6574 7191 LLP 18** 28 - - - RATIO 155.71 - - -VT LLC -** 179 464 676 LLP RATIO VA LLC 1733 2963 4215 5398* 8206 9974 LLP 29** 56 86 178* 73 RATIO 75.27 62.77 46.10 136.63WA LLC 597** 2889 4243 6279 9134 LLP 300** 133 128 124* RATIO 31.90 49.05 73.66WI LLC 2360 3473 4124* 6149 8136 LLP 19** 891 973 809 RATIO 4.63 6.32 10.06WV LLC 206 - - -* 400 660 LLP 7** 19 RATIO 34.74WY LLC 1035 1086 1302 1407 1841* 1879 LLP 26 RATIO 72.27 NOTES = STATUTE NOT EFFECTIVE

-= DATA NOT REPORTED TO IACA = ONE MEMBER LLCs ALLOWED (* DENOTES PART YEAR) = LLP STATUTE HAS FULL SHIELD (* DENOTES PART YEAR)

** = STATUTE EFFECTIVE PART OF THE YEAR ***= LLP AND LLC EFFECTIVE AS OF SAME MONTH AND YEAR

****= NUMBER OF MEMBERS REQUIRED TO FORM LLC NOT SPECIFIED

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Table 3 -Summary State Formation Data

STATE LLC/YEAR LLP/YEAR N LLC/LLP LLC/(LLC+LLP) ND 575.50 346.50 2 1.66 0.62 MN 2445.75 1168.25 4 2.09 0.68 PA 1780.29 422.00 3.5 4.22 0.81 SD 542.67 118.67 3 4.57 0.82 AK 534.00 89.00 1 6.00 0.86 TX 7987.80 1085.20 5 7.36 0.88 WI 8080.67 891.00 3 9.07 0.90 SC 2702.89 249.78 4.5 10.82 0.92 MA 3509.67 303.00 3 11.58 0.92 MD 3777.00 300.33 3 12.58 0.93 AL 4027.00 272.50 2 14.78 0.94 ID 1890.33 126.33 3 14.96 0.94 NY 11882.89 787.78 4.5 15.08 0.94 IN 4096.33 261.67 3 15.65 0.94 CO 9528.33 582.67 3 16.35 0.94 DC 1245.00 73.50 2 16.94 0.94 FL 3124.33 177.67 3 17.59 0.95 OH 6121.71 333.43 3.5 18.36 0.95 NE 1113.00 60.00 1 18.55 0.95 NC 4861.80 261.60 5 18.58 0.95 AZ 7400.00 321.50 2 23.02 0.96 IA 1915.50 76.00 4 25.20 0.96 KY 2382.44 94.22 4.5 25.29 0.96 RI 1233.00 44.50 2 27.71 0.97 MO 6002.67 209.67 3 28.63 0.97 HI 1481.33 48.67 1.5 30.44 0.97 KS 1974.00 61.00 3 32.36 0.97 CA 17773.33 527.00 3 33.73 0.97 WV 660.00 19.00 1 34.74 0.97 ME 732.00 19.67 3 37.22 0.97 LA 3802.00 99.50 6 38.21 0.97 AR 2047.00 47.00 1 43.55 0.98 OR 11489.00 263.00 3 43.68 0.98 MS 1669.50 35.50 2 47.03 0.98 WA 6552.00 128.33 3 51.05 0.98 NJ 11803.50 213.50 2 55.29 0.98 IL 4627.75 81.25 4 56.96 0.98 NH 2010.00 34.00 2 59.12 0.98 CT 11090.67 181.67 3 61.05 0.98 VA 9264.33 131.00 3 70.72 0.99 WY 1879.00 26.00 1 72.27 0.99 OK 3721.00 42.00 1 88.60 0.99 MI 14022.25 140.75 4 99.63 0.99 TN 633.67 47.33 3 133.89 0.93 NV 3715.00 24.00 1 154.79 0.99 UT 4360.00 28.00 1 155.71 0.99 DE 13455.40 26.00 5 517.52 1.00

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GA 5505.00 10.00 4 550.50 1.00 MT * * 0 * * NM * * 0 * * VT * * 0 * * LLC/YEAR LLP/YEAR LLC/LLP LLC/(LLC+LLP) MEAN 4854.76 226.89 59.06 0.94 MED. 3718.00 127.33 28.17 0.96 STD. DEV. 4220.33 270.79 106.56 0.07

LLC Taxed Differentially from LLP Complex LLC Statute

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Table 4 - Regression Results

ALL OBSERVATIONS LLC/LLP < 300 CONSTANT 3.45** 2.73** 3.22** 2.78** (31.81) (6.70) (32.55) (8.66) LLC DIFF. TAX -1.61** -1.73** -1.39** -1.38** (-4.11) (-4.23) (-4.21) (-4.23) COMPLEX LLC STATUTE -0.97** -0.82** -0.74** -0.60** (-2.75) (2.18) (-2.51) (-2.04) ONE MEMBER LLC (FULL YEAR) 0.26 -0.09 (0.96) (-0.43) ONE MEMBER LLC (PART YEAR) -0.14 -0.34 (-0.40) (-1.17) LLP RESTRICTED 0.14 0.66** (0.34) (2.02) LLP FULL SHIELD (FULL YEAR) -0.54** -0.89** (-2.18) (-4.35) LLP FULL SHIELD (PART YEAR) 0.52 0.33 (1.03) (0.79) YEAR = 1995 0.7 0.34 (1.44) (0.87) YEAR = 1996 0.76* 0.6* (1.69) (1.69) YEAR = 1997 0.73 0.82** (1.60) (2.25) YEAR = 1998 0.98** 1.14** (2.09) (3.03) N 145 145 136 136 SSR 220.07 200.01 144.58 115.90 SE REGRESSION 1.24 1.23 1.04 0.97 R SQUARED 0.14 0.22 0.14 0.31 ADJ. R SQ. 0.12 0.15 0.13 0.25 LOG LIKELIHOOD -235.99 -229.07 -230.95 -182.10 t-statistics in parentheses ** Statistically significant at .05 level for a two-tailed test. * Statistically significant at .10 level for a two-tailed test.

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Figure 1

TimeVA VB

T T* T'

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Figure 2A

TimePV(V

A - C

A)

PV(VB - C

B)

X

Y

Z

T* T'T

Figure 2B

TimePV(V

A - C

A)

PV(VB - C

B)

X

Y

Z

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Figure 3

AVERAGE LLC & LLP ADOPTIONS PER YEAR

0.00

2000.00

4000.00

6000.00

8000.00

10000.00

12000.00

14000.00

16000.00

18000.00

0.00 500.00 1000.00 1500.00 2000.00

AVERAGE LLP ADOPTIONS/YEAR

AV

ER

AG

E L

LC

AD

OP

TIO

NS

/YE

AR

20:1

10:1

5:1

2:1

1:1

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Figure 4 - Sensitivity of Coefficients

Notes: Vertical line shows range of values. Hash mark shows value of coefficient from the all observations regression, reported in Column 2 of Table 4.

-3

-2

-1

0

1

2

3

4

Con

stan

t

Tax

Com

plex

1 M

em1

Mem

(PY

)LL

P R

estri

cted

LLP

Ful

lLL

P F

ull (

PY

)

y95

y96

y97

y98

Coefficient

Val

ue

of

Co

effi

cien

t

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