Texas Joins the Series LLC Crowd
Texas has joined the seven other states that have authorized series LLCs. The Texas bill authorizing series LLCs was signed by Governor Perry in May and will become effective on September 1, 2009. S.B. 1442. The states that currently authorize series LLCs are Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee and Utah.
Most state LLC acts allow an LLC to provide for classes of members with different member rights per class. But a series LLC can go further by establishing multiple series of assets, members and managers. The debts and obligations of a series will be enforceable only against the series’ assets, and will not be enforceable against the other series in the LLC or against the LLC generally, and vice versa. The members associated with a series can be given separate rights and duties with regard to the assets of the series.
The separation of assets and partitioning of liabilities between series, all within one LLC, can avoid many of the inefficiencies and costs associated with multiple related entities. For example, a series LLC could be used to hold multiple parcels of real estate, each in a separate series and all within the one LLC. Or, separate divisions of a business could be held by one LLC, but with each division in a separate series.
The Texas statute is similar in many respects to the Delaware act. Both authorize an LLC’s operating agreement to establish one or more designated series. Both acts provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
(a) the records of the series account for its assets separately from the assets of any other series or the LLC generally,
(b) the operating agreement states the liability limitations, and
(c) the certificate of formation gives notice of the limitations on liability.
Each series may in its own name sue and be sued, contract, and hold title to its assets, including real estate and personal property.
Series LLCs can be useful, but there are legal uncertainties involved in their use. Series LLCs are relatively new – Delaware was the first state to authorize series LLCs, in 1996, and there is almost no case law on them. Major areas of uncertainty involve taxation, bankruptcy, and doing business in multiple states.
There are many open tax questions with regard to series LLCs. Although the Internal Revenue Service issued a Private Letter Ruling in 2008 and clarified that each series’ federal tax characterization is determined independently, other state and federal tax questions remain.
It is unclear whether an LLC series will be treated as a debtor in federal bankruptcy court, or whether the bankruptcy court will ignore the series and only consider the entire LLC. The result may depend on whether the relevant state law will treat the series as a separate entity with its own liability shield.
Including Texas there are now eight states whose LLC acts authorize series LLC, but that leaves 42 other states with no series provisions in their acts. It is not at all clear what the courts of a non-series state would do when faced with a claim by a local creditor against an out-of-state series LLC formed under the laws of, say, Delaware. Will the non-series state honor the series structure and respect the internal liability shield? Would a non-series state even allow a series of an LLC formed under the laws of another state to register to transact business in the non-series state?.jpg)
The law of series LLCs is an infant, still a little unsteady on its feet. But at one time LLCs were new and LLC law was the infant. There were many articles back then pointing out the uncertainties and risks of using LLCs when they were first adopted by Wyoming in 1977 and later by other states. Many conservative lawyers recommended against using LLCs in the early years of their authorization by the various states, but eventually all the states authorized LLCs. Today LLC law is more mature and LLCs are the most popular entity form for new businesses. History predicts that the question for series LLCs is not whether they will become routinely used, but when.
Another State Pierces the Veil to Reach Managers
Courts will “pierce the corporate veil” to allow creditors of an LLC to assert claims against the LLC’s owners, in a proper case. Marc Ward recently discussed just such an LLC veil-piercing case, in which the U.S. District Court for the Eastern District of Michigan upheld an LLC creditor’s claim against the single member of the LLC.
There are far fewer cases where the LLC’s veil is pierced to allow an LLC’s creditors to reach a non-member manager or officer of the LLC. I recently discussed such a case from Colorado, in which the court held that a manager could be held personally liable for the LLC’s breach of contract even though the manager was not a member, here. Sheffield Servs. Co. v. Trowbridge,No. 08CA0059, 2009 WL 1477003 (Colo. App. May 28, 2009).
Now another state court has held that an LLC’s claimants can pierce the veil and assert their claims against those involved in the management and operation of the LLC, even if the managers are not members. Equity Trust Co. v. Cole, 766 N.W.2d 334 (Minn. Ct. App. 2009).
Equity Trust was a consolidation of eight lawsuits. One hundred and seventy-eight plaintiffs sued a myriad of corporations, LLCs and individuals on theories of breach of fiduciary duty, breach of contract, misrepresentation, conspiracy, civil theft, and violations of the Minnesota Consumer Fraud Act and the Minnesota Securities Act. The plaintiffs alleged a large-scale real estate investment fraud scheme, orchestrated by the individual defendants. Default judgments were entered against the entities, and the plaintiffs sought to pierce the veil and hold the individual defendants personally responsible for the default judgments.
The court’s veil-piercing analysis considered the corporations and LLCs together, without distinguishing one type of entity from the other. The court did not discuss Minnesota’s LLC Act, but its analysis was consistent with the statute. The Act applies the corporate rules on veil piercing to LLCs: “The case law that states the conditions and circumstances under which the corporate veil of a corporation may be pierced under Minnesota law also applies to limited liability companies.” Minn. Stat. § 322B.303 (2008).
The court first applied an alter-ego analysis and found many of the alter-ego factors to be present, including insufficient capitalization, failure to observe entity formalities, insolvency at the time of the transactions, siphoning of funds by those owning or controlling the entity, and the absence of corporate records. Equity Trust,766 N.W.2d at 339. The court then examined the second prong of the test, whether piercing the veil is necessary to avoid injustice or fundamental unfairness. This prong was easily satisfied, “[c]onsidering that the entities were operated in furtherance of a large-scale real estate fraud scheme.” Id. at 340, 341.
The individual defendants argued that the corporate and LLC veils should not be pierced because the individuals were not shareholders or members of the entities. The court held to the contrary: “If veil piercing were solely dependent on a party’s ownership interest in an entity, unscrupulous parties could avoid personal liability under the doctrine by simply acting in a capacity that does not involve ownership.” Id. at 339.
Equity Trust, like Sheffield, involved non-members who dominated and controlled the LLCs, disregarded the LLCs, and used LLC funds for their own individual purposes. In both cases the courts held that in those circumstances equity would intervene and pierce the veil to avoid injustice or fundamental unfairness.
What can managers and owners of an LLC do to forestall the LLC’s creditors from piercing the veil and reaching the assets of the owners and managers? In short, follow the golden rule: If you don’t want the LLC to be disregarded, don’t disregard it yourself. Some specifics are:
- Observe the state LLC filing requirements. These usually include the initial certificate of formation, an annual report, keeping an up-to-date agent for service of process, and paying the state’s annual fee. In most states, failure to comply will ultimately result in the dissolution and termination of the LLC.
- Have a written operating agreement and comply with its requirements for meetings, approvals and other formalities.
- Keep adequate business and accounting records.
- Maintain the records required by the state’s LLC Act. For example, Washington requires that an LLC maintain at its principal place of business the following:
(a) A current and a past list of each member and manager;
(b) A copy of its certificate of formation and all amendments thereto;
(c) A copy of its current operating agreement and all amendments, and a copy of any prior agreements;
(d) Unless contained in its certificate of formation or operating agreement, a written statement of:
(i) The amount of cash and a description of the agreed value of the other property or services contributed or promised by each member;
(ii) The requirements for any additional contributions agreed to be made by each member; and
(iii) Any right of any member to receive distributions which include a return of all or any part of the member’s contribution.
(e) A copy of the LLC’s federal, state, and local tax returns and reports, if any, for the three most recent years; and
(f) A copy of any financial statements of the LLC for the three most recent years.
- Adequately capitalize the LLC. (The courts recite this factor, but unless the Company is grossly undercapitalized or the LLC Act’s limits on distributions are violated, it should not normally have much weight in contract cases, since creditors can adjust credit terms when extending credit. It may be given more weight when tort claims are involved.)
- Keep separate bank accounts for the LLC. Do not commingle personal funds and LLC funds.
Washington Bobbles a Recent Amendment to the LLC Act
The 2009 Regular Session of the Washington Legislature amended the LLC Act, effective July 26, 2009. 2009 Wash. Sess. Laws Chap. 437. Two changes to the LLC Act were implemented. One was straightforward: the time period for an administratively dissolved LLC to seek reinstatement was extended from two years to five years.
The other change is problematic. The new section of the Act allows a voluntarily dissolved LLC to apply to the Secretary of State “for reinstatement” within 120 days after the effective date of the dissolution. If an application for reinstatement is made under the new law, and assuming the LLC’s name is available, the Secretary of State is directed to reinstate the LLC, in which case the reinstatement relates back to and takes effect as of the date of dissolution. (If the name is not available, the application for reinstatement must include an amendment to the certificate of formation to change the name.)
The problem with this new law is that it simply doesn’t make sense. When a Washington LLC is dissolved, nothing is filed with the Secretary of State. Dissolution of an LLC can be achieved by the written consent of all members, and then its affairs must be wound up. RCW 25.15.270. Dissolution is a change of status that begins the winding-up process, but it is not a public event.
Why would a voluntarily dissolved LLC apply for reinstatement? What is it that would be reinstated? Not the certificate of formation, since it is not affected by the LLC’s dissolution.
Even stranger, this new law requires that if no application for reinstatement is made within 120 days of the date of an LLC’s voluntary dissolution, the Secretary of State “shall cancel” the LLC’s certificate of formation. But since the voluntary dissolution of an LLC does not require a public filing, the Secretary of State will not be aware of an LLC’s dissolution, and therefore in almost all cases would be in no position to take action to cancel the dissolved LLC’s certificate of formation.
The consequences of canceling an LLC’s certificate of formation can be severe, since if the LLC’s certificate of formation is cancelled, the LLC ceases to exist. RCW 25.15.070(2)(c). And as I recently discussed in a post about Chadwick Farms Owners Ass’n v. FHC LLC (May 14, 2009), the Washington Court has held that canceling an LLC’s certificate of formation not only terminates its existence, but also abates all pending lawsuits by or against the LLC. There is currently no method under the Act to reinstate a cancelled certificate of formation.
It appears that the new section was intended to authorize an LLC to reinstate its certificate of formation within 120 days after filing a certificate of cancellation. The staff of the Secretary of State’s office has told me that they recognize the problems with the new statutory section and don’t intend to begin cancelling certificates of formation 120 days after voluntary LLC dissolutions. They are considering interpreting the new section to authorize applications for reinstatement of cancelled certificates of formation, but it’s hard to find that language in the session law.
I think it’s a safe prediction that this new law will be up for revision at the next session of the Legislature.
