LLC Manager Is Personally Liable for LLC's Failure to Pay State Agency, Without Piercing the Veil
The sole manager of a Michigan limited liability company has been held potentially liable for the LLC’s failure to pay assessments due under the Michigan Agricultural Commodities Marketing Act (ACMA). Dep’t of Agric. v. Appletree Mktg., L.L.C., No. 137552, 2010 WL 841173 (Mich. Mar. 10, 2010). The case illustrates that an LLC’s liability shield is not absolute – an LLC manager can be personally liable for some types of nonpayment by the LLC.
The ACMA established the Michigan Apple Committee to carry out marketing programs funded by assessments on apple distributors. Distributors are required to deduct a portion of the purchase prices they pay to apple producers, and to hold the funds in trust and remit them to the Committee. Mich. Comp. Laws § 290.651 et seq.
Appletree Marketing, L.L.C. withheld the required amounts from its payments to apple producers in 2004 and 2005, but failed to remit those amounts to the state. The LLC instead used the funds to pay other debts, and later became insolvent and defunct. The state sued the LLC and Steven Kropf, the LLC’s manager, to recover the unpaid assessments.
The trial court entered judgment against the LLC for the unpaid amounts, but dismissed the state’s claim against Kropf on grounds that the state’s ACMA remedy against the LLC was exclusive. Michigan’s Supreme Court reversed, holding that the ACMA explicitly preserved all other lawful remedies, including claims for common law conversion and statutory conversion. The court then examined the issue of Kropf’s potential personal liability.
Under the ACWA, the funds withheld by the LLC were held intrust for the Committee. When the LLC used those funds for other purposes, it asserted dominion and control over the Committee’s money and therefore committed the tort of conversion.
To decide whether the state could pursue claims for common law and statutory conversion against Kropf, the court looked to existing Michigan law:
Michigan law has long provided that corporate officials may be held personally liable for their individual tortious acts done in the course of business, regardless of whether they were acting for their personal benefit or the corporation’s benefit.
Appletree, 2010 WL 841173, at *7. Corporate officers may be held individually liable when they cause the corporation to act unlawfully. Id.
Kropf participated in the tort by causing the LLC to divert the Committee’s funds to other purposes. Although the prior case law involved officers of corporations, the court applied those cases to the LLC’s manager without discussion, apparently by analogy.
The court made clear that this was not a case of piercing the veil of the LLC. “However, we have never required that a plaintiff pierce the corporate veil in order to hold corporate officials liable for their own tortious misconduct, and thus it is unnecessary to pierce the corporate veil in this case.” Id.
The court concluded that Kropf could be personally liable if the facts established the necessary participation: “There is no question that, if the facts prove either common law or statutory conversion, Kropf can be held personally liable and may not hide behind the corporate form in order to prevent liability for his active participation in the tort.” Id. Because the claim against Kropf had been dismissed on summary judgment, the court remanded the claim against Kropf back to the trial court for further proceedings.
Business people use limited liability companies to shield themselves from personal liability for the companies’ debts and obligations. But the shield is not impenetrable, as Appletree shows.
Normally an LLC manager is not personally liable merely because the manager caused the LLC to breach a contract; breach of contract is not a tort. The contract, however, can establish a relationship where the conduct constituting breach of contract also constitutes a tort.
Assume the parties agree that an LLC will receive property and hold it in trust, or hold it as a bailee. If the LLC misappropriates the property and refuses to return it to the other party, it has probably committed the tort of conversion. Then, the LLC manager who caused the LLC to convert the property will be personally liable for the tort.
Tort remedies can sting. For example, under Michigan’s conversion statute, a person damaged because of another’s theft, embezzlement or conversion may recover three times the amount of actual damages plus costs and reasonable attorneys’ fees. Mich. Comp. Laws § 600.2919a.
Appletree involved an intentional tort by the LLC, but claims against managers can also occur in negligence cases. Sometimes injured parties claim that an LLC manager’s inadequate supervision and management resulted in the company’s negligent injury to the plaintiff. The law is less clear here, although in many of these cases courts do hold managers liable for acts and omissions related to supervision and management. But that’s a discussion for another day.
How Not to Draft an Attorneys' Fees Clause
Many LLC operating agreements include a fee-shifting provision, a clause that requires the losing party in litigation between members to pay the prevailing party’s reasonable attorneys’ fees. These fee provisions are usually relegated to the boilerplate sections near the end of the operating agreement, and often don’t get much attention when the agreement is being prepared. A ruling last month from the Idaho Supreme Court shows that if the attorneys’ fees clause is not carefully crafted, it may not work the way the parties intended.
In Henderson v. Henderson Investment Properties, L.L.C., No. 35138, 2010 WL 569890 (Idaho Feb. 19, 2010), the Supreme Court reversed the trial court’s award of $21,552 in attorneys’ fees. The LLC in the case was formed by a husband and wife and their son and daughter-in-law to operate a sandwich shop. Acrimony later developed between the generations, and the father brought suit to dissolve the LLC. The Idaho LLC Act allows a court to order dissolution if actual or threatened irreparable harm results either from member deadlock or from illegal, oppressive or fraudulent acts of the controlling members. Idaho Code Ann. § 53-643.
Mr. Henderson alleged both deadlock and illegal, oppressive or fraudulent acts, with resulting irreparable harm. The trial court dismissed the complaint, holding that although there had been a deadlock it had not resulted in actual or threatened irreparable injury, and that there had been no illegal, oppressive or fraudulent acts. The trial court also awarded attorneys’ fees to the son and daughter-in-law, based on this provision in the LLC’s operating agreement:
In any action or proceeding brought to enforce any provision of this Agreement, or where any provision is validly asserted as a defense, the successful party is entitled to recover reasonable attorneys’ fees in addition to any other available remedy.
The Supreme Court analyzed that language and reversed the award of attorneys’ fees because it found that the plaintiff did not seek “to enforce any provision of the Agreement,” as required by the clause. The plaintiff instead sought dissolution, which is a statutory remedy.
If the parties had been asked about this clause when they signed their operating agreement, they probably would have interpreted it to mean that in any litigation about their rights and duties as members, the winner would have been entitled to recover its reasonable attorneys’ fees.
This clause did not work that way because it applied only to contractual disputes, i.e., disputes over the terms of the operating agreement. The clause did not apply to any of the rights of members that are defined by the statutory provisions of Idaho’s LLC Act. In this case the dispute was over dissolution, a purely statutory remedy. The irony is that if the operating agreement had simply parroted the language of the statute’s dissolution remedy, Idaho Code Ann. § 53-643, then under the court’s reasoning the defendants would have been entitled to attorneys’ fees.
Many important rights of LLC members, such as sharing of profits, rights to distributions, and rights to certain records of the LLC, are controlled by provisions in Idaho’s LLC Act. The Act allows some of those provisions to be waived or modified in the operating agreement, while others are non-waivable. That approach is typical of other states’ LLC statutes.
Under an attorneys’ fees clause like that in Henderson, and under that court’s reasoning, the right of the winning party to get a judgment for attorneys’ fees will depend on whether the dispute was governed by the LLC statute or by specific terms in the operating agreement. That does not seem like the result most business people would intend when they put an attorneys’ fees clause in their operating agreement.
A better solution, of course, is to use a broader attorneys’ fees clause. One example I’ve seen is:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement or to interpret or enforce any rights under this Agreement, [the prevailing party may recover.]
The language “any controversy arising out of this Agreement” may be broad enough to cover both contractual and statutory claims, although it is perhaps susceptible to the argument that statutory rights not referred to in the operating agreement do not “arise out of” the agreement.
I've also seen another approach that would have changed the result in Henderson, but it may be too broad for some situations:
In the event that any dispute between the Company and the Members or among the Members should result in litigation, [the prevailing party may recover.]
This language literally applies to “any dispute” between members, which could cover a dispute between members that has nothing to do with the LLC. A more natural interpretation would limit the scope of the clause to member disputes that have something to do with the LLC, i.e., with their status as members of the LLC. But to be safe, something like the following might be best:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement, or to interpret or enforce any rights under this Agreement or the [name of State] Limited Liability Company Act, [the prevailing party may recover.]
Some LLC operating agreements require that disputes be settled by binding arbitration instead of litigation. A recently-published treatise on drafting operating agreements for Delaware LLCs has a nice treatment of arbitration and attorneys’ fees, among other things. John M. Cunningham & Vernon R. Proctor, Drafting Delaware Limited Liability Company Agreements: Forms and Practice Manual (2009).
In the model operating agreements provided by Cunningham and Proctor, arbitrable matters include “material matters: (1) That arise under or relate to this Agreement or that relate to the LLC…” Cunningham & Proctor, supra, at Form 6.1, § 30.3. Their model agreement then goes on to assign attorneys’ fees to the nonprevailing party:
To the extent that an arbitrator determines that a party to an arbitration has failed to prevail in that arbitration, the arbitrator shall allocate to that party the costs of the arbitration, including reasonable attorneys’ fees and fees payable to the arbitrator.
Cunningham & Proctor, supra, at Form 6.1, § 30.11(c). This approach allows the arbitration to cover any dispute related to the operating agreement or the LLC, and applies the “loser pays” rule to the entire arbitration. This approach would avoid the type of problem dealt with in the Henderson case.
The clause at issue in Henderson, and the court’s ruling, show in microcosm why contract drafting is difficult. The unexpected scenario can rise up to swat the drafter. I’ll wager that when the parties put together their operating agreement in the Henderson case, they paid little or no attention to the exact words of the clause. Before any disputes arose I’m sure they would have said that any dispute directly related to the LLC was intended to be covered by the “loser pays” rule of the clause. But yet it wasn’t.
It was not a case of the language being unclear (although some might argue that); it was primarily a case of the language not reaching far enough in its scope. The Henderson case is an object lesson in vignette form for lawyers who draft contracts. The lesson? Know the underlying law and the context in which you’re drafting, and don’t rely too quickly on language taken from other contracts.
The IRS Again Loses in Attempt to Limit the Deductibility of LLC Losses
The Tax Court has again ruled against the Internal Revenue Service in a case on the deductibility of a member’s LLC losses. Newell v. Commissioner, T.C.M. 2010-23 (Feb. 16, 2010). Last year I wrote about the three prior cases, here.
In these cases the IRS has taken the position that its regulations require a presumption that LLC losses are “passive activity losses” (passive losses). Under the regulations this presumption is difficult to overturn, so in many cases LLC losses are treated as passive losses. And for most taxpayers, passive losses are far less useful than active losses (losses not resulting from passive activities). Taxpayers generally prefer to use losses to offset taxable income, but passive losses can only be used to offset income from other passive activities, and not against income such as wages, interest, and dividends.
The Tax Court ruling in Newell is consistent with the prior cases in its interpretation of the IRS’s regulations. The regulations create a presumption that losses incurred by a limited partner in a limited partnership are passive losses, and make it difficult to overcome the presumption. The IRS has taken the position that a member of an LLC should be treated like a limited partner of a limited partnership for purposes of the regulation. The courts, including the Tax Court last month in Newell, have rejected the IRS’s argument.
This latest case should give additional comfort to LLC members, that they should be able to use LLC losses to offset “active” income such as wages. LLC members will still need to demonstrate that they materially participate in the LLC’s management, but they will be able to use the more flexible rules of the IRS’s regulations, without the need to overcome the presumption against material participation.
The IRS could of course change these regulations to explicitly treat LLCs in the same way that limited partnerships are treated. Because LLCs are relatively new, the IRS may still be trying to figure out how to deal with them while limiting the potential for abuse.
