LLC Member Sues for Injury to LLC; Connecticut Court Dismisses Suit for Lack of Standing
An LLC is a legal entity that is separate and distinct from its members, and an injury to an LLC is not the same as an injury to its members. Failure to take that distinction into account when commencing a lawsuit can lead to the dismissal of claims. An example of this unfortunate (at least from the plaintiff’s point of view) result is O’Reilly v. Valletta, 55 A.3d 583 (Conn. App. Ct. Nov. 20, 2012).
Background. HUB Associates, LLC and its sole member, John O’Reilly, sued Robert Pformer for violations of the Connecticut Unfair Trade Practices Act (CUTPA). HUB had leased real estate for a restaurant, and Pformer was a board member of the condominium association that managed the leased premises. The suit claimed that Pformer interfered with HUB’s efforts to advertise its business on the leased premises.
The trial court dismissed the CUTPA claims against Pformer on grounds that Pformer’s alleged conduct involved the management of a condominium and did not constitute “acts or practices in the conduct of any trade or commerce,” as is required to prove a violation of CUTPA. Id. at 586. O’Reilly appealed, but HUB did not appeal. Id. at 584 n.1.
The Appeal. Pformer argued on appeal that the trial court’s ruling in his favor was correct. But he went further and argued on appeal, for the first time, that O’Reilly lacked standing to bring the claim against him and that O’Reilly’s claim should therefore be dismissed for lack of subject matter jurisdiction.
Standing and subject matter jurisdiction sound technical, but they address fundamental issues of the court’s power and who may bring a lawsuit. Subject matter jurisdiction is the authority of a court to adjudicate the type of controversy presented. Courts have no power to decide cases over which they lack jurisdiction. Subject matter jurisdiction may not be waived by a party, and it may be raised by any party or by the court at any stage of the proceedings, including on appeal. Id. at 586.
One aspect of subject matter jurisdiction is standing. A court has no jurisdiction over a claim if the claimant does not have standing to assert the claim. Normally a party will have standing if it alleges direct injury to itself – the claimant’s injury must not be indirect or remote. Id. at 587.
The court considered O’Reilly’s claim and his status as the sole member of HUB. (HUB’s claim was not before the Appellate Court because the trial court had ruled against it and it had not appealed.) The court noted that an LLC is a distinct legal entity, with separate existence from its members. Therefore, “[a] member or manager … may not sue in an individual capacity to recover for an injury based on a wrong to the limited liability company.” Id.
O’Reilly’s CUTPA claim against Pformer was based entirely on allegations of Pformer’s violations of HUB’s rights and expectations that arose from HUB’s status as lessee of the premises and operator of the restaurant. Id. As sole owner of HUB, O’Reilly may have been harmed indirectly by Pformer’s alleged injuries to HUB, but the only direct harm was to HUB. The court therefore concluded that O’Reilly lacked standing, that the trial court lacked subject matter jurisdiction over the claim, and that the trial court improperly rendered judgment for Pformer on the merits of O’Reilly’s CUTPA claim. The case was remanded to the trial court to dismiss for lack of subject matter jurisdiction.
Comment. O’Reilly addresses basic issues that are sometimes taken for granted. The key to the court’s ruling is the separate nature of LLCs, their status as distinct legal entities. They can sue and be sued, own property, and enter into binding contracts. If an LLC is injured by a breach of contract, for example, it can sue the other party for breach of that contract. But its members, even a sole member, would not have standing to sue for breach of the contract because only the LLC was directly injured.
O’Reilly is also instructive about the power in litigation of the issue of subject matter jurisdiction. New legal issues cannot generally be brought up on appeal, but subject matter jurisdiction cannot be waived and can be brought up at any stage of litigation, including on appeal. If there is no subject matter jurisdiction, the claim is dismissed.
Corporate Parent's Attempt to Disregard the Separate Nature of Its Wholly Owned LLC In Order to Support Insurance Claim Is Rejected by Federal Court
Businesses with wholly owned subsidiaries usually take care to treat them as separate entities, in order to maintain each subsidiary’s liability shield. But in a Sixth Circuit case last month, the parent company argued the opposite – that the separate nature of its wholly owned LLC should be disregarded. In order to recover on an insurance policy that did not list the LLC as a named insured, the parent contended that the LLC’s loss was actually a direct loss to the parent. The court disagreed. Tooling, Mfg. & Techs. Ass’n v. Hartford Fire Ins. Co., No. 10-2480, 2012 WL 3931802 (6th Cir. Sept. 11, 2012).
Background. The Tooling, Manufacturing & Technologies Association is a Michigan trade association, and is the sole member of TMTA Insurance Agency, LLC, a Michigan LLC. The Agency sells insurance policies to the Association’s members. The Association’s principal revenue source is insurance commissions paid to the Agency, and the Association receives the entire benefit or loss from the Agency’s operations.
The Association hired Mark Tyler to be the Agency’s general manager. The Agency has no employees, and Tyler was paid and employed by the Association. Id. at *1.
In 2003 the Association purchased an employee fidelity insurance policy from Hartford Fire Insurance Company. The policy covered the Association and six other named insureds, but not the Agency. Shortly thereafter Tyler began diverting commission payments that were due to the Agency.
The thefts, totaling $715,000, came to light in 2007. The Association notified Hartford and filed a claim against the policy. Hartford refused to pay and the Association brought an action in state court seeking a declaratory judgment and damages. Hartford removed the case to federal district court on the basis of diversity jurisdiction. The trial court found for Hartford, and the Association appealed.
Under the policy, Hartford promised to pay for loss or damages resulting directly from theft by an employee of the insured. There was no dispute that there was a theft or that Tyler was an employee of the Association, but Hartford refused to pay the claim on the grounds that (1) the Agency is a separate entity under Michigan law, (2) the Agency was not a named insured under the policy, and (3) the policy only applied to direct losses by an insured, and any loss to the Association was indirect. Id. at *3.
The Court’s Analysis. The court’s first question was whether the Agency was covered by the policy. If so, the Association would be entitled to recover under the policy. The policy did not name the Agency as an insured, but the Association argued that the close relationship between the Association and the Agency essentially erased any difference between the two for purposes of the insurance policy. In short, the Association claimed that the injury to the Agency was equivalent to an injury to the Association. The Association also pointed out that the only reason the Agency was created as a separate entity was to satisfy Michigan’s state insurance licensing requirements. Id. at *4.
The court looked first to the language of the policy, which stated that it was for the benefit only of the named insureds. The Agency was not a named insured (although six other related entities were listed as named insureds). The Agency was treated as a separate legal entity under the policy and for the purpose of being licensed to receive insurance commissions.
The court also reviewed the history of a separate lawsuit in state court, in which the Association had sought recovery of the commissions from Tyler and in which Tyler had counterclaimed for unpaid commissions. Tyler’s counterclaim did not include the Agency, and the Association argued in state court that the Agency was a separate entity and that there were no grounds for Tyler’s claim against the Association. The Association’s separate treatment of the Agency in that lawsuit supported the conclusion that the Association and the Agency should be treated separately under the Hartford policy. The court also recognized that Michigan’s LLC statute treats LLCs as separate from their members. Id. at *5 n.6; see Mich. Comp. Laws § 450.4504(2).
The court therefore held that the Agency had no rights or benefits under the policy and that the policy did not cover any of the Agency’s losses due to the theft. Tooling, Mfg. & Techs. Ass’n, 2012 WL 3931802, at *5. But that conclusion did not resolve the case, because the court still had to determine whether the Association’s theft-related loss of income from the Agency resulted directly from Tyler’s theft. If so, the Association’s loss would be covered by the policy.
The court reviewed the two contending interpretations used by courts in various jurisdictions: (a) “direct” means immediate or without anything intervening; or (b) “direct” means proximately caused by the originating action, which the court saw as a more flexible standard.
The Court of Appeals rejected an unpublished opinion from the Michigan Court of Appeals which held that in the context of a property damage insurance policy, the word “direct” means “immediate” or “proximate.” Acorn Inv. Co. v. Mich. Basic Prop. Ins. Ass’n, No. 284234, 2009 WL 2952677, at *2 (Mich. Ct. App. 2009). Because it was an unpublished opinion, the Acorn opinion would have no precedential value in Michigan courts, but courts in the Sixth Circuit will follow unpublished state court opinions on points of state law unless the court is convinced that the highest court of the state would decide otherwise. Tooling, Mfg. & Techs. Ass’n, 2012 WL 3931802, at *8. The Tooling court determined that the Michigan Supreme Court would not follow Acorn, ruled that “direct” in the policy means immediate or without anything intervening, and concluded that the Association’s loss of income from the Agency was not a direct result of Tyler’s theft, under the policy.
The court therefore affirmed the district court’s ruling that Hartford’s insurance policy did not cover the Association’s loss from Tyler’s thievery.
Comment. The Association’s attempt to disregard the separate nature of the Agency and treat the Agency’s loss as a direct loss of the Association was doomed by the Association’s own actions. The Association formed the Agency under state law as a separate entity, licensed the Agency under the state insurance authority as a separate entity, and claimed the benefit of the Agency’s separate existence as a defense against Tyler’s counterclaim in the state court lawsuit.
Those are all normal and reasonable actions, and only worked against the Association because of its attempt to assert an inconsistent position in its suit against Hartford.
Member Avoids Personal Liability for LLC's Withheld Taxes
An LLC member ordinarily is not liable for the debts and liabilities of an LLC simply by virtue of being a member. E.g., Wash. Rev. Code § 25.15.125; Or. Rev. Stat. § 63.165. Many states, however, impose personal liability for unpaid taxes on those within a business who have authority for paying taxes withheld from employee wages, or for paying sales taxes collected from customers. If one of those statutes applies, being a member of the LLC will not shield the employee, manager or officer from the statute’s reach.
Kelly Haugen, a 10% member of an Oregon LLC, was assessed liability by the Oregon Department of Revenue for the LLC’s failure to pay Oregon income taxes withheld from employee wages. Haugen v. Dep’t of Revenue, No. TC-MD 100052C, 2011 Ore. Tax LEXIS 187 (Or. T.C. Apr. 26, 2011). The LLC was manager-managed, and Haugen was not the LLC’s manager. Haugen occasionally signed checks for the LLC, and a form filed by the LLC with the state indicated that Haugen was responsible for hiring and firing employees. Id., at *2-3. The Department of Revenue asserted liability against Haugen because of his part ownership of the LLC and because he signed checks for the business. Id. at *6.
Oregon requires employers to withhold and pay Oregon income taxes from wages paid to employees. Or. Rev. Stat. § 316.167. Personal liability for unpaid tax withholdings is imposed on “[a]n officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee or member is under a duty to perform the acts required of employers by ORS 316.167 ….” Or. Rev. Stat. § 316.162(3)(b).
Finding a paucity of case law on the liability of LLC members, the Haugen court analogized Haugen’s status to that of a corporate officer for the purpose of determining liability. Haugen, 2011 Ore. Tax LEXIS 187, at *6. The court applied prior Oregon case law involving corporate officers, and found that Haugen would be liable if he had the actual authority and control to pay or direct payment of the tax withholdings. Id. at *7. The evidence indicated that Haugen did not have authority to unilaterally sign checks or make important financial decisions – he had authority to sign checks only under the direction of the 90% owner and manager, after obtaining specific consent to sign each check. Also, Haugen did not have general authority as a member, because the LLC was manager-managed, and Haugen was not a manager.
The court concluded that because Haugen “was not in a position to pay the withholdings or direct the payment of the withholdings at the time the duty arose to withhold or pay over the taxes,” he was not an “employer” under Or. Rev. Stat. § 316.162. Haugen, 2011 Ore. Tax LEXIS 187, at *11-12. The court therefore canceled the Department of Revenue’s Notice of Liability against Haugen.
Kelly Haugen escaped liability for the unpaid taxes because of his lack of authority. Had his been a member-managed LLC, or if he had had discretion to sign checks without prior approval, the court presumably would have upheld the tax assessment against him.
Many of the comparable statutes from other states are at least as strict in finding managers and check signers to be personally liable for failure to pay tax withholdings and sales taxes over to the state. The strict approach is not surprising, given that in these cases the business has in effect been a tax collector for the state and (at least in the state’s view) is holding the state’s money. The Haugen case should be a wake-up call for LLC managers and check signers to avoid the temptation of financing the business in troubled times by holding on to tax withholdings or sales taxes.
An LLC's Property Is Not the Members' Property
A recent New York case dealt with one of the most fundamental characteristic of LLCs – the LLC as a legal entity. Sealy v. Clifton, LLC, 890 N.Y.S.2d 598, 2009 N.Y.App. Div. LEXIS 9020 (N.Y.App.Div. 2009). One of two LLC members, each owning a 50% interest, asked the trial court to partition the LLC’s real estate. In a partition action, real estate held by joint tenants or tenants in common is divided into portions so that each co-owner is awarded full, individual ownership of a portion of the real estate. The trial court refused to dismiss the partition action, but the Appellate Division reversed and required dismissal by the trial court.
Under state LLC laws, an LLC is a legal entity, in effect a legal person. An LLC can sue and be sued, own property, enter into contracts, and do many of the things that an individual human being can do. E.g. N.Y. Ltd. Liab. Co. Law §§ 203(d), 202.
Since an LLC is a legal person, the property it owns is the property of the LLC, not of the members. The New York LLC Act is clear: “A membership interest in the limited liability company is personal property. A member has no interest in specific property of the limited liability company.” N.Y. Ltd. Liab. Co. Law § 601. Other state LLC laws have similar provisions.
Relying on Section 601, the Sealy court held that the LLC, not its members, owned the real estate. Because the members were not co-owners of the real estate, the partition action had to be dismissed. Sealy, 2009 N.Y.App. Div. LEXIS 9020, at *1. Prior New York law allowed partition actions to be brought only by co-owners.
Perhaps the reasoning of the Sealy plaintiff was: “I am a part owner of the LLC; the LLC owns the real estate, therefore I am a part owner of the real estate.” In other words, something like “I own the box, ergo I own what’s inside the box.” The analogy is not apt, but perhaps it convinced the trial judge, since he refused to throw out the partition request.
That theory breaks down because an LLC is a legal entity, a legal person. The real estate in Sealy was owned by the LLC, not by the members. The only way a member could reach the real estate would be to cause the dissolution and winding up of the LLC. In that process either the real estate would be liquidated and its proceeds distributed to the members, or the real estate could be divided by the LLC and the individual parcels of the real estate distributed in kind to the members. But the member apparently had not pursued dissolution.
The legal personhood of LLCs, like that of corporations, partnerships and other entities, is a legal doctrine thoroughly woven into our legal, business, financial and political systems. It allows the law to treat LLCs as persons for many purposes – but not all. For example, LLCs cannot marry, adopt children, hold public office, or vote in public elections.
Some constitutional rights apply to legal entities. For example, the U.S. Supreme Court last month invalidated a federal ban on corporate expenditures for public communications intended to affect federal elections. The Court held that the First Amendment’s mandate that “Congress shall make no law … abridging the freedom of speech” applies to corporations. Citizens United v. Fed. Election Comm’n, 175 L. Ed. 2d 753 (2010). The Court’s opinion saw corporations as entitled to be heard in the political arena, like individuals. This was a controversial five-to-four decision that overruled prior Supreme Court precedent.
The boundaries of the legal doctrine that treats corporations and LLCs as persons will continue to be mapped and delineated. And as in Citizens United, the boundary may shift from time to time.
