LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
Colorado Pierces the LLC Veil for Managers
Two weeks ago the Colorado Court of Appeals held in Sheffield Services Co. v. Trowbridge, No. 08CA0059, 2009 WL 147703 (Colo. App. May 28, 2009), that a manager of a limited liability company could be held personally liable for the LLC’s breach of contract even though the manager was not a member. The Colorado LLC Act provides that when a party seeks to hold a member of an LLC liable for the “improper actions” of the LLC, the court is to apply the Colorado law applicable to piercing the veil of a corporation. Colo. Rev. Stat. § 7-80-107(1). The statute does not mention LLC managers, but the court found that the statute did not preclude applying corporate veil-piercing principles to managers of LLCs as well as to members.
The vast majority of corporate veil-piercing cases involve claims against shareholders, but Colorado has previously extended the corporate veil-piercing doctrine from shareholders to directors. LaFond v. Basham, 683 P.2d 367 (Colo. App. 1984). In LaFond the defendant was not a shareholder, but he was a director, president and general manager; dictated all policy and activity on the part of the corporations; “clearly dominated both his wife and son, the only stockholders, insofar as . . . corporate matters were concerned”; and used corporate assets for his personal gain. Id. at 369, 370. The LaFond court held that on those facts, equity would not stand aside and allow valid creditors’ claims to be defeated by application of the corporate shield.
The Sheffield court extended the LaFond rule to LLC managers, adopting the reasoning of other courts that “LLC managers are similar to corporate officers or directors” and that LLCs should be treated like corporations when considering whether to disregard the legal entity. 2009 WL 1477003, at *6. The court applied to LLC managers the same rules applied to corporations: to pierce the LLC veil, the LLC must be the manager’s alter ego, to recognize the separate existence of the LLC would perpetrate a fraud or defeat a rightful claim, and to pierce the veil would lead to an equitable result.
The first condition for piercing the veil is that the LLC be the “alter ego” of the manager or member. In Sheffield the appeal was on a summary judgment ruling, so the description of the facts was sketchy. But the Sheffield court did describe the various factors relevant to whether a corporation would be viewed as the alter ego of a shareholder, and implied that they would apply to an LLC:
· The entity is operated as a distinct business entity.
· Assets and funds are commingled.
· Adequate corporate records are maintained.
· The nature and form of the entity’s ownership and control facilitate misuse by an insider.
· The business is thinly capitalized.
· The entity is used as a “mere shell.”
· Legal formalities are disregarded.
· Funds or assets of the entity are used for noncorporate purposes.
2009 WL 1477003, at *5.
The Colorado LLC Act, however, removes compliance with legal formalities from the alter ego analysis for LLCs:
For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.
Colo. Rev. Stat. § 7-80-107(2). The Sheffield court did not discuss this section’s applicability to an alter ego analysis, but this provision should provide some comfort for members and managers of LLCs that fail to observe all of the applicable “formalities or requirements.” Nonetheless, good business practice and a prudent approach to risk management suggest that Section 7-80-107(2) should not be relied on when establishing and operating an LLC. Practices such as keeping separate bank accounts and accounting records, properly forming and maintaining the LLC under the applicable state law, keeping records of meetings of members and managers, and properly signing contracts in the name of the LLC, are not difficult and should be used at all times.
