Piercing the Veil vs. Direct Member Liability in Connecticut
Claimants against LLCs often go beyond the LLC and seek recovery from individual members or managers of the LLC. They do that because in many cases, to quote Willie Sutton, that’s where the money is. The LLC may not be able to satisfy a claim, but a member or manager who turns out to be liable on the claim may have deeper resources to satisfy the claimant.
Under the state LLC statutes, a member or manager is not liable for the debts of the LLC simply by virtue of being a member or manager, but sometimes the circumstances can result in personal liability for a member or manager. Two recent Connecticut cases dealt with attempts to reach LLC members and managers.
Piercing the Veil. Last month the Connecticut Court of Appeals decided Breen v. Judge, 124 Conn. App 147, 2010 Conn. App. LEXIS 420 (Sept. 28, 2010). In 2006 Breen obtained a judgment against Patriot Truck Equipment, LLC for money loaned to the LLC. In 2007 Breen sued Judge, the managing member of the LLC, on grounds that the corporate veil of the LLC should be pierced in order to hold Judge personally liable for the LLC’s debt. The trial court denied the veil-piercing claim, and Breen appealed.
Usually an LLC is treated as a separate legal person, and its debts are separate from the debts of its members or managers. Piercing the veil is an exception that ignores the legal distinction between the LLC and its members or managers, with the result that a manager or member may be held liable for the debts of the LLC.
Connecticut law allows an LLC’s veil to be pierced under either the “instrumentality test” or the “identity test.” To pierce the veil under the instrumentality test, the plaintiff must show that (1) the defendant completely dominated the LLC’s finances, policies, and business practices, (2) the defendant used that control to commit fraud, waste or a dishonest or unjust act, or to violate a legal duty, and (3) the defendant’s conduct caused the injury or loss complained of. Breen, 2010 Conn. App. LEXIS 420, at * 7-8.
The court listed ten factors relevant to whether an entity is dominated or controlled, and reviewed the relevant factors considered by the trial court. At all times Judge was no more than a 50% owner of the LLC. The LLC was a properly formed company doing business in Connecticut. The LLC followed the various entity-related formalities, such as keeping separate books, filing company tax returns, and filing dissolution documents when it dissolved. The LLC operated a truck-outfitting business with increasing sales for each of its first three years, although it ultimately failed. Based on those factors the court found that neither the instrumentality test nor the control test was satisfied, and therefore affirmed the trial court’s decision not to pierce the LLC’s veil.
Breen is a good example of what an LLC and its members and managers should do to avoid a pierced veil and personal liability for the LLC’s debts. It’s not rocket science: have a legitimate business, properly form the LLC, keep books and records, file tax returns, don’t use the LLC’s bank account as the member’s personal checkbook, and so on.
Tort Claims. Piercing the veil is not the only way a creditor can reach the members or managers of an LLC. The Connecticut Supreme Court in August decided a case where the plaintiff raised tort claims against an LLC member: Sturm v. Harb Dev., LLC, 298 Conn. 124, 2010 WL 3306933 (Aug. 31, 2010). (A tort is an actionable, civil wrong, such as negligently or intentionally causing harm to someone. Examples include negligently causing an auto accident, fraud, and breach of a fiduciary duty. A party injured by a tort may be able to recover damages from the tortfeasor if requirements such as causation and proof of damages are satisfied.)
Harb Development, LLC built a home for Mr. and Mrs. Sturm. The Sturms were unhappy with the result and sued both the LLC and John Harb, a member of the LLC. The Sturms asserted violations of the Connecticut Unfair Trade Practices Act, negligence in the construction of their home, violations of the Connecticut New Home Construction Contractors Act, and fraudulent and negligent misrepresentation.
Harb asserted that the Sturms’ claims against him arose from his membership and management of the LLC and were fundamentally the same as their claims against the LLC. Harb pointed to Conn. Gen. Stat. § 34-133(a), which provides that an LLC member or manager is not liable for the LLC’s debts “solely by reason of being a member or manager.” He argued that therefore the Sturms were required to plead facts adequate to pierce the LLC’s veil in order to state a valid claim, and that they had failed to do so. The trial court agreed and dismissed all claims against Harb in his individual capacity. Harb, 298 Conn. at 129.
The Sturms emphasized on appeal that their claims against Harb were tort claims based on his own actions, that he was personally liable in tort despite being a member or manager of the LLC, and that therefore it was not necessary to pierce the veil to establish his personal liability.
The Supreme Court reviewed the well-trodden case law on the tort liability of an LLC member or manager. Members and managers are not personally liable for the LLC’s torts merely because of their status as a member or manager. But if they commit or participate in the tort, or direct the LLC’s tortious act, they will be liable even if the LLC is also liable. Id. at 132-33. Nowhere in the prior cases was the injured party required to show that the LLC’s veil should be pierced in order to allow recovery against a manager or member who personally participated in or directed the LLC’s tortious act.
The court found Harb’s reliance on Conn. Gen. Stat. § 34-133(a) to be unfounded. The Connecticut LLC Act only excludes liability for the LLC’s debts “solely by reason of being a member or manager.” Conn. Gen. Stat. § 34-133(a) (emphasis added). The court concluded that the statute was not intended to preclude the common-law, individual liability of members or managers who participate in wrongful conduct, and that therefore the trial court improperly denied the claims against Harb for the plaintiffs’ failure to plead the elements of a veil-piercing claim. Harb, 298 Conn. at 137-38.
Harb’s attempt to transmute the Sturms’ tort claim against him into a veil-piercing claim was imaginative, although ultimately unsuccessful. This tactic likely reflects a recognition that piercing the veil is difficult and less predictable than proving a tort claim. As the Breen court said, “Ordinarily the corporate veil is pierced only under exceptional circumstances.” Breen, 2010 Conn. App. LEXIS 420, at *9 (quoting Naples v. Keystone Bldg. & Dev. Corp., 295 Conn. 214, 233, 990 A.2d 326 (2010)). Not only are exceptional circumstances usually required, but predicting the outcome of a veil-piercing case is challenging. As Peter Oh recently indicated in the abstract to a research paper, here, “Exactly when the veil of limited liability can and will be circumvented to reach into a shareholder’s own assets has befuddled courts, litigants, and scholars alike.”
Connecticut Orders LLC Dissolution and Winding Up - Member Acrimony Prevents LLC from Carrying On Its Business
It’s a classic fact pattern that is all too familiar to many business lawyers. Two good friends decide to start a business. In their enthusiasm they create a 50/50 ownership structure and launch the business. Later, things change. One starts devoting more time to the business. Or maybe the business develops a commercial relationship with a separate company owned by one of the friends, which benefits only that one. Their business relationship becomes asymmetrical. Their views of how each should be compensated or how the business should be conducted diverge.
That’s essentially what happened in Saunders v. Firtel, 978 A.2d 487 (Conn. Sept. 22, 2009). Saunders and Firtel were friends who began a business relationship in the mid-1980s. Saunders joined Firtel as an employee and shareholder in Adco Medical Supplies, Inc. (Adco) in 1986. Saunders held 49% of the stock, Firtel held 51%. Firtel was President and Saunders Vice President, and they agreed that each would receive the same annual salary. In 1999, when things were still going well, Saunders and Firtel formed Barbur Associates, LLC (Barbur), a Connecticut LLC in which each owned a 50% interest. Barbur acquired real estate and leased it to Adco on an oral month-to-month lease.
The stage was now set. By 2004, Saunders had become dissatisfied because he perceived that he was doing most of the work but receiving the same compensation as Firtel. Saunders advised Firtel that the 1986 agreement for equal compensation was no longer acceptable. Firtel responded by firing Saunders from Adco in July 2004, lowering the rent charged by Barbur to Adco, unilaterally authorizing repairs by Barbur to the building Adco rented, and arranging a $5,000 loan from Barbur to Adco. Adco refused to pay Saunders his salary for 2004. Shortly thereafter, Saunders and Firtel ceased having any business or personal relationship, and made accusations against each other of theft, breach of fiduciary duty, self-dealing and other “improper and felonious conduct.” Saunders, 978 A.2d at 500 n.22.
Saunders sued Adco for his unpaid 2004 compensation, and for a decree ordering the dissolution and winding up of Barbur. The trial court found for Saunders on his wage claim and ordered double damages pursuant to Conn. Gen. Stat. § 31-72. The trial court also ordered a dissolution and winding up of Barbur, under Conn. Gen. Stat. §§ 34-207 and 34-208.
The Connecticut LLC Act authorizes the superior court to order dissolution “whenever it is not .jpg)
reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” Conn. Gen. Stat. § 34-207. The LLC Acts of Washington, Delaware, New York and many other states have similar provisions, as does NCCUSL’s Revised Uniform LLC Act. The essence of this test is whether or not the business of the LLC can be carried on in a reasonable way. The court has discretion; this is an equitable proceeding in which factors such as oppression, wrong-doing or deadlock are considered.
The court concluded that “the trial court’s order of dissolution is well supported by the evidence.” Saunders, 978 A.2d at 500. In reaching its conclusion, however, the court simply recited the facts identified above. The court did not examine Barbur’s articles of organization or operating agreement to see if the business was being carried out in conformity with the articles or the operating agreement, or refer to any such examination by the trial court. The two Connecticut cases cited by the court don’t seem particularly relevant, since both involved dissolutions of corporations for deadlock under prior corporate statutes. Those statutes, unlike Connecticut’s LLC Act, allowed dissolution for deadlock or other good and sufficient reasons. The court may have concluded that the various abuses by Firtel and the hostility and lack of cooperation between Firtel and Saunders simply made it impossible for the LLC to carry on any business, but the court’s analysis is conclusory and opaque.
Contract provisions don’t necessarily make disagreements between members go away, but sometimes they can provide helpful mechanisms to mitigate disputes and keep the parties out of court. For example, Saunders and Firtel apparently had no provisions in Barbur’s operating agreement to deal with deadlock. If their operating agreement had had a provision that allowed either party to initiate a buy-out process, they might have avoided litigation. A business person may assume that the initially cordial relationship with a potential business partner will continue indefinitely, but his or her lawyer should ask the hard-edged questions to challenge that assumption and help the parties build some safety nets into their agreement.
