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.
When a Connecticut LLC filed suit to collect rent from its tenant, the tenant defended on grounds that the LLC members who approved the lawsuit owned only 50% of the LLC and therefore lacked the requisite majority vote. The LLC riposted that under the Connecticut LLC Act, the vote of its member who voted against the lawsuit had to be disregarded because her husband owned 20% of the tenant, and the Connecticut Supreme Court agreed. 418 Meadow St. Assocs., LLC v. Clean Air Partners, LLC, 43 A.3d 607 (Conn. 2012).
Background. State LLC statutes differ on how and to what extent members may bring lawsuits on behalf of LLCs. Some states allow derivative suits, in which one member can bring a suit on behalf of the LLC, subject to a number of restrictions. E.g. Delaware, Washington, and Illinois. The restrictions on LLC derivative suits are similar to those imposed on corporations. For example, the member must have been a member at the time of the alleged wrongdoing and at the time of filing the derivative suit, the member must make a prior demand of the LLC’s management (unless excused because it would be futile), and disinterested members or management may later terminate the suit.
Connecticut takes a different tack. Members holding a majority interest in an LLC may authorize a lawsuit on behalf of the LLC, whether or not the LLC is manager managed, unless the LLC’s operating agreement provides otherwise. Conn. Gen. Stat. § 34-187. Other states with similar provisions include Massachusetts and Wisconsin.
Connecticut’s section 34-187 and the other similar state LLC acts appear to have been based on Section 1102 of the Prototype Limited Liability Company Act (the “Prototype”), which was published in 1992 by the American Bar Association’s Committee on LLCs, Partnerships and Unincorporated Entities. The Prototype is reproduced at 3 Larry E. Ribstein & Robert R. Keatinge, Ribstein and Keatinge on Limited Liability Companies, App. C (2d ed. 2012). The Prototype’s comment to Section 1102 discusses the differences between the derivative suit approach and Section 1102’s approach, and makes clear that Section 1102 replaces the derivative action.
Section 34-187 addresses conflicts of interest among the members when voting to approve a lawsuit. In determining the member vote on a lawsuit, the vote of any member “who has an interest in the outcome of the suit that is adverse to the interest of the limited liability company” is excluded. The Prototype’s comment to Section 1102 makes clear that interested members are excluded both as votes and in determining the number of votes necessary for a majority. Without the exclusion, a member that is or has an interest in the prospective defendant could vote against and block the LLC’s lawsuit.
An article published earlier this year examines (i) how the states that have adopted the Prototype’s Section 1102 have resolved member disputes, (ii) the differences between derivative suits and the direct suit approach of Section 1102, and (iii) the recommendations for member suits in the ABA’s Revised Prototype Limited Liability Company Act. James R. Burkhard, Resolving LLC Member Disputes in Connecticut, Massachusetts, Pennsylvania, Wisconsin, and the Other States that Enacted the Prototype LLC Act, 67 Bus. Law. 405 (2012). I wrote about the ABA’s publication last year of the Revised Prototype LLC Act, here.
The Lawsuit. Barbara Levine owned 50% of 418 Meadow Associates, LLC (Meadow), and Michael Weinshel and Mark Wynnick owned the other 50%. Meadow leased office space to Clean Air Partners, LLC (Clean Air).
A dispute arose between Meadow and Clean Air over the lease, and Weinshel and Wynnick brought suit in Meadow’s name to enforce the lease and collect rent from Clean Air. Barbara Levine’s husband, Steven Levine, owned 20% of Clean Air, however, and Barbara Levine objected to the lawsuit and did not vote to bring the action.
Clean Air defended the suit by claiming that Meadow lacked standing because member approval of the suit by majority vote was necessary, and Weinshel and Wynnick held only 50% of the member interest in Meadow and therefore lacked a majority. Meadow countered that Barbara Levine had an interest in the outcome of the lawsuit that was adverse to the LLC’s interest, because of her husband’s part ownership of Clean Air.
The trial court found that Barbara Levine’s indirect interest in Clean Air, through her husband’s part ownership of Clean Air, was insufficient to disqualify her as a voting member. With Barbara Levine voting against the lawsuit, the votes of Weinshel and Wynnick did not form a majority. The trial court therefore found that Meadow lacked standing and gave judgment for Clean Air. The Appellate Court affirmed and the Supreme Court accepted review.
The court began with the language of the statute, pointing out that “adverse interest” is not defined in Section 34-187 or elsewhere in the Connecticut LLC Act, and that therefore it should be construed according to its common usage. After reviewing a number of definitions, the court concluded that adverse interest should be construed broadly:
Simply put, the term “adverse” in § 34-187(b) encompasses any interest of a member that is contrary or opposed to the limited liability company’s interest in the outcome of the litigation. We therefore conclude, contrary to the trial court, that the statute’s application is not limited to circumstances in which a member’s adverse interest is a proprietary one.
43 A.3d. at 616.
The court therefore ruled that when LLC members desire to approve a lawsuit by the LLC and a spouse of one of the members is part owner of or maintains a position of control in a defendant company, then that member is considered to have an interest in the outcome of the suit that is adverse to the LLC’s interest and that member’s vote will be excluded. Id. The court viewed its broad interpretation of “adverse interest” as consistent with the overall approach of the LLC Act, which provides default rules for LLC governance but allows the members to depart from those rules in their operating agreement. Members desiring a different rule for initiating a lawsuit can specify that in the LLC’s operating agreement.
The decisions of the trial court and the Appellate Court were reversed and the case was remanded for further proceedings.
Comment. The members’ resort to Section 34-187 in 418 Meadow Street is unusual because the dispute did not involve a claim by one member against another member or manager. Most LLC lawsuits that are brought as derivative suits or as member-initiated direct actions (e.g., under Connecticut’s Section 34-187) involve disputes between members over breaches of fiduciary duty or breaches of the LLC’s operating agreement. Here the dispute was between the LLC and its tenant, and had it not been for one member’s spouse being part owner of the tenant it presumably would have been a routine business decision for the LLC to file suit to recover unpaid rent.
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 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.