Creditors of Colorado LLC Have No Standing to Sue Members Who Received Unlawful Distribution

The Colorado LLC Act prohibits an insolvent LLC from making a distribution to a member. Insolvency is defined as the LLC’s liabilities exceeding its assets, with minor exceptions. Colo. Rev. Stat. § 7-80-606. The Act also mandates that a member who receives a distribution and who knows at the time that the LLC is insolvent is personally liable to the LLC for the amount of the distribution. Id.

What happens when a creditor of an insolvent LLC is aware that a member received a distribution, knowing of the insolvency? Suing the LLC won’t accomplish much if it’s insolvent. Can the creditor sue the member to recover the unlawful distribution? That was the question before the Colorado Supreme Court in a case decided earlier this month. Weinstein v. Colborne Foodbotics, LLC, No. 10SC143, 2013 WL 2475569 (Colo. June 10, 2013).

Colborne Foodbotics, LLC received a $225,202 arbitration award against Boulder Partnership, LLC, a Colorado limited liability company. Colborne sued the LLC’s two members and its two managers, alleging that the managers authorized a distribution to the members that rendered the LLC insolvent and that the members were aware of the insolvency when they received the distributions. Colborne asserted that the members were liable to Colborne for their knowing receipt of the unlawful distributions, and that the managers were liable to Colborne for violating their fiduciary duties to the LLC’s creditors. Id. at *1.

At trial the defendants successfully contended that Colborne had no standing to sue the members or the managers, and the trial court dismissed Colborne’s claims. Id. The Court of Appeals reversed and the Supreme Court granted certiorari. (I discussed the Court of Appeals’ decision, here.)

The Supreme Court began by reviewing the fundamentals of LLCs. The court emphasized that neither members nor managers of an LLC are personally liable for debts incurred by the LLC. Colo. Rev. Stat. § 7-80-705. The court also took pains to distinguish LLCs from corporations. “An LLC is distinct from a corporation and is not governed by the Colorado Business Corporation Act, which applies only to corporations.” Id. at *3. The court pointed out that corporation common law does not apply to LLCs (with one exception under the Act for piercing the veil), quoting Section 7-80-109: “The rule that statutes in derogation of the common law are to be strictly construed shall have no application to this article.”

Unlawful Distribution. Colorado’s LLC Act allows an LLC to state a claim against a member who knowingly receives a distribution if the LLC is or will be rendered insolvent:

A member who receives a distribution in violation of subsection (1) of this section, and who knew at the time of the distribution that the distribution violated subsection (1) of this section, shall be liable to the limited liability company for the amount of the distribution.

Colo. Rev. Stat. § 7-80-606(2) (emphasis added).

This provision of the LLC Act is similar to Section 7-108-403(1) of Colorado’s Business Corporation Act, which allows a corporation to sue its directors for authorizing a distribution that renders the corporation insolvent. The plaintiff pointed out that two Colorado appellate cases have extended the statute’s rule and allowed creditors of a corporation to sue the corporate directors for authorizing an unlawful distribution. The plaintiff argued that because the language in the LLC Act is similar to the language in the Business Corporation Act, the holdings of those two cases should apply as well to the LLC Act. Weinstein, 2013 WL 2475569, at *3.

The Supreme Court disagreed. “Because LLCs and corporations are different business entities, it is reasonable that the common law applicable to corporations does not apply to an LLC in the context of a claim for unlawful distribution.” Id. at *4. The court refused to extend the LLC’s remedy for unlawful distributions as it had previously done with corporations, and concluded that only the LLC, and not a creditor, may assert the LLC’s claim for an unlawful distribution. Id.

Fiduciary Duty. The plaintiff pointed out that the Colorado Court of Appeals had previously ruled, in Sheffield Services Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009), that a manager of an insolvent LLC owes a limited fiduciary duty to the LLC’s creditors, and argued that Boulder’s managers had breached that fiduciary duty to the plaintiff. Id. at *4-5.

The Supreme Court again emphasized that LLCs are distinct from corporations. The court noted that managers are not liable under the LLC Act for the debts of the LLC, and that the Act extends no fiduciary duty to creditors. Id. at *5. The court stated that the LLC Act does not extend corporation common law to an LLC except for veil-piercing claims, and overruled Sheffield to the extent it applied the corporate fiduciary duty for directors of an insolvent corporation to the managers of an insolvent LLC. “We hold that absent statutory authority, the manager of an insolvent LLC does not owe the LLC’s creditors the same fiduciary duty that an insolvent corporation’s directors owe the corporation’s creditors.” Id.

The court accordingly reversed the Court of Appeals and ordered the case remanded to the trial court to reinstate its order dismissing the plaintiff’s claims.

Comment. Most state LLC statutes provide that an LLC member who knowingly receives a distribution from an insolvent LLC is liable to the LLC. And it is not uncommon for a judgment creditor of an LLC to find out that the LLC is insolvent and that funds were distributed to members who knew of the insolvency.

For example, a fact pattern and statute similar to those in Weinstein were before the Washington Court of Appeals in Shinstine/Associates, LLC v. South-N-Erectors, LLC, No. 39277-1-II, 2010 WL 3405399 (Wash. Ct. App. 2010) (unpublished), which I discussed, here. The result was the same as in Weinstein.

Although the creditor’s direct claim against the insolvent LLC’s members was denied in Weinstein and in Shinstine, other remedies are available. The court in Shinstine pointed out in a footnote that in post-judgment proceedings, a receiver could be appointed to give effect to the judgment against the LLC by asserting the LLC’s claim for recovery of unlawful distributions from the member. Alternatively, a judgment creditor could foreclose on the LLC’s asset, i.e., the LLC’s claim against the member who received the wrongful distribution, and then itself assert the claim against the member.

Or, a judgment creditor in this situation could simply file an involuntary bankruptcy against the LLC, assuming the bankruptcy prerequisites were met. The bankruptcy trustee would assert the LLC’s claim against the member. Or the creditor could use state fraudulent conveyance or fraudulent transfer statutes to unwind the distribution.

Delaware Supreme Court Upholds Bar on Derivative Suits by Creditors of Insolvent LLCs

During the past two months I have been on an extended vacation – very nice. Thanks to my colleagues Janet Jacobs and John Laney for guest-authoring posts, here and here.

Last week the Delaware Supreme Court ruled on the appeal of CML V, LLC v. Bax, in which the Court of Chancery held last year that a creditor of an insolvent LLC does not have standing to maintain a derivative suit in the name of the LLC against its managers. I wrote about that surprising result here – surprising because it is inconsistent with the corporate rule.

Delaware’s Supreme Court affirmed the Court of Chancery decision, holding that “Section 18-1002 of the LLC Act, by its plain language, limits LLC derivative standing to ‘member[s]’ or ‘assignee[s],’ and thereby denies derivative standing to LLC creditors.” CML V, LLC v. Bax, No. 735,2010, 2011 Del. LEXIS 480, at *24 (Del. Sept. 2, 2011) (brackets in the original).

The Court’s conclusion turned on its analysis of Sections 18-1001 and 18-1002 of the Delaware LLC Act:

§ 18-1001. Right to bring action. A member or an assignee of a limited liability company interest may bring an action in the Court of Chancery in the right of a limited liability company to recover a judgment in its favor if managers or members with authority to do so have refused to bring the action or if an effort to cause those managers or members to bring the action is not likely to succeed.

§ 18-1002. Proper plaintiff. In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and:

(1) At the time of the transaction of which the plaintiff complains; or

(2) The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction.

The Court characterized Section 18-1001 as creating a statutory right, and Section 18-1002 as requiring that the plaintiff be an LLC member or an assignee of a member. The Court emphasized the mandatory language in Section 18-1002: “must be a member or assignee,” and found Sections 18-1002 and 18-1002 to be unambiguous. CML, 2011 Del. LEXIS 480, at *11.

CML argued that (i) Section 18-1001 authorizes derivative standing to members or assignees but is not by its language exclusive, (ii) Section 18-1002 addresses only the chronology of such a member’s or assignee’s status, and (iii) when the two sections are read together they are similar in their effect to the comparable provisions of the Delaware General Corporation Law, Del. Code Ann. tit. 8, § 327, which has long been interpreted as allowing derivative standing for creditors of insolvent corporations.

CML’s position is buttressed by what the Court of Chancery characterized as an awkward fact:

[V]irtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit. Particularly in light of Production Resources and Gheewalla, an exclusive reading of Section 18-1002 would cause LLC derivative actions to differ markedly from their corporate cousins. If practitioners widely understood the derivative standing provisions to have this effect, one would expect treatises, articles, and commentaries to call attention to that fact. … [O]ne also would expect courts to have encountered parties raising the statutory provisions as a defense. Yet the universe of authorities favoring the no-standing position consists of (i) a single sentence at the end of a footnote in one Delaware treatise, see Symonds & O’Toole, supra, § 9.09, at 9-61 n.270, and (ii) abbreviated treatment in an unreported district court decision, see Magten, 2007 WL 129003, at *3.

            Many commentators, by contrast, have assumed that creditors of an insolvent LLC can sue derivatively. In light of this assumption, they have debated vigorously whether an LLC agreement can limit the fiduciary duties that the creditors would invoke. That question never arises if creditors lack standing to sue under Section 18-1002.

CML V, LLC v. Bax, No. 5373-VCL, 2010 Del. Ch. LEXIS 220, at *12-13 (Del. Ch. Nov. 3, 2010) (footnote omitted).

This widespread reading of Sections 18-1001 and 18-1002 significantly undercuts the Court’s assertion that these two sections are unambiguous.

Nonetheless, the Court has spoken and the rule is now clear, at least until changed by legislative action. Given the gulf between the Court’s reading of the statute and the widespread past interpretations by commentators and practicing lawyers, it would not be surprising to see legislative action on this point. As the Court said, “The General Assembly is well suited to make that policy choice and we must honor that choice.” CML, 2011 Del. LEXIS 480, at *13.

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.