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.

New York Court Holds Distribution Was Not a Misappropriation

Is it a distribution or a misappropriation when a managing member of an LLC withdraws funds from the LLC for his own use? That was the dispositive issue in Mostel v. Petrycki, 885 N.Y.S.2d 397 (N.Y. Sup. Ct. Sept. 2, 2009). It was dispositive because the answer to that question determined which of two different statutes of limitations applied.

Mostel had a judgment against Fulcrum Global Partners, LLC, a Delaware LLC (Fulcrum), from a prior lawsuit. Fulcrum went out of business and Mostel was unable to recover from Fulcrum on his judgment, so he brought a lawsuit against Petrycki, the founding member and CEO of Fulcrum. Mostel claimed that a $300,000 withdrawal from Fulcrum by Petrycki was a fraudulent conveyance under New York’s Debtor and Creditor Law, N.Y. Debt. & Cred. Law §§ 273, 273-a, 276 and 276-a.

According to Mostel, Petrycki’s withdrawal was a fraudulent conveyance because it was without consideration, and rendered Fulcrum insolvent and without assets to satisfy the judgment against it. If the withdrawal was a fraudulent conveyance, Mostel’s judgment against Fulcrum could reach the $300,000 in Petrycki’s hands.

Petrycki, however, asked for Mostel’s suit against him to be dismissed on grounds that his $300,000 withdrawal was a distribution to him by Fulcrum, and the lawsuit was therefore barred by the three-year statute of limitations in the New York Limited Liability Company Act and the Delaware Limited Liability Company Act.

Mostel riposted that the six-year statute of limitations applicable to the fraudulent conveyance claim should apply. (Mostel’s suit was filed more than three years and less than six years after the withdrawal.) Mostel argued that the $300,000 withdrawal was not a distribution because Petrycki did not have authority to withdraw the funds and had applied them for his personal use.

Since Fulcrum was a Delaware LLC, the court examined both the Delaware and New York LLC Acts. Both statutes provide that if a member receives a distribution that causes the liabilities of the LLC to exceed its assets, and if the member knew of the resulting insolvency at the time of the distribution, then the member is liable to the LLC for return of the distribution. Both statutes also provide that a member’s liability for receiving a wrongful distribution will end three years after the distribution, unless a lawsuit is brought on the claim before the end of the three years. N.Y. Ltd. Liab. Co. Law § 508; Del. Code Ann. tit. 6, § 18-607. Finding no difference between the two states’ laws, the court said it need not decide which state’s law governed – the result would be the same in either case. Mostel, 885 N.Y.S.2d at 399 n.1.

The New York courts had previously determined that in the case of an LLC distribution which is both wrongful under Section 508 of the LLC Act and a fraudulent conveyance under the Debtor and Creditor Law, the three-year limitations period of the LLC Act overrides the six-year limitations period of the Debtor and Creditor Law. O’Connell v. Shallo, 323 B.R. 101 (S.D.N.Y. 2005). So if the $300,000 withdrawal was a distribution, the three-year limitations period of the LLC Act would apply, and Mostel’s claim would be barred. If it was a misappropriation and therefore not a distribution, Mostel’s suit could go forward.

The New York LLC Act defines “distribution” as “the transfer of property by a limited liability company to one or more of its members in his or her capacity as a member.” N.Y. Ltd. Liab. Co. Law § 102(i). Fulcrum’s Operating Agreement gave all members the right to request a return of their invested capital, subject to the approval of the managing member. The agreement did not provide for any additional procedures when a managing member seeks a return of its own invested capital.

Mostel’s complaint conceded that Petrycki was the managing member and that his $300,000 withdrawal was a return of his capital contribution, so the court rather straightforwardly concluded that the withdrawal was an authorized distribution to Petrycki. The three-year limitations period applied and Mostel’s claim was time-barred. Mostel’s complaint was dismissed.

The lessons from this case? Apart from the obvious, of course – don’t delay filing a lawsuit for so long that a statute of limitations bars the claim – the case underscores the importance of written LLC agreements. It also shows the need for the members to consider carefully the distribution provisions in their agreement. Interim distributions should be authorized by the agreement, and the parties should think about what procedures or approvals will be necessary for different types of distributions. For example, in Fulcrum’s agreement, distributions on request of a member for return of its invested capital were allowed if approved by the managing member, and that provision validated Petrycki’s withdrawal as a distribution.