Kentucky Finds Sole Member Not Personally Liable on Lease That LLC Entered into While Administratively Dissolved
Administrative dissolution is a remedy that states use to enforce their annual-fee and annual-report requirements for LLCs. The dissolved LLC must wind up and liquidate its business, but can be reinstated if it pays the back fees and files its report. The reinstatement will then relate back and take effect as of the date of the dissolution. If the LLC waits too long, typically three or five years, it can no longer be reinstated.
Administrative dissolution is common. It often happens by inadvertence, and when an LLC’s management learns of the problem it will usually act quickly to reinstate the LLC if there is still time to do so. In those cases the unplanned dissolution results in no change to the LLC’s operations, since management is at first unaware of the problem and then fixes it as soon as possible.
This common scenario played out in a recent Kentucky case. A Kentucky LLC was administratively dissolved and later entered into a real estate lease. The LLC subsequently defaulted on its lease, and the landlord sued both the LLC and its single member. Shortly after the lawsuit was filed, the LLC applied for and was granted reinstatement by the Kentucky Secretary of State.
The landlord’s theory was that the single member was liable either because the dissolution stripped her of her statutory immunity as a member, or because she was an agent and lacked authority to act for the LLC. The trial court and the Court of Appeals found that the LLC’s member was not personally liable on the LLC’s lease, and the Supreme Court affirmed in a lengthy and detailed opinion. Pannell v. Shannon, 425 S.W.3d 58 (Ky. March 20, 2014).
Member Liability. The Kentucky LLC Act provides that an LLC’s member or manager is not personally liable for the LLC’s obligations merely by reason of being a member or manager. Ky. Rev. Stat. Ann. § 275.150(1). (All state LLC statutes have a similar provision.) The landlord, however, pointed out that Section 275.300(2) requires a dissolved LLC to not carry on any business except that appropriate to wind up and liquidate its business and affairs, and argued that an LLC member that violates that prohibition loses its limited liability protection even if the LLC is later reinstated.
When an LLC is reinstated after administrative dissolution, “the reinstatement shall relate back to and take effect as of the effective date of the administrative dissolution, and the limited liability company shall resume carrying on business as if the administrative dissolution had never occurred.” Ky. Rev. Stat. Ann. § 275.295(3)(c) (repealed in 2011, but in force when the events in this case occurred). Reinstatement literally undoes the dissolution. Pannell, 425 S.W.3d at 68.
The landlord argued that the word “resume” in the statute implies that the LLC had to have ceased doing business while administratively dissolved. The court acknowledged that “resume” appears to create some ambiguity, but read “resume” in context as a reference to the retroactive nature of reinstatement. The court also supported its interpretation with an analysis of subsequent statutory revisions which clarified that an LLC’s dissolution does not take away the limited liability protection of an LLC member or agent, using the in pari materia canon of construction. Id. at 70-72. (In pari materia refers to the principle of statutory construction that if a subsequent statute on the same subject clarifies language in a prior statute, the court may be guided by the legislative clarification.)
The court found that it would be illogical to enforce the winding-up-only limits on a dissolved LLC if the LLC was not intended to be wound up, as would be the case with an administratively dissolved LLC whose owners and management were unaware that it had been dissolved. And if the LLC were strictly barred from taking any non-winding-up activities, it would be prevented from filing the paperwork to end the administrative dissolution, a classic catch-22. Id. at 74.
The court also emphasized the LLC Act’s strong preference for limited personal liability, positing that an LLC’s liability shield for members should not be lost through an LLC’s failure to pay a $15 annual fee or submit an annual report. The court found this conclusion to be consistent with the general rule in most jurisdictions that LLC members are not personally liable for actions taken during a period of dissolution followed by reinstatement. Id. at 76.
Agent Liability. The court saw this as a two-part issue: did Ann Shannon, the LLC’s only member and its only manager, have personal liability (1) by reason of merely being an agent of the dissolved LLC, or (2) because she acted as an agent without authority?
After distinguishing several cases from other jurisdictions, the court concluded that “[t]he retroactivity of the reinstatement statute, when read with the provision making the company exist even after dissolution and the statutes creating immunity for agents, makes an agent immune if personal liability is alleged solely because the agent is an agent.” Id. at 80.
The landlord contended that Shannon lacked the authority to act on behalf of the LLC because it did not exist when she executed the lease on behalf of the LLC. But the LLC Act is clear: “A dissolved limited liability company shall continue its existence...” Ky. Rev. Stat. Ann. § 275.300(2). The landlord contended that the statute’s limit on acts other than winding-up activities limited Shannon’s authority, but the court again pointed out that if that were true, the LLC would not be able to seek reinstatement, because an LLC can only act through an agent. Pannell, 425 S.W.3d at 83.
The landlord also took the position that because the LLC was reinstated only after he filed suit, the court’s reading of the statute would have an inequitable result. The court, however, saw reinstatement as being only between the LLC and the state. “[The landlord] cannot be allowed to take advantage of the LLC’s failure to file its report and pay what amounts to a tax to bypass the LLC and hold its owners or agents liable, at least not once the failures have been remedied.” Id. at 84.
The Supreme Court accordingly affirmed the dismissal of the landlord’s claim against the LLC’s sole member.
Comment. You can’t help smiling when you read some opinions, from the sheer pleasure of reading a careful, scholarly, and well-written opinion. This is one. The Shannon opinion not only reaches the right result, but does so by carefully disposing of the several legal theories raised by the landlord. The court’s analysis recognizes
- the primacy of limiting the liability of LLC members and managers,
- that a dissolved LLC continues to exist,
- that the statutory requirement for winding up a dissolved LLC does not apply to an unintentional dissolution such as an administrative dissolution, and
- that dissolution is not a creditor’s-rights issue but is between the LLC and the state (in the case of an administrative dissolution) or between the LLC and the members (in the case of an intentional dissolution).
And a tip of the hat to Thomas E. Rutledge, a Kentucky lawyer and the current chair of the Committee on LLCs, Partnerships and Unincorporated Entities of the Business Law Section of the American Bar Association. Tom has written extensively on LLC law, and his writings are cited several times in the Shannon opinion.
An LLC member ordinarily is not liable for the debts and liabilities of an LLC simply by virtue of being a member. E.g., Wash. Rev. Code § 25.15.125; Or. Rev. Stat. § 63.165. Many states, however, impose personal liability for unpaid taxes on those within a business who have authority for paying taxes withheld from employee wages, or for paying sales taxes collected from customers. If one of those statutes applies, being a member of the LLC will not shield the employee, manager or officer from the statute’s reach.
Kelly Haugen, a 10% member of an Oregon LLC, was assessed liability by the Oregon Department of Revenue for the LLC’s failure to pay Oregon income taxes withheld from employee wages. Haugen v. Dep’t of Revenue, No. TC-MD 100052C, 2011 Ore. Tax LEXIS 187 (Or. T.C. Apr. 26, 2011). The LLC was manager-managed, and Haugen was not the LLC’s manager. Haugen occasionally signed checks for the LLC, and a form filed by the LLC with the state indicated that Haugen was responsible for hiring and firing employees. Id., at *2-3. The Department of Revenue asserted liability against Haugen because of his part ownership of the LLC and because he signed checks for the business. Id. at *6.
Oregon requires employers to withhold and pay Oregon income taxes from wages paid to employees. Or. Rev. Stat. § 316.167. Personal liability for unpaid tax withholdings is imposed on “[a]n officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee or member is under a duty to perform the acts required of employers by ORS 316.167 ….” Or. Rev. Stat. § 316.162(3)(b).
Finding a paucity of case law on the liability of LLC members, the Haugen court analogized Haugen’s status to that of a corporate officer for the purpose of determining liability. Haugen, 2011 Ore. Tax LEXIS 187, at *6. The court applied prior Oregon case law involving corporate officers, and found that Haugen would be liable if he had the actual authority and control to pay or direct payment of the tax withholdings. Id. at *7. The evidence indicated that Haugen did not have authority to unilaterally sign checks or make important financial decisions – he had authority to sign checks only under the direction of the 90% owner and manager, after obtaining specific consent to sign each check. Also, Haugen did not have general authority as a member, because the LLC was manager-managed, and Haugen was not a manager.
The court concluded that because Haugen “was not in a position to pay the withholdings or direct the payment of the withholdings at the time the duty arose to withhold or pay over the taxes,” he was not an “employer” under Or. Rev. Stat. § 316.162. Haugen, 2011 Ore. Tax LEXIS 187, at *11-12. The court therefore canceled the Department of Revenue’s Notice of Liability against Haugen.
Kelly Haugen escaped liability for the unpaid taxes because of his lack of authority. Had his been a member-managed LLC, or if he had had discretion to sign checks without prior approval, the court presumably would have upheld the tax assessment against him.
Many of the comparable statutes from other states are at least as strict in finding managers and check signers to be personally liable for failure to pay tax withholdings and sales taxes over to the state. The strict approach is not surprising, given that in these cases the business has in effect been a tax collector for the state and (at least in the state’s view) is holding the state’s money. The Haugen case should be a wake-up call for LLC managers and check signers to avoid the temptation of financing the business in troubled times by holding on to tax withholdings or sales taxes.
LLC agreements sometimes require members to contribute additional capital upon demand of the LLC. This is risky business for the members. The LLC may unexpectedly ask for more capital when the members are not expecting it. And worse, sometimes creditors will attempt to force the LLC to call for capital from the members, in order to satisfy the creditor’s claim.
In just such a case, the Kentucky Supreme Court last month overruled the trial court and the Court of Appeals, holding that the creditor could not force the members to contribute capital to the LLC to cover the creditor’s claim. The members of the LLC had agreed in its operating agreement to contribute additional capital on the call of the LCC’s manager:
“The Investor Members . . . shall be obligated to contribute to the capital of the Company, on a prorata basis in accordance with their respective Percentage Interests, such amounts as may be reasonably deemed advisable by the Manager from time to time in order to pay operating, administrative, or other business expenses of the Company which have been incurred, or which the Manager reasonably anticipates will be incurred, by the Company.”
Racing Inv. Fund 2000, LLC v. Clay Ward Agency, Inc., No. 2009-SC-000007-DG, 2010 Ky. LEXIS 180, at *12 (Ky. Aug. 26, 2010).
Subsequent litigation resulted in a judgment against Racing Investment Fund 2000, LLC (Racing Fund) for unpaid insurance premiums. The LLC partly paid the judgment by tendering its remaining assets to Clay Ward, the judgment creditor. Not satisfied with part payment, Clay Ward contended that the operating agreement’s provision for additional capital calls provided a way for Racing Fund to obtain funds to satisfy the judgment, and that the court should order the LLC to make the call. The trial court agreed and ordered Racing Fund to call for additional capital from the members to satisfy the judgment. The LLC was held in contempt of court when it failed to comply with the court’s order. Id. at *4.
The Kentucky Supreme Court viewed the unpaid insurance premiums, which were the basis of the judgment against the LLC, as a legitimate business expense. The court also recognized that under the operating agreement the manager could have made a capital call against the members to fund payment of the judgment. But the court declined to order the LLC to make the capital call, saying that the capital call provision in Racing Fund’s operating agreement “is not a post-judgment collection device by which any legitimate business debt of the LLC can be transferred to individual members by a court-ordered capital call.” Id. at *17.
The court’s refusal to order a capital call turned on the limited liability provision of Kentucky’s LLC Act, which is emphatic: “no member, manager, employee, or agent of a limited liability company … shall be personally liable by reason of being a member [or] manager … under a judgment, decree, or order of a court, agency, or tribunal of any type, or in any other manner … for a debt, obligation, or liability of the [LLC], whether arising in contract, tort, or otherwise.” Ky. Rev. Stat. § 275.150(1). The court described the limited liability of LLC members and managers as the “centerpiece” of an LLC. Racing Inv. Fund, 2010 Ky. LEXIS 180 at *5.
Clay Ward contended that the operating agreement’s capital call provision should be applied to Racing Fund’s debt on the judgment, and that the court should order the capital call to satisfy the judgment. But because of the centrality of limited liability in LLCs, the court required that to be enforceable, any assumption by members of personal liability must be stated in unequivocal terms, leaving no room for doubt about the parties’ intent. Id. at *16. The Racing Fund agreement did not meet this standard, said the court. Id.
It is unclear where the court was drawing the line. Was the LLC’s capital call provision inapposite because the manager elected not to make the capital call, because the LLC was defunct and the judgment was therefore not an ongoing expense of the business, or because the court did not interpret “operating, administrative, or other business expenses of the company” to include a judgment against the company (even though the court recognized that the judgment was for an unpaid business expense)? If the LLC’s members had included language covering judgments, even judgments at a time when the LLC was insolvent and defunct, would Clay Ward’s claim still have failed if the manager declined to call for additional capital?
What is clear is that the drafting lessons from this case are legion. Members who agree in advance to subsequent capital calls usually have some expectations about those capital calls. The drafter should reflect those expectations in the agreement.
First, don’t create unlimited member liability for additional capital calls. Use a cap of some sort.
Second, don’t rely on the manager’s judgment. Things change over the life of an LLC; a new manager may come in with a different view of how much additional capital the company requires from its members.
Third, carefully define terms such as “operating, administrative or other business expenses.” For example, say the LLC is hit with a large, uninsured tort claim that resulted from its business operations. Is that an operating or business expense? The agreement should have definitions that would answer such questions.
Fourth, if capital calls are authorized, consider providing that if a member does not satisfy the capital call, the exclusive remedy is some form of economic adjustment to the defaulting member’s LLC interest. Adjustments such as dilution, subordination, or partial forfeiture of a non-contributing member’s interest are expressly validated by some state LLC Acts. E.g., Wash. Rev. Code § 25.15.195(3); Del. Code tit. 6, § 18-502(c).
Fifth, consider adding a “no third-party beneficiary” clause, to make clear that no creditor or other third party has any right to rely on or to enforce any of the provisions of the operating agreement, including any obligation of members to contribute capital. Such a clause could also be considered for the LLC’s certificate of formation, which unlike most LLC agreements is a public document.