Piercing the veil is a legal doctrine that allows a claimant against an LLC to disregard the LLC’s liability shield and additionally assert its claim against a member of the LLC. Plaintiffs are often motivated to raise a veil-piercing claim when the LLC has few or no assets.
Background. In most states the requirements for piercing the veil will include some disregard by the member of the LLC’s separate existence, and some degree of injustice, fraud, or wrongdoing. Veil-piercing cases come up frequently. Just this year I have written about them here (Georgia), here (New York Federal District Court, applying Delaware law), and here (Colorado).
In some situations an LLC member may find itself with direct, personal liability for actions taken on behalf of an LLC, even without piercing the veil. That can happen when the member’s actions on behalf of the LLC constitute a tort against the claimant, such as fraud or breach of fiduciary duty. Then there is no need to pierce the veil – the member is directly liable for its own wrongdoing. For an analysis of such a case, see my article, here, about Sturm v. Harb Development, LLC, 298 Conn. 124, 2010 WL 3306933 (Aug. 31, 2010).
North Dakota Supreme Court. An LLC member can also be directly liable if it turns out that the LLC did not exist or that the claimant was not aware of its existence. The North Dakota Supreme Court recently had such a case in Bakke v. D & A Landscaping Co., LLC, No. 20110308, 2012 WL 3516859 (N.D. Aug. 16, 2012).
In 2006 Andrew Thomas discussed a landscaping project with Randall and Shannon Bakke. They were given Thomas’s business card, which referred to “D & A Landscaping” and “Your front to back landscaping company,” and showed his name with no title. Id. at *1. He later submitted a written proposal to the Bakkes, which indicated that it was “[r]espectfully submitted D & A Landscaping 426-4982 Per Andy Thomas,” and after that a second proposal submitted by “D & A Landscaping Per Andy Thomas.” Id.
In 2008 the Bakkes accepted the proposal and Thomas carried out the landscaping project. The Bakkes claimed that they only learned that D & A Landscaping was a legal entity when they received Thomas’s invoice, which directed payment to “D & A Landscaping, Inc.” Id. They later learned that D & A Landscaping Company, LLC was formed in 2005 and dissolved in 2008. Id.
In 2010 the Bakkes sued D & A Landscaping Company, LLC and Thomas, alleging fraud, breach of contract, and negligence in connection with the landscaping project. At trial the jury found that D & A Landscaping Company, LLC was not liable to the Bakkes, and that Thomas was liable to the Bakkes for breach of contract, negligence, and fraud. Thomas argued on appeal that there were insufficient facts to pierce the veil of D & A Landscaping Company, LLC and hold Thomas personally liable. Id. at *2.
Court’s Analysis. The court pointed out that “[t]he precursor to piercing a legal entity’s veil to impose liability on the owner is entity liability.” Id. Because the jury found that the LLC was not liable to the Bakkes, there was no LLC liability to be transferred to Thomas, and the veil-piercing theory did not apply. The jury had instead found that Thomas acted individually, on his own behalf, when he entered into and then breached the contract with the Bakkes.
The Supreme Court found that there was evidence to support the jury’s finding that Thomas was individually liable. That evidence included Thomas’s business card, the estimate, a drawing, and proposals, none of which showed that D & A Landscaping was an LLC or that Thomas was acting as an agent for the LLC. Id. at *3. Thomas’s veil-piercing argument therefore failed, and the jury’s verdict was affirmed. Id. at *5.
Comment. Lao-tzu says in the Tao Te Ching that “a journey of a thousand miles begins with a single step.” Likewise, starting and running a business without unexpected personal liability should begin with the formation of a corporation or an LLC, and using it correctly. Thomas’s dispute came to a bad end, from his perspective, because he didn’t properly use the LLC he had formed. He used the company name without any indication that it was an LLC, and he never used a title or indicated he was acting on behalf of the LLC he had formed.
The basic rules are straightforward:
1. In printed materials such as contracts, advertising, and business cards, always use the full name of the LLC, including the entity designator such as “LLC” or “limited liability company”.
2. Always use the title of the LLC’s representative in letters, business cards, emails, and other communications from the representative. E.g., President, or Manager.
3. When signing a contract on behalf of the LLC, always use the full name of the LLC, the title of the person signing, and an indicator that the signer is signing in a representative capacity, such as “By” or “Its”. An example would be:
Acme Limited Liability Company
By: Wile E. Coyote, Vice President of Beta Testing
A claimant against a Georgia limited liability company can pierce the veil and assert its claim against the LLC’s members if the members have sufficiently disregarded the LLC’s separate existence and there is some degree of injustice, fraud, or wrongdoing. The Georgia Court of Appeals recently held that a series of real estate and cash transfers back and forth between an LLC and its members did not show enough disregard of the LLC as a separate entity to pierce the veil. Sun Nurseries, Inc. v. Lake Erma, LLC, 730 S.E.2d 556 (Ga. Ct. App. July 12, 2012).
The case involved a dispute over payment for landscaping services rendered by the plaintiff to a golf course owned and managed by two LLCs. The principal claim was for breach of an oral contract for the services, but additional claims for quantum meruit, fraud, attorneys’ fees and conversion were also raised. The two LLCs did not contest the claims and the plaintiff added the LLCs’ members to its complaint, presumably to increase the collectability of the judgment it hoped to obtain.
The trial court ruled in favor of the LLCs’ members on all of the plaintiff’s claims, and in favor of the LLCs on the fraud and conversion claims. The jury returned a verdict for the plaintiff on its remaining claims against the two LLCs. Id. at 560-61. The plaintiff appealed the dismissal of the fraud and conversion claims and the claims against the members.
The Court of Appeal’s discussion of the fraud, fraudulent transfer, and conversion claims is unremarkable, and I will pass on to its veil-piercing analysis. The court began by considering whether the defendants had disregarded the separate existence of the LLCs as legal entities. Id. at 564-65. The plaintiff claimed that a transaction involving a series of property transfers, loans and cash transfers showed disregard of the separateness of the entities.
In the transaction at issue, one of the two LLCs transferred 93 real estate lots to two of its members, who then used the lots as collateral and borrowed $5.2 million from a local bank. The members then transferred the loan proceeds to the LLC, and quitclaimed the lots to the LLC. One of the members testified that he and the other member determined that it was “simpler” to obtain the loans themselves rather than having the LLC borrow the funds directly. Id. at 560. This is puzzling, because with this approach the two members were personally liable to the bank on the loans. A loan to the LLC would have shielded the members from personal liability.
The standard used by the court for disregard of the corporate entity was that “[t]he plaintiff must show that the defendant disregarded the separateness of legal entities by commingling on an interchangeable or joint basis or confusing the otherwise separate properties, records or control.” Id. at 564 (quoting Christopher v. Sinyard, 723 S.E.2d 78, 80 (Ga. Ct. App. 2012)). The court pointed out that:
- the transfers of property to the LLC members were to facilitate a loan for the benefit of the LLC,
- the loan proceeds and the real estate lots were returned immediately to the LLC,
- the members did not make personal use of the loan proceeds,
- the cash flow generated by the loans apparently allowed the LLC to continue operating, and
- the transaction was properly reflected on the LLC’s books and in the public record.
Id. at 565. The court said that on these facts, the transfers and loans did not represent an abuse of the corporate form. Id. The fact that the loan proceeds “may have been used to replenish the company coffers after the 2005 distributions, and thus may have indirectly benefitted the members’ own ends along with the [LLC’s], does not in and of itself constitute abuse of the corporate form.” Id.
The court concluded that the loan and property transfers were insufficient to evidence a disregard by the members of the LLC’s separate identity, and affirmed the trial court’s ruling against the veil-piercing claim. Id.
The result here is not surprising, but I can see why the plaintiff thought that there was some disregard of the entity nature of the LLC. The back-and-forth property transfers don’t appear economically justifiable, because the result leaves the two members with personal liability for the loans. A conventional loan taken out directly by the LLC would have shielded them from personal liability if the LLC defaulted. Plaintiffs tend to bore in when defendants take inexplicable actions such as these loans by the members.
South Carolina Supreme Court Rules That LLC Does Not Shield Its Member From Liability for His Tortious Conduct
A limited liability company will generally shield its members and managers from the LLC’s debts and obligations, but the shield is not absolute. LLC members or managers who carry out an LLC’s tort can in some cases be personally liable for the injured party’s damages. The South Carolina Supreme Court had to decide such a case earlier this year. 16 Jade St. LLC v. R. Design Constr. Co., LLC, No. 27107, 2012 WL 1111466 (S.C. Apr. 4, 2012).
(A tort is not a breach of contract – it is an actionable, civil wrong. Examples include fraud, breach of a fiduciary duty, and negligently causing an auto accident. A party injured by a tort may be able to recover damages from the wrongdoer if requirements such as causation and proof of damages are satisfied. Tort law has its origins in the English common law and is part of the common law of all U.S. states.)
Background. Carl Aten and his wife were the only members of R. Design Construction Co., LLC, a construction contractor. R. Design contracted with Jade Street for the construction of a four-unit condominium, and Aten served as R. Design’s general manager on the project. Jade Street had numerous complaints of defects in the construction, and ultimately R. Design walked off the job. Jade Street sued R. Design and Aten for negligence, breach of implied warranties, and breach of contract.
The trial court found that R. Design was liable for breach of contract, negligence, and breach of implied warranties. It also found that Aten was personally liable for his negligence. Id. at *2.
The Court’s Analysis. Aten argued on appeal that South Carolina’s Uniform Limited Liability Company Act (ULLCA) shielded him from personal liability for any negligence he committed while working for R. Design. The relevant ULLCA language states:
Except as otherwise provided in subsection (c), the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.
S.C. Code § 33-44-303(a). (Subsection (c) provides for member liability if the LLC’s articles of organization so provide and the member has consented in writing to that provision. It was not applicable to Aten.)
The court saw the question as one of statutory interpretation – did the legislature intend the LLC statute to shield members from personal liability for acts they commit in furtherance of the LLC’s business? 16 Jade St., at *2. The court noted that this was a question of first impression in South Carolina.
Looking first to other states, the court pointed out that a majority of the states that have examined similar statutory language “have concluded that a member is always liable for his own torts and cannot rely on his status as a member of an LLC as a shield.” Id at *3 (citing cases from half a dozen states). The court also cited a number of scholarly articles which opine that LLC statutes do not insulate a member from tort liability “primarily due to the common law concept that one is always liable for his torts.” Id. In the spirit of two-handed lawyers, the court also referred to a few courts that have concluded that their states’ LLC statutes do shield a member from personal liability for at least some types of torts.
Having surveyed the landscape, the court then dissected the language of Section 33-44-303(a). The first sentence says that the liabilities of the LLC, whether arising in contract or in tort, are solely the liabilities of the LLC. Since an LLC is a fictional entity and can act only through an agent such as a member or manager, that sentence seems to say that the member or manager who carries out the LLC’s tort does not thereby incur any personal liability. “[T]his language suggests R. Design alone is responsible for torts committed by Aten in the course of the company’s business.” Id. at *4. The court saw the second sentence as reinforcing the first, by stating that merely being or acting as a member or manager of an LLC will not cause the member or manager to be liable for the LLC’s obligations.
The court recognized, however, that interpreting the statute to shield LLC members or managers who commit torts in furtherance of the LLC’s activities would remove a long-standing common law remedy for injured parties. The court accordingly applied a higher standard of review. “Statutes will not be held in derogation of the common law unless the statute itself shows that such was the object and intention of the lawmaker, and the common law will not be changed by doubtful implication.” Id. at *5 (quoting 82 C.J.S. Statutes § 534 (2009)).
The court then referred to the majority view of the courts of other states, comments from the legislative history of Section 33-44-303, and comments from Section 304 of NCCUSL’s Revised Uniform Limited Liability Company Act (RULLCA). Id. These all follow the principle that shielding LLC members and managers from the LLC’s debts and obligations does not apply to claims seeking to hold members or managers liable for their own tortious conduct. These authorities treat members or managers, even when acting on behalf of the LLC, as also acting on their own behalf when committing a tort.
The court also reviewed the rule for corporations – i.e., that a shareholder is not liable for the debts or obligations of the corporation but is responsible for the consequences of its own conduct – and could find no evidence that the legislature intended to change that rule with respect to LLCs. Id.
Finding no clear legislative intent to restrict the common law, the South Carolina Supreme Court ruled in a three-to-two decision that Section 33-44-303(a) “does not insulate the [member] tortfeasor himself from personal liability for his actions.” The court accordingly affirmed the trial court’s finding that Aten was personally liable for torts he committed in furtherance of R. Design’s business. Id. at *6.
The brief dissenting opinion argued that the statute was clear and unambiguous and not amenable to an interpretation that a member tortfeasor of an LLC is personally liable for torts committed in the furtherance of an LLC’s business. Id. at *7. The dissent did not address the majority’s point that interpreting the statute to shield those who commit torts would derogate from the common law and therefore required a higher standard of review.
Comment. Both the majority and the dissenting opinions ignored the inherent ambiguities in Section 33-44-303(a). For one, the first sentence cannot mean what it seems to say. Ignoring the reference to subsection (c), it says: “the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company.” No exceptions are noted. Read literally, it precludes joint liability of an LLC. Consider the following hypothetical. An LLC borrows money from a bank, and the LLC’s sole member guarantees the LLC’s payment obligation to the bank. A literal reading of the first sentence would mean that only the LLC is liable to repay its debt and the member is shielded from the guarantee obligation it willingly agreed to.
For another, consider that even reading the first two sentences together would not change the result, if the member was acting as a member. The statute does not explicitly require that the member act on behalf of the LLC, only that the member be “acting as a member.” What does that mean? Members in a manager-managed LLC have the status of members and the right to vote for managers, but they don’t act on behalf of the LLC.
The majority opinion acknowledged that removing the LLC’s liability shield for members who commit torts on behalf of the LLC “appears to strip away one of the main reasons why a person chooses to form an LLC,” and the court expressed particular concern about single-member LLCs. Jade St., 2012 WL 1111466,at *5. But to have held the other way would have been to open the floodgates – wouldn’t we all want our own single-member LLC to shield us from what would otherwise be liability for our own torts?
South Carolina’s statute allows an LLC to be organized for any lawful purpose. S.C. Code § 33-44-112(a). You could form an LLC for the purpose of owning and driving your personal vehicle. Under the dissent’s view of Section 33-44-303(a), you would presumably be “acting as a member” and therefore would not be liable for any injuries caused by your negligent driving.
This is a far-fetched example, of course, but it shows the lack of clarity in the statute. Given that ambiguity, the majority opinion arrived at what appears to be the correct result, particularly in light of its agreement with the majority of other courts and commentators that have considered this issue for comparable statutes, and with the comments to NCCUSL’s RULLCA.
Business people use LLCs when starting a new business venture so they can be shielded from personal liability for the venture’s obligations. Limited liability for members is a fundamental part of the states’ LLC laws. The Pennsylvania LLC Act, for example, states:
Except as provided in subsection (e), the members of a limited liability company shall not be liable, solely by reason of being a member, under an order of a court or in any other manner for a debt, obligation or liability of the company of any kind or for the acts of any member, manager, agent or employee of the company.
15 Pa. Cons. Stat. § 8922(a). (Subsection (e) is only applicable if the LLC’s certificate of organization provides that some or all of the members are personally liable for the debts or liabilities of the LLCs. That is almost never done.)
The members can of course give up their liability shield, either intentionally in a contract or sometimes by mistake. One part of a contract that can be a pitfall for LLC members is the signature block, the place at the end of the contract where the parties sign it. (I assume the contract is in writing.)
The standard way to indicate that an LLC (and none of its members) is a party to a contract is to use the LLC’s name and the title of the signing member (or manager if it is manager-managed). Unfortunately this detail is sometimes overlooked or mishandled.
In Hazer v. Zabala, 26 A.3d 1166, 2011 Pa. Super. LEXIS 2227 (Pa. Super. Ct. Aug. 11, 2011), Juan Zabala signed his name to a lease, and underneath printed “DBA/ZABALA BROKER, LLC.” Hazer, 26 A.3d at 1170. (The lease did not otherwise recite the name of the tenant.) The landlord sued Zabala when the rent was not paid, and Zabala defended on the ground that the LLC, not Zabala, was the party to the lease.
The court disagreed. It recognized “DBA” as an abbreviation for “doing business as,” and saw the acronym as an indication that Zabala Broker, LLC was simply another name for Juan Zabala. “‘DBA’ identifies an equivalency or single identity between the appellations.” Id. at 1170.
Zabala’s signature did not identify himself as an officer, member or agent of the LLC, and the court found that the corporate rule applied to LLCs: “Corporations necessarily act through agents and if one so acting is to escape personal liability for what he intends to be a corporate obligation, the limitation of his responsibility should be made to appear on the face of the instrument.” Id. (internal quotation marks and citations omitted). Zabala’s failure to use any title such as “member” or “managing member” doomed his appeal.
The court was also unswayed by the fact that rent checks from an account in the name of Zabala Broker, LLC were accepted by the landlord. The court affirmed the trial court’s finding that the landlord was justified in accepting the checks in the belief that they were simply paid on behalf of Mr. Zabala.
The court’s analysis focused on the notion that “DBA” is used to indicate an alternative name for an individual or entity. It usually is, and the court’s analysis would have made perfect sense if Juan Zabala had used “Zabala Broker” as a DBA. What is odd is that he included “LLC” in the DBA, i.e., “Zabala Broker, LLC.” That indicates that he was holding himself out as a limited liability company, which doesn’t make sense. An individual is not an entity. It would seem more logical to view the use of “DBA Zabala Broker, LLC” as an awkward attempt to indicate that he was signing on behalf of the LLC, in a representative capacity.
However, the court also pointed out in a footnote that Zabala Broker, LLC was not formed until December 15, 2008, two and a half months after the lease was signed. Id. Although the court didn’t discuss the fact that the LLC did not exist at the time of signing the lease, that nonexistence supports the court’s conclusion that Zabala had not clearly indicated that he was signing in a representative capacity.
Lawyers routinely and reflexively write contractual signature blocks using the entity’s name and the title of the signing individual. In most cases where an incorrect signature block is used the signer is inexperienced or rushed, without an attorney to review and catch the mistake. In the song The End of the Innocence, Don Henley sings “The lawyers dwell on small details.” But sometimes those small details can cause large problems, and that’s what happened in Hazer v. Zabala.
Many states impose personal liability for unpaid sales taxes and income tax withholdings on LLC managers and employees who are responsible for paying the taxes. For example, in an Oregon Tax Court case I recently blogged about, here, a 10% LLC member and non-manager who occasionally signed checks for the LLC was assessed liability for the LLC’s unpaid income tax withholdings by the Department of Revenue. Because he had authority to sign checks only under the direction of the 90% owner and manager, the Tax Court held that he was not personally liable.
New York has long taken a far different, nay draconian, approach.
Like many other states, New York imposes personal liability for payment of unpaid sales taxes on corporate and LLC employees and managers having a duty to the entity to act for it in complying with the sales tax. N.Y. Tax Law §§ 1133, 1131(1). But the New York statute goes further and imposes personal liability on “any member of a partnership or limited liability company” for the LLC’s sales tax obligations. N.Y. Tax Law § 1131(1). It is irrelevant whether the LLC member is a manager or employee – even passive investors are jointly and severally liable for 100% of the LLC’s New York sales tax obligations. (There is no comparable rule for shareholders of a corporation.)
The rule applies to any LLC that is obligated to collect New York sales taxes – it is not limited to LLCs formed under New York law. For example, the members of a Delaware LLC making retail sales in New York would be subject to personal liability for the LLC’s unpaid sales taxes. The New York Department of Taxation has not hesitated to pursue LLC members for sales taxes under the rule, even passive investors.
The Tax Department’s new policy provides partial relief for minority members, i.e., those whose ownership interest and distributive share of the LLC’s profits and losses are less than 50%. Technical Memorandum TSB-M-11(6)S (Apr. 14, 2011). A minority member will now be liable only for its pro rata share of the taxes, i.e., the product of the LLC’s sales tax liability multiplied by the greater of the member’s percentage of ownership interest or its percentage share of the profits and losses of the LLC.
The policy imposes several conditions before a minority member is eligible for relief. The member must document its ownership interest and percentage share of the LLC’s profits and losses, demonstrate that it was not under a duty to act for the LLC in complying with the LLC’s sales tax obligations, and cooperate with the Tax Department in providing information about other potentially responsible persons and about the structure and ownership of tiered entities, including out-of-state entities.
The new policy provides no relief for LLC members owning 50% or more of the LLC, who will each continue to be personally liable for all LLC sales tax obligations. But by reducing the personal liability of minority members to a pro rata share of the LLC’s tax obligations it can dramatically limit a minority member’s exposure.
The Washington legislature is currently considering a bill that would apparently require any contract that calls for the payment of money by an LLC or corporation, to include an extra signature by an authorized representative that would render the representative personally liable for any amounts due on the contract. HB 1535. In other words, under this bill any LLC or corporation making a contractual commitment that involves the payment of money would have to include a personal guarantee from a natural person.
This would be an extraordinary change to Washington law. No other state has anything comparable in its laws.
The Background. The bill would upend the familiar principle of the law that “when an agent makes a contract on behalf of a disclosed or partially disclosed principal whom he has power to bind, he does not thereby become liable for his principal’s nonperformance.” Griffiths & Sprague Stevedoring Co. v. Bayly, Martin & Fay, Inc., 71 Wn.2d 679 , 686, 430 P.2d 600 (1967). See Restatement (Second) of Agency § 320 (1958).
When an LLC manager (or a corporate officer) signs a contract on behalf of a company, the manager usually signs only as an agent of the company. The fact that the manager is signing as an agent is reflected in the typical signature block:
By: Wile E. Coyote
Vice President of Product Development
Under these well-accepted rules, LLC managers and corporate officers can sign contracts on behalf of their company without fear of becoming personally liable. If the rule were otherwise it would be exceedingly difficult to find a manager willing to sign for an LLC or corporation.
The Bill. The heart of the bill is a requirement that any “business payment contract” must contain an additional signature line, directly following and on the same page as any other signature line that the authorized business representative must sign. The additional signature line must be immediately preceded by the following legend in bold, 14-point or larger typeface:
By signing this contract you, the undersigned, agree to become PERSONALLY LIABLE for any sums due pursuant to this document, regardless of whether you are signing on behalf of a limited liability company, corporation, or nonprofit corporation.
This bill, if passed, will clearly make it difficult for LLCs to find managers willing to sign contracts for their LLC.
Drafting and Interpreting Statutes. The language of HB 1535 has some internal conflicts. I have described above the interpretation that I and other business lawyers that I have talked to have given to the bill. It is possible, however, that it was intended to simply require a warning legend on guarantee contracts, although that is a more difficult interpretation. In any event it needs to be clarified.
It is not an easy thing, to draft statutes so that they are clear, unambiguous and sufficiently detailed. This has repeatedly been driven home to me in my participation on a Bar committee that has reviewed proposed legislation.
HB 1535 is scheduled for public hearing in the Washington legislature’s House Committee on Business & Financial Services at 1:30 p.m. Tuesday, February 1, 2011, in Olympia, Washington. At the hearing I expect we will learn what is behind this bill and what the intent of its sponsors is. More information is available about the bill’s scheduled hearings here.
Most business people know that if they want to avoid personal liability when they sign a contract on behalf of an LLC, they should use the name of the LLC and their title. A typical example would be:
By: John Smith, Member [For a member-managed LLC]
But what’s the result if language in the contract states that the signing member is personally liable? In Losh Family, LLC v. Kertzman, 155 Wn. App. 458, 228 P.3d 793 (April 12, 2010), the Washington Court of Appeals recently ruled that the language in the contract can overrule the form of signature.
William and Teresa Grover formed Grover International, LLC in 2005 and shortly thereafter acquired a business. In connection with the acquisition they received an assignment of the seller’s real estate lease. Their LLC signed the assignment using a conventional corporate style of signature, as “Grover International, LLC by William Grover member.” Losh Family, LLC, 155 Wn. App. at 461.
So far so good. But the lease assignment said that the lease was assigned to “William and Teresa Grover as individuals, dba Grover International, LLC” (“dba” of course being the customary abbreviation for “doing business as”). Id. The lease assignment in fact referred five different times to the assignee as “William and Teresa Grover as individuals, dba Grover International, LLC.” Id. at 463.
In 2006 the Grovers sold their business, and the new buyer later defaulted on the lease. The owner of the real estate sued the Grovers, the LLC, their seller and their buyer. The trial court ruled on summary judgment that all defendants were liable jointly and severally, including William and Teresa Grover individually.
The Court of Appeals expeditiously determined that the language in the assignment referred to the Grovers personally and that the LLC’s signature did not limit the assignment’s imposition of personal liability on the Grovers. The court referred to the “long established principle that where an agreement contains language binding the individual signer, ‘additional descriptive language added to the signature does not alter the signer’s personal obligation.’” Id. at 464 (quoting Wilson Court Ltd. v. Tony Maroni’s, Inc., 134 Wn.2d 692, 700, 952 P.2d 590 (1998)).
The Losh fact pattern is the sort that lawyers involved in mergers and acquisitions hate to see. Inconsistent agreements tend to be disputed and to yield unpredictable results. The Losh contract was seriously inconsistent, and under one interpretation the Grovers would be personally liable for a lease obligation under a document that they signed only in a representative capacity. And indeed, so ruled the court.
Mr. Grover likely took no consolation from the court’s admonition that if he “did not want to be personally bound on the assignment, he should have insisted on the elimination of the language within the agreement that designated the assignee as ‘William and Teresa Glover as individuals’” (which ignores the balance of the phrase, “dba Grover International, LLC”). Id.
It is puzzling that the Losh court did not analyze the conflicting language in the contract as an ambiguity that would allow the admission of extrinsic evidence. The court ignored the large body of law which recognizes that an ambiguous or contradictory contract may be clarified by the admission of extrinsic evidence to determine the parties’ intent. E.g., Berg v. Hudesman, 115 Wn.2d 657, 801 P.2d 222 (1990).
The court also ignored the fact that the contract’s identification of the parties was not a completely clear statement that personal liability was intended. The contract language did not refer simply to the Grovers individually, but also referred to the Grovers doing business as Grover International, LLC, which at the time was an existing LLC. The phrase “doing business as” is usually used only for situations where a corporation or LLC does business under an alternate name. In Losh, however, the dba referred to an existing and separate entity, not just an alternate name for the Grovers.
The court’s ruling illustrates how simple inconsistencies in a contract quicken the blood of gimlet-eyed litigators and lead to arguable judicial decisions.
Upcoming Event - Seminar for Washington Condominium Developers on Dissolution and Cancellation of Limited Liability Companies
Stoel Rives LLP is hosting a complimentary breakfast seminar in Seattle on Thursday, October 8, 2009, entitled “A Law Update for Condominium Developers: Practical Advice for Dissolution and Cancellation of Limited Liability Companies.” The seminar topics will include:
- The life cycle of a condominium LLC
- The recent Washington Supreme Court ruling in Chadwick Farms Owners Association v. FHC LLC
- Dissolution and cancellation of LLCs
- Limitations on liability protection afforded by an LLC
- How to “wind up” the business of the LLC
- How to avoid personal liability for the obligations of an LLC
The Chadwick Farms case was discussed in my prior blog post, here. Chadwick Farms is especially relevant to condo developers because of the project-oriented nature of the condo development business, and because of the strong Washington law on the implied warranty given to new condo buyers. The process of dissolving, winding up and cancelling a condo developer’s LLC will often present the developer with some difficult choices—this seminar will discuss the pros and cons of the alternatives.
Registration and breakfast begin at 7:30 a.m., and the presentation runs from 8:00 to 9:30 a.m. Limited space is still available, so if you're interested in attending you can see the location and other details and register here.
Washington Supreme Court: LLC Can Terminate All Lawsuits by Filing Certificate of Cancellation - Personal Liability for Improper Winding Up
On May 14, 2009 the Washington Supreme Court ruled five to four that a Washington LLC cannot sue or be sued once its certificate of formation has been canceled, and any pending lawsuits by or against the LLC abate upon cancellation of the certificate of formation. The result is the same whether the certificate of formation is canceled by the LLC’s voluntary filing of a certificate of cancellation, or by the Secretary of State because of the LLC’s failure to pay its license fees, have a registered agent, or file its annual report. The court also held that those who improperly wind up an LLC can face personal liability to the creditors of the LLC. Chadwick Farms Owners Ass’n v. FHC LLC (May 14, 2009).
The result seems a little startling, to say the least, and the ruling’s potential for abuse is obvious. A defendant LLC in the middle of a lawsuit, where the tide is turning against it, can file a certificate of cancellation and end the lawsuit. Apparently the plaintiff’s only recourse would then be to attempt to show that the members or managers involved in the winding up did so improperly, such as by failing to satisfy or make adequate provisions for paying the LLC’s liabilities, or perhaps to try to establish that illegal distributions had been made to the members.
The opinion involved two consolidated cases, both decided on summary judgment. In each case the LLC’s certificate of formation was canceled, once in the middle of a lawsuit against the LLC and once prior to the filing of a lawsuit against the LLC. One LLC’s certificate of formation was canceled by the Secretary of State for failure to pay license fees and file reports. RCW 25.15.290. The other LLC’s certificate of formation was canceled voluntarily by the LLC after a dissolution vote by its members. RCW 25.15.270.
Most of the opinion deals with two questions: (1) does cancellation of an LLC’s certificate of formation bar the LLC from filing or continuing a lawsuit, and (2) does cancellation of the certificate of formation bar a plaintiff from filing or continuing a lawsuit against the LLC? The court answered both questions in the affirmative; cancellation of the LLC’s certificate of formation ends all suits by or against the LLC and bars any further lawsuits by or against the LLC.
To reach that seemingly draconian result, the court reviewed the LLC Act’s dissolution and winding-up provisions. Dissolution is a change in the status of the LLC that can occur (a) on the date of specific events set forth in the certificate of formation, (b) on the written consent of all members, (c) 90 days after dissociation of the last remaining member unless within the 90 days the assignees vote to admit one or more new members, (d) by judicial decree, or (e) by action by the Secretary of State for nonpayment of fees. RCW 25.15.270. Once dissolved, the LLC’s affairs “shall be wound up.” Upon the completion of winding up, the certificate of formation must be canceled. RCW 25.15.080.
Note that the LLC Act’s dissolution procedures are quite different from those of Washington’s Business Corporation Act (BCA). Under the BCA, a corporation may dissolve (after board and shareholder approval) by filing articles of dissolution with the Secretary of State. RCW 23B.14.030. A dissolved corporation continues its corporate existence but may not carry on any business except that appropriate to wind up and liquidate its business and affairs. RCW 23B.14.050. The contrast is stark: a corporation commences dissolution with a public filing and continues its existence indefinitely while winding up; but an LLC commences dissolution by a vote of its members (i.e., no public filing) and after winding up terminates its existence by filing a cancellation of its certificate of formation.
The court in Chadwick relied on the language of the Act to conclude that cancellation of the certificate of formation terminates the existence of the LLC:
A limited liability company formed under this chapter shall be a separate legal entity, the existence of which as a separate legal entity shall continue until cancellation of the limited liability company’s certificate of formation.
RCW 25.15.070. And, said the court, if the LLC does not exist it cannot sue or be sued. The Act’s survival statute did not alter the court’s conclusion. RCW 25.15.303 provides that “[t]he dissolution of a limited liability company does not take away or impair any remedy available against that limited liability company, its managers, or its members for any right or claim existing” so long as an action is commenced “within three years after the effective date of dissolution.” The dissent read this section as applying whether or not the certificate of formation was canceled within three years after dissolution; the majority instead read Section 303’s survival period to be truncated by an intervening cancellation of the certificate of formation.
Under this ruling, an LLC involved in unwelcome litigation could vote to dissolve and then end the lawsuit by canceling its certificate of formation. However, the statute requires that the LLC’s affairs “shall be wound up” upon dissolution, and that the LLC “pay or make reasonable provision to pay all claims and obligations, including all contingent, conditional, or unmatured claims and obligations, known to the limited liability company,” including known claims for which the identity of the claimant is unknown. Assets may be distributed to members only upon completion of winding up, i.e., after paying or making provision for all claims.
In both Chadwick cases, claims of personal liability were raised against those involved in winding up the LLCs, for failure to pay or make provision for claims. The statute implies that there can be personal liability: “Any person winding up a limited liability company’s affairs who has complied with this section is not personally liable to the claimants of the dissolved limited liability company by reason of such person’s actions in winding up the limited liability company.” RCW 25.15.300. The court easily drew the inference and found that personal liability to claimants may result if the persons winding up the LLC do not comply with RCW 25.15.300.
The Chadwick case will have significant impacts on how litigation with LLCs is conducted, and raises many questions. The temptations on defendant LLCs to dissolve (no public filing is required), wind up, make some arguable provisions for any claims, and then threaten to cancel or actually cancel their certificate will in some cases be irresistible. That scenario raises the question: just exactly how can an LLC make provision for a claim against it in a pending lawsuit when the LLC is about to end the lawsuit and terminate its very existence? Perhaps the manager that carries out the winding up could hold any funds set aside for claimants. If the lawsuit against the LLC is abated, the claimant will likely sue the manager anyway on an “improper winding up” theory. If the case turns in that direction, will the litigation then have to fully determine the merits of the original claim against the LLC, when the LLC is not participating in the lawsuit because its existence has been terminated?
Chadwick only involved claims of personal liability against the manager or members that carried out the winding up. But RCW 25.15.235, not discussed by the Chadwick court, can in some cases create personal liability for members who receive liquidating distributions from a dissolved LLC. Section 235 requires LLCs to refrain from making distributions to members if the LLC is insolvent under either test: it is unable to pay its debts as they become due in the ordinary course, or its liabilities exceed the fair value of its assets. A member who receives a distribution in violation of Section 235 and who knew of the violation at the time of the distribution is liable to the LLC for the amount of the distribution. The Chadwick court relied on RCW 25.15.300, which refers to liability to claimants on the part of those winding up the dissolved LLC. RCW 25.15.235, on the other hand, could be invoked by claimants against a dissolved and canceled LLC in order to reach members who knowingly received an illegal distribution, even if they were not involved in the winding up. But Section 235 only refers to the member’s liability to the LLC, not to third-party claimants. If the LLC’s certificate of formation has been canceled, could a claimant reach the member that received the illegal distribution?
The Chadwick opinion raises a host of such questions, but the law of the case may be short-lived. The court seemed to recognize that its ruling could in some cases yield unsatisfactory results, and noted that according to the house and senate bill reports, a comprehensive review of the LLC Act is underway (presumably by a Washington State Bar Association committee). In an apparent invitation to the state legislature, the court said “[i]f the result here is not what the legislature wants, it will be positioned to make additional changes deemed necessary.” I think it’s a safe prediction that some revisions to the dissolution and winding-up provisions of Washington’s LLC Act will be coming soon.