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.

Iowa Court Denies Request by Holders of LLC Charging Orders for Quarterly Financials

Several judgment creditors obtained charging orders against their debtors’ interests in three LLCs, along with an order requiring the LLCs to provide quarterly cash flow statements. The LLCs objected to disclosure of their quarterly cash flows, and on appeal the Iowa Court of Appeals found that there was no statutory authority for the required disclosure and reversed the disclosure orders. Wells Fargo Bank, Nat’l Assoc. v. Continuous Control Solutions, Inc., No. 11-1285, 2012 WL 3195759 (Iowa Ct. App. Aug. 8, 2012).

Background. Iowa’s courts are authorized, on application by a judgment creditor of an LLC member or assignee, to enter a charging order against the judgment debtor’s economic interest in the LLC. Iowa Code § 489.503. A charging order requires the LLC to pay to the judgment creditor any distributions that would otherwise be paid to the judgment debtor. Id.

In Wells Fargo Bank the judgment creditors petitioned the trial court for charging orders, and also asked for an order requiring the three LLCs to provide quarterly cash flow statements “to verify no distributions have been made to the judgment debtors or any other entity or person with an ownership interest in these limited liability companies.” Wells Fargo Bank, 2012 WL 3195759, at *2. The judgment creditors may have been channeling Ronald Reagan and his mantra, “trust, but verify.” Or perhaps half of it.

The trial court relied on Iowa Code Section 489.503(2)(b), and included the disclosure requirement in its charging order. Id. Section 489.503(2) states:

2.    To the extent necessary to effectuate the collection of distributions pursuant to a charging order in effect under subsection 1, the court may do all of the following: 

a.    Appoint a receiver of the distributions subject to the charging order, with the power to make all inquiries the judgment debtor might have made.

b.    Make all other orders necessary to give effect to the charging order.

The Court of Appeals. The judgment creditors relied on Section 489.503(2)(b), which authorizes the court to make all other orders “necessary to give effect to the charging order.” The Court of Appeals began its analysis by noting that that section does not specifically authorize the disclosure orders that were requested. The court gave only a nod to Section 489.503(2)(a), which refers to the “power to make all inquiries the judgment debtor might have made,” presumably because the judgment creditors’ argument did not rely on it.

The court reviewed the comments in NCCUSL’s Revised Uniform Limited Liability Company Act (RULLCA) § 503, which Section 489.503 is modeled on, and found no support for including rights to information in an order “necessary to give effect to the charging order.” The court concluded that Section 489.503(2)(b) only authorizes orders that affect economic rights, not governance rights such as rights to information. Id. at *3.

The court’s conclusion was supported by Section 489.502(1)(c)(2), which provides that a transferee of an LLC member’s interest is not entitled to access to records or other information concerning the LLC’s activities (except upon the LLC’s dissolution). A charging order is a lien on the judgment debtor’s economic interest, and since the holder of a member’s economic interest is not entitled to access to the LLC’s records, the holder of a lien on the member’s economic interest should similarly be denied access to the LLC’s records or other information. Id.

The court vacated the trial court’s disclosure orders, stating: “To effectuate a charging order, Iowa Code section 489.503 authorizes a court to order an L.L.C. to disclose financial information to a court-appointed receiver only. We conclude there is no statutory authority for the disclosure orders the district court issued in this case.” Id.

Comment. The court’s conclusion seems correct, given the “pick your partner” principle inherent in LLC law. An assignee of an LLC interest has no rights to information from the LLC, so why should the holder of a charging order, which puts the judgment creditor in a position similar to that of an assignee, have more rights to information than the assignee?

The court’s opinion leaves open, however, what the result would have been if the judgment creditors had asked for appointment of a receiver for the distributions, and the receiver had then asked for the financials under the authority of Section 489.503(2)(b): “with the power to make all inquiries the judgment debtor might have made.” The Court of Appeals acknowledged that the judgment debtor retains its management power and rights to information, even after the entry of a charging order against its interest. Wells Fargo Bank, 2012 WL 3195759, at *2. The NCCUSL comments to RULLCA section 503 don’t answer that question.

Disobedience of Ohio Court Order Lands LLC's Controller and Single Member in Jail

Sometimes pushing the envelope is not a good strategy, and that’s clearly the case when your litigation strategy ends you up in jail. In an Ohio case the judge found an after-the-fact excuse for disobedience of the court’s order to be insufficient, held the LLC’s owner and its controller in contempt of court, and sentenced them to seven days in the county jail. Spero v. Project Lighting, LLC, No. 2011-P-0002, 2011 WL 6371881 (Ohio Ct. App. Dec. 19, 2011).

Background. Spero involved a dispute over a joint venture made up of several limited liability companies. Two were owned 50-50 by defendant Sam Avny and plaintiff Mitchell Spero. One of the LLCs was owned by Avny and ownership of the fourth was disputed. Id. at *1.

In the course of the litigation a receiver was appointed to take possession of all the assets of the three LLCs other than the one owned by Avny, Project Light, LLC. Two months later the trial judge entered a detailed order calling for the funds in all bank accounts controlled by the three LLCs “to be transferred immediately to the exclusive control of the Receiver,” and directing that “[a]ll funds derived from the sale of any Prospetto inventory will be deposited with the Receiver and remain under his control pending further order of the Court.” Id. (Prospetto was one of the three LLCs.)

When the plaintiffs learned that the court’s order had not been complied with, they filed a motion requesting that the defendants be held in contempt of court. After an adversarial hearing, the trial court found beyond a reasonable doubt that Sam Avny and Anthony DeAngelis, the controller of the three LLCs, had disobeyed the court’s order by causing at least $89,000 of proceeds from the sale of Prospetto’s inventory to be deposited in Project Light’s bank account. Id. at *2.

The court found DeAngelis, Avny, and Project Light to be in contempt of court. They were each fined $250, and DeAngelis and Avny were sentenced to serve seven days in the county jail.

Analysis. DeAngelis and Avny argued unsuccessfully on appeal that the trial court lacked jurisdiction because (1) a notice of appeal was filed before the contempt hearing, and (2) a subsequent settlement agreement disposed of the contempt issue.

The Court of Appeals held that when a case goes up on appeal, the trial court retains jurisdiction over collateral matters such as contempt of court. In considering the effect of the settlement, the court distinguished civil contempt, which is remedial in nature, from criminal contempt, which is intended to punish the offender for acts in disregard of the court’s authority. The sanctions in Spero were for criminal contempt and could therefore be pursued even after the underlying action was no longer pending. Id. at *3.

DeAngelis and Avny’s central argument was that there was not a clear violation of the trial court’s order because of the way the funds were handled. DeAngelis testified that although the money in question was deposited into Project Light’s bank account, “it was clearly earmarked on the books as payable to Prospetto Light so that all of that money could be segregated and any time that it was called for, it could be turned over.” Id. at *5.

The court didn’t buy it. First, the trial court’s order was clear: “all funds derived from the sale of any Prospetto inventory will be deposited with the Receiver and remain under his control pending further order of the Court.” Id. at *6. Second, the earmarking procedure was inadequate and plainly contravened the court’s order. And third, DeAngelis testified that he believed Project Light had paid for the inventory sold by Prospetto and therefore was entitled to be paid for it, although he never informed the receiver of his belief and the receiver was not aware until later that the funds had been diverted. Without saying so, the court implied that DeAngelis’s motivation was for Project Light to retain the funds notwithstanding the court’s order.

DeAngelis and Avny also argued that the seven-day jail term was unreasonable and disproportionate to their acts. The Court of Appeals pointed out, however, that under the Ohio statute that authorizes criminal contempt sanctions, a first offense may be punished by a fine of up to $250, and up to 30 days in jail. Ohio Rev. Code § 2705.05(A)(1). In light of the statutory potential for a 30-day sentence and the discretion accorded the trial court, the Court of Appeals found seven days not to be disproportionate to the conduct. Spero, 2011 WL 6371881, at *6. The trial court’s ruling was affirmed. Id. at *7.

Comment. Although this case involved LLCs, the issues were not LLC-specific. But LLC dissolutions and court-ordered receivers are not uncommon, and the lessons of the case are worth considering.

The result here underscores the importance of paying attention to the wording of a court order. Unilaterally implementing a non-compliant procedure (here, depositing the funds to the wrong company’s account but earmarking the source of the funds), which might have been allowed by the court if properly requested, is simply asking for trouble. Failing to disclose the process to the court-appointed receiver compounded the difficulty. Placing the funds in the wrong account and not disclosing the situation to the receiver could have led to the receiver’s filing of inaccurate reports to the court, and conceivably could have led to the receiver’s having inadequate funds to carry on the operations of the three jointly owned LLCs.

The maxim “It’s easier to ask forgiveness than it is to get permission” (generally attributed to U.S. Navy Rear Admiral Grace Hopper) is bad advice when it comes to a court order.

Appointment of Receiver Upheld for Delaware LLC

The appointment of a receiver is one of the oldest equitable remedies. A receiver can receive, preserve, and manage property and funds, and even take charge of an operating business, as directed by the court. Appointing a receiver is a powerful remedy, not undertaken lightly by the courts.

The Delaware Court of Chancery in September had to decide if a receiver should be appointed for an LLC whose members were embroiled over claims of breach of fiduciary duty, breach of contract and tortious interference with contractual opportunity. Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. 4113-VCN, 2010 Del. Ch. LEXIS 184 (Del. Ch. Sept. 2, 2010).

The plaintiffs in Ross asked the court for two things: one, to allow them to amend their complaint to add a request for the appointment of a receiver; and two, to immediately appoint a receiver. They wanted a receiver with power to manage the LLC’s affairs, to protect and preserve its assets, and to recover any losses the LLC suffered at the hands of the defendants.

The Ross court made short shrift of the defendants’ argument that the appointment of a receiver was unavailable because it was not authorized by either the Delaware LLC Act or the LLC’s operating agreement:

“The Court has inherent power as a court of equity to grant such remedies as would be just, whether or not such remedies are expressly provided for by statute or contract. There is no reason to conclude that the appointment of a receiver pursuant to the Court's general equity powers would be unavailable under the facts alleged in the proposed Amended Verified Complaint.”

Id. at *7-8. The plaintiffs were therefore free to amend their complaint to request the appointment of a receiver.

But the plaintiffs were not content to wait for trial – they also moved the court for an immediate appointment of a receiver, alleging that the defendants were in effect looting the LLC and had caused its insolvency through gross mismanagement and self-dealing.

The court was faced with two possible standards. The defendants argued that a receiver could be appointed only under the court’s general equity power. Under that standard a receiver will only be appointed where there is fraud or gross mismanagement, causing imminent danger of great loss that cannot otherwise be prevented. Id. at *23. This is a high bar.

The plaintiffs pointed out that Delaware’s LLC Act provides that in any case not governed by the Act, the rules of law and equity are to govern. They cleverly argued that therefore the standard for appointing receivers under Delaware’s General Corporation Law should apply. DLLCA § 18-1104; DGCL § 291. Under Section 291 a corporate insolvency suffices for the appointment of a receiver, although the courts have required additional facts demonstrating that a receiver is necessary to protect the rights of the company or the moving parties. For an insolvent entity, that standard is usually much less challenging than the “fraud or gross mismanagement” standard.

The Ross court noted that the LLC Act was written long after passage of the corporate statute, that in some cases provisions from the corporate statute were included in the LLC Act, and that therefore the omission from the LLC Act of a provision like Section 291 was intentional and not inadvertent. Ross, 2010 Del. Ch. LEXIS 184 at *18. The court saw no need to engraft the corporate statutory standard on the LLC Act, and ruled that it could appoint a receiver only in accordance with its general equity powers. Id. at *20.

Since the court concluded that it could appoint a receiver only under its equity jurisdiction, the plaintiffs needed to present “clear evidence of fraud, gross mismanagement, or other extraordinary circumstance causing imminent danger of real loss” to succeed on their motion for appointment of a receiver. Id. at *36. As so often happens, setting the standard determined the outcome.

The court reviewed in detail the plaintiffs’ numerous allegations of wrongdoing and the defendants’ contrary assertions, which disputed much of the plaintiffs’ facts and conclusions. With a nice double negative, the court opined that it “cannot conclude that the Plaintiffs have not asserted facts that, if true and accurate, would meet this high standard.” Id. (How could the plaintiffs have asserted true but inaccurate facts?) But because material facts relevant to the plaintiffs’ assertions remained in dispute, the court denied the motion: “it will be necessary to hold a trial in order to further develop the necessary factual record for a fair assessment of their application.” Id.

The Ross court’s approach is an example of a court relying on its equity powers to apply an equitable remedy for an LLC or its members, notwithstanding that the applicable LLC Act does not explicitly call out that remedy. For another example, last year New York and Indiana reached similar conclusions regarding the equitable remedy of a court-ordered accounting, which I discussed here.

 

Washington LLC Member Knowingly Receives Unlawful Distribution - What's the Remedy?

The Washington LLC Act prohibits an insolvent LLC from making a distribution to a member. RCW 25.15.235(1). Either type of insolvency will do – the LLC is unable to pay its debts as they come due in the usual course of business, or the LLC’s liabilities exceed the fair value of its assets. Furthermore, a member who receives such an unlawful distribution and who knows at the time that the LLC is insolvent, “shall be liable to [the] limited liability company for the amount of the distribution.” RCW 25.15.235(2).  

 

How does this rule play out when a third party makes a claim against the LLC? I had always assumed that in this scenario a court would allow an LLC’s creditor to assert the claim against the distribution-receiving member as well, probably by piercing the LLC’s veil. But the analysis of the Washington Court of Appeals in a recent case turned out to be a little more complex.

 

In Shinstine/Assoc. LLC v. South-N-Erectors, LLC, No. 39277-1-II, 2010 Wash. App. LEXIS 1976 (Wash. Ct. App. Aug. 31, 2010) (unpublished), the defendant LLC stipulated to a judgment in favor of the plaintiff Shinstine for $127,850.58. Shinstine also sought to hold the LLC’s sole member, Roger Hicks, personally liable for Shinstine’s judgment against the LLC. Shinstine claimed the LLC made an improper distribution to Hicks that rendered the LLC insolvent and therefore violated RCW 25.15.235. The trial court agreed and pierced the LLC’s veil, holding Hicks personally liable for Shinstine’s judgment against the LLC.

 

The Court of Appeals began its analysis with the proposition that generally LLC members and managers are not personally liable for the LLC’s obligations. RCW 25.15.125(1). The Act provides an exception, however: “Members of a limited liability company shall be personally liable for any act, debt, obligation, or liability of the limited liability company to the extent that shareholders of a Washington business corporation would be liable in analogous circumstances.” RCW 25.15.060.

  

 

The Shinstine court looked to a case that involved an unlawful corporate distribution, Block v. Olympic Health Spa, Inc., 24 Wn. App. 938, 604 P.2d 1317 (1979), rev. denied, 93 Wn.2d 1025 (1980). In Block, the court had held that an insolvent corporation’s distribution to its sole stockholder and president, who was well aware of the company’s insolvency, did not require piercing the corporation’s veil. Block, 24 Wn. App. at 950. (The corporate rule when a shareholder knowingly receives an unlawful distribution from an insolvent corporation is similar to the LLC rule: the shareholder is liable for return of the distribution to the corporation. RCW 23B.08.310.)

 

 

The court in Block refused to pierce the veil because to do so would have allowed the plaintiff to secure a preference over the other creditors of the corporation. Block, 24 Wn. App at 950. The Block court’s reasoning was persuasive to the Shinstine court: “To hold otherwise would permit creditors to get a preference over other creditors otherwise prohibited by law.” Shinstine, 2010 Wash. App. LEXIS 1976 at *12-13. The Shinstine court applied the Block rule and reached the same result on the same reasoning – it held that the LLC’s veil would not be pierced to allow Shinstine’s claim to reach Hicks.

  

 

Was Shinstine left with no recourse? Apparently not. The court stated in a footnote:

 

 

Shinstine was not without remedy. Without disregard Shinstine could have had a receiver appointed pursuant to RCW 7.60.025(1)(c), which permits any party to request appointment of a receiver after a judgment in order to give effect to the judgment. The receiver could have sought reimbursement from Hicks or South-N-Erectors’ behalf if the distribution was in violation of RCW 25.15.235(1), and then pay those funds to Shinstine.

 

 

Id. at *13 n.5. My litigation colleagues tell me that receivers indeed can be appointed under this statute, for this purpose, but counsel for the plaintiff must go to court and make the necessary showing for appointment of the receiver. Doable, but not simple.