LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
A First -- New York Applies De Facto Corporation Doctrine to LLCs
New York’s highest court, the Court of Appeals, held last month that the doctrine of de facto corporations applies to LLCs. In re Hausman, No. 08854, 2009 NY LEXIS 4145 (Dec. 1, 2009). “De facto corporations” is an equitable doctrine that can be applicable when founders have attempted to form a corporation but failed to fully comply with the statutory requirements. The New York court is apparently the first appellate court in the nation to resolve this issue (other than the Fifth Circuit in Western Sec. Corp., 303 F. App'x 173 (5th Cir. 2008), an opinion that the Fifth Circuit has determined should not be published and which for most purposes is not precedent.)
It sometimes happens that founders of a corporation or LLC to enter into contracts, incur debts or take other actions on behalf of the entity before its formation. But if an agent enters into a contract on behalf of a non-existent entity, under agency law the other party to the contract will usually be able to hold the agent personally liable. The de facto corporation doctrine can permit judicial recognition of the entity’s existence, thereby avoiding personal liability of the agent.
In most states, including New York, an LLC begins to exist when its articles of organization or certificate of formation are filed with the appropriate state agency. E.g., N.Y. Ltd. Liab. Co. Law § 203. But occasionally founders jump the gun and act on behalf of the LLC before the filing is made, sometimes by mistake and sometimes knowing that the articles were not yet filed.
When creditors later claim that the founders are personally liable for contracts entered into before the LLC existed, the founders may defend on the grounds that a de facto corporation existed. There are also other situations, such as in Hausman, where the effectiveness of a conveyance or some other action will depend on whether the LLC existed at the time of the action, and the de facto corporation doctrine may then come into play.
Hausman was a probate proceeding. Lena Hausman’s will left real estate to her son and daughter and to the children of two predeceased sons. Before her death, the son and daughter executed articles of organization and prepared an operating agreement for a New York LLC. Lena Hausman then deeded the real estate to the son and daughter’s LLC, but the articles of organization for the new LLC were not filed with the New York Department of State until 14 days later.
Lena Hausman died seven months later and her will was admitted to probate. In the probate proceedings, the children of the predeceased sons claimed that the real estate should pass by will because Lena’s deed did not convey the real estate to a valid LLC. They pointed out that the LLC did not exist at the time of the deed. The probate court concluded that the deed to the LLC was valid because the LLC was a de facto corporation when the deed was executed.
The Court of Appeals held that the de facto corporation doctrine is applicable to LLCs. “The statutory schemes of the Business Corporation Law and the Limited Liability Company Law are very similar, and we see no principled reason why the de facto corporation doctrine should not apply to both corporations and limited liability companies.” Hausman at *3. The court cited to no other authority, but implicitly recognized that the equitable considerations which support the doctrine for corporations apply to LLCs as well.
The Court of Appeals pointed out that the de facto corporation doctrine requires (1) a law under which the entity might be formed, (2) an attempt to form the entity, and (3) an exercise of the entity’s powers thereafter. Under the facts in Hausman, the court concluded that the second prong was not satisfied¾even though the doctrine was applicable, no de facto LLC existed because there had been no attempt to file the articles of organization until weeks after the deed conveying the real estate was executed.
It is worth noting that many other states have abolished the doctrine of de facto corporations. See, e.g., Equipto Div. Aurora Equip. Co. v. Yarmouth, 134 Wn.2d 356, 367, 950 P.2d 451 (1998). Many of those states have adopted variations of the Model Business Corporation Act, which is intended to abolish the de facto corporation doctrine. See Model Bus. Corp. Act §§ 2.03, 2.04 (2008). Presumably the states that have abolished the de facto corporation doctrine would not apply it to LLCs.
Washington Bobbles a Recent Amendment to the LLC Act
The 2009 Regular Session of the Washington Legislature amended the LLC Act, effective July 26, 2009. 2009 Wash. Sess. Laws Chap. 437. Two changes to the LLC Act were implemented. One was straightforward: the time period for an administratively dissolved LLC to seek reinstatement was extended from two years to five years.
The other change is problematic. The new section of the Act allows a voluntarily dissolved LLC to apply to the Secretary of State “for reinstatement” within 120 days after the effective date of the dissolution. If an application for reinstatement is made under the new law, and assuming the LLC’s name is available, the Secretary of State is directed to reinstate the LLC, in which case the reinstatement relates back to and takes effect as of the date of dissolution. (If the name is not available, the application for reinstatement must include an amendment to the certificate of formation to change the name.)
The problem with this new law is that it simply doesn’t make sense. When a Washington LLC is dissolved, nothing is filed with the Secretary of State. Dissolution of an LLC can be achieved by the written consent of all members, and then its affairs must be wound up. RCW 25.15.270. Dissolution is a change of status that begins the winding-up process, but it is not a public event.
Why would a voluntarily dissolved LLC apply for reinstatement? What is it that would be reinstated? Not the certificate of formation, since it is not affected by the LLC’s dissolution.
Even stranger, this new law requires that if no application for reinstatement is made within 120 days of the date of an LLC’s voluntary dissolution, the Secretary of State “shall cancel” the LLC’s certificate of formation. But since the voluntary dissolution of an LLC does not require a public filing, the Secretary of State will not be aware of an LLC’s dissolution, and therefore in almost all cases would be in no position to take action to cancel the dissolved LLC’s certificate of formation.
The consequences of canceling an LLC’s certificate of formation can be severe, since if the LLC’s certificate of formation is cancelled, the LLC ceases to exist. RCW 25.15.070(2)(c). And as I recently discussed in a post about Chadwick Farms Owners Ass’n v. FHC LLC (May 14, 2009), the Washington Court has held that canceling an LLC’s certificate of formation not only terminates its existence, but also abates all pending lawsuits by or against the LLC. There is currently no method under the Act to reinstate a cancelled certificate of formation.
It appears that the new section was intended to authorize an LLC to reinstate its certificate of formation within 120 days after filing a certificate of cancellation. The staff of the Secretary of State’s office has told me that they recognize the problems with the new statutory section and don’t intend to begin cancelling certificates of formation 120 days after voluntary LLC dissolutions. They are considering interpreting the new section to authorize applications for reinstatement of cancelled certificates of formation, but it’s hard to find that language in the session law.
I think it’s a safe prediction that this new law will be up for revision at the next session of the Legislature.
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.
Courts Continue to Find an Accounting Remedy
A recent decision of the New York Appellate Division, Gottlieb v. Northriver Trading Co. LLC (Jan. 27, 2009), garnered some controversy when it recognized that members of an LLC may seek an equitable accounting under common law. The New York LLC Law does not explicitly authorize an accounting remedy, and the court’s decision has been characterized by Professor Larry Ribstein as an example of the unpredictability of New York’s LLC law and as a contribution to the “impenetrable murk” of New York’s LLC Law.
The Gottlieb opinion relied on the reasoning of New York’s highest court in Tzolis v. Wolff. The court in Tzolis had to decide whether members of an LLC may bring a derivative suit on the LLC’s behalf, even though there were no provisions authorizing or governing derivative suites in New York’s LLC Law. The Tzolis court reasoned by analogy to both corporations and limited partnerships. The New York courts had in the past found an equitable right to a derivative suit for shareholders of a corporation and for limited partners in a limited partnership. In neither of those prior cases, at the times of their holdings, was there a statutory authorization of derivative suits for shareholders or limited partners.
Two recent cases from other states have dealt with this issue, both handed down just a month after publication of the New York court’s opinion in Gottlieb. One state had statutory language explicitly authorizing an accounting, one did not. Both upheld the availability of an accounting.
In February the Indiana Court of Appeals concluded in Perkins v. Brown that the trial court erred when it failed to order an accounting of an LLC’s finances in connection with the dissolution of the two-member LLC. Without discussing or analyzing whether Indiana’s LLC Act authorizes an accounting, the court simply concluded that an accounting was necessary to determine the LLC’s creditors and expenses and whether any improper distributions had been made. Indiana’s LLC Act does not expressly authorize an accounting, but it does provide that “[a] court may enforce an operating agreement by injunction or by granting other relief that the court in its discretion determines to be fair and appropriate in the circumstances.” Section 23-18-4-7(a). That section was also not discussed by the court.
In another February decision, the South Carolina Supreme Court recognized that its courts have “broad judicial discretion in fashioning remedies in actions by a member of an LLC against the LLC and/or other members,” including the remedy of an accounting. Historic Charleston Holdings, LLC v. Mallon. The court proceeded to reverse the trial court’s order for an accounting, but only because “a full financial accounting would unnecessarily prolong this otherwise simple matter.” The court’s conclusion about the authority for an accounting was based on South Carolina’s LLC Act. South Carolina has enacted the ULLCA, and Section 33-44-410(a)of South Carolina’s Act states that “[a] member or manager may maintain an action against a limited liability company or another member or manager for legal or equitable relief, with or without an accounting as to the company’s business . . . .”
In contrast to the explicit ULLCA language, the Revised Uniform Limited Liability Company Act (RULLCA), currently recommended by the National Conference of Commissioners on Uniform State Laws, states that “[u]nless displaced by particular provisions of this Act, the principles of law and equity supplement this Act.” Section 107. Many courts would likely see that as an implicit statutory approval of the accounting remedy for LLCs. RULLCA has been adopted by Idaho and Iowa.
The right to seek an accounting has long been recognized by U.S. courts as an equitable remedy with origins in England’s Chancery Courts. 1 Dan B. Dobbs, Law of Remedies 609-14 (2d ed. 1993). An accounting is generally available when there is a claim of breach of fiduciary duty or other wrongdoing, and is often used in partnership dissolution cases.
Washington, the state where I practice, danced around the issue of an LLC accounting in 2007, but concluded that it need not reach that issue on the facts of the case. Noble v. A&R Envtl. Services, LLC, 140 Wn. App. 29, 164 P.3d 519 (2007). One party appealed the trial Court’s refusal to order an accounting. The Court of Appeals decided that the trial court had not made sufficient findings of fact, remanded the case for adequate findings, and concluded that it need not reach the accounting argument.
The three opinions handed down this year (in New York, Indiana and South Carolina) all recognized that on request of a member of an LLC, an accounting may be ordered in appropriate situations. In none of the three was an accounting to be automatically granted – the analysis is fact-specific and will likely depend on whether there was fraud, breach of fiduciary duty or other wrongdoing, and whether the facts are complex enough to warrant the accounting process. The courts find the authority either in their LLC statute (explicitly or implicitly), by analogy to partnership and corporate law, or under general principles of equity.
These three opinions seem to reflect an unspoken reluctance to rule out the accounting remedy unless the applicable LLC Act expressly bars it, and I’m not aware of any LLC Act that does so. It seems likely that in the absence of such a statutory prohibition, most courts, when first presented with the issue and on request of a member of an LLC, will order an accounting in appropriate situations.
