Wyoming’s new LLC Act in 2010 changed the standard for veil-piercing claims by eliminating any consideration of an LLC’s failure to observe formalities relating to its activities or management. That sounds like a big change, but it didn’t affect the result in American Action Network, Inc. v. Cater America, LLC, No. 12-1972 (RC), 2013 WL 5428857 (D.D.C. Sept. 30, 2013).
This case was a breach of contract action. American Action Network, Inc. (AAN) hired Cater America, LLC, a Colorado LLC, to organize a Lynyrd Skynyrd concert during the 2012 Republican National Convention in Tampa, Florida. AAN claimed that it paid $150,000 to Cater as a refundable ticket deposit and that it loaned another $200,000 to Cater. The concert was cancelled on account of weather.
Cater claimed the $150,000 was payment for services it performed, and refused to repay either amount. AAN brought a breach of contract action against Cater, and also against Cater’s sole member, Robert Jennings, on an alter ego or veil-piercing theory. Jennings moved to dismiss the veil-piercing claim on grounds that AAN’s complaint failed to state a claim, under Federal Rule of Civil Procedure 12(b)(6). (A motion under Rule 12(b)(6) tests whether the facts alleged in the complaint, if proved true at trial, could support relief under the applicable law.)
Choice of Law. The court first had to decide which state’s law applied. Jennings claimed that Wyoming law governed the veil-piercing claim. AAN argued that Wyoming law did not apply, but took no position as to which state’s law should apply. Id. at *6. The court assumed, without deciding, that Wyoming law applied. It did so because under its analysis AAN’s veil-piercing claim survived even if Jennings’ contention that Wyoming law applied was correct.
’Tis a passing strange result for more than one reason. First, according to the court the parties did not substantively analyze the proper choice of law issue. Even odder is the fact that Cater was a Colorado LLC, formed under Colorado’s LLC statute in 2008, yet the court applied Wyoming law.
Generally the law of the state of formation of a corporation or LLC will govern veil-piercing claims. See, e.g., Howell Contractors, Inc. v. Berling, No. 2010-CA-001755-MR, 2012 WL 5371838 (Ky. Ct. App. 2012). I blogged about Howell, here. The court in Howell cited several federal cases in support of the rule that the law of an entity’s state of formation governs veil-piercing issues.
Piercing the Veil. The court pointed out that Wyoming has previously applied the equitable doctrine of piercing the veil to LLCs. E.g., Gasstop Two, LLC v. Seatwo, LLC, 225 P.3d 1072 (Wyo. 2010) (veil-piercing factors lie in four categories: fraud, inadequate capitalization, failure to observe company formalities, and intermingling of LLC’s and member’s business and finances).
The Wyoming LLC Act was substantially amended effective July 1, 2010, however, and the revisions touched on the veil-piercing issue. The relevant portion of the LLC Act now reads:
The failure of a limited liability company to observe any particular formalities relating to the exercise of its powers or management of its activities is not a ground for imposing liability on the members or managers for the debts, obligations or other liabilities of the company.
Wyo. Stat. Ann. § 17-29-304(b) (emphasis added). Subparagraph (b) is new – the prior Act made no reference to the LLC’s observance of any particular formalities.
The court determined that this new subsection merely precludes consideration of one factor in a veil-piercing analysis, and quoted approvingly a commentator’s analysis of Section 17-29-304(b): “other categories…, including fraud, inadequate capitalization, and intermingling the business and finances of a company and its member, remain as grounds for piercing the LLC veil”). Cater, 2013 WL 5428857, at *9 (quoting Dale W. Cottam et al., The 2010 Wyoming Limited Liability Company Act: A Uniform Recipe with Wyoming “Home Cooking”, 11 Wyo. L. Rev. 49, 63-64 (2011)).
Based on its determination that the remaining veil-piercing factors continue to be applicable, the court concluded that AAN’s complaint alleged sufficient facts to adequately plead a veil-piercing claim (although the court never set forth AAN’s specific allegations). Jennings’ motion to dismiss AAN’s claims against him was therefore dismissed. Id. That claim will now go to trial.
Comment. The court expressed hesitancy “to conclusively interpret a Wyoming state law as a matter of first impression where the parties have not provided briefing analyzing the statute’s text and where it is not even clear that Wyoming law would apply.” Id. Nonetheless, it’s hard to imagine a Wyoming court taking a different view of Section 17-29-304(b).
Wyoming’s statutory removal of informality from the factors used to determine whether an LLC’s veil should be pierced is a good change. LLCs are often operated informally, and the lack of any particular formalities in an LLC’s management or exercise of its powers rarely if ever would be a serious factor in causing harm or injustice to an LLC’s creditor or contractual counter-party.
The National Conference of Commissioners on Uniform State Laws (NCCUSL) was formed in 1892 to promote uniformity in state laws by providing states with proposed legislation. NCCUSL’s record has been mixed, but it has had notable successes in the area of commercial and business law. Examples include the Uniform Commercial Code (in cooperation with the American Law Institute), the Uniform Partnership Act, and the Uniform Trade Secrets Act.
LLC law has not been one of NCCUSL’s shining successes. NCCUSL released its first Uniform LLC Act (ULLCA) in 1995, after almost all the states had already adopted LLC statutes. ULLCA has since been adopted by only eight states.
In 2006 NCCUSL released a revised version, the Revised Uniform Limited Liability Company Act (RULLCA). In 2008 RULLCA was enacted by Idaho and Iowa.
Earlier this year Nebraska and Wyoming enacted RULLCA, doubling the number of RULLCA states from two to four. Nebraska’s new law was signed by the governor on April 1, 2010. It becomes effective January 1, 2011 and has a two-year transition period. The new Wyoming Act was signed by the governor on March 8, 2010 and became effective July 1, 2010, with a four-year transition period.
There is significant variation among the current state LLC laws, other than those of the eight states that enacted ULLCA, and the four states that have now adopted RULLCA. Many were originally modified versions of the states’ limited partnership laws, while some were copied in part from other states’ laws, from ULLCA, and from the ABA’s 1992 Prototype Limited Liability Company Act.
RULLCA has been criticized. Larry E. Ribstein, An Analysis of the Revised Uniform Limited Liability Company Act, 3 Va. L. & Bus. Rev. 35 (2008). Professor Ribstein has referred to it as “the incredibly misguided Revised Uniform Limited Liability Company Act,” here. His view is that RULLCA “threaten[s] to impose substantial risks and costs on limited liability companies … that there is little reason for states to adopt the Act, and that practitioners should be wary about advising clients to form under it.” Id.
The major criticisms of RULLCA include the following issues. Ribstein, supra, at 78-79.
- Unworkable provisions on shelf registration, i.e., creating an LLC with no initial members
- No provisions for series LLCs
- An overly broad definition of the elements of the operating agreement
- Unclear rules on the agency power of members and managers
- Broader fiduciary duties than the traditional duties of loyalty and care, with uncertain boundaries, and intricate restrictions on operating agreement waivers of fiduciary duties
RULLCA is a valuable resource for states looking to review and revise their LLC statutes, but its prognosis for becoming widely adopted looks bleak.
Given the relatively recent appearance of LLCs on the legal stage, a variety of state approaches may not be such a bad thing. Over time, case law will play out against the statutory backdrops, LLC statutes will be revised based on business needs and the results of litigation, and lawyers and business people can in effect vote with their feet by forming LLCs using whatever states’ laws best fit their needs.
This month Illinois became the latest state to pass enabling legislation for low-profit limited liability companies, or L3Cs, joining Vermont, Michigan, Utah and Wyoming. The new Illinois law becomes effective on January 1, 2010. According to the Nonprofit Law Blog several other states are considering adopting L3C laws.
An L3C is a limited liability company whose primary purpose is not to earn a profit but to “significantly further the accomplishment of one or more charitable or educational purposes.” E.g., Ill. Pub. Act 096-0126 (SB 0239). An L3C is not a nonprofit and is not precluded from earning a profit, but income or property appreciation may not be a significant purpose of the company. An L3C is a hybrid, a business entity formed to carry out charitable or educational purposes, and designed to attract philanthropic as well as private investment. In almost all respects other than its purpose, an L3C is treated like any other LLC, including income taxes.
To qualify as an L3C under the state laws, the LLC:
● must significantly further the accomplishment of one or more charitable or educational purposes within the meaning of IRC section 170(c)(2)(B);
● would not have been formed but for the accomplishment of the charitable or educational purposes;
● does not have as a significant purpose the production of income or the appreciation of property, although the fact that the company produces significant income or capital appreciation is not conclusive evidence of a profit motive; and
● does not have as a purpose the accomplishment of any political or legislative purpose.
These state law requirements parallel the Internal Revenue Code requirements for the target of a “program-related investment” by a private foundation. IRC § 4944(c). In addition, each of the five states requires that the name of the L3C contain either the abbreviation “L3C” or the words “Low-Profit Limited Liability Company.”
Vermont was the first state to pass legislation to authorize L3Cs, in April 2008. As of August 20, 2009 there were over 60 L3Cs formed in Vermont. In a little over a year four more states have amended their LLC Acts to authorize L3Cs. Illinois, the latest of the four, is a heavyweight in terms of its industry and commerce. L3Cs are here to stay and are growing in use and in public recognition.
There are two principal reasons why L3Cs are taking off. The first is the hope that L3Cs will attract program-related investments (PRIs) by private foundations. By combining philanthropic investment with private capital, L3Cs can offer the possibility of major social impact.
If an investment by a private foundation meets the Internal Revenue Code’s requirements for a PRI, the investment will count towards the foundation’s annual distribution requirements and will not jeopardize the foundation’s charitable purpose. IRC § 4944(c). PRIs by private foundations are not common occurrences today, in part because of the high transaction costs to the foundation in verifying that the target of the investment will meet the PRI requirements. The promoters of state laws authorizing L3Cs expect that foundations will be more willing to invest in companies organized as L3Cs.
A company’s status as an L3C under state law, however, is not adequate to qualify the L3C for a PRI. And if a private foundation makes an investment with an L3C and the investment turns out not to qualify as a PRI, the foundation can be assessed substantial taxes and penalties. The result is that unless and until the IRS issues guidance about qualifying L3Cs for PRIs, private foundations will likely conclude that they must continue to incur the transaction costs involved in determining the correctness of a specific PRI. Those costs often include expensive private letter ruling requests to the IRS.
These tax issues are well described in Allison Evans, Christine Petrovits & Glenn Walberg, L3C: Will New Business Entity Attract Foundation Investment?, 63 The Exempt Organization Tax Review 457 (2009). It appears that without regulatory guidance from the IRS or changes to the tax laws, private foundations will continue to be reluctant to make program-related investments in LLCs, whether or not they are structured as L3Cs.
Branding is the second reason why L3Cs appear to be attractive for companies with social missions. By being labeled as an L3C, companies send a signal to their customers, employees, vendors and communities that they have a charitable or educational purpose, even though they are not a nonprofit. The L3C movement appears to have tapped into this vein of entrepreneurial desire to provide public benefit.
We can expect continued growth in the number of states that authorize L3Cs and in the number of L3Cs being formed. That should increase the pressure for the IRS and federal regulators to come up with a more economically efficient way for L3Cs to qualify for program-related investments, so that private foundations will not be deterred from making investments in L3Cs compatible with the foundation’s mission.
Texas has joined the seven other states that have authorized series LLCs. The Texas bill authorizing series LLCs was signed by Governor Perry in May and will become effective on September 1, 2009. S.B. 1442. The states that currently authorize series LLCs are Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee and Utah.
Most state LLC acts allow an LLC to provide for classes of members with different member rights per class. But a series LLC can go further by establishing multiple series of assets, members and managers. The debts and obligations of a series will be enforceable only against the series’ assets, and will not be enforceable against the other series in the LLC or against the LLC generally, and vice versa. The members associated with a series can be given separate rights and duties with regard to the assets of the series.
The separation of assets and partitioning of liabilities between series, all within one LLC, can avoid many of the inefficiencies and costs associated with multiple related entities. For example, a series LLC could be used to hold multiple parcels of real estate, each in a separate series and all within the one LLC. Or, separate divisions of a business could be held by one LLC, but with each division in a separate series.
The Texas statute is similar in many respects to the Delaware act. Both authorize an LLC’s operating agreement to establish one or more designated series. Both acts provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
(a) the records of the series account for its assets separately from the assets of any other series or the LLC generally,
(b) the operating agreement states the liability limitations, and
(c) the certificate of formation gives notice of the limitations on liability.
Each series may in its own name sue and be sued, contract, and hold title to its assets, including real estate and personal property.
Series LLCs can be useful, but there are legal uncertainties involved in their use. Series LLCs are relatively new – Delaware was the first state to authorize series LLCs, in 1996, and there is almost no case law on them. Major areas of uncertainty involve taxation, bankruptcy, and doing business in multiple states.
There are many open tax questions with regard to series LLCs. Although the Internal Revenue Service issued a Private Letter Ruling in 2008 and clarified that each series’ federal tax characterization is determined independently, other state and federal tax questions remain.
It is unclear whether an LLC series will be treated as a debtor in federal bankruptcy court, or whether the bankruptcy court will ignore the series and only consider the entire LLC. The result may depend on whether the relevant state law will treat the series as a separate entity with its own liability shield.
Including Texas there are now eight states whose LLC acts authorize series LLC, but that leaves 42 other states with no series provisions in their acts. It is not at all clear what the courts of a non-series state would do when faced with a claim by a local creditor against an out-of-state series LLC formed under the laws of, say, Delaware. Will the non-series state honor the series structure and respect the internal liability shield? Would a non-series state even allow a series of an LLC formed under the laws of another state to register to transact business in the non-series state?
The law of series LLCs is an infant, still a little unsteady on its feet. But at one time LLCs were new and LLC law was the infant. There were many articles back then pointing out the uncertainties and risks of using LLCs when they were first adopted by Wyoming in 1977 and later by other states. Many conservative lawyers recommended against using LLCs in the early years of their authorization by the various states, but eventually all the states authorized LLCs. Today LLC law is more mature and LLCs are the most popular entity form for new businesses. History predicts that the question for series LLCs is not whether they will become routinely used, but when.