Corporations Flashcards
Summary
ABC is a limited liability company (LLC) governed by state LLC law and the terms of its operating agreement. Alice and Carla mostlikely do not have any legal basis to object to Bob’s ownership interest in a competing business because of the express terms of ABC’s operating agreement.
Alice, Bob, and Carla likely are personally liable to the designer for ABC’s debt up to the amount each member received from the sale of ABC’s assets because the attempted dissolution and winding up of ABC was improper. Alternatively, they may be personally liable to the designer on a piercing-the-veil theory because their siphoning of the proceeds from the sale of ABC’s assets was inequitable, though not necessarily because the company’s books failed to reflect Alice’s payment of company debts.
Did Alice and Carla have any legal basis to object to Bob’s co-ownership of the Metro Inn?
Alice and Carla most likely do not have any legal basis to object to Bob’s decision to own an interest in a competing business in light of the express terms of the ABC operating agreement.
Rule
ABC is a limited liability company (LLC). An LLC is a form of business association that combines many of the most attractive features of corporations and partnerships. Like corporations, an LLC generally provides its investors—called “members”—with limited liability for firm debts. Like general partnerships, LLCs provide members with considerable flexibility in developing rules for decision making and control. Because LLCs are a relatively new form of business association bearing many similarities to corporations and partnerships, courts often turn to either corporate or partnership law to analyze issues in the LLC context.
Application
Here, the issue of whether Alice and Carla have any legal basis to object to Bob’s ownership of an interest in a competing firm will turn on the duties and obligations that Bob owes to his fellow LLC members. Courts generally hold that members of an LLC, like partners in a general partnership, are in a “fiduciary relationship.” See McConnell v. Hunt Sports Enterprises, 725 N.E.2d 1193, 1214–16 (Ohio Ct. App. 1999). This fiduciary relationship is defined as a relationship in which members owe one another the duty of utmost trust and loyalty. Id. As a result, in an LLC, as in a general partnership, direct competition by members would ordinarily be precluded as a violation of the duty of loyalty. Id.; see also ULLCA § 409(b)(3) (members have a duty to “refrain from competing with the company in the conduct of the company’s activities before the dissolution of the company”).
Although the question does not state that ABC’s 100-room luxury hotel project and the 200-room Metro Inn would compete, their similarity and proximity in the same town suggest that they would likely compete. Further, the fact that Alice and Carla are bothered by Bob’s interest in Metro Inn suggests that competition is a strong possibility.
However, here the LLC operating agreement expressly allows members to have an interest in a business that competes with the firm. Under most LLC statutes, members of an LLC can agree to restrict or limit the duty of loyalty, provided the opt-out is specified in the operating agreement. Thus, the operating agreement controls over the provisions of the statute. In this case, when they became members of ABC, Alice and Carla agreed to abide by the terms of the operating agreement, which expressly allow any member (i.e., Bob) to manage, own, and otherwise have an interest in a business that competes with the firm.
Operating Agreement
States differ slightly on how the opt-out must be structured in order to be effective. Some states, including Delaware, provide for total freedom of contract. See Elf Atochem North America, Inc. v. Jaffari, 727 A.2d 286 (Del. 1999) (applying Delaware LLC Act § 18-1101(b)). In these states, the terms of the operating agreement govern, unless they conflict with a mandatory statutory provision designed to protect third parties. Id. at 292. Since Bob’s interest in Metro Inn involves only the relationship between the contracting members—Alice, Bob, and Carla—this exception is not implicated.
However, most states that permit opt-outs of the duty of loyalty follow the general approach set forth in the Uniform Limited Liability Company Act (2006). According to ULLCA § 110(d)(1)(C), “If not manifestly unreasonable, the operating agreement may . . . restrict or eliminate the duty . . . to refrain from competing with the company in the conduct of the company’s business before the dissolution of the company.” In addition, so long as it is not “manifestly unreasonable,” the operating agreement may also “identify specific types or categories of activities that do not violate the duty of loyalty.” Id. § 110(d)(2).
In this case, the operating agreement is not a general waiver of the duty of loyalty, but specifies the activities that do not violate the duty, namely “managing, owning, or otherwise having an interest” in any competing business. Further, most courts would likely find this provision not “manifestly unreasonable.” See McConnell, 725 N.E.2d at 1193.
Whether the provision is “manifestly unreasonable” is a question of fact. Nonetheless, assuming that Alice and Carla each had notice of the provision when they signed the operating agreement, it will be difficult for them to claim surprise. The provision clearly allowed each member to manage, own, or otherwise have an interest in a competing business. This type of provision, which is typical in commercial real estate deals, appears reasonable. Many investors will likely want to be free to invest and exercise ownership rights in other similar real estate ventures in the same area or town.
Is the designer entitled to hold Alice, Bob, and/or Carla personally liable to thedesigner
(a)
because the winding up was improper, or
The designer may be able to hold Alice, Bob, and Carla proportionately liable, up to the amount of the proceeds each received in dissolution, for ABC’s debt to the designer because the winding up of ABC following dissolution was improper.
Rule
Like a corporation, the LLC provides limited liability for its members. ULLCA § 304(a). This means that members of an LLC may not generally be held personally liable for the debts of the firm. The general rule, however, does not apply in a few situations, including when (1) the proper procedures for dissolution and winding up have not been followed, and (2) a court decides to “pierce the LLC veil.”
Application
Here, the designer may be able to hold Alice, Bob, and Carla liable for ABC’s debts on the ground that the winding up of ABC was improper. In the absence of a contrary agreement or court order, dissolution of an LLC requires consent of all the members. ULLCA § 701(a)(2). In this case, the requirement of unanimous consent has been met since Bob gave his consent to Carla and Alice selling all of ABC’s assets and property. Although ABC was properly dissolved by the unanimous consent of the three members, see id., the problem was that the winding up process was flawed.
Dissolution and Winding up Process
After dissolution, as part of the winding up process, the LLC must provide notice of the dissolution to creditors so that they can make claims against the dissolving entity. ULLCA §§ 702(b)(1), 703 (notice procedure for “known claims”); see also New Horizons Supply Cooperative v. Haack, No. 98-1865, 1999 WL 33499 (Wis. Ct. App. Jan. 28, 1999);LARRY E. RIBSTEIN &ROBERT R.KEATINGEON LIMITED LIABILITY COMPANIES § 11.6 (2d ed. 2004).The notice sent to creditors must outline the steps that are necessary for enforcing their claims. ULLCA § 703(b). Here, it is clear from Carla’s statement that the designer’s claim was known at thetime of dissolution and that ABC did not provide sufficient notice to the designer of the dissolution.
When such procedures have not been followed, and if the LLC’s assets have been liquidated and distributed to the members, then a creditor’s claim against the LLC may be enforced against each of the LLC members to the extent of the member’s proportionate share of the claim or to the extent of the assets of the LLC distributed to the member in liquidation, whichever is less. ULLCA § 704(d)(2). However, a member’s total liability for creditor claims may not exceed the total value of assets distributed to the member in dissolution. Id.
While the facts state that no articles of dissolution were filed with the state, the filing of such notice is not required for a proper dissolution of an LLC. See ULLCA § 702(b)(2)(A). As a result, the designer can recover proportionately from Alice, Bob, and Carla personally for ABC’s debt up to the amount that each member received in the improper winding up after dissolution.
Is the designer entitled to hold Alice, Bob, and/or Carla personally liable to the designer (b)
because of the piercing-the-veil theory?
The designer may be able to hold Alice, Bob, and Carla jointly and severally liable for the debt it is owed from ABC on a “piercing the LLC veil” theory.
Rule
As an alternative basis for holding Alice, Bob, and Carla personally liable for ABC’s debts, the designer could pursue a claim for piercing the LLC veil. Piercing the veil in the LLC context is a common-law equitable doctrine that prevents members from hiding behind the veil of limited liability in situations where they have improperly used the LLC form. See Kaycee Land and Livestock v. Flahive, 46 P.3d 323 (Wy. 2002). To pierce the LLC veil, courts generally apply the same analysis and factors as in cases where a third party attempts to pierce the corporate veil and hold shareholders of a corporation personally liable for firm debts. This requires analyzing whether members have treated the LLC as a separate entity or whether it has instead become the “alter ego” of the members. If the latter is true, members will not be permitted to “enjoy immunity from individual liability for the LLC’s acts that cause damage to third parties.”Id. at 327.Each member for whom the veil is pierced becomes subject to joint and several liability to the creditor bringing the claim.
Application
Among the factors that courts have used under the alter ego doctrine in the corporate context is whether the “dominant shareholder siphoned corporate funds,” a factor also used in the LLC context. See Wilson v. Thorn Energy, LLC, 787 F. Supp. 2d 286, 295 (S.D.N.Y. 2011). In arguing for piercing the LLC veil, the designer will likely assert that the three members of ABC improperly distributed to themselves the proceeds of the asset sale, thus disregarding the separateness of firm and personal finances. The use of business funds for personal use is a frequent factor for piercing in both the corporate and LLC contexts.
Alice, Bob, and Carla, all of whom received the proceeds of the asset sale when ABC was liquidated, will have a difficult time arguing that this distribution was not inequitable. Although they did not misrepresent ABC’s weak financial situation to the designer, their siphoning of assets would seem to be conclusive. See Comment to ULLCA § 304(b) (“key piercing factor” is the disregard of LLC’s “economic separateness” from its owners, such as when owner “writes checks on the company’s account for personal expenses”). In fact, in the corporate context when courts determine that business assets have been intermingled and used for personal use, piercing follows in about 85 percent of the cases. See Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study, 76 CORNELL.L.REV. 1036, 1063 (1991).
In addition, courts have identified the intermingling of personal and business funds as a factor for piercing in the corporate context, as well as in the LLC context. See Sea-Land Services, Inc. v. Pepper Source, 941 F.2d 519 (7th Cir. 1991). The designer might point to Alice’s use of personal funds to pay the concrete supplier and other creditors of ABC, expecting that ABC would later reimburse her. The designer might further assert that Carla and Alice engaged in “fraud” by altering ABC’s financial statements to cover up Alice’s personal payments, as further justification for piercing the LLC veil on equitable grounds.
Nonetheless, Alice, Bob, and Carla may be able to argue that the failure to follow corporate formalities in the accounting of Alice’s “advances of funds” to the LLC (that is, her undisclosed payment of firm debts, subject to later reimbursement) is not enough to pierce the veil. The LLC statutes in most states, including those that follow the Uniform Limited Liability Company Act, provide that “the failure of a limited liabilitycompany to observe any particular formalities relating to . . . management of its activities” is not a proper ground for imposing personal liability on members for debts of the firm. See ULLCA § 304(b). Moreover, because Alice and Carla were trying to keep the business afloat during difficult financial times, Alice’s undisclosed advances of funds did not harm the firm’s creditors, but actually worked to their advantage. In this sense, Alice’s payments could be equated to additional capital contributions to the firm, not the improper siphoning of assets. Thus, taken alone, the off-the-books advances by Alice to ABC might not be sufficient to justify piercing, but this does not “cleanse” the inequitable nature of the distribution of proceeds to the three members when ABC was dissolved while the firm’s debts remained unpaid.
Note
[NOTE: The question specifically asks whether Alice, Bob, and Carla are “personally” liable to the designer and not whether the three might be liable to the LLC as members who consented to an improper distribution by the LLC—that is, a distribution that rendered the company unable to pay its debts as they became due. See ULLCA § 406(a) (imposing liability on members in a member-managed LLC who consent to an improper distribution, as definedin ULLCA § 405).]
[NOTE: California, Idaho, Iowa, Nebraska, Utah, and Wyoming have enacted the 2006 act. (Kansas and Minnesota are considering doing so.)]
