The limited liability company, or “LLC,” combines the flexibility of a partnership with the limited liability of a corporation. It has become in many cases the entity of choice for businesses in the United States. Because of this, LLC issues often arise in lawsuits. This article will examine some of the common issues that arise in litigation related to LLCs.
Some initial background regarding LLCs will be helpful first. LLCs are created by statute. In the U.S., each state has enacted an LLC statute that controls the creation and operation of LLCs. The Uniform Law Commission, a council of practitioners and academics, has created a model LLC statute that many states have enacted in whole or in part.
The members may enter into a contract memorializing their agreement as members and stating how the LLC will be run. This is known as an LLC’s “operating agreement.” The operating agreement can cover all aspects of the members’ LLC operations, including ownership interests, appointment of managers, voting rights, tax treatment, dissolution (or dissolving) of the company, and any number of other items the members may agree upon among themselves. LLC operating agreements may be lengthy or short. LLC statutes often provide that if the members do not enter into an operating agreement, the provisions of the state’s LLC statute become the effective operating agreement for the members.
LLC statutes typically provide that members have limited liability for the actions of the company. At the same time, the LLC entity eliminates many of the formalities required of shareholders in corporations. These dual advantages make the LLC entity attractive to business people wanting maximum flexibility and minimum exposure to liability for company operations.
With this background in mind, this article will next examine common issues that arise in litigation with respect to LLCs.
There are two principal types of actions involving LLCs. The first is among members of the LLC itself. The second is between the LLC and third parties. There are common issues that arise in each scenario.
Actions among members:
Actions among members of the LLC often include disputes over the amount of a member’s ownership interest; contract claims for breach of the operating agreement; and dissolution of the entity. Each of these will be discussed next.
Ownership interests: Disputes over a member’s ownership interest are extremely common. One may ask why, when the operating agreement is designed to set out what the members’ respective ownership interests are. The answers are manifold. Sometimes the parties don’t enter an operating agreement. Sometimes they put one together but don’t sign it. Sometimes there is a dispute about what the operating agreement is. Oftentimes there are allegations that the parties entered into oral agreements instead of or in addition to a written operating agreement. Quite often, the members dispute the value attributed to each members’ contribution. This is especially common if the members contribute something other than money, for example, if the members’ contribution consists of services rather than cash. As often, the members dispute what the contribution was intended to be.
Each of these scenarios plays out again and again in court disputes. The takeaway lesson is simple: pay close attention to preparing and signing a good operating agreement that is complete and covers and addresses what each member’s ownership interest is, what each member’s contribution is, that there are no other agreements among the members other than what are contained in the operating agreement, and that any amendment to the operating agreement must be in writing and signed by the members to be effective. It is a wise investment of resources to engage legal counsel to accomplish these objectives at this stage rather than be required to litigate over them later on at much greater expense of resources.
Contract claims for breach of the operating agreement:
Another common dispute among members to an LLC involves contract claims for breach of the operating agreement. These take many forms but, unsurprisingly, often involve members’ claims that they are not receiving all the funds to which they are entitled under the operating agreement or that another member has received more than the amount to which that member is entitled. Other claims that are advanced are as many and varied as the terms of the operating agreement themselves. They typically entail a claim that a member has violated a specific term of the written agreement. Underlying virtually every such dispute is a monetary dispute, whether or not it appears that way on the surface. This makes sense since the American civil courts system typically concerns itself primarily with compensating claimants for their losses.
A subset of these claims, often advanced as a companion to a breach of contract claim, is a claim for breach of fiduciary duty. These most often appear when the member is also a manager. The manager is tasked with running day-to-day operations of the LLC. The manager owes a special or fiduciary duty to act in the best interest of the company for that purpose. If the manager fails to do so, the members may sue for damages as a result. These claims often appear side by side with contract claims though they arise outside the contract based on a separate duty owed.
Dissolution of the LLC:
One final issue that appears frequently in LLC disputes is that of dissolving the LLC. The operating agreement may provide for events that require the LLC to be dissolved. In addition, LLC statutes typically provide for dissolution of an LLC under judicial supervision if certain requirements are met. The statutes most often provide for such dissolution when there is deadlock among the members or managers or fraud, oppression, or misconduct directed at the complaining member or threatening the viability of the company. If the requirements of the statute are met, the court may order the LLC dissolved and direct that it be wound up. Winding up an LLC consists of marshaling its assets, resolving all claims, paying its creditors, and distributing any leftover assets among its members.
Quite often, the claim that the entity should be dissolved leads to a buyout of the complaining member. This may be done either formally or informally. Formally, many LLC statutes provide for the entity to exercise a buyout right once a dissolution claim is asserted. The operating agreement may also so provide. Informally, regardless whether the statute or the operating agreement provide for it, once members are to a point that they no longer want to work together, cannot break their impasse, and are suing each other, a separation is both inevitable and desirable. In such instances, it makes sense to “divorce” the members from each other and let them go their separate ways. This is often done through mediation or direct settlement negotiations, and typically involves an accountant to value the business or a member’s ownership interest.
Actions by third parties:
Actions by third parties against LLCs quite often involve two types of potential liability for LLC conduct toward third parties: liability of the company and liability of its members. This article will discuss each of these.
Liability of the company:
Actions by third parties against the LLC are common when the LLC has been involved in an underlying transaction. As a simplest example, an LLC may be sued for nonpayment of a bill. When an LLC is sued, the entity, not its members, is the party to the suit. As mentioned, an LLC is a statutory person separate from its members, and it may sue or be sued in its own name in the courts. A member is typically not liable for the obligations of the LLC. The extent of the member’s liability is the extent of its investment in the LLC. Therefore, any claim against the LLC is typically resolved using only the LLC’s assets.
Liability of the members:
Members are not typically responsible for the LLC’s debts or obligations. Occasionally, however, third parties claim that the members themselves should be responsible for the LLC’s obligations. This is most often done by claims that are variably called “alter ego” or “piercing the veil.” The theory behind such a claim is that the member, often a sole member of a one-person LLC, has treated the LLC as if it were merely an extension of the member. This could be the case especially if the member has commingled the member’s own funds with the LLC or used the LLC’s funds for personal items without properly accounting for a draw or, as is often expressed, used the LLC as the member’s own personal bank account. If proven, the member may be held liable to pay the obligations of the LLC. This scenario is therefore an exception to the general rule that a member would not be liable for the obligations of the LLC.
The theories of “alter ego” and “piercing the veil” derive from the law applying to corporations. The law is developing slowly, and some courts have expressed hesitancy to apply to LLCs the case law that applies to corporations with its required formalities and distinctions. Other courts, however, have seen the law as applicable as well to LLCs and have proceeded accordingly. The law in this area continues to develop.
Alter ego law calls for examining various factors to determine whether the LLC is being run as a separate entity. The takeaway is that, even though LLCs provide flexibility and relax the formalities of corporations, it is important to remember that the LLC is separate from its members and should be treated as such as its own self-sustaining entity. Good legal counsel and good accounting practices can contribute to assuring this is accomplished.
In sum, there are certain common issues that present themselves again and again in LLC litigation. This article has identified several of the most common. The variety of these is as endless as the individual LLC, its members, and the unique circumstances that present themselves in LLC disputes. Being aware of them early on can allow members to take preventative action to avoid conflict over these matters down the road.