Personal Liability and the LLC: Insights from State Statutes and Court Decisions
One of the advantages of forming an LLC is the personal liability protection it offers for the personal assets of the members. Because “LLC” is an acronym for “limited liability company,” it is sometimes incorrectly believed that the asset protection offered by an LLC is superior to the protection offered by a corporation; that it is impossible, or at least more difficult, for a creditor or other third party to “pierce” the LLC and hold the members liable than it would be for the same creditor to “piece the corporate veil” and hold shareholders in a corporation personally liable.
As this article explains, state statutes contain different provisions describing the scope of protection afforded to the members of an LLC. Further, given the relatively young age of these statutes, there is not a large volume of case decisions addressing this issue. That said, there appears to be a pattern developing for applying the same principles to LLC members as are applied to corporate shareholders.
A Review of Selected State LLC Statutes
There are two main categories of statutes: those that appear to insulate LLC members and managers from virtually any liability for the debts and obligation of the LLC business, and those that subject LLC members to potential personal liability based on the same standards as corporate shareholders. Here are examples of each type.
The Delaware LLC Act describes a member’s liability to third parties as follows:
“Except as otherwise provided by this chapter, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company.” (§18-303)
Idaho’s Uniform Limited Liability Company Act contains almost identical language and adds this provision:
30-6-304. (2) 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.
In Delaware, Idaho and other statutes adopting this broad protection, it would be difficult to find circumstances where a party would be permitted to pursue personal liability against a member or manager for any claim that arose out of the operation of the LLC’s business.
In stark contrast to the broad protection of these statutes, other state statutes specifically allow for imposing personal liability on an LLC member or manager in certain situations.
California’s Limited Liability Company Act is an example of this second category of state LLC statutes, as shown in the language of Corporations Code §17101 that provides:
(b) A member of a limited liability company shall be subject to liability under the common law governing alter ego liability, and shall also be personally liable under a judgment of a court or for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, under the same or similar circumstances and to the same extent as a shareholder of a corporation may be personally liable for any debt, obligation, or liability of the corporation; except that the failure to hold meetings of members or managers or the failure to observe formalities pertaining to the calling or conduct of meetings shall not be considered a factor tending to establish that a member or the members have alter ego or personal liability … .
(c) Nothing in this section shall be construed to affect the liability of a member of a limited liability company (1) to third parties for the member's participation in tortious conduct, or (2) pursuant to the terms of a written guarantee or other contractual obligation entered into by the member, other than an operating agreement.”
Court Decisions Interpreting the LLC Statutes
It’s instructive to see how a couple of courts have applied these types of statutes to impose personal liability on LLC members and managers, or permit claims for personal liability to proceed in view of the language of such statutes.
An Early Unpublished Decision: Stone v. Hobby
One of the first examples of a court applying the principle of “piercing the corporate veil” to hold members of an LLC personally liable is found in the 2001 case of Stone v. Frederick Hobby Associates II, LLC decided by a Connecticut Superior Court. Here are the salient facts.
The Stones, husband and wife, entered into a sales agreement to purchase a residence that was only partially completed and required various “punch list” items to be finished. The seller was a Connecticut LLC.” The sales agreement contained certain express warranties concerning the condition of the premises, and provided for the completion of the "punch list" items within 60 days of date after the date of the agreement.
Lawsuit Seeks Personal Liability of Members
The Stones later filed a lawsuit claiming the property had substantial defects and the seller failed to timely complete all the punch-list work set forth in the sales agreement. The Stones also alleged that around the closing date the members of the LLC transferred substantially all of its assets, including the proceeds from the sale of the subject property, to another Connecticut LLC, that had the identical members as the LLC that signed the sales agreement.
The Stones asked the court to pierce the corporate veil of the selling LLC so as to hold the second LLC and its two members personally liable, and further requested the court to freeze certain personal assets of the LLC members pending a trial. The court found that the Stones were likely to prevail at trial on the merits and agreed to freeze these personal assets pending the trial.
The Connecticut LLC Statute on Member Liability
The court further noted that Connecticut's LLC statute provides (with certain exceptions) that a member or manager of an LLC is not liable for any debt, obligation or liability of the to any third party, whether arising by contract, tort, or otherwise, solely by reason of being a member of manager of the LLC. However, the court stated that "[t]he limitation on liability provided by incorporation or the formation of a limited liability company is not . . . without boundaries." The court held that the same rationale that applies in connection with piercing the corporate veil also applies in the case of an LLC. Specifically, the court found that certain rules applied in the corporation setting and known as the “instrumentality rule” and “identity rule” could also be applied in the LLC setting.
The “Instrumentality and Identity Rules” of Personal Liability
According to the court, the instrumentality rule requires proof of three elements: 1) complete domination and control of both the entity's policy and business practices; 2) use of such control to commit fraud or wrong, breach of a legal duty, or a dishonest or unjust act (such as using such control to avoid personal liability previously assumed by an individual); and 3) the control and breach of duty must be the direct cause of the injury or loss.
With respect to the identity rule, the court stated that the "[t]he identity rule is generally employed in a situation where two corporations or companies are, in reality, controlled as one entity because of common owners, officers, directors, members or shareholders, and because of a lack of observance of corporate or company formalities between the two entities,” but further stated that "in an appropriate case . . . the rule may also be employed to hold one or more individuals liable."
The court found that both tests were likely to be satisfied to enable the Stones to pierce the corporate veil of the selling LLC to reach the assets of the second LLC and the two members. Here are the main facts that the court pointed to:
- The same two individuals were the sole members of both LLCs, and the LLC’s office was located in the private home of one of the members (although the LLC did not pay any rental for such space).
- The selling LLC never had any assets other than the residential property that the Stones purchased from it.
- At a meeting of the parties to try and resolve the dispute, the attorney who formed the selling LLC on behalf of the two members said "go ahead and sue us [the selling LLC]. There is no money in [it]. Why do you think we set it up as an LLC in the first place?"
According to the court, "[t]his . . . statement evidences an intent on the part of the individual defendants . . . to use the limited liability company as a shield in order to avoid responsibility for contractual obligations owed to the plaintiffs."
- The court further found that the selling LLC had used a number of other, often confusing, names and that the Connecticut transfer tax return executed in connection with the sale of the subject property stated that the grantor was not an LLC and was signed by one of the members in his individual capacity.
It should fairly be pointed out that published decisions in other states have generally required a stronger showing than the court in the Stone case before holding LLC members personally liable. While many courts are inclined to apply the same rules to LLC members as to corporate shareholders for piercing the corporate veil, other courts have typically required a showing of fraud or other conduct more extreme than a breach of a contractual agreement.
There probably is no good reason why the "piercing the corporate veil" doctrine should not be applied to LLCs, at least where the particular fact situation warrants its applicability. There are many decisions in every state where courts have held corporate shareholders personally liable. LLC members and their attorneys are well-advised to learn the lessons from these cases and strictly adhere to the guidelines they provide for avoiding personal liability. These include establishing and maintaining the separateness of the LLC and its members regarding bank accounts, stationery, accounting books and records, and ensuring that all agreements and other documents are signed in the name of the LLC and not by a member as an individual.
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