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A Massachusetts appellate court recently pierced the liability veil of a single-member limited liability company because of its failure to keep “corporate records.” According to the LLC Law Monitor, in Kosanovich v. 80 Worcester Street Associates, LLC, No. 201201 CV 001748, 2014 WL 2565959 (Mass. App. Div. May 28, 2014) the Massachusetts Appellate Division, pierced the limited liability veil of a single-member LLC based on only one factor: the LLC’s failure to maintain business records.

Background – Piercing the Corporate Veil

Shareholders and other equity owners of corporations, as a general rule, will not be personally liable for the debts and other liabilities of the corporation. If a corporation owes a creditor money, the creditor cannot seek payment from the shareholders’ personal assets, even when the corporation is owned by only one or two people, because corporations have “limited liability.” This is commonly called the “corporate veil,” or the “liability veil.” Limited liability extends by law to other statutory entities, such as limited liability companies (LLCs), and limited partnerships.

However, under certain circumstance the courts may “pierce the corporate veil” to hold one or more shareholders (corporation), members (LLC) or limited partners personally liable for the debts of the company or partnership. The court may take this action when justice requires, but in doing so, normally considers a number of factors to determine if the company has maintained its separate identity. In Colorado, the factors are:

• whether a corporation is operated as a separate entity;

• commingling of funds and other assets between the company and its owners;

• failure to maintain adequate corporate records or minutes;

• the nature of the corporation’s ownership and control;

• absence of corporate assets and undercapitalization;

• use of a corporation as a mere shell, instrumentality, or conduit of an individual or another corporation;

• disregard of legal formalities and the failure to maintain an arms-length relationship among related entities; and

• diversion of the corporation’s funds or assets to non-corporate uses.[1]

The Massachusetts Case

In the Kosanovich case Milan Kosanovich purchased a condominium from 80 Worcester Street Associates, LLC (WSA), which was owned by Jeffrey Feuerman. WSA agreed to repair any defects in the condominium for up to one year after closing.

During the following year Kosanovich complained of defects, and Feuerman repaired some but not all of the problems. Kosanovich sued WSA and Feuerman for breach of contract, breach of an implied warranty of habitability, and violations of the Massachusetts Consumer Protection Act. At trial the judge ruled in favor of Kosanovich and awarded him $9,000 in damages. The judge also pierced WSA’s veil and found Feuerman personally liable for the damages award.

On appeal the appellate court examined the factors applicable to “piercing the corporate veil” (Massachusetts applies 12-factors, which are similar to the 8-factor test under Colorado law).

Feuerman ran WSA out of his house and his car and he had no bookkeeping records, tax records or returns, checkbook, or records of payments to subcontractors. The Massachusetts appellate court held that was enough to pierce the veil, saying that “Feuerman’s failure to maintain or produce records hindered the court’s ability to establish the twelve factors, including intermingling of assets, thin capitalization, and insolvency…. Feuerman’s failure to maintain business records coupled with his sole ownership and pervasive control of WSA supported the [trial] judge’s decision to pierce the corporate veil.”

Lawyers have an old saying that “bad facts make bad law,” and veil piercing cases often provide facts that cause courts to stretch the law to find liability when justice requires. The Kosanovich case likely fits that model, since undoubtedly Feuerman took all the money out of his company, and didn’t do the promised work, leaving no funds to pay the judgment.

However, the Colorado Limited Liability Company Act contains one key provision that may lead to a different outcome were the Kosanovich case brought in Colorado:

§ 7-80-107. Application of corporation case law to set aside limited liability
(1) In any case in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law.

(2) For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.

There is no similar language in the Massachusetts Limited Liability Company Act, and so a Colorado court could not hold that the failure to maintain business records by itself was a reason to pierce the corporate veil. Nevertheless, even in Colorado, the failure to maintain company records remains a factor that, when combined with one or more other factors showing the company is a mere alter-ego for the owner, will support imposing liability on the owner(s) if justice requires it. In fact, in a 2009 Colorado case, McCallum Family L.L.C. v Winger, 221 P.3d 69 (Colo. App. 2009), the court pierced the liability veil to impose personal liability on a person who was not an owner, director, or officer, but who was a mere employee. In that case, even though Marc Winger was not an owner, director, or officer of the company, the court found that he “managed the entire business” and routinely used company funds to pay his personal bills, and his wife was a director, a 50% shareholder, and president, and his mother was a director, a 50% shareholder, vice president, and secretary. Thus, the court held that the company was his alter ego and that he would be liable for the debts of the company.

Colorado appellate courts have resolved claims under the alter ego doctrine 21 times. In those cases, the corporate veil has been pierced nine times and maintained 12 times; Federal courts applying Colorado law have pierced the veil in seven of 22 cases.[2]

While the Kosanovich case may have not been decided on the same grounds by a Colorado court, a Colorado court could well reach the same result on other grounds; these cases serve as a valuable reminder that the relatively simple requirement of keeping separate company books and records, have annual meetings (at least on paper), and observing basic corporate and governance formalities, remains important to preserving the limited liability that business owners expect when they chose the corporate or LLC form to do business.

[1] Cherry Creek Card & Party Shop, Inc. v. Hallmark Marketing Corp., 176 F.Supp.2d 1091 (D.Colo.,2001); See 1 Colo. Prac., Methods Of Practice § 1:58 (7th ed.), Kathy Stricklan Krendl.

[2] 1 Colo. Prac., Methods Of Practice § 1:58 (7th ed.), Cathy Stricklan Krendl

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In a little noticed case reported on December 19, 2011, Condo v. Conners, the Colorado Supreme Court issued a decision on a common contract drafting problem – the effect of an anti-assignment clause.

Historically, when contracting parties wanted to prohibit each other from assigning the contract, a lawyer would include language reading something like: “A party shall not assign, sell or otherwise transfer its rights under this agreement without the written consent of the other party.”

Back in the day, that language accomplished the parties’ intent, because courts held it meant that a party did not have the power to assign a contract, and any assignment without consent would be void and treated as though it never happened. That is the “classical” or “historical” rule.

Over the last 10-20 years, a new rule has developed; some courts have held that language prohibiting assignment does not mean the parties can’t assign, it means that if they do it is a breach of the contract, but the assignment still stands. The foundation of the new rule is a public policy that the law favors assignability of contract rights. Under the new rule if a party assigns the contract without consent and in breach of the contract language, the other party could not bring an action to void or ignore the assignment, but could only bring an action for damages – a very bad outcome for someone who simply doesn’t want to be in a contract with a party he didn’t chose! Moreover, in most situations it is very difficult to measure and prove damages arising from a prohibited assignment.

Anti-assignment clauses are found in many types of contracts, but are particularly important in contracts where people are going into business together, like partnership agreements, joint venture agreements and limited liability company operating agreements. For example, if three people decide to join-up and start a business, they are usually counting on one another to contribute some special area of expertise, to invest time and money, and to be there for the others, at least until the business is established. They do not want to suddenly find they have a new business partner because one of them sold his interest or transferred it in a divorce, and that is exactly what happened in this case.

In Condo v. Conners, three people formed a Colorado limited liability company and signed an operating agreement that said “a member shall not sell, assign, pledge or otherwise transfer any portion of its interest in [the Company] without the prior written approval of all of the Members”. One of the members got a divorce, and as part of the divorce settlement he tried to assign his membership interest to his wife. The other two members did not consent, so he assigned his wife only the right to receive distributions, and also agreed to follow her instructions when voting his membership interest. When he later sold his membership interest to his partners, his ex-wife sued to void the sale and enforce the earlier assignment to her.

The outcome of the case hinged on the new rule versus classic rule debate – if the new rule applies, the assignment to the ex-wife in violation of the operating agreement is not void, but the two partners would have a breach of contract claim against the husband – the wife wins. If the classic rule applies, the wife loses because the assignment to the wife in violation of the operating agreement would be void and treated as though it never happened.

The dispute made it to the Colorado Supreme Court, where the wife argued that a Colorado LLC operating agreement should not be interpreted under contract law, but rather as a formation or governing document like corporation articles or bylaws. Fortunately, the Supreme Court disagreed. Looking to Delaware case law, In re Seneca Invs. LLC, 970 A.2d 259 (Del. Ch. 2008), the Supreme Court held that operating agreements are contracts and shall be interpreted under prevailing contract law. This part of the decision is important because limited liability company acts are divided into two categories: (1) those with extensive default rules governing the conduct of the company’s governance (like corporation acts), and (2) those with very few or no default rules, leaving all or most matters to the contract between the members (contractarian acts). The Delaware Act follows the contractarian view, and several years ago Colorado changed its limited liability company act to remove most of the default rules and became a contractarian act similar to the Delaware model. A holding by the Supreme Court that an LLC operating agreement was something other than a contract would have undermined the intent of the Colorado legislature in overhauling the LLC Act, and diminished one of the primary benefits of an LLC – the flexibility to constitute, govern and operate your company in the manner you wish, without extensive statutory constraints.

However, the Supreme Court also recognized that an LLC operating agreement is different from the average commercial contract, because it has a statutory scheme at its foundation – the Colorado Limited Liability Company Act. Each operating agreement must be interpreted as a contract, but within the language and requirements of the act. For example, the husband’s operating agreement prohibited assignment of “any portion of” the membership interest. The Supreme Court looked to C.R.S. Sec. 7-80-102(10), which says that a membership interest in an LLC includes the “right to receive distributions”, and C.R.S. Sec. 7-80-108(4), which requires the courts to give “maximum effect” to the operating agreement. Since the right to receive distributions is part of a membership interest, and the husband assigned his right to receive distributions, then he assigned a “portion” of his membership interest, in breach of the operating agreement.

In light of the breach, the court had then to decide whether to apply the modern rule and let the assignment stand anyway, or apply the classical rule and void the assignment. So, when faced with the opportunity to say which rule applies to contracts in Colorado, the Supreme Court…………punted. Instead of adopting a hard and fast rule for the interpretation of anti-assignment clauses, or even anti-assignment clauses only in operating agreements, the Supreme Court held that either rule might apply to a contract under Colorado law, and which rule applies can only be determined by discerning the intent of the parties and the facts of a specific case. In THIS CASE, the Supreme Court applied the classical rule, holding the assignment by the husband to his wife was void because the language of the operating agreement, read in conjunction with the language of the statute, indicated that the parties wanted to restrict who they would do business with and prevent any assignment without consent. The ruling implies that similar language in other operating agreements might be interpreted the same way, but it is not a rule. Moreover, the court specifically said it was not rejecting the modern rule, which might apply to other contracts, including other operating agreements, if the facts and intent warranted.

The lessons from this decision are not new. Courts seldom adopt a hard and fast rule when it is unnecessary to decide the case before them – doing so often invokes the law of unintended consequences, and restricts the flexibility of courts to fashion justice in other cases. It is up to the parties to say what they want. Since at least 2003 and possibly earlier, legal commentators have been advising lawyers who want to strictly prohibit assignment of a contract to address this very issue. In Negotiating and Drafting Contract Boilerplate (ALM Publishing 2003), Tina Stark dedicates an entire chapter to this issue (Chapter 3, Assignment and Delegation).

Recommendation

An anti-assignment clause in an important contract should not be thrown in as “standard language” or culled from form boilerplate. If you might want to assign the contract or certain rights or obligations in the future, but don’t want to raise the issue during negotiations, then vague language of the type used in Condo v. Conners may be best – leave that fight for another day. But if it is important to you that the contract not be assigned, language of the following type will avoid the type of analysis and uncertainty reflected in Condo v. Conners:

No party may assign its rights or delegate its obligations under this Agreement, without the written consent of the other party. Any purported assignment or delegation in breach of the preceding sentence shall be void.

Problem solved!

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