The ‘limited liability company’, like the corporation, is a creature of state law. The first states to adopt the LLC as a form of business organization did so less than 20 years ago. Other states followed after the American Bar Association drafted a proposed uniform law for LLCs, and by the late 1990’s a majority of the states had laws allowing for the formation of LLCs. This is a relatively short time ago yet the LLC has been become quite popular as a form of organization for start-ups and businesses with a small number of owners. Many new businesses are now set up as LLCs rather than corporations. There are two reasons for this. First, an LLC offers pass-through tax treatment without the added complexity of a Subchapter S election or the restrictions on Sub S share ownership. (An LLC can elect to be treated as a corporation for tax purposes but in the absence of such an election, pass-through tax treatment applies.)
The second advantage of an LLC is the absence of corporate formalities. An LLC can be managed by its members (owners) or by appointed managers. There is no specific requirement in state LLC laws for the election of officers or the holding of periodic meetings of members or managers. One might even say that state law leaves the matter of ‘corporate’ governance to the members. To the extent the members adopt governance procedures, they are typically set out in an Operation Agreement for the LLC that establishes many of the rights and obligations of the members and, if applicable, the authority of the managers.
In effect, the LLC is like a general partnership. However, unlike a general partnership, the LLC offers limited liability to the members, i.e., the members are not personally responsible for the debts or other liabilities of the LLC. Their liability is limited to the amount of their investment, as is the case for shareholders of a corporation.
That’s the good news. The bad news is that the absence of corporate formalities that make a LLC attractive also create a vulnerability. With regard to corporations, failure to follow corporate formalities (meetings of directors and shareholders, minute books, etc.) can be one factor in a court’s decision to allow the corporate “veil” to be pierced, thereby allowing a creditor or plaintiff to reach the personal assets of the shareholders. But the converse is true as well. If the corporation has a record of observing corporate formalities, it becomes harder to pierce the corporate veil. In the case of a LLC, if on-going organizational formalities are ignored, it deprives the members of one element of a defense when the plaintiff claims that the LLC had no separate identity from that of the members.
We are starting to see court cases that address the issue of piercing the “LLC veil” and this trend is likely to continue.
Connecticut. Last month, in Breen v. Judge, 124 Conn. App 147, 2010, the Connecticut Court of Appeals affirmed the trial court’s decision not to pierce the LLC’s veil. In 2007, Breen, a creditor of Patriot Truck Equipment, LLC sued Judge, the managing member of the LLC, seeking to hold him personally liable for the LLC’s debt. Connecticut law allows an LLC’s veil to be pierced if the plaintiff can show that (i) the defendant completely dominated the LLC’s finances, policies, and business practices, (ii) the defendant used that control to commit fraud, waste or a dishonest or unjust act, or to violate a legal duty, and (iii) the defendant’s conduct caused the injury or loss complained of. The court in Breen listed ten factors relevant to whether an entity is dominated or controlled, and reviewed the relevant factors considered by the trial court. At all times Judge was no more than a 50% owner of the LLC. The LLC was a properly formed company doing business in Connecticut. The LLC followed the various formalities, such as keeping separate books, filing company tax returns, and filing dissolution documents when it dissolved. Based on those factors the court affirmed the trial court’s decision not to pierce the LLC’s veil.
New Jersey. In another recent unreported case, Brown Hill Morgan v. Lehrer, the Appellate Division of the State of New Jersey considered the question of whether the doctrine of “piercing the corporate veil” applied to a limited liability company. The Court said “we can perceive no reason in logic or policy why the principles should not be fully applicable in the context of a limited liability company.” This case supports the proposition that when a party in litigation claims that the corporate (or LLC) veil should be pierced, thereby allowing access to the owners’ personal assets, the court will look at various factors, “including whether or not the company is grossly undercapitalized, the day to day involvement of the company’s directors, officers and personnel,” and whether personnel from affiliated companies fail to distinguish between different entities when conducting operations. Traditionally, a court would also consider whether a corporation failed to observe corporate formalities, lacked corporate records, and merely acted a façade for the owners’ or a parent company’s operations. In a case involving an LLC, the lack of corporate formalities and lack of corporate records would presumably not be negative factors, but that is not to say that having them would not be positive factors. Moreover, “formalities” does not necessarily mean formalities required by state law. If the Operating Agreement for the LLC says that there will be an annual meeting of members, then the annual meetings should be held and minutes should be maintained as a record of those meetings.