Limited Liability Company Considerations for Conducting Business: A Top Five List

Formation of a limited liability company (“LLC”) is a popular and viable alternative to a corporation or a partnership. An LLC features both the limited liability of a corporation and the tax advantages of a partnership. In addition, the LLC model offers great flexibility in choosing the appropriate rules to govern unique businesses, including the option for centralized or decentralized management structures.

This Insight highlights some of the key considerations to keep in mind while conducting business as a limited liability company. Observance of these considerations, which are not exhaustive, will greatly enhance the likelihood that members of the LLC will enjoy the intended benefits and the purposes for which the LLC was formed.

I.          Standing/Authority to Sue

In order for an LLC to enforce any claims it has in court, it must establish standing/authority to sue.^[1] Generally, to have standing in a particular state, the LLC must be registered to transact business in that state and do such things as are necessary to remain in good standing in that state (e.g., file an annual report and pay taxes).^[2]   In some cases, courts have dismissed lawsuits where a company has failed to file an annual report.^[3]  Additionally, failure to pay taxes may result in the company lacking good standing and therefore lacking capacity to sue.^[4]   Therefore, to ensure that the LLC can enforce any claims it has in court, it should be registered to transact business in all states where it would potentially need to enforce such claims and should comply with all statutory requirements (e.g., filing annual reports and paying taxes).^[5]

II.        Nature of LLC; Mischaracterization of LLC

Sometimes, signatories for limited liability companies mistakenly sign contracts without using the “LLC” designation.^[6]  In such cases, some courts will construe the company as a partnership instead of an LLC. This may result in personal liability for the members of the LLC, which effectively destroys any protection from liability that was intended by formation of the LLC. Therefore, contracts signed by the company should always include “LLC” or “Limited Liability Company” as appropriate.

III.       Limited Liability of Members and Managers; Personal Liability under Agency or Other Law

As mentioned above, an LLC generally shields its members from liability for the company’s obligations.^[7]  However, there are circumstances in which members may be held personally liable for the LLC’s obligations. Here are a few examples:

1. If a member has an oral side agreement to reimburse the LLC for payments made on a note, which he signed in his capacity as a member of the LLC, the individual may be held personally liable.^[8]
2. When signing contracts or other obligations, members should always include their title (e.g., Chief Executive Officer) and the LLC’s name. This will ensure that any breach of contract claims against the member individually will be dismissed, especially when there is no evidence that the member intended to be personally liable.^[9]  Any contractual obligations assumed by the LLC belong to the entity, not the individual signatories or the LLC’s members.^[10]  Individuals who sign a contract that indicates title but does not name the LLC, can bind themselves (instead of the LLC) on the contract by virtue of the individual’s failure to respond to a request for admissions.^[11]   If the signature block of the contract states the name of the company without the “LLC” designation, a court may still consider the variance too insignificant to find the individual signatory personally liable.^[12]   This finding is further bolstered if there is no evidence that the other party to the contract was ever misled about the company’s identity as an LLC.^[13]  However, a person who knowingly omits “LLC” in the signature block is liable for any indebtedness, damage, or liability caused by the omission.^[14]  Even when an individual signs a contract as president of the LLC, a court may hold the individual personally liable if the contract includes personal guarantee language.^[15]  The bottom line: (1) contracts should never include personal guarantee language and signature blocks should always include (2) the signing person’s title and (3) the company’s name, including the “LLC” designation.
3. Members of an LLC who personally participate in tortious conduct (bad acts) of the company may be held personally liable for the consequences of their conduct.^[16]   Members or managers may be personally liable if they, in their individual capacities, damage someone else’s contractual or business relationships.^[17]  For example, if a member makes a down payment under a contract of the LLC to purchase real estate and uses a personal check that bounces, he is personally liable for the bad check.^[18]  An agent or an officer who participates in the commission of a tort is liable whether or not he is acting on behalf of another or the LLC.^[19]  Even if officers and agents of the company are not participating “hands on” at every step, they may be held personally liable for violations.^[20]  This liability is not based solely on their membership in the LLC. Rather, it is the fact that they are present and participating in the operations of the company while a violation is being committed (either by them or the company) that incurs the liability.^[21]  The LLC’s members are not, however, always liable for bad acts of another person associated with the company: if an employee commits a tort without approval or knowledge of the member, then the member may remain insulated by the LLC.^[22]
4. As for negligent conduct, a manager of an LLC may be held personally liable for approving, directing, actively participating in, or cooperating in the company’s negligent conduct.^[23]
5. An LLC’s officers may be held personally liable if they are acting on behalf of the company, and the company, through bad faith misrepresentation, breaches a contract.^[24]

IV.       Piercing the Veil

Generally, limited liability companies are treated as independent legal entities. Therefore, as noted previously, the LLC status shields members with ownership interests in the company from being held personally liable for the liabilities of the LLC. However, under certain circumstances, the legal concept of “piercing the corporate veil” allows for a member of the company to be held personally liable for the company’s liabilities.

For a party to successfully pierce the LLC veil, he or she will usually have to prove that the LLC ignored formalities and protocols, such as voting to approve major actions in a duly authorized meeting, or otherwise failed to comply with the terms of the company’s operating agreement.

A. Instrumentality Theory

Delaware law imposes a high threshold to pierce the LLC veil.^[25]   However, in cases where the veil has been pierced, Delaware courts have often adopted an “instrumentality” theory. This occurs where a company is an extension of an individual, such as where an individual uses a company to make gifts to others. Generally, prevailing under this theory requires a showing of control over the company in a way that caused harm, either through wrongful acts or fraud.^[26]  Factors that may lead a court to pierce the veil include failure to follow formalities (comply with operating agreement requirements for approval by vote of transactions), overlapping ownership and management, common office space, lack of arm’s length dealing, preferences exercised in favor of family owned entities, unity of interest, or lack of independence and injustice/inequity.^[27]  Additionally, the veil may be pierced when there exists a lack of sufficient funds for the company to operate, coupled with evidence of intent, at the time of funding, to avoid payment of future debts of the company.^[28]

Satisfaction of only one or a few of these factors, however, will not necessarily result in piercing the veil. For example, some courts have stated that any lack of formalities must lead to some misuse of the LLC form to justify piercing.^[29]  Additionally, from a totality of the circumstances perspective, even where some formalities are not strictly followed, evidence that other formalities were followed (e.g., filing papers, making loans, having a bank account and operating in the company’s name) can help prevent an LLC’s corporate veil from being pierced.^[30]  Finally, one court has stated that members of an LLC are not personally liable when they follow company rules, refrain from commingling personal funds with company funds, do not borrow or use company assets for their own purposes, and do not exercise greater control than any managing members of a company.^[31]

B. Alter Ego Theory

Another approach to piercing the veil is the “alter ego” theory. Many states have adopted this theory, and typically apply it when a corporation (or LLC) is deemed merely a front for another entity. Although Delaware courts often adhere to the “instrumentality” theory of veil piercing and the Delaware Supreme Court has not expressly adopted the alter ego theory, lower courts in the state have applied the latter on multiple occasions.^[32]   Additionally, one of the most authoritative passages on the alter ego theory was written by a Delaware judge applying a federal standard. She wrote that the alter ego analysis:

includes whether the corporation was adequately [funded] for the corporate undertaking; whether the corporation was solvent; whether dividends were paid, corporate records kept, officers and directors functioned properly and other corporate formalities were observed; whether the dominant shareholder siphoned corporate funds; and whether, in general, the corporation simply functioned as a façade for the dominant shareholder … [N]o single factor could justify a decision to disregard the corporate entity, but that some combination of them was required and that an overall element of injustice or unfairness must always be present, as well.^[33]  Despite Delaware’s mere implicit adoption of the alter ego theory, courts in other states have applied it to Delaware companies in actions pending in their jurisdictions. In those instances, to establish alter ego liability, New York courts have required evidence of 1) a single economic unit and 2) injustice.^[34]  Courts have held that a 30% ownership interest is insufficient to make a controlling decision (constituting a single economic unit) in a Delaware company.^[35]

New York case law also integrates the alter ego theory, and may allow for veil piercing “[w]hen a corporation [or limited liability company] has been so dominated by . . .  another corporation and its separate entity so ignored that it primarily transacts the dominator’s business instead of its own and can be called the other’s alter ego.”^[37]  Delaware courts have stated that LLC managers fall under the definition of a fiduciary, as managers are “vested with discretionary power to manage the business of the LLC” and members have an expectation that managers will act in their interest.^[39]

A. Breach of Fiduciary Duties

Generally, managers can avoid breaching the fiduciary duties of loyalty and care by not engaging in self-dealing (conflicts of interest), serving the best interests of the LLC, and informing themselves of all information reasonably available. To prevent against self-dealing, the law imposes a duty of full candor and disclosure by the LLC members when the company takes actions.^[40]  Members are required to maintain loyalty to the LLC and should refrain from taking part in transactions where a majority of the board is interested or lacks independence.^[41]

The law has some measure of presumption, however, that actions by directors are valid. According to the business judgment rule, directors are presumed to act on an informed basis, in good faith, and in the honest belief that the action taken is in the best interest of the company.^[42]  However, to be protected under the rule, directors must first inform themselves of all reasonably available information before making business decisions.^[43]  Finally, members and managers are not personally liable for breach of fiduciary duty to each other, the LLC, or any party to the LLC operating agreement if such breach of fiduciary duty was based on a good faith reliance on the provisions of the LLC operating agreement (unless the LLC operating agreement specifically provides for such personal liability).^[44]  However, they may still be personally liable for breach of contract (the LLC operating agreement), despite their good faith reliance on the contractual terms of the LLC operating agreement (unless otherwise provided in the LLC operating agreement).^[45]

B. Disclaimer of Fiduciary Duties

Case law amongst states, on issues related to fiduciary duty disclaimers in LLC operating agreements, has been generally scarce. However, many limited liability companies find Delaware law particularly appealing because it offers great flexibility in restricting or eliminating managers’ fiduciary duties. Section 18-1101 of the Delaware LLC Act (“Act”) authorizes that:

[t]o the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.^[46]

Recently, New York courts applying Delaware law have provided some clarity to the disclaimer issue. A provision drafted into an LLC operating agreement, which sets forth a specific managerial standard or expectancy, may implicitly limit default fiduciary duties of managers (i.e., the traditional fiduciary duties of care and loyalty that apply by default when the LLC operating agreement is silent on the issue).^[47]  Therefore, an operating agreement provision need not be explicit in order to effectively limit default fiduciary duties. Conversely, lower courts in Delaware have stated that fiduciary duties are owed in the absence of explicit provisions, and the intent to eliminate or limit fiduciary duties must be unambiguous.^[48]

It is worth noting that the Delaware Supreme Court has not definitively ruled whether the Act levies default fiduciary duties.^[49]  Lower courts in Delaware, however, have determined that the Act does impose default duties.^[50]   Notwithstanding the uncertainty, the ideal way to take advantage of Delaware’s flexibility is to carefully craft an LLC operating agreement, with explicit language, which reflects the desired standard for fiduciary duties.

Conclusion

Forming your business as an LLC can offer the benefits of limited liability, favorable tax treatment, and managerial flexibility. However, there are several guidelines that must be followed in order to receive and/or preserve those benefits. To ensure that the LLC operates properly and provides the desired benefits, it is important to follow certain procedures, including filing annual reports, paying taxes on time, using proper signature blocks, keeping minutes of meetings, separating personal money from the company’s money, and observing other formalities.

This is just a guide. Observance of these considerations will greatly enhance the likelihood that the benefits and purposes, for which the LLC was formed, will be realized.

John J. Hanley focuses his practice on first and second lien financings; private placements of debt and equity securities; and the purchase and sale of loans, securities, trade claims and other illiquid assets. His clients include business development companies, specialty lenders, investment banks, hedge funds, actively managed CLOs, special purpose vehicles, and other financial institutions. Read more.

Chae Kim – Chae Kim is a Rimon intern. He joins Rimon for the summer after completing his first year of law school, at California Western School of Law, where he is ranked in the top 10% of his class. As an intern, he supports Rimon Partners by conducting legal research and drafting, reviewing, and revising a wide range of legal documents and correspondence.

Nothing contained herein is to be considered as the rendering of legal advice for specific cases or circumstances. The material herein is intended for educational and informational purposes only.