Tuesday, June 21, 2016

LLC Member Crimes Not Crimes of the LLC (and LLCs Are Not Corporate Entities)

Last week, a federal court determined that an insurance disclosure that asked about an "applicant's" criminal history did not apply to an LLC member's individual criminal past.  In Jeb Stuart Auction Servs., LLC v. W. Am. Ins. Co., No. 4:14-CV-00047, 2016 WL 3365495, at *1 (W.D. Va. June 16, 2016), the court explained: 

“Question Eight” on the [insurance] application asked, “DURING THE LAST FIVE YEARS (TEN IN RI), HAS ANY APPLICANT BEEN INDICTED FOR OR CONVICTED OF ANY DEGREE OF THE CRIME OF FRAUD, BRIBERY, ARSON OR ANY OTHER ARSON-RELATED CRIME IN CONNECTION WITH THIS OR ANY OTHER PROPERTY?” Hiatt, on behalf of Jeb Stuart (who [sic] was the sole [LLC] applicant for the insurance policy), answered, “No.” Hiatt signed the application and left.

As you might imagine, Hiatt had been convicted of "hiring individuals to wreck cars so that he could receive the proceeds from the applicable insurance policies," and, yep, about a month later, the building burned down.  Id. at *2.

The insurance company cancelled the policy because it claimed Hiatt had lied on the application, and Hiatt sued for the improper cancellation of the policy because he did not lie (he prevailed) and for attorneys fees claiming “the insurer, not acting in good faith, has either denied coverage or failed or refused to make payment to the insured under the policy.” Id. at *3.  Judge Kiser determined that not attorneys' fees were warranted: 

Neither party was able to rely on a case on point regarding the issue of whether questions on an LLC's insurance application asking about criminal history applied to the members of the LLC, to the corporate entity, or to both. Although I believe the answer to that question is clear, I am not aware of any other court being called upon to answer it. Therefore, although it was unsuccessful in asserting its defense to Jeb Stuart's claim, West American's position did present a novel legal question. As such, the final Norman factor weighs in favor of a finding of good faith.
Id. at *5.  I'll buy that, though I think it's a stretch. Would the court have thought this was a close call if an employee signed Amazon or IBM instead of Jeb Stuart? I doubt it.  Maybe the court meant that a small business or single-member LLC makes it a closer call?  Should it?  I don't think so. Suppose Jeb Stuart was the claimant, but the property was under water, so all of the recovery was supposed to go to a bank.  Would this tactic be appropriate then?  I would think not, and it would seem "less close," I suspect. Hopefully, this case answering the question will put this to rest, but I don't love it.  Still, I concede it is a plausible interpretation, but wrong, when put in context. 
 
The Judge explains his thinking, stating that "[p]rimarily, as West American argued, the question of whether an LLC has a prior criminal history is, admittedly, confusing." Id. at *4.  As I just noted, I don't think that's remotely true if it's a large entity.  We care about who gets the payment, not who signs, I think. That is, the question is designed to track incentives, not applicants.  Maybe -- maybe -- this is a harder case if the question were about the "beneficiary" or "real party in interest" and not the "applicant." 
 
The Judge notes, "Criminal laws typically target and punish individuals, and the types of crimes addressed by Question Eight overwhelmingly ensnare individuals, not corporate entities." Id.  I'll buy that.  He continues: "Therefore, although the question, by its terms, applied to the applicant (the LLC), a reasonable person reading Question Eight might interpret it to apply to the individuals that make up the LLC." Id.  Perhaps, but not always. Again, now I worry about the size of the entity.  And who the applicant is.  
 
Judge Kiser finished: "Undoubtedly, that is what West American envisioned when it drafted the application, and Question Eight in particular. This factor weighs in favor of West American."  But we construe ambiguity against the drafter for a reason, right?  Is it clear that's what they meant?  I don't know that it is, especially because this appears to be their standard form, not something applying to just this application. 
 
What's clearly wrong is the discussion of Jeb Stuart as "a single-member limited liability corporation ('LLC')." Id. at *1.  (It's a limited liability company.) As are the statements above (did you think I missed them?) calling LLCs "corporate" entities  at Id. **4-5.  
 
On the facts here, this seems like a reasonable outcome, but I don't like the path this is headed down.  That is, this case suggests that it might be reasonable for a sophisticated entity to argue that because "some people" think something.   Even if they knew (or should have known) better.  Even worse, by conflating LLCs and corporations, this case helps reinforce inaccuracies in what "some people" think.

https://lawprofessors.typepad.com/business_law/2016/06/llc-member-crimes-not-crimes-of-the-llc-and-llcs-are-not-corporate-entities.html

Corporations, Joshua P. Fershee, LLCs, Unincorporated Entities | Permalink

Comments

I would think the statute pursuant to which the LLC at issue was organized would provide strong guidance to the court. Most LLC statutes I have looked at make clear that an LLC and its members are separate and distinct "persons", some even prohibit the joinder of both an LLC and a member in the same proceeding. Many explicitly declare the LLC's assets not to be the assets of its members. Then, case law often holds that an LLC is not an alter ego of a member. And, federal bankruptcy courts recognize that ownership distinction in a setting in which the court would otherwise want to grab as many assets as it could. Accordingly, I quite agree that the opinion discussed is unnecessarily reliant on what people think not on what the law requires.

Posted by: Craig Sparks | Jun 23, 2016 4:54:34 AM

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