Tuesday, January 29, 2019

WV Proposal to Eliminate LLC Veil Piercing: Reasonable Concept, Needs A Lot of Work

Back in 2011, I wrote, in a Harvard Business Law Review Online article, that the default rule in analyzing all LLC questions should be one taken from CML V, LLC v. Bax, 6 A.3d 238 (Del. Ch. Nov. 3, 2010): “[T]here is nothing absurd about different legal principles applying to corporations and LLCs.” I still believe that. I further argued:

Where legislatures have decided that distinctly corporate concepts should apply to LLCs—such as allowing piercing the veil or derivative lawsuits—those wishes (obviously) should be honored by the courts. And where state LLC laws are silent, the court should carefully consider the legislative context and history, as well as the policy implications of the possible answers to the questions presented. Courts should put forth cogent reasons for their decisions, rather than blindly applying corporate law principles in what are seemingly analogous situations between LLCs and corporations. [footnotes omitted]

In 2014, I discussed a case West Virginia case in a post here at Business Law Prof Blog, More LLC Veil Piercing Forced into State Statutes. In that post, I was critical of a West Virginia Supreme Court of Appeals decision reading veil piercing into the state's LLC statute.  My main issue with that case, Kubican v. The Tavern, LLC, 232 W.Va. 268, 752 S.E. 2d 299 (2013), was that" Virginia’s veil-piercing test stated more clearly than other states . . .  that corporate formalities are the main issue for the unity of interest test" for veil piercing an LLC. This is problematic because, of course, LLCs don't have many formalities, and none of them are "corporate" (because LLCs are not corporations). 

To be fair, the opinion wisely directed that, for LLC veil piercing, courts  “disregard of formalities requirement.” But the overlay of corporate formalities and corporate traditions remain in the numerous other factors courts are to consider, and thus analysis of the factors are likely to occur with through a decidedly corporate filter.  That's not reasonable or fair for LLCs. 

The West Virginia legislature is looking to remedy this, and overrule the Supreme Court of Appeals, has proposed Senate Bill 258

ARTICLE 3. RELATIONS OF MEMBERS AND MANAGERS TO PERSONS DEALING WITH LIMITED LIABILITY COMPANY.

§31B-3-303. Liability of members and managers.

(a) Except as otherwise provided in §31B-3-303(c) of this code, the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager. It is the intent and policy of the Legislature that for any claim against a limited liability company arising after the effective date of the reenactment of this section during the regular session of the Legislature, 2019, common law corporate “veil piercing” claims may not be used to impose personal liability on a member or manager of a limited liability company, and that the West Virginia Supreme Court of Appeals decision in Joseph Kubican v. The Tavern, LLC, 232 W.Va. 268, 752 S.E. 2d 299 (2013) be nullified.

(b) The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company.

(c) All or specified members of a limited liability company are liable in their capacity as members for all or specified debts, obligations, or liabilities of the company if:

(1) A provision to that effect is contained in the articles of organization; and

(2) A member so liable has consented in writing to the adoption of the provision or to be bound by the provision.

As noted above, I have supported legislative action to allow or disallow LLC veil piercing. Where LLC veil piercing is to be allowed, I have advocated for a clearly stated LLC-specific test. And were veil piercing to be eliminated, I have advocated for legislation making that clear, too.  This proposal has this last option right. 

That said, I have a couple significant objections to the proposed statute, as written.  First, and most significant, the statute could be read to eliminate the possibility of personal liability for any company debt for any member of an LLC.  The proposed legislation seeks to modify the following: "A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager."  By dropping "solely," this proposal appears to limit other potential sources of liability (that are not veil piercing), which are traditionally considered liability related to the actions or a member.  By analogy, the Model Business Corporation Act provides, "(b)  A shareholder of a corporation is not personally liable for any liabilities of the corporation (including liabilities arising from acts of the corporation) except (i) to the extent provided in a provision of the articles of incorporation permitted by section 2.02(b)(2)(v), and (ii) that a shareholder may become personally liable by reason of the shareholder’s own acts or conduct." § 6.22 Liability of Shareholders (emphasis added).  

Where an individual LLC member acts in a way that should lead to liability (promises to pay individually, seek to deceive, etc.), the possibility for direct liability to the member is proper and is generally recognized by even the most ardent advocates of abolishing veil piercing. For example, the most prominent scholar on this front, Prof. Bainbridge, in his article, Abolishing LLC Veil Piercing, "advocates a regime of direct liability: Did the defendant-members do anything for which they are appropriately held personally liable?" I concur.  

[Author's note: the proposed statute was amended today adding "solely" back into the statute.  That amendment occured after I wrote this, but before it posted, so someone else was on it.]

Next, 

It is the intent and policy of the Legislature that for any claim against a limited liability company arising after the effective date of the reenactment of this section during the regular session of the Legislature, 2019, common law corporate “veil piercing” claims may not be used to impose personal liability on a member or manager of a limited liability company, and that the West Virginia Supreme Court of Appeals decision in Joseph Kubican v. The Tavern, LLC, 232 W.Va. 268, 752 S.E. 2d 299 (2013) be nullified.

This is problematic because it applies to all prior negotiated relationships, meaning that contracts would have been negotiated with veil piercing available. This may, in some way, impacted how people negotiated guarantees in contracts.  In a prior post, I criticized the Wyoming high court for making  LLC veil piercing easy and suggesting that laws should not encourage parties to seek guarantees: 

The court cites potential abuse of LLC laws if they were to adopt such a rule that motivates companies to ask for guarantees. instead adopting a rule that could incentivize companies like Western actively avoid ask ingfor guarantees. Why? Because if you ask for a guarantee and are refused, it could be used against you later.  But if you don’t ask, you may get to piece the veil and seek a windfall recovery by getting a post hoc guarantee that was not available via negotiation. 

This West Virginia proposed legislation would likely lead more parties to seek guarantees, which I see as a good thing.  But this is a significant change to the legal landscape, and it seems to me the whole thing should be prospective.  Thus, new interactions, new contracts or renewals, etc., should be under the new law, but that there should be at least some look-back period.  One could argue that a "claim against a limited liability company arising after the effective date" related to a 2014 contract is a claim that "arose" before the effective date because a "claim" is different from a "lawsuit." For me, I would probably amend it to say something like, for events leading to a lawsuit against a limited liability company arising after the effective date . . . .." This would have the added benefit of preserving claims for events preceding the effective date that were not filed or discovered but are still within the statute of limitations.  This seems more equitable to me.  

Anyway, I am intrigued by the concept of eliminating LLC veil piercing, but I think this needs more thought. 

[Author's note 2: The amended language mentioned above added substantial changes to part (c), which I am inserting below.]

An additional amendment now adjusts part (c) t0 read (my comments inserted in  bold):

(c) All or specified members of a limited liability company are liable in their capacity as members for all or specified debts, obligations or liabilities of the company if:

(1) A provision to that effect is contained in the articles of organization; and

 

(2) A member so liable has consented in writing to the adoption of the provision or to be bound by the provision.

(1) A provision to that effect is contained in the articles of organization, and a member so liable has consented in writing to the adoption of the provision or to be bound by the provision; [This is currently item 12 of the West Virginia Secretary of State Articles of Organization of Limited Liability form.] 

(2) The member against whom liability is asserted has personally guaranteed the liability or obligation of the limited liability company in writing; [Good to make this clear, I suppose, though that is a personal obligation that attaches to the indidvudal. This is less necessary with "solely" added back to part (a).]

(3) As to a tax liability of the limited liability company, the law of the state or of the United States imposes liability upon the member; or [Also a personal obligation that attaches to the indidvudal.]

(4) The member commits actual fraud which causes injury to an individual or entity. [True before this law was proposed as a personal obligation that attaches to the indidvudal. The potential problem with this list of items 1-4 is that it may serve to limit or eliminate other forms of personal liablity that existed under prior law.  Hopefully, the "solely" langauge keeps all direct liability intact, but sometimes when a list like this is created, it is also read to mean it is the exclusive list of direct liability available.]

(d) Enterprise liability. — In circumstances where the members of a limited liability company are, in whole or in part, corporations, limited  liability companies, or other entities which are not human beings, then  if a jury shall determine that the liability of a limited liability company sounding in tort arose as part of the activities of a joint enterprise, those entities which are part of the joint enterprise with the limited liability company may be liable for the liability  of the limited liability company which arose as part of the business operations of the joint enterprise, not as a piercing of the veil, but instead under the doctrine of joint enterprise liability. [This is an attempt at preserving the concept of enterprise liability as introduced in Walkovsky v. Carlson. I rather like the idea, but I think this language could be more clear.  I hope to have time to draft proposed changes soon.]

(e) Member as tortfeasor. — Nothing in this section shall immunize or shield a member of a limited liability company, solely because he or she is a member of a limited liability company, from liability for his or her own tortious conduct that proximately causes injury to another party while the member is acting on behalf of the limited liability company.  In such circumstance, the liability of a member is not through veil piercing, but rather primary, as against any tortfeasor. [I like this and think it is critical to make clear. It does run the risk of including things I don't think it always should, such as providing indivdual liablity for a company's business tort claims, such as a toritious interference with contract.] 

(f) Clawback authority. — If a member is proved to have committed any of the following acts, then a creditor of the limited liability company whose judgment the limited liability company cannot satisfy may seek clawback from the member under this subsection: Provided, That the limited liability company’s judgment creditor may proceed in the shoes of the limited liability company [like a derivative suit?] to clawback funds from the member in order to reimburse the limited liability company for either the amount of the judgment against the limited liability company or the amount transferred from the limited liability company to the member in bad faith, whichever is less. [This may work for a business that is on going, but lacks funds for a particular creditor. However, where the LLC is in the zone of insolvency, it could be used to prioritize one creditor over another, possibly improperly.  That is, it appears this intends for the clawback funds to go to the creditor.  Once the funds come back to the LLC, though, it seems to me those funds should still need to be disbursed properly in consideration of all creditors with outstanding claims.]  

 The wrongful acts which will justify clawback (but not veil piercing) are:

(1) Conflicted exchange;

(2) Insolvency distribution; or

(3) Siphoning of funds. 

            (g) Definitions. — As used in this section:

“Conflicted exchange” means a transfer of money or other property from a limited liability company to a member of the limited liability company (or to any other organization in which the member has a material financial interest) in exchange for services, goods, or other tangible or intangible property of less than reasonable equivalent value.

“Insolvency distribution” means a transfer of money or other property from a limited liability company to a member of that limited liability company (or to any other organization in which the member has a material financial interest), in respect of the member’s ownership interest, that renders the limited liability company insolvent.

“Insolvent” means, with respect to a limited liability company, that the limited liability company is unable to pay its debts in the ordinary course of business. Claims that are unusual in nature or amount, including tort claims in claims for consequential damages, are not to be considered claims in the ordinary course of business for the purposes of this section.

“Siphoning of funds” means whether the manager or majority member has siphoned funds from the limited liability company in violation of the articles of organization, the operating agreement, or this article. [I would have hoped that all avenues to recover for improper distributions would remain. I am okay with listing them, as long as none are excluded by creation of the list.]

 That's all for now. This is a pretty big proposal, and it won't surprise me if it passes. If they are committed to it, I sure hope they take the time to get it right. 

https://lawprofessors.typepad.com/business_law/2019/01/wv-proposal-to-eliminate-llc-veil-piercing-reasonable-concept-poor-execution.html

Joshua P. Fershee, Legislation, LLCs | Permalink

Comments

Thanks Josh. This is interesting. To me, there is no principled reason why piercing would not apply in the LLC context. While I agree that the factors for piercing might be different in the two settings (e.g., a failure to follow formalities, as you point out, doesn't fit well in the LLC context), the idea that a member might disregard the separateness of the legal entity is just as applicable in the LLC setting as it is in the corporation setting. It seems to me that if the legislature thinks that piercing is a problem because it is an unpredictable doctrine, then it should abolish it in all settings. Similarly, if it is believed that the doctrine has value, it should be maintained in all settings. But eliminating it from one setting but not another without an explanation of why the eliminated setting is different always bothers me. (This reminds me indirectly of states that cabin in fiduciary duty in the partnership setting, but do not cabin in such duties in the LLC statute. While it is true that different entities do not have to be treated the same, one would hope for an explanation as to why the different treatment is justified.)

Posted by: Doug | Jan 30, 2019 6:05:48 AM

Thanks for the thoughtful comment, Doug. I have to disagree that there is “no principled reason why piercing would not apply in the LLC context.” First, if one thinks the whole veil piercing concept is fundamentally flawed, removing veil piercing from LLCs is a good start. I think one can be principled in seeking to abolish veil piercing in LLCs. To remain principled, one need not say, “all or nothing.” Furthermore, I think there is at least arguably value in seeing how people, the market, etc., respond to LLCs if veil piercing is abolished. Let the entity types be even more different and see what happens. (States as “laboratories of democracy,” and the like.) Are people less willing to do business with LLCs san veil piercing? Insurers?

I agree that an explanation for why is necessary, though I also think courts need to do more explaining than lawmakers (they will end up explaining to voters, one way or another). That is, as I have noted about Flahive previously, the court there simply read in veil piercing even though the statute was silent. I find the simple, “well, corporations have it” to be lacking.

Finally, as to an explanation, I think the LLCs are different from corporations because they lack significant formalities, which was part of the plan. Veil piercing was designed around the idea of a highly formalized entity with a lot of requirements. LLCs were designed to eliminate many of those and thus should be seen through a different lens.

I find veil piercing unsatisfying because it potentially puts at risk for personal liability other members/shareholders who were not wrongdoers. Rarely will a court go down that path, fortunately, but because they won’t, I would prefer to rethink, and perhaps expand, concepts of direct liability. Most cases where the veil is pierced could be decided on fraud grounds, or perhaps even a creative use of agency law (more on that later). Ultimately, I share the concern that some people are using entities to commit bad acts. I am just not at all convinced that veil piercing is having a significant effect in policing those bad actors.

Posted by: Joshua Fershee | Jan 30, 2019 8:23:03 AM

I keep recommending the Texas approach, which is veil piercing only when the entity (of whatever type) is used to commit actual (not constructive) fraud for the personal gain of the shareholder/member. I don’t see any reason why small business owners (who do things like mixing up business and personal) should have any liabilities that public shareholders don’t unless they are engaged in fraud.

Posted by: Frank Snyder | Jan 30, 2019 10:59:14 AM

With all due (in this instance, substantial) respect, the “let the market assess the situation” makes no sense to me. The primary policy reasons for the piercing theory pertain to:

• involuntary creditors; and
• trade creditors that:
o lack the resources and scale of operations necessary to make assessing the risks of non-payment both feasible and worthwhile; and
o the bargaining power necessary to cause a party to consider (let alone provide) a personal guarantee.

In the long run, the WVA legislation may prompt states to consider revising the current statutory deference to the law of the state of formation on piercing claims. For example, compare the current, ubiquitous approach with the language of the Uniform Protected Series Act (adopted already in Nebraska; on its way to adoption in Virginia; pending in several other states):

ULLCA (901)(a) The law of the jurisdiction of formation of a foreign limited liability company governs: … (2) the liability of a member as member and a manager as manager for a debt, obligation, or other liability of the company; ….

and Uniform Protected Series Act sec. 402(c):

(c) This section [stating the piercing rules for a domestic protected series] applies to a claim seeking to disregard a limitation of liability applicable to a foreign series limited liability company or foreign protected series and comparable to a limitation stated in Section 401, if:
(1) the claimant is a resident of this state or doing business or registered to do business in this state; or
(2) the claim is to establish or enforce a liability arising under law of this state other than this [act] or from an act or omission in this state.

Posted by: Daniel Kleinberger | Feb 8, 2019 12:58:21 PM

I think those judges tend to get the right result and recognize fraud and Greenhunter-like "intentional undercapitalization" when they see it. I, however, think that in lieu of veil piercing, we should be using expanded concepts of fraud and misappropriation of funds that attach to the wrongdoer directly.

That said, as to the West Virginia proposal, I agree that it very much ignores the nonconsensual creditor. But the law generally doesn’t tend to worry too much about nonconsensual creditors who are harmed by judgment proof tortfeasors or those with limited resources, so this really starts to call into question how serious we are about the concept of limited liability as opposed to protecting the injured. Instead of veil piercing, again, I am drawn to a broader sense (and availability) of direct liability that attaches to wrongdoers.

As to the idea of letting the market respond, I meant that in the largest sense and to include the market for entity law (as Roberta Romano might call it), which would include the possibility that states would start disregarding state of formation veil piercing law and using (for example) that of the forum state. I very much agree that is a risk. I think those behind the WV have not thought it through very well, and instead think they can compete in the entity law market and become the new Delaware (or Nevada). The motivation does appear, at least, to be something of a race to the bottom. I, nonetheless, think veil piercing could be reasonably be re-thought because of its amorphous and seemingly random applications.

Ultimately, I share the concern that involuntary creditors and others are often not getting what they are due, but I am not very convinced that veil piercing has done a lot to protect most of them. I tend to think we can do better both as to fairness and to doctrine. But then again, perhaps I am being overly optimistic on both fronts.

I very much appreciate the thoughtful comments and insight.

Posted by: Joshua Fershee | Feb 19, 2019 7:47:18 AM

Post a comment