978-1285770178 Lecture Note BL ComLaw 1e IM-Ch03 Part 1

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whole or in part.

2 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

whole or in part.

1. Limited Liability of Members

Members have limited liability [ULLCA 303].

CASE SYNOPSIS—

Case 3.1: ORX Resources, Inc. v. MBW Exploration, LLC

ORX Resources, Inc., partnered with MBW Exploration, LLC, and others to share the expenses and

profits of a venture to explore and develop a certain tract of land known in Louisiana. Mark Washauer signed

the agreement with ORX on behalf of MBW, which came into existence later. Washauer paid for part of

MBW’s participation with personal checks. When the rest of the payment—more than $84,220—was not

forthcoming, ORX filed a suit in a Louisiana state court against MBW and Washauer. The court pierced the

LLC veil and held the defendants jointly and severally liable. They appealed.

A state intermediate appellate court affirmed. “Piercing the veil of an LLC is justified to prevent the use of

the LLC form to defraud creditors.” Here “Washauer used MBW as a shell and tired to avoid paying a

legitimate debt of the LLC.” Other factors to be used in determining whether to apply the alter ego doctrine

include commingling LLC and member funds, undercapitalization, failure to provide separate bank accounts,

failure to follow statutory formalities for forming the LLC and transacting its affairs, and failure to hold regular

member and manager meetings. All of these existed in the facts of this case (for example, MBW had not held

a meeting in more than a year at the time of this case).

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Notes and Questions

Why is the liability of the members of LLCs limited with respect to the firm’s debts and other

obligations in the first place? The liability is limited to encourage business activity. If the member of an LLC

were liable for the firms’ transgressions and obligations whether or not the member knew of or participated in

those actions, the economic activity of the firm would be severely curtailed. Every act of the company would

arguably need to be approved by every member. In most organizations, this process would slow business to

less than a crawl, while each act and its options and consequences were reviewed.

Are there other rules that apply to corporations that should be applied to LLCs? If so, which ones

and why? If all of the principles that govern corporations should also apply to LLCs, should all

distinctions between these two business forms be done away with? If not, why should any

distinctions be retained?

ANSWERS TO LEGAL REASONING

QUESTIONS AT THE END OF CASE 3.1

1. One of the advantages of the LLC is that its members enjoy limited personal liability for the

company’s obligations. In view of this fact, does the possibility that a court may hold an LLC member

CHAPTER 3: OTHER ORGANIZATIONAL FORMS FOR SMALL BUSINESSES 3

whole or in part.

personally liable for the LLC’s debts reduce the utility of the LLC form of business organization?

Explain. One of the main attractions of the LLC is that it offers limited liability to its owners. If the courts

routinely disregarded the LLC form and held members personally liable, it certainly would diminish the utility

of this organizational form. The courts, though, rarely pierce the veil of an LLC (or a corporation) and only do

so when it would be blatantly unfair to a plaintiff, such as a creditor, to do otherwise. Because piercing the veil

of an LLC is such an unusual occurrence, it is hard to imagine how this possibility could reduce the overall

utility of this business organizational form. Clearly, those who decide to avail themselves of this form of

business must realize that certain requirements must be met if they are to enjoy the advantages, such as

limited liability, that this business form offers. When organizational requirements (such as periodic meetings of

members), capitalization requirements, and requirements concerning the strict separation of LLC funds from

personal funds are not met, it is only fair that the form be disregarded by the courts in the interests of

protecting creditors. Indeed, if the members of the company themselves disregard the basic requirements of

doing business as an LCC, why shouldn’t the court also be able to disregard the LLC form to hold the

members personally liable? If the courts could not do this, it would be unfair to creditors who in good faith

dealt with an LLC that, in fact, was merely the “alter ego” of the member-owner of the business.

2. What does jointly and severally mean in terms of liability? Would ORX prefer that Washauer and

MBW be held personally liable jointly and severally, or that Washauer alone be held personally liable?

Explain. The phrase “joint and several liability” is usually associated with the partnership. In the context of a

partnership, the phrase means that each partner is can be held jointly liable for the partnership’s obligations,

as well as liable for the full amount of a partnership debt. Here, the court held that Washauer could be held

personally liable jointly and severally with MBW. In other words, Washauer and MBW could be jointly

responsible for the LLC’s debt, or, alternatively, each entity could be fully responsible for the obligation.

Holding that Washauer and BMW were jointly and severally liable was probably advantageous for ORX,

because ORX could look to both entities for payment and thus have a greater chance of recovering the full

debt.

3. How might members of LLCs avoid the liability to which Washauer was subject in this case?

Normally, the liability of the members of a limited liability company (LLC) is limited to the amount of their

investment in the firm. A court can make an exception to this limited liability and hold a member personally

liable if the member undercapitalizes the firm, uses it to commit fraud, commingles personal and LLC funds,

fails to observe required formalities, or otherwise treats the LCC as his or her “alter ego.” All of these

circumstances existed here. (For example, MBW had not held a meeting in more than a year at the time of

this case.)

Thus, if a future member of an LLC wishes to avoid the liability imposed on the member in this case, one

option is to carefully observe the formalities for setting up and maintaining the LCC as a business

organization apart from its members’ personal interests. The members might limit each other’s access to, or

use of, company funds, for example. Also, a member might want assurance that the firm is viable and the

other members are trustworthy by, for example, requiring a certain level of financial investment in the

business.

4. MBW appears to have been a one-member LLC. If the firm had had more members, how might that

have affected the result in this case? The numbers of members would not likely have changed the result in

this case, although it certainly would affect the number of parties from which ORX could seek to recover. If all

whole or in part.

ADDITIONAL CASES ADDRESSING THIS ISSUE —

Other cases in which courts were asked to “pierce the veil” of a limited liability company (LLC) in–

clude the following:

• Hollowell v. Orleans Regional Hospital, 217 F3d 379 (5th Cir. 2000) (under Louisiana law, the LLC veil

may be pierced where the LLC is operating as the alter ego of its members or where the members are

committing fraud or deceit on third persons through the LLC).

• GMAC Commercial Mortgage Corp. v. Gleichman, 84 F. Supp.2d 127 (D.Me. 1999) (in a piercing claim

involving a one-member LLC, the court applied corporate concepts without considering whether the LLC

entity warranted any different analysis and stated that, where one company pays a major obligation of another

and both are owned by the same person, that payment may evidence domination).

• Ditty v. CheckRite, Ltd., 973 F.Supp. 1320 (D.Utah 1997) (that a person played an active role in the

company’s business “is, at best, only marginally probative of the factors considered when determining

whether to pierce the [LLC] veil”).

• Hamilton v. AAI Ventures, L.L.C., 768 So.2d 298 (La.App. 1 Cir. 2000) (in a suit involving an LLC, the

court invoked the corporate piercing doctrine: “applying the jurisprudence applicable to limited corporate

liability, we note there are limited exceptions to the rule of non-liability of shareholders for the debts of a

corporation, whereby the court may ignore the corporate fiction and hold the individual members or member

liable”).

commingles personal and company funds or fails to observe company formalities.

3. Other Similarities to Corporations

LLCs are entities apart from their owners. An LLC can sue or be sued, enter into contracts, and

hold title to property [ULLCA 201].

name must include an LLC designation.

2. Preformation Contracts

With respect to the preorganization contracts of LLCs, courts generally apply the well-established

principles of corporate law relating to preincorporation contracts.

whole or in part.

CHAPTER 3: OTHER ORGANIZATIONAL FORMS FOR SMALL BUSINESSES 7

members of an LLC. Presumably, a manager of a manager-managed LLC always has a fiduciary duty to the

company, just as any manager of any business organization has a fiduciary duty to the company or

partnership. The issue is whether individual members of an LLC can sue a manager for not acting ethically in

the best interests of each member. The members can avoid this issue to some extent by specifying in detail in

the management contract what the duties of the manager are.

ANSWER TO “WHAT IF THE FACTS WERE DIFFERENT?”

QUESTION IN CASE 3.2

Suppose that Leslie owned a majority in Polk Plumbing. Could his “firing” of Dusty and Lezanne

still be considered evidence of a breach of fiduciary duty? Explain. Yes. Leslie’s firing of Dusty and

Lezanne would be subject to consideration of a breach of fiduciary duty even if Leslie owned a majority of the

shares in the LLC. The operating agreement provides for such a “recall or replacement” only on the vote of a

majority of the members—not at the behest of members holding a majority of the shares.

ANSWER TO “THE LEGAL ENVIRONMENT DIMENSION”

QUESTION IN CASE 3.2

Under what circumstances might the employment–at–will doctrine apply to the members of an

LLC? The members of an LLC could be subject to the employment at-will doctrine if they worked for the firm

and the operating agreement did not restrict the conditions of their discharge, as in this case. Employee

members of an LLC could then be discharged for any or no reason if (1) there were no express or implied

contract terms that limited their dismissal; (2) there was no tortious conduct supporting an action for wrongful

discharge; or (3) there was no ground for making an exception on the basis of public policy.

C. THE LLC OPERATING AGREEMENT

• Whether the death or departure of a member will trigger dissociation or dissolution (or both).

• Formal members meetings.

• The apportionment of voting rights.

1. State Statutes Fill in Gaps

whole or in part.

10 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

economic purpose. Venture Sales was formed to develop a subdivision. More than a decade later, however,

the LLC’s property remained undeveloped. Because the LLC was not meeting its purpose, dissolution was

warranted.

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Notes and Questions

What does the outcome in this case suggest to potential members of LLCs who want to avoid the

dispute in which Venture Sales became embroiled? If a future member of an LLC wishes to avoid the

dispute that developed among the members of the LLC in this case, one option is to act on a firm’s “economic

purpose” within a reasonable time. A member might obtain assurance that a firm is viable and the other

members are willing to act to further its purpose by, for example, requiring a level of financial investment in

the business greater than the size of the contributions by the parties here.

It might be argued that Fordham and Thompson violated their fiduciary duty of care by not acting

on the LLC’s economic purpose in a timely manner. Does the manager of an LLC always owe a

fiduciary duty to the members? One would think that the principle of fiduciary duties by a manger to the

members of an LLC would go without saying. But, there is a difference between a fiduciary duty to the LLC

and a fiduciary duty to the members. Presumably, a manager of an LLC always has a fiduciary duty to the

company, just as any manager of any business organization has a fiduciary duty to the firm. The issue is

whether an individual member of an LLC can sue the manager for not acting ethically in the best interests of

each member. The members can avoid this issue to some extent by specifying their expectations of the

manager in the operating agreement or other contract.