Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
1
whole or in part.
2 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
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).
..................................................................................................................................................
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.
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.
..................................................................................................................................................
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.
2 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
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).
..................................................................................................................................................
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.
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.
..................................................................................................................................................
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.
