Limited Liability Limited

Limited liability companies went mainstream in 1988, began to capture the market for closely held businesses in 1997, and now have the lion’s share of that market. Since the advent of limited liability companies, a corporate-like liability shield, in addition to pass-through status under federal income tax law, has been one of two hallmarks of a limited liability company. Indeed, for many years courts have described the limited liability company as “a hybrid business entity [that] provides members with limited liability to the same extent enjoyed by corporate shareholders.”

The LLC shield should therefore be easy to understand: a limited liability company shields its members in essentially the same way as a corporation shields its shareholders. Yet courts and practitioners still occasionally misunderstand the intended purpose and proper effect of the LLC shield.

The two poster children for this problem are Dass v. Yale, a decision of the Illinois court of appeals, and SDIF Limited Partnership 2 v. Tentexkota, an action brought in federal district court in South Dakota. Dass held that the LLC shield immunizes a member-manager for direct liability for the member’s own tortious conduct. In Tentexkota, members of a South Dakota limited liability company sought to escape their personal guarantees of the LLC’s debt by arguing that the LLC liability shield invalidated the guarantees. The federal court rephrased the guarantors’ argument as a question and certified the question to the South Dakota Supreme Court.

Both cases turned on what the relevant statutory language did not say. In Dass, the court noted that “the language of the [Illinois] LLC Act [had been] changed by removing language explicitly providing for personal liability,” pointed out that “[g]enerally, a change to the unambiguous language of a statute creates a rebuttable presumption that the amendment was intended to change the law,” ignored the possibility that the deleted language had been redundant, and allowed the rebuttable presumption to override the plain meaning of the Illinois shield language. The defendants in Tentexkota argued that the South Dakota shield language should be interpreted as invalidating personal guarantees, in part because South Dakota had failed to revise its shield language (derived from the first Uniform Limited Liability Company Act) in accord with revisions made in 2006 by the Revised Uniform Limited Liability Company Act).

Neither Dass nor Tentexkota are still at issue. This year, Illinois legislatively abrogated Dass, and Tentexkota settled before the South Dakota Supreme Court answered the certified question. However, the problem illustrated by these cases remains. Hence this article, which seeks “to make clear beyond peradventure” the proper purpose and intended effect of the LLC shield.

The analysis is necessarily rooted in history and begins with sole proprietorship and ordinary general partnerships:

Fully understanding the LLC shield requires understanding owner liability in sole proprietorships and ordinary general partnerships, the two principal structures for doing business that predated the advent of corporations. In both these structures, owners are personally liable for the debts of the business merely on account of being an owner. It was the purpose of the corporation to negate that status liability[,] …. sever the relationship between owner status and personal liability[,]… and to do nothing else.

From this perspective, two fundamental points are clear. As a matter of concept, the liability shield follows ineluctably from an entity’s status as a legal person separate and distinct from each and all the entity’s owners. Because in general one person is not responsible for the obligations of another, “[t]he ‘separate entity’ characteristic is fundamental to a limited liability company and is inextricably connected to … the liability shield.” ULLCA (2013) § 108(a), cmt.

In practical terms, the liability shield’s sole function is to negate the automatic “pass through” liability that owners once had for the obligations of their business. Thus, the shield has nothing to do with liability arising from a person’s own conduct in connection with an entity’s business—whether that person is an owner, a manager, an employee, an independent contractor, or otherwise.

Because the member or manager liability at issue is solely vicarious, the shield is irrelevant to claims seeking to hold a member or manager directly liable on account of the member’s or manager’s own conduct. Put another way, “[t]here is no question” that “the member-manager of a limited liability company who causes his business to breach common law and statutory duties may be held independently liable for his personal torts.”

The official comments to ULLCA (2013) contain several examples of this proposition, including one applicable to law firms in particular:

EXAMPLE: A limited liability company provides professional services, and one of its members commits malpractice. The liability shield is irrelevant to the member’s direct liability in tort. However, if the member’s malpractice liability is attributed to the LLC under agency law principles, the liability shield will protect the other members of the LLC against a claim that they must make good on the LLC’s liability.

Put another way:

A Tort Is a Tort Is a Tort—Being an agent does not immunize a person from tort liability. A tortfeasor is personally liable, regardless of whether the tort was committed on the instructions from or to the benefit of a principal. A tortfeasor cannot defend itself by saying, “Well, I did what I did to serve my principal.”

Likewise, when a member makes a contract in the member’s own name, the member’s contractual obligations are outside the shield—even if the contract’s purpose is to benefit the company. For example: “A manager personally guarantees a debt of a limited liability company. [The liability shield] is irrelevant to the manager’s liability as guarantor.”

One additional, very practical point warrants mention—namely, role liability. “Provisions of regulatory law [both state and federal] may impose liability on a member or manager due to a role the person plays in the LLC.” In some instances the liability results from conduct, in others from status or position (e.g., more than 10% of the existing ownership interests), in others from a combination.

In any event, when “role liability” is at issue, the LLC shield is inapposite, because the liability is not “of a limited liability company” and almost never arises “solely by reason of the member acting as a member or manager acting as a manager.”

A New York case, Pepler v. Coyne, provides a good example. A limited liability company terminated an employee, the employee sued the company for unlawful termination on the basis of disability, and named the two manager-members of the company as individual defendants. When one of the member-managers (Coyne) invoked the LLC liability shield as a defense and moved to dismiss, the trial court granted the motion. The appellate court reversed:

Coyne’s contention that he is personally exempt from liability by virtue of [the LLC shield] is without merit. The general statutory exemption [under the LLC statute] from personal responsibility for an organization’s debts, obligations and liabilities does not extend to violations of [the anti-discrimination statute] by a person with an ownership interest in, [and] the power to make personnel decisions for, the organization. Thus, Coyne is amenable to liability upon proof that he became a party to Stone’s discriminatory termination of plaintiff “‘by encouraging, condoning, or approving it.’”

Finally (though contrariwise), the corporate and the LLC shield may differ in one important respect—that is, whether disregard for “entity formalities” is grounds for disregarding the liability shield and “piercing the veil.” This topic is somewhat complicated, and a future column will discuss the issue in some detail. In the meantime, you can hear the topic discussed as part of a panel discussion at the ABA Business Law Section’s 2019 Annual Meeting in Washington, D.C. —“10 Things Corporate Lawyers Must Understand about How a Limited Liability Company is NOT a Corporation” (Thursday, September 12 from 2 to 3:30 PM, Salon 1, M2).

But otherwise, as per a decision of the 11^th Circuit: “The limited liability company (LLC) is a … hybrid form of business entity that combines the liability shield of a corporation with the federal tax classification of a partnership.”Thus, consistent with the LLC shield’s corporate law antecedents, the LLC shield’s proper purpose is to disallow purely status-based member liability for an LLC’s debts. The effect of the LLC shield should be limited accordingly.