Operating LLCs

In Kosanovich v. 80 Worcester Street Associates, LLC, the Massachusetts Appellate Division ruled that a single-member LLC’s veil should be pierced because of poor record keeping.  This case is particularly interesting because it seems inconsistent with previous rules and cases.

Here, the plaintiff bought a condominium from the single-member LLC.  In the agreement between the parties, the LLC was to repair any defects of the condominium within one year of the purchase date.  The LLC then failed to repair some of the defects, and the plaintiff sued for breach of contract and breach of an implied warranty.  The judge not only sided with the plaintiff, but also pierced the veil, holding the member of the LLC personally liable.  On appeal, the court started with the veil-piercing rule which states that the veil should only be pierced to defeat fraud or injustice.  Then, the court listed 12 factors that determine if piercing the LLC’s veil was justified.  These factors include:

• (1) common ownership,
• (2) pervasive control,
• (3) confused intermingling of business assets,
• (4) thin capitalization,
• (5) nonobservance of corporate formalities,
• (6) absence of corporate or LLC records,
• (7) no payment of dividends or distributions,
• (8) insolvency at the time of the litigated transaction,
• (9) siphoning away of corporation’s funds by dominant shareholder or member,
• (10) nonfunctioning of managers, or officers and directors,
• (11) use of the corporation or LLC for transactions of the dominant shareholders or members, and
• (12) use of the corporation or LLC in promoting fraud.

The court noted that when analyzing these factors, the veil-piercing was justified.  In particular, the court looked to the pervasive control and poor record keeping to support the trial court’s decision.  The court suggested that the poor record keeping applied to the other factors, since the LLC member could not provide documents convincing the court otherwise.

This decision seems odd because this case was not regarding fraud or injustice (the reason the court stated that veil-piercing should exist).  Also, the burden of proof in this case seemed to have shifted to the LLC member by suggesting that it was this duty to keep good records to show that the 12 factors weighed in his favor.  Still, one of the ways to prevent a veil piercing is to formally treat the LLC as a business.  This means keeping good books and records, and following the formalities of ordinary businesses.

An LLC’s Operating Agreement can modify basic functions of LLC members or managers.  This includes indemnification clauses which may require the LLC to indemnify members or managers against lawsuits.  In Branin v. Stein Roe Inv. Counsel, a disagreement arose when the LLC amended the indemnification provision.  Unlike the old provision, the new indemnification rules prevented an employee from being indemnified in certain circumstances.  That employee, Francis Branin, filed suit arguing that his original indemnification rights should not be replaced by the new amendment.  The Delaware Court of Chancery agreed.

In this case, Branin was being sued by his former employer for soliciting former clients.  After 10 years of litigation, the charges were eventually dismissed.  In this interim period, the LLC which Branin worked for changed their indemnification clause in the operating agreement.  This second version of the indemnification clause was much more stringent, and would not cover Branin’s $3million legal fees.  The question then became the following: Does the second version of the indemnification preclude the indemnification allowed under the original clause?

The court decided that the first agreement included an enforceable indemnification clause.  Also, after looking to previous cases involving indemnification clauses, the Delaware Court of Chancery ruled that the right to be indemnified vests when the initial lawsuit was filed.  Due to Branin’s right being vested under the first version of the indemnification provision, the second version had no effect.  This shows that LLCs cannot rid their responsibility to indemnify once the provision has been triggered.  Therefore, LLCs should design these types of clauses carefully and not blindly accept a boilerplate indemnification clause which may expose the LLC to more liability than desired.