|July 26, 2011|
ORX Resources v. MBW Exploration, L.L.C. and Mark B. Washauer, a recent case from the Louisiana Fourth Circuit Court of Appeal, establishes that the owner of an LLC may be found personally liable for the obligations of the company.
One of the primary reasons that people form limited liability companies (LLCs) is to insulate themselves from personal liability. Lawyers often advise their clients that there are less “corporate” formalities to observe for LLCs than for corporations, and therefore it will be harder for a claimant to “pierce the corporate veil” and impose personal liability on the owners of the LLC.
That is true, but it is not foolproof. ORX Resources v. MBW Exploration, L.L.C. and Mark B. Washauer, a recent case from the Louisiana Fourth Circuit Court of Appeal (the state appeals court with jurisdiction over New Orleans), establishes that the owner of an LLC may be found personally liable for the obligations of the company.
The case involved an LLC that was an investment vehicle for two members to take an interest in an oil and gas venture. The lead individual was Mr. Mark Warshauer. The LLC defaulted on a payment of $84,220.01, and suit was brought against the company and Mr. Warshauer personally.
First, the court had to decide a purely legal issue: is it legally possible, at all, for a member of an LLC to be held personally liable for the obligations of the company? A federal court decision under Louisiana law had previously answered “yes.” In the ORX Resources case, for the first time a Louisiana court reached the same conclusion.
An LLC is a simpler, less cumbersome legal entity than a corporation, but it nevertheless insulates its owners from liability. The Louisiana LLC law explicitly provides that members of an LLC are not to be held liable for the obligations of the company. The LLC law provides only three specific exceptions to this rule: fraud; breach of professional duty (e.g. legal or medical malpractice); and negligent or wrongful acts outside of one’s capacity as a member of the LLC.
Did the Legislature intend these three categories to be the only possible grounds for imposing personal liability on a member of an LLC? The court decided that this is not the case.
There are several legal theories that have developed through the years for “piercing the corporate veil” of a corporation. One of them is that an owner of the corporation disregards the corporation as a separate entity and treats it as his or her “alter ego.” Under these circumstances, the law does not allow the sham corporation to insulate the shareholder from liability.
The ORX Resources court is the first Louisiana court to apply the “alter ego” theory to “pierce the veil” of a Louisiana LLC.
This, alone, is legally significant because it opens the door for other courts to apply other theories toward a similar result, and it may signify the beginning of the erosion of the barrier to liability that an LLC establishes for its members.
Under Louisiana law, an LLC is a separate and distinct legal “person.” It has its own existence and legal rights. That is the conceptual key to the “alter ego” doctrine. An LLC cannot be treated as an extension of the personal conduct and affairs of its owner. Rather, the owner must act consistently with the idea that the LLC is separate and distinct from himself or herself.
The ORX Resources court applied five factors to determine whether MBW Exploration was really the “alter ego” of Mr. Washauer. Members of Louisiana LLCs will do well to pay attention to these factors, to avoid repeating the kind of conduct that led to personal liability on the part of Mr. Washauer.
1. Comingling funds between the LLC and the member. When Mr. Washauer paid invoices addressed to the LLC on two separate occasions, he did so once with a check from his personal account and another time with a check from another company controlled by him. Neither debt was paid from company funds.
2. Undercapitalization. This factor is closely related to factor #1 above. If the LLC is to have a separate, independent existence, it must have its own funds. In Mr. Washauer’s case, the LLC had no capital at all. The law allows an LLC to be “minimally” capitalized. As the LLC needs funds to pay its obligations, either equity or debt need to be provided to the company, and then used by the company to make the payments. And all of this needs to be documented.
3. Failure to provide separate bank accounts and records. You can see that factors #1, 2 and 3 all are tied together. The LLC must have its own bank account(s). That is where money should go into and come out from the company, to sustain its separate existence and operation. The company should have records to document funds received by the company, both debt and equity, and to document the company’s payment of its obligations.
4. Failure to follow legal formalities. Mr. Washauer conducted business in the name of the LLC for 21 months before the entity was even created. Don’t repeat that mistake. Additionally, when you sign documents, sign them in the name of the LLC, acting through its duly authorized member or manager. When you open accounts, they should be in the name of the LLC. Since the LLC is a legal person that enters into its own contracts, it must always act in its own name, not the name of its member. Put the company name on all correspondence. Endorse all checks in the company’s name. Remember, that is the company’s money being deposited.
5. Failure to hold regular meetings. This one is tricky. Corporations must have meetings of both directors and shareholders. LLCs are not required to have any meetings.
Nevertheless, the persons in charge of the LLC do occasionally need to get together on matters pertaining the company’s affairs, either in person or via a document signed by all (or most) of them. Unless the LLC documents establish a manager with total authority over the company’s affairs, there are still some company actions that fall to the members. The members should sign documentation showing their agreement when the company does take any such action.
In the end, the “alter ego” doctrine gives a court the ability to “pierce the veil” of an LLC if the court feels that justice calls for a member of the company to stand behind its debts. The more egregious the situation, the more likely it is for the veil to be pierced.
The court in ORX Resources never comes out and says so, but one infers that something about Mr. Washauer’s conduct really offended the court. The problem is that one can never know what will offend a court.
So, if you are participating in an LLC, take the extra effort to follow the recommendations outlined above. In general, act consistently with the idea that the LLC has its own separate existence, and is not an extension of yourself. If you do so, then you will go a long way toward making sure that, unlike Mr. Warshauer, the company’s liabilities remain separate from yours.