The same virtues which make the Limited Liability Company (“LLC”) an attractive entity choice for investors — limited liability and few required formalities — also make it susceptible to management choices that may jeopardize the liability shield normally provided for its members and managers.
Potential member/manager liability for debts of an LLC is built into the statute which governs creation of LLCs. CA Corp Code § 17703.04(b) provides that a member or manager of an LLC may be personally liable for the debts, liabilities and obligations of the LLC pursuant to common law alter ego principles “under the same or similar circumstances and to the same extent as a shareholder of a corporation”. A member/manager of an LLC may also be personally liable to third parties (1) for tortious conduct in which the member participates and/or (2) pursuant to the terms of a written guarantee or other contract into which the member enters, other than the operating agreement. CA Corp Code § 17703.04(c) A proviso to § 17703(b) states that failure to hold meeting of members or managers, or the failure to observe formalities for such meetings, may not be considered in establishing alter ego liability unless the LLC’s articles of organization or operating agreement expressly require the holding of such meetings.
Under California case law, alter ego liability arises where two conditions are met: (1) there is such a unity of interest and ownership that the individuality, or separateness, of the person and entity has ceased and (2) adherence to the fiction of separate existence would sanction a fraud or promote injustice. In re Schwarzkopf, 626 F3d 1032 (9 Cir. 2010) (in corporate context); Adobe Sys. v. My Choice Software, LLC (2014) 2014 U.S. Dist. Lexis 161059, at *10-12 (N.D. Cal, San Jose Div), involving an LLC and citing CC 17703.04(b).
The factors that militate toward finding alter ego liability include: (1) commingling of assets, (2) treatment of the assets of the entity as the individual’s own, (3) failure to maintain records, (4) undercapitalization, and (5) use of the entity as a shell for the individual. Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal. App. 2d 828 (1962); Ontiveros v. Zamora, 2009 U.S. Dist. LEXIS 13073, at *7 (E.D. Cal. Feb. 20, 2009).
Under California law, the alter ego liability of members or managers of a foreign LLC doing business in California are governed by the law of the state of the LLC’s formation. CA Corp Code § 17708.01(a)(2). Given that Delaware LLCs are very common, that state’s alter ego rules are of some interest.
Delaware’s alter ego law as applied to LLCs is similar to that state’s alter ego law as applied to corporations. To prevail against an individual shareholder of a corporation under Delaware alter-ego theory, a plaintiff must show a mingling of the operations of the entity and its owner plus an “overall element of injustice or unfairness.” NetJets Aviation, Inc. v LHC Communs., LLC 537 F.3d 168 (2 Cir. 2008). There, the Court of Appeals held that the manager and controlling member of a Delaware LLC could be held personally liable for LLC obligations given evidence showing that he and the LLC “operated as a single entity”. The evidence supporting that conclusion consisted of testimony and documentary evidence showing, inter alia, that the manager/member: (1) undercapitalized the LLC from its formation; (2) used the LLC as an vehicle for personal investments; (3) invested LLC funds in other entities; (4) transferred money back and forth between personal and LLC accounts; (5) used LLC funds for personal expenses; and (6) treated LLC funds transferred to the manager/member as “loan receivables” on the LLC books without any repayment plan or written agreement. (537 F.3d at 180-183).
This e-bulletin was prepared by Daryl G. Parker, Esq., at Pachulski Stang Ziehl & Jones LLP, firstname.lastname@example.org.