Even limited liability companies don't offer complete protection

by Heath Alexander

Heath Alexanderpractices with James, McElroy & Diehl PA in Charlotte. He received a bachelor’s in business administration from UNC Chapel Hill in 1976 and his law degree from its School of Law in 1979. His practice is concentrated in the fields of partnership, corporate and limited liability company law, taxation and finance, including mergers and acquisitions, venture capital transactions, private offerings of securities, wealth transfer and estate planning.

Business owners and lawyers alike often refer to limited liability companies as affording their owners and operators the advantage of “corporate shareholder liability protection.” Corporations, though, are not impregnable: Courts may hold corporate shareholders, officers or directors liable in appropriate circumstances by “piercing the corporate veil.” To date, North Carolina courts have not had occasion to “pierce the veil” of an LLC. However, it is nearly certain that the courts, in the right situation, would apply the corporate doctrine of veil piercing: No one credibly believes that an LLC is “bulletproof.”

In Raper v. Oliver House LLC, a 2006 Court of Appeals case, the court was presented with an LLC veil-piercing claim but determined that a mandatory arbitration clause in the plaintiff’s contract controlled and remanded the case for arbitration. In the 2008 N.C. Supreme Court case of State ex rel. Cooper v. Ridgeway Brands Manufacturing LLC, the court held that the attorney general had alleged sufficient facts, taken as true, to survive the defendant’s motion to dismiss on the issue. In neither case did the court reach the merits of the pierce-the-LLC-veil claim.

In North Carolina, the courts follow the so-called “instrumentality rule” to pierce the corporate veil and find corporate shareholders liable where the corporation is operated as a “mere instrumentality or tool” of its shareholders. The three elements of the rule are stated by the N.C. Supreme Court in Glenn v. Wagner:
(1) Control, not mere majority or complete stock control, but complete domination, not only of finances but of policy and business practice in respect to the transaction attacked, so that the corporate entity as to this transaction had no separate mind, will or existence of its own; and 
(2) Such control must have been used by the defendant to commit fraud or wrong, to perpetrate the violation of a statutory of other positive legal duty, or a dishonest or unjust act in contravention of plaintiff’s legal rights; and 
(3) The control and breach of duty must proximately cause the injury or unjust loss complained of.

The factors most commonly cited in analyzing the first prong, control, are inadequate capitalization, noncompliance with corporate formalities, complete domination or control of the corporation so that it has no independent identity and excessive fragmentation of a single enterprise into separate corporations. Factors less commonly cited but also recognized by the courts include nonpayment of dividends, insolvency of a debtor corporation, siphoning of funds by a dominant shareholder, nonfunctioning of other officers and directors and absence of corporate records.

The pierce-the-veil doctrine is an equitable one and therefore equitable defenses, such as unclean hands, will be available to parties defending it. Piercing the veil has also been recognized by state courts as a “drastic remedy” that should be invoked “only in an extreme case where necessary to serve the ends of justice.”

It is not known at this point how the legal analysis for piercing an LLC veil in North Carolina might differ, if at all, from the corporate analysis. Courts outside the state that have applied the veil-piercing doctrine to LLCs have, more often than not, simply applied the corporate analysis without discussion of the differences. Yet there are important distinctions between corporations and LLCs. LLCs have far fewer formalities to be observed; there are no requirements for annual meetings or for elections of directors or officers, no required reports to shareholders, no requirements for dividends. (Note that North Carolina LLCs are required by statute to keep certain records, but that the LLC Act provides that failure to do so “shall not be grounds for imposing liability on any person for the debts and obligations” of the LLC.) Management of an LLC can be quite informal. One of the reasons business venturers form LLCs rather than corporations is the relaxed formality and flexibility of management, easily affording managers control and dominance of the entity through the operating agreement. The ease with which contributions to, and distributions from, an LLC may be made make the initial capitalization of an LLC much less significant to business owners. A few courts have recognized the distinction between the two forms: For example, the New Jersey Superior Court has noted that “adherence to corporate formalities, dominion and control by the owner and undercapitalization, as veil piercing factors, should be weighed differently in the LLC context.”

North Carolina courts should follow this lead. It would be unfortunate indeed if the very advantages that lead North Carolina business owners to use LLCs become factors in imposing liability on them. But in the Ridgeway case noted above, the court’s heading referred to the defendant LLC as a “North Carolina corporation” even though it had been an LLC since its formation, and the court went on to discuss the Glenn v. Wagner corporate instrumentality rule in detail without ever noting that the defendant LLC was not a corporation. The federal court for the Western District of North Carolina, in a bankruptcy case, at least noted that LLCs are not corporations but found that “in the face of the absence of such authority [as to how to apply veil-piercing to LLCs], the Court will conclude that the ‘instrumentality rule’ as enunciated in Glenn is a fair guide for the proof required to disregard” a North Carolina LLC.

What if the LLC is administratively dissolved by the state before the events giving rise to the claim occur? In one North Carolina case, a corporate shareholder, director and officer was protected from liability notwithstanding the dissolution of the corporation, but the decision was predicated on the officer’s lack of knowledge of the dissolution. It remains possible that an officer or director of a corporation or a manager of an LLC with knowledge of an administrative dissolution might be held personally liable for obligations of the entity arising after dissolution. It is less clear whether a shareholder who holds no office or a nonmanaging member of an LLC would be held liable. In any event, note that by statute, reinstatement of a dissolved corporation generally solves the problems, because the reinstatement relates back to the date of dissolution “as if the dissolution had never occurred.” The rule is explicitly made applicable to LLCs by the NC LLC Act.

It should be remembered that managers or members of an LLC can be held liable in some instances without resort to the “drastic remedy” of veil-piercing. Managers of an LLC are liable by statute for their own negligence, wrongful acts or misconduct, in addition to the general case law holding officers liable for their own misdeeds. Managers who vote for an unlawful distribution and members who knowingly receive an unlawful distribution can be liable to the LLC as well.

Inevitably, North Carolina’s courts will apply the corporate veil-piercing doctrine to LLCs in some form. Ideally, the courts will focus on the substantive commission of fraud or wrong, and place less emphasis on the factors more peculiar to corporations, such as formalities, record-keeping, capitalization, dividends, and delegation of management. Nevertheless, LLC owners are well-advised to maintain adequate records, refrain from commingling personal and entity funds, sign contracts and engagements in the name of the LLC, correspond in the name of the LLC and do all the other little things which indicate to the outside world that a separate business entity is alive and functioning.