Illinois LLCs – The Asset Protection Advantage

A Technical Analysis

Among sophisticated investors and other high-asset/high-net worth individuals and businesses, the topic of “asset protection” is bound to arise. As many became painfully aware during the recent Great Recession, bad things can happen to good people. In my article Asset Protection – Lessons Learned, I discussed how properly structuring one’s holdings could have prevented, or at least mitigated, much of the financial devastation and anguish experienced by business owners, investors, real estate developers, doctors and others caught off-guard by the drastic economic collapse of 2007-2010.

RSP_LogoFull_2PMSOften, there is confusion about what the term asset protection really means. Some imagine a shadowy network of off-shore trusts and secret bank accounts in foreign lands set up by unscrupulous characters to cheat innocent creditors. This is simply not true. In this article I will not debate the claimed pros and cons of secret bank accounts and so-called off-shore asset protection trusts. I will say, however, that under most circumstances, they don’t work for U.S. citizens residing in the U.S.A.

Legitimate asset protection is nothing more or less than properly ordering one’s business and financial affairs in a way that does not unnecessarily expose all assets to claims of creditors.

The right of persons and businesses to limit their liability and exposure of their assets to claims of creditors is the well settled in the U.S.A. The United States of America, and each individual state, has a plethora of laws authorizing and recognizing the legitimacy of corporations and other limited liability entities as a means by which an investor can segregate assets and limit exposure to liability.

No person has a legal or moral obligation to structure his or her affairs in a way that makes it easy for a creditor of one business or professional enterprise to attach assets of the investor not committed to that enterprise. This protection may be impinged if the person or business engages in conduct tantamount to fraud, but actions explicitly authorized by applicable statute can hardly be characterized as being fraudulent. Fraud is an intentional tort requiring, among other elements, intentional breach of a duty owed to the person claimed to be harmed. If a statute expressly authorizes conduct, it implicitly, if not explicitly, negates any duty to act in a manner contrary to that authorized by the statute.

This article presents a technical analysis of certain asset protection attributes of an Illinois limited liability company expressly authorized by the Illinois Limited Liability Company Act, 805 ILCS 180/1-1 et seq (the “Illinois LLC Act”). The remarkably robust asset protection value of an Illinois limited liability company is measured by two key attributes:

1. The ability, expressly authorized by the Illinois LLC Act, to include in an LLC operating agreement provisions that protect the limited liability company and its business and assets from claims owed to others by members of the LLC – an attribute that creates a huge advantage vs. a corporation, as discussed in Part I, below; and

2. Enhanced protection of Members and Managers from liability for debts, contracts and torts incurred by the LLC, or resulting from acts or omissions of a Member or Manager while acting on behalf of the LLC, to an extent measurably greater than the protection afforded officers, directors and shareholders of a corporation.

Although one might reasonably expect that the order in which these key attributes are discussed would be reversed, the Part I discussion precedes the Part II discussion because the matters to be discussed in Part I are best considered at the outset, when the operating agreement is being drafted; while the matters discussed in Part II will most directly apply later, once a judgment creditor is seeking to enforce its judgment.

PART I: Key Statutory Provisions to Consider When Drafting the Operating Agreement

A limited liability company is typically governed by two main sources of governing authority. First and foremost, the enabling statute which authorizes the creation of a limited liability company and establishes its legal characteristics. Second, the organizational documents, including, in Illinois, the Articles of Organization, and an internal document governing the limited liability company’s ownership and management, known as an “operating agreement”.

To gain the full asset protection value afforded to an Illinois limited liability company, it is necessary to pay close attention to the powers expressly authorized by the Illinois LLC Act, and to strategically draft the operating agreement in a manner that utilizes those asset protection benefits expressly permitted by the Illinois LLC Act.

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A. Key Sections to Consider.

Seven sections of the Illinois LLC Act are of particular interest in terms of asset protection when drafting the operating agreement. A brief summary of these sections as they pertain to this discussion is as follows:

805 ILCS 180/15-15. The factors a manager may take into consideration in discharging its duties as manager of the LLC are set forth in this section.

805 ILCS 180/30-1. A member of an LLC is not a co-owner of the LLC’s property and has no transferable interest in the LLC’s property. The economic interest a member owns is called a “distributional interest,” which entitles the holder thereof to receive its share of any distributions made by the LLC.

805 ILCS 180/30-5. A transfer of a distributional interest does not entitle the holder thereof to become or exercise any rights of a member. A transfer entitles the transferee to receive, to the extent transferred, only the distributions to which the transferor would be entitled.

805 ILCS 180/30-10. A transferee may become a member only as permitted in accordance with the terms of the LLC operating agreement. A transferee who does not become a member is not entitled to participate in the management or conduct of the LLC’s business, and may not require access to information concerning LLC transactions, or inspect or copy any LLC records.

805 ILCS 180/30-20. Sets forth the exclusive means by which a judgment creditor of a member or transferee may satisfy a judgment out of the judgment debtor’s distributional interest in an LLC.

805 ILCS 180/35-1. On application of a transferee, asserting equitable grounds for dissolution, an LLC may be dissolved only upon a judicial determination that it is equitable to wind up the LLC’s business.

805 ILCS 180/35-3. An operating agreement or the articles of organization may provide a means by which a new member can spring into existence, effective as of the date the last remaining member of the LLC becomes dissociated.

B.   The Asset Protection Advantage of Illinois LLCs vs. Corporations, Generally:

As a general proposition, a judgment creditor with a judgment against a corporate shareholder can attach that shareholder’s shares to satisfy the judgment. After attachment, the judgment creditor becomes the owner of the shares, with the right to vote those shares (assuming they are voting shares) on matters calling for shareholder action, including election of the board of directors, sale of assets, etc. Some protection against this outcome can be gained by means of a shareholders’ agreement that restricts transferability of shares. If there is a single shareholder, however, or if a judgment is entered against all of the shareholders, the protection afforded by a shareholder agreement may be unavailable.

Under the Illinois LLC Act, the rights and remedies of a judgment creditor are substantially limited.

Section 30-20 of the Illinois LLC Act sets forth the exclusive remedy by which a judgment creditor of an LLC member or a member’s transferee may satisfy a judgment vis-à-vis the judgment debtor’s distributional interest in an LLC. The Illinois appellate court has confirmed the enforcement regime provided in §30-20. Bank of America, N.A. v. Freed, 2012 IL App (1st) 110749, ¶¶37 – 42, 983 N.E.2d 509.

Pursuant to §30-20 of the Illinois LLC Act:

A court may impose a charging order on the distributional interest of the judgment debtor. 805 ILCS 180/30-20(a).

A charging order creates a lien on the judgment debtor’s distributional interest. 805 ILCS 180/30-20(b).

A court may order foreclosure of the lien at any time, but the purchaser at the foreclosure sale has only the rights of a transferee. Id.

Section 30-10 of the Illinois LLC Act sets forth the scope of rights of a transferee. Unless provided otherwise in the operating agreement, the transferee does not become a member of the LLC and therefore has no right to participate in management or to conduct the LLC’s business, no right to require access to information concerning LLC transactions, and no right to inspect or copy LLC records. 805 ILCS 180/30-10(d).


PRACTICE NOTE:

Relative to a manager-managed LLC, case law confirms that the right to manage the LLC is not a property interest that can be transferred. Grochocinski v. Campbell (In re Campbell), 475 B.R. 622 (Bankr. N.D.Ill. 2012). In a gratuitous comment (see 475 B.R. at 631 n.6), however, the Campbell court suggested that the result would be different if the LLC were to be member-managed. The footnote is dicta — and, while arguably a correct interpretation of Section 541(c)-1 of the Bankruptcy Code, is likely incorrect outside a bankruptcy setting, based on the express language of the Illinois LLC Act. Prudence suggests, however, that for asset protection purposes, a manager-managed LLC is preferable.


C. The Charging Order

In a typical case, the operating agreement may very likely grant the manager of a manager-managed limited liability company the authority and discretion to determine if and when distributions will be made to interest holders. If the judgment creditor is holding only a charging order lien against the distributional interest of a member, the judgment creditor will receive nothing if no distributions are made.

At first glance it may appear that foreclosing on a distributional interest and acquiring the rights of the judgment debtor in the distributional interest is the logical next step if the judgment is not being satisfied pursuant to a charging order entered in accordance with 805 ILCS 180/30-20(a). It should be noted, however, that foreclosing on the charging order lien and becoming the actual owner of the distributional interest is not without risk to the judgment creditor.

LLCs are, with rare exceptions, taxed as partnerships, with all profits and losses passed through to the owners of distributional interests (whether they own that interest as a member or as merely a transferee). As many partners in partnerships, including many partners in law firm partnerships, are painfully aware, this attribute of partnership taxation can result in dreaded “phantom income”; that is, partnership-level income that is taxable to the partner even though no cash is distributed to the partner. This same rule of pass-through tax liability applies to virtually all LLCs. (The exception being the rare case in which an LLC makes an IRS election to be taxed as a “C” corporation.)

As long as a judgment creditor has only a charging order lien imposed under §30-20, the judgment creditor is merely a lienholder, not an owner of the distributional interest. Accordingly, the tax consequences of phantom income inure to the judgment debtor, who remains the owner of the distributional interest. If, however, a judgment creditor forecloses on the lien created by the charging order, as permitted under §30-20(b), the purchaser at the foreclosure sale becomes the owner of the distributional interest, with all the attendant tax consequences that flow with that ownership. If taxable profits are allocated to the distributional interest holder, but no cash distribution is actually made, the judgment creditor, as owner of the foreclosed-on distributional interest, is liable to pay taxes on the allocated profit. As a consequence, the judgment creditor may conceivably find itself in a worse financial circumstance than existed before foreclosure of its charging order lien.

D. Authority of Manager To Withhold Distributions

If the manager of a manager-managed limited liability company elects to not distribute profits, the owner of the distributional interest is exposed to the risk of incurring tax liabilities as a consequence of phantom income. For this reason, some operating agreements require distribution of available cash flow in amounts necessary cover the potential tax liability of the LLC’s members and distributional interest holders. Experience suggests this may be the exception rather than the rule.

Some may question whether a manager has the right, in the faithful discharge of the manager’s fiduciary duties, to withhold distributions to interest holders if cash is available. To find support, they may point to §15-3(g) of the Illinois LLC Act, through incorporation of §15-3(d), which provides that in the exercise of its duty of care to the LLC and its members, an LLC manager must exercise any rights arising under the Illinois LLC Act or under the operating agreement consistent with the obligation of good faith and fair dealing. 805 ILCS 180/15-3.

As negotiating leverage, they may also note that §35-1(5) of the Illinois LLC Act provides that:

“[o]n application by a transferee of a member’s interest, a judicial determination [may be made] that it is equitable to wind up the company’s business.”

. . . arguing that the claimed breach of the manager’s fiduciary duty to distribute available income creates a circumstance that would make it equitable to wind up the company’s business.

Consider, however, §15-15, which provides:

“In discharging the duties of their respective positions, members and individual managers may, in considering the best long term and short term interests of the limited liability company, consider the effects of any action (including without limitation, action that may involve or relate to a change or potential change in control of the limited liability company) upon employees, suppliers, and customers of the limited liability company or its subsidiaries, communities in which offices or other establishments of the limited liability company or its subsidiaries are located, and all other pertinent factors.”

If an LLC manager can make a plausible case that it is in the best long-term or short-term interests of the LLC to build cash reserves for reinvestment in the company to grow its business or to fund capital improvements, such case may likely serve as reasonable justification for a manager’s decision to withhold distributions of cash flow to interest holders in the faithful discharge of its duties — notwithstanding that interest holders may incur phantom income tax liability.

If the case can be made that the manager is acting within the scope of its authority under the operating agreement and discharging its duties in accordance with the statutory standard established by §15-15, a powerful argument would likely exist that it would be an abuse of the court’s discretion to determine that the manager’s exercise of such expressly granted authority creates an equitable ground to wind up the LLC’s business under §35-1(5).


PRACTICE NOTE

If an LLC member is subject to claims of creditors that may mature into a charging order, consider whether an LLC operating agreement that does not grant a manager full discretion to determine whether to make distributions may be amended to grant the manager full discretion. Query: Does such an amendment constitute a fraudulent transfer within the meaning of the Uniform Fraudulent Transfer Act (UFTA), 740 ILCS 160/1, et seq.? Can a fraudulent transfer ever occur when there has been no transfer or encumbrance of an asset? If the ability to be a manager is not a property interest in a manager-managed LLC (see Grochocinski v. Campbell (In re Campbell), 475 B.R. 622 (Bankr. N.D.Ill. 2012)), can amending the scope of the manager’s authority constitute the transfer or encumbrance of an asset or property interest within the meaning of the UFTA?


E. The Springing Member

The foregoing argument notwithstanding, if the judgment debtor were to be the sole member of a manager-managed limited liability company, with the result that upon foreclosure of the charging lien under 805 ILCS 180/30-20 the judgment creditor became the sole economic interest holder as owner of 100 percent of the distributional interest, a compelling case might be made that equity requires the business of the LLC to be wound up if requested by such 100% owner.

But what if, after foreclosure of the charging order on 100 percent of the distributional interest of the judgment debtor, the judgment creditor was, in fact, still not the owner of 100 percent of distributional interests in the LLC? What if, as of the time the foreclosure and transfer occurred, there was another distributional interest holder — which was, in fact, the sole member? Might that make a difference in the court’s determination that it is equitable to wind up the LLC’s business?

Based on the hypothetical facts we have been examining (i.e., foreclosure of 100 percent of the distributional interest held by all LLC members), how could this factual twist ever come into play?

Here’s how:

Consider §35-3(c)(2) of the Illinois LLC Act, which permits the articles of organization or operating agreement to provide for a new member to, essentially, spring into existence effective as of the dissociation of the last remaining member. (Transfer of all of a member’s distributional interest is an act of dissociation. See 805 ILCS 180/35-45(3).)

Suppose the operating agreement provides that within six months after dissociation of the last remaining member, the manager has the right to cause the LLC to issue, say, a one-percent distributional interest in the LLC to the manager, upon contribution by the manager to the LLC of an amount equal to one percent of the aggregate balance of all capital accounts, and that upon such occurrence the manager shall be admitted as a member? Upon being admitted as a member owning a one-percent distributional interest, the manager would be the sole member, with the ability to give unanimous approval to all actions requiring approval of the members. Might that make a compelling case that the LLC remains as a fully functioning entity capable of carrying out its business purpose? Consider, particularly, if the LLC operates a business as a going concern, with employees, vendors, and community stakeholders who benefit from the LLC’s continued existence and operation. Is it likely a court will find equitable grounds to order that the business of the LLC be wound up?

Obviously, each case must be judged on its own merits. But once again, from the standpoint of negotiating on behalf of a judgment debtor, plausible arguments well-grounded in fact and warranted by existing law that can create doubt in the mind of a judgment creditor as to the likely success of its enforcement efforts are valuable tools in reaching a favorable settlement.

IMG_0156F. How Do These LLC Provisions Aid a Commercial Real Estate Borrower?

Narrowly speaking, one might wonder how everything discussed above helps in the typical commercial loan scenario in which the limited liability company is the borrower, with direct liability, and the LLC members are guarantors, also with direct liability. If the LLC members have a single project with a single loan from a single lender, the point is well taken. The lender does not need to go through the members to get to the LLC’s income and assets. It can simply enforce its judgment against the LLC, while simultaneously, if it so chooses, also pursuing the guarantor members.

But what if the guarantor members are active real estate investors/developers (or other investors/professionals) who don’t have just one project (or business) through one LLC and one lender, but rather have two or more projects (or businesses) through two or more separate LLCs with loans from two or more separate lenders?

EXAMPLE: Consider this fact scenario:

Project A is owned by LLC A and financed by Lender A for $5,000,000 (Loan A).

Project B is owned by LLC B and financed by Lender B for $8,000,000 (Loan B).

The members of LLC A are X and Y, who jointly and severally guaranty Loan A.

The members of LLC B are X and Z, who jointly and severally guaranty Loan B.

LLC A and LLC B are each manager-managed LLCs, in each case managed by XYZ Management LLC, which is owned by X, Y, and Z as equal members. XYZ Management LLC is not a member of either LLC A or LLC B. XYZ Management LLC is jointly managed by X, Y, and Z.

Project B is doing well and has equity of $7,000,000, with annual net cash flow after debt service of $650,000, with taxable profits after depreciation of $600,000.

Project A is in default and facing a $3,000,000 deficiency after sale of the collateral, resulting in a personal judgment in favor of Lender A against members X and Y on their personal guaranties.

Assume X and Y have no other attachable assets.

Applying the asset protection-friendly provision of the Illinois LLC Act, (coupled with a thoughtfully structured operating agreement) what may be the likely outcome of Lender A’s efforts to enforce its judgments?

Lender A obtains a $5,000,000 judgment against LLC A and pursues members X and Y on their personal guaranties. After disposing of the collateral owned by LLC A for $2,000,000, Lender A obtains a $3,000,000 joint and several judgment against members X and Y on their personal guaranties.

Through a citation to discover assets or otherwise, Lender A learns that X is a 50-percent member of LLC B, which has net equity of $7,000,000. Lender A also learns that X and Y are members of XYZ Management LLC, each owning 33.3 percent of that LLC.

Lender A wishes to satisfy its $3,000,000 judgment by attaching the 50-percent membership interest of X in LLC B.

Pursuant to §30-20 of the Illinois LLC Act, 805 ILCS 180/30-20, Lender A’s exclusive remedy relative to the LLC interest of member X is to obtain a charging order, which is a lien against distributions payable to X. With LLC B having net cash flow after debt service of $650,000 per year, the most Lender B expects to receive is $325,000 per year, based on the 50-percent membership interest of X.

In fact, XYZ Management LLC (the manager of LLC A) decides to reserve $650,000 per year for capital repairs and improvements and as a reserve against possible tenant vacancies and other contingencies. XYZ Management LLC elects not to make any distributions to members. As a consequence, pursuant to Lender A’s charging order, Lender A gets nothing, because X is not entitled to receive any distributions from LLC B on its distributional interest.

Lender A is unhappy. Lender A contemplates foreclosing its lien on the distributional interest of X pursuant to §30-20(b). If it does so, Lender A will become the owner of the 50-percent distributional interest of X in LLC B and will be subject to taxable phantom income of $300,000 per year (50 percent of the hypothetical $600,000 per year in taxable income) as the owner of a 50-percent distributional interest. Instead of being better off, Lender A may be worse off, having incurred a substantial income tax liability.

As an alternative, Lender A decides to try to force a liquidation of LLC B, so that it will receive 50 percent of the hypothetical $7,000,000 in equity in the project owned and operated by LLC B. To do this, Lender A decides to pursue the interests of X and Y in XYZ Management LLC. Since X and Y each owns 33.3 percent of XYZ Management LLC, Lender A assumes it can take control of XYZ Management LLC by obtaining a charging order on the interests of X and Y in XYZ Management LLC and then acquiring 66.6 percent via foreclosure of its charging order lien pursuant to §30-20(b).

Lender A contemplates that by acquiring the ownership interests of two out of three members of XYZ Management LLC, including the interests of two out three of its managers, Lender A will control XYZ Management LLC and, through that control, will be the manager of LLC B and can direct a sale or liquidation of LLC B’s assets.

Unfortunately for Lender A, it discovers that by foreclosing on the interests of X and Y in XYZ Management LLC, Lender A acquires, pursuant to §30-20(b), only the interests of a transferee, with no right to vote as a member and no right to participate in management of XYZ Management LLC per §30-10(d). Therefore, Lender A still has no management authority with respect to LLC B.

Query: Based on the foregoing hypothetical facts and likely outcome of its enforcement efforts, might the lender be willing to consider settlement with X and Y for less than full payment?

G. What Is the Defaulted Borrower’s Exit Strategy?

Asset protection can be more an “art” than a science. There is no magic formula for success in protecting the assets and income of commercial real estate borrowers when a loan goes bad, but there are effective strategies that can help facilitate settlement upon favorable terms that may avoid catastrophic financial ruin.

http://www.dreamstime.com/stock-photo-confused-business-man-thinking-wich-way-to-go-image28551060A principal objective of asset protection — and even most defensive efforts on behalf of a commercial real estate borrower in the event of default on a commercial real estate loan — is typically to motivate the lender to settle on favorable terms. What terms a borrower or guarantor may consider favorable depends on the facts and circumstances of the particular case.

Often, the favorable outcome being sought is a release of the loan guarantors from personal liability on their loan guaranties. This may require the payment of some money by the guarantors, but ideally substantially less that the full exposure on the personal guaranty.

Generally, the lender is seeking to maximize its recovery. If it can recover the entire indebtedness and costs of collection, the lender will seek full recovery. If full recovery becomes doubtful, however, most lenders will settle for an approximation of what the lender reasonably expects it will net through continued forced collection efforts. The lender’s objective of maximizing recovery has been expressly incorporated into financial institution supervisory guidance through the joint financial regulators’ Policy Statement on Prudent Commercial Real Estate Loan Workouts, www.fdic.gov/news/news/financial/2009/fil09061a1.pdf.

Weighing the costs of recovery against the amount of recovery likely to be obtained is a relevant factor for lenders to consider in maximizing their recovery. Money has “time value” as well. The more quickly money is recovered, the more value it has. The fact that a judgment may be accruing interest at nine percent per annum, or that the borrower and its guarantors are liable to pay costs of collection, including reasonable attorneys’ fees, becomes fairly meaningless if the borrower and guarantors have no assets or income from which the lender can readily recover its claim. If the borrower and/or guarantors are properly positioned to borrow funds from friends or family to pay even a modest settlement that is equivalent to, or slightly exceeds, what the lender can readily recover through forced collection efforts, settlement is a plausible outcome.

The more difficult and doubtful collection efforts become, the more likely one may be to obtain favorable settlement terms.

H. Timing Consideration for Asset Protection

Asset protection strategies are most effective when planned far in advance. Transfers of assets into a limited liability company or other asset protection-friendly vehicle can come too late if not completed well in advance of financial difficulties. The statute of limitations for a transfer constituting a fraudulent transfer is four years. 740 ILCS 160/10. Fortunately for most commercial real estate borrowers, Illinois business owners and Illinois licensed professionals, no transfer may be necessary for them to avail themselves of the asset protection advantages of an Illinois LLC since most commercial real estate projects financed in the past several years, and most Illinois based businesses, and many Illinois licensed professions, have been owned from the outset in an Illinois LLC. Creative amendment to an existing operating agreement may be sufficient to increase the level of asset protection.

Planning ahead is the ideal solution — but sometimes you just have to take what the statute gives you. For Illinois LLCs, the Illinois LLC Act actually gives quite a lot.

PART II: Immunity from Liability of Members and Managers

In Part I of this article, we discussed the key sections of the Illinois LLC Act which protect the LLC, its business, and other members, if any, by limiting recovery vis-à-vis the LLC of a judgment entered against an LLC member.

Of equal or greater value is 805 ILCS 180/10-10, as interpreted and sustained in Dass v. Yale, 2013 IL App (1st) 122520; 3 N.E.3d 858.

A. 805 ILCS 180/10-10 provides, as follows:

“(a) Except as otherwise provided in subsection (d) of this Section, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.

(b) (Blank)

(c) The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of company powers or management of its business is not a ground for imposing personal liability on the members of managers for liabilities of the company.

(d) All or specified members of a limited liability company are liable in their capacity as members for all or specified debts, obligations, or liabilities of the company if:

(1) a provision to that effect is contained in the articles of organization; and

(2) a member so liable has consented in writing to the adoption of the provision or to be bound by the provisions.”

B. Dass v. Yale, 2013 IL App (1st) 122520; 3 N.E.3d 858, cert. denied.

In Dass v. Yale, the plaintiff claimed that Yale, the sole managing member of Wolcott LLC, an Illinois limited liability company, defrauded the plaintiff in connection with the sale of a condominium unit by making false representations plaintiff claimed constituted, inter alia, common law fraud. See id., ¶ 2.

RSP_LogoFull_2PMSYale moved to dismiss the claims against him, asserting he was insulated from liability under Section 10-10 of the Illinois LLC Act. The plaintiff objected, claiming the legislature never intended Section 10-10 of the Illinois LLC Act to shield limited liability company members or managers who commit fraud. The trial court disagreed, and sided with defendant Yale, finding that members and managers are immune from liability under Section 10-10 of the Illinois LLC Act and granted Yale’s motion to dismiss. Id. ¶ 3. The plaintiff appealed.

The Appellate Court noted that plaintiff Dass was not asserting a right to pierce the LLC entity veil, using any recognized piercing test (which will be discussed in Part II – C, below), but rather was asserting liability of Yale based, essentially, upon the general notion (as incorporated in the legislative comments to Section 303 of the Uniform Limited Liability Company Act (the “Uniform Act”)) that an agent, even while acting on behalf of a principal, is jointly and severally liable for tortious conduct committed by the agent. Id. ¶¶ 36, 40. Arguing that Section 10-10 of the Illinois LLC Act is substantively similar to Section 303 of the Uniform Act, plaintiff Dass asserted that Yale should be liable for the claimed fraud (or, at least, should have to answer for the claim, rather than be dismissed pursuant to Yale’s motion to dismiss).

The Appellate Court also noted that Section 303 of the Uniform Act and the comments accompanying Section 303 may normally be persuasive authority in interpreting Section 10-10 of the Illinois LLC Act due to similar language used in each, even though neither Section 303 nor the comments are formally a part of the Illinois LLC Act. Id., ¶¶ 40-41.Taking into consideration of the history of the Illinois LLC Act and other cases interpreting the history, however, the Appellate Court determined that the trial court was correct in finding that Yale is shielded from liability. The court stated:

“Indeed, examining the history of the LLC Act itself demonstrates that the trial court was correct in interpreting section 10-10 to shield Yale from liability. The current language of section 10-10 has been in effect since January 1, 1998. See Pub. Act. 90-0424 (eff. Jan. 1, 1998). Prior to that, section 10-10 read:

(a) A member of a limited liability company shall be personally liable for any act, debt, obligation or liability of the limited liability company or another member or manager to the extent that a shareholder of an Illinois business corporation is liable in an analogous circumstance under Illinois law.

(b) A manager of a limited liability company shall be personally liable for any act, debt, obligation or liability of the limited liability company or another member or manager to the extent that a shareholder of an Illinois business corporation is liable in an analogous circumstance under Illinois law. 805 ILCS 180/10-10 (West 1996).

Generally, a change to the unambiguous language of a statute creates a rebuttable presumption that the amendment was intended to change the law. Here, the language of the LLC Act was changed by removing language explicitly providing for personal liability. As we noted in Puleo, “[a]s we have not found any legislative commentary regarding that amendment, we presume that by removing the noted statutory language, the legislature meant to shield a member or manager of an LLC from personal liability.” Dass, 2013 IL App (1st) 122520, ¶ 41 (internal citations omitted).”

The court also noted that “the express language of section 10-10 (currently) provides that ‘the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the liabilities of the company.’ We see no reason why the reasoning of Puleo and Carollo, which focused on the language of the LLC Act and its amendment, would not apply to a liability arising in tort, as in the case at bar, when such a scenario is expressly contemplated by the language of section 10-10. Accordingly, we affirm the trial court’s dismissal of plaintiffs’ complaint.” Id. ¶ 44 (emphasis in original) (internal citations omitted).

The plaintiff petitioned the Illinois Supreme Court for leave to appeal, which was denied on March 26, 2014. 2014 WL 1385161, 5 N.E.3d 1123 (Ill. Mar. 26, 2014). Thus, the decision stands as the binding law of Illinois.

C. Piercing the LLC Entity Veil

In a footnote, the Appellate Court in Dass v. Yale stated as follows: “We note that Puleo was somewhat limited in Westmeyer v. Flynn, 382 Ill. App. 3d 952, 960, 321 Ill. Dec. 406, 889 N.E.2d 671 (2008), where we found that section 10-10 did not bar actions involving piercing the

R. Kymn Harp Robbins, Salomon & Patt, Ltd.

R. Kymn Harp
Robbins, Salomon & Patt, Ltd.

corporate veil. However, in the case at bar, there has been no claim that the corporate veil should be pierced.” Dass, 2013 IL App (1st) 122520, at n. 7.

With that footnote, it is at least appropriate to consider the circumstances under which the entity veil of an Illinois limited liability company might properly be pierced.

With one significant exception, Illinois limited liability companies are subject to the same piercing rules as Illinois corporations. Buckley v. Abuzir, 2014 IL App (1st) 130469; 8 N.E.3d 1166; Denmar Builders, Inc. v. Suhadolnik (In re Suhadolnik), No. 08-A-7116, 2009 WL 2591338, at *4 (Bankr. C.D. Ill. Aug. 20, 2009).

Illinois courts have developed fairly uniform rules on the subject of veil-piercing. “Courts may pierce the corporate veil, where to corporation is so organized and controlled by another entity that maintaining the fiction of separate entities would sanction fraud or promote injustice. Buckley, 2014 IL App (1st) 130469, ¶ 12. A party seeking to pierce the corporate veil must make a substantial showing that one corporation is a dummy or a sham for another.” Id.; In re Estate of Wallen, 262 Ill. App. 3d 61, 68 (2d Dist. 1994).

Illinois courts will pierce the corporate veil when the following two-part test is satisfied: “(1) where there is such a unity of interest and ownership that the separate personalities of the corporation and the parties who compose it no longer exist; and (2) circumstances are such that adherence to the fiction of a separate corporation would promote injustice or inequitable circumstances. Tower Investors LLC v. 111 East Chestnut Consultants, Inc., 371 Ill. App. 3d 1019, 1033-34 (1st Dist. 2007).

The first part of the test generally refers to the failure of the corporation to observe corporate formalities. The second part of the test looks to whether circumstances exist that would effectively sanction fraud if the veil is not pierced.

The first part of the two-part test for veil piercing does not apply to limited liability companies under the Illinois LLC Act, by reason of the express language of 805 ILCS 180/10-10(c), which provides “The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company.” Id.

Note, however, that “while the Act provides specifically that the failure to observe corporate formalities is not a ground for imposing personal liability on the members of an LLC, it does not bar other bases for corporate veil piercing, such as alter ego, fraud or undercapitalization.” Westmeyer v. Flynn, 382 Ill. App. 3d 952, 960 (1st Dist. 2008); Denmar Builders, Inc., 2009 WL 2591338, at *4; In re Polo Builders, Inc., 388 B.R. 338, 384 (Bankr. N.D. Ill. 2008).

An in-depth discussion of the overall topic of LLC veil piercing is beyond the scope of this article. Generally speaking, however, it is not as simple as some attorneys seem to think. Under proper circumstances, however, piercing may be allowed.

Enlightening discussions of the topic of veil piercing can be found in cases such as: Judson Atkinson Candies, Inc. v. Latini-Hohberger Dhimantec, 529 F.3d 371 (7th Cir. 2008); Buckley v. Abuzir, 2014 IL App (1st) 130469; and On Command Video v. Roti, 705 F.3d 267 (7th Cir. 2013). As a general proposition, however, merely losing money, failing in business, or depleting available capital through the ordinary course of business operations will not be a sufficient basis to pierce the entity veil to get to the assets of LLC members or managers. A party seeking to pierce the entity veil must make a substantial showing that the entity is a sham or was used to intentionally mislead or defraud in circumstances that would promote injustice. Mere inability of an LLC to satisfy or pay its liabilities, without more, is not enough. See On Command Video, 705 F.3d at 272; In re Estate of Wallen, 262 Ill. App. 3d at 68; Buckley, 2014 IL App (1st) 130469; 8 N.E.3d 1166; and Tower Investors LLC, 371 Ill. App. 3d at 1033-34.

*Publishing Note: Parts of this article first appeared in the Commercial Real Estate handbook published by the Illinois Institute for Continuing Legal Education as part of the author’s 2013 chapter supplement [Chapter 4.S.] to “Commercial Real Estate Financing from the Borrower’s Perspective”.