When Limited Liability Companies Bust Apart
|By Jared M. Wilkerson, Esq. (Marks Gray, P.A.)|
The limited liability company has become the go-to business structure for startups. It affords members a freedom of movement and protection from personal liability not easily obtained in other forms, and at an initial cost irresistible to those just getting their feet wet in the field of enterprise. Such newcomers are often not so savvy in the procedural mandates of the Florida LLC, and due to the recent overhaul of Chapter 608 (now 605) of the Florida Statutes, that is a condition which their attorneys may unfortunately share. Therefore, when perceived betrayals pop up, as they often do, the potential for internal litigation between members is extremely high, and the process, often messy. The following common scenario sets the stage for the considerations of attorneys who represent past or present members in these disputes.
Tom and Larry are the only members of a limited liability company in Florida called Doomed Construction, LLC (“Doomed”).
After years of working together, Tom notices that profits are routinely below his expectations. He reviews several files from past jobs and finds what he believes to be a pattern of theft by Larry. Tom confronts Larry with a snapshot of his findings, and Larry admits that he cannot explain the apparent discrepancies on the spot. Rather than argue, Larry tells Tom that he has wanted to make a change for a while, and that it might be best if the two simply part ways. To avoid damage to either’s professional reputation with accusations of criminal conduct, Tom and Larry agree that Larry will sign an agreement of withdrawal from the company effective immediately. In exchange, Tom will oversee the completion of Doomed’s contracts, wind up the company, and distribute any remaining capital equally.
During the winding up, Tom forms New Day, LLC (“New Day”), which takes on new projects from the Doomed customer base to ensure a smooth transition after dissolution. Under Tom’s direction, Doomed hires New Day as a subcontractor to complete portions of the outstanding Doomed jobs and pays New Day accordingly. When the jobs are completed, some of the profit that would have been retained by Doomed has been paid to its subcontractor, New Day.
Tom winds up and dissolves Doomed and distributes far less capital to Larry than he had anticipated. When Larry learns about New Day’s involvement, he threatens to sue Tom for self-dealing regarding the final distribution. Tom reminds Larry that he is lucky to have gotten anything considering the perceived theft.
Both parties run out and get lawyers. Larry wants to know if he can sue Tom on behalf of himself or if the company must do it. Tom wants to know to what degree, if any, he is protected from personal liability under the applicable statutes and the operating agreement, and whether Larry’s withdrawal precludes him from complaining about Tom’s decisions in winding up the company or even bringing the suit in the first place.
First, it is worth noting that virtually every aspect of the litigation between Tom and Larry could have been avoided if either of them had sought legal counsel when Larry first agreed to withdraw. If the operating agreement did not dictate a valuation method for Larry’s interest, Larry could have been advised to initiate appraisal rights under chapter 605 of the Florida Statutes (1). Unless prohibited by the operating agreement, Tom could then have purchased Larry’s interest, and any issues with payment would have been a simple creditor/debtor dispute not involving the company. Alternatively, Doomed could have issued a special distribution allowing the LLC to buy back Larry’s shares within ninety days (2) or Larry could have become a creditor to the LLC and received payment prior to Tom receiving a final distribution upon dissolution (3)(4). In either event, the court likely would have issued an order determining whether the appraisal costs would be borne either by the LLC or one of the parties.(5)
The problem, of course, is that small LLCs generally avoid hiring an attorney until the situation devolves into a full-blown lawsuit between members. By the time we meet Tom and Larry, the problem is frustratingly more complicated because the company no longer exists and any capital it might have used for an unanticipated suit has been distributed to its members. The question of who then pays for the litigation centers on who is actually suing whom and under what authority.
Even after dissolution, An LLC can still sue or be sued (6), and members may bring direct or derivative actions against other members.(7) With small LLCs, this disproportionately empowers the member bringing the suit because he need not petition the LLC to bring the suit on its own behalf,(8) yet the LLC will likely ultimately have to foot the bill for the litigation to the benefit of the member initiating the suit at the detriment of his targeted co-member.(9)
However, in order to have the standing to bring a derivative action, the would-be derivative enforcer must have been a member at the time that the suit was commenced and must have been a member at the time that the conduct giving rise to the cause of action occurred.(10)
In the case of Tom and Larry, this presents a problem for Larry’s pending claims to the extent that they are derivative in nature. Arguably, Larry ceased to be a member when he voluntarily withdrew from the company, and all of Tom’s offending actions occurred after Larry left.(11)
Therefore, Larry might be better off suing Tom directly. Divining the circumstances under which one LLC member may directly sue another has been the cause of great consternation for Florida courts for the better part of the last half-century. The current rule of law can be boiled down to the following synthesis: A direct action can only be brought if the injury complained of is not one which naturally flows from a direct harm to the company and that injury is separate and distinct from those sustained by other members.(12) In other words, if the perceived betrayal causes the company to lose money first, then the action to recover is derivative.(13)
Here, an argument that New Day’s profits mean that Tom suffered no injury and that Larry’s own injury must, therefore, be separate and distinct, is irrelevant. To have any cause of action, Larry must logically assert that Tom’s conduct lowered Doomed’s profit before it could be distributed to Larry, and thus Larry’s injury invariably flows from a direct harm to the company. Therefore, the two-prong test dictates that Larry initiates a derivative action, which again, Larry cannot do if he was not a member through to dissolution.
However, Florida courts recognize an exception to the rule. If the plaintiff member can establish a cause of action based upon the other member’s breach of a contractual or statutory duty owed directly to the plaintiff member, he may then bring the suit on his own behalf directly against the offending member without involving the LLC.(14) Florida Statutes section 605.04091 outlines the fiduciary duties and obligations of loyalty, care, and good faith and fair dealing that members and managing members owe not only to the company but also to each other.(15) Although these duties may be limited to some extent by the company’s operating agreement, they cannot be done away with altogether.(16) Therefore, Larry’s best approach is to frame his causes of action such that all of Tom’s alleged misconduct falls under a breach of these duties. This also works to Larry’s advantage because a breach of fiduciary duty may afford him access to punitive damages.
Once again, Larry’s status as a member at the time of the alleged breach will be a determining factor in Larry’s standing to bring the suit. If he was no longer a member, then Tom owed him no such duties. Larry’s chief argument will be that his membership did not terminate until he was effectively compensated for his interest in the company upon the final distribution.(17) Tom will have to argue that regardless of the timing of payment, upon Larry’s withdrawal, Larry’s interest was no longer that of a member, but merely that of a transferee, and therefore no duties of loyalty or care applied during the winding up period.(18) The wording of the operating agreement regarding withdrawal procedures may be determinative here.
The above distinctions are critically important to both parties and their respective attorneys because the nature in which a claim is brought between members of a defunct LLC dictates who may be forced to pay the initial costs of maintaining or defending the suit. It also has a strategic impact on how awards for claims and counterclaims may be offset against the other in a final judgment. For example, if you defend Tom for all claims brought against him directly, you may be tempted to bring a counterclaim against Larry for embezzlement or conversion in the name of the LLC in order to rope Tom’s expenses under the LLC’s litigation costs, which may or may not be covered by the LLC or even its insurer.(19) This could be a costly mistake down the road because any award that the LLC would receive would not offset any award that Larry might receive in his direct suit against Tom. Tom would have to pay that award in full(20), then hope that the LLC could collect against Larry, who may or may not have squirreled that money away somewhere in an attempt to make himself judgment proof(21). The same analysis applies to Larry’s decision to bring a derivative claim on behalf of the LLC if Tom decides to counter with a personal suit claiming a direct injury from Larry’s possible thievery.
Ultimately, a sort of chess game ensues where the best option is often to base one’s strategy not on a preconceived plan of moves, but rather on a measured reaction to the opponent’s actions, keeping the client’s end goals in mind. However the opposing party files, it is generally cheaper for the client to respond in kind, through amendments or otherwise, and rely upon the rules to limit what damage the other party can do.
(1) § 605.1006, Fla. Stat.; §§ 605.1066 – 605.1072, Fla. Stat.
(2) Assuming that would not constitute an improper distribution under § 605.0405, Fla. Stat.
(3) § 605.1067; § 605.0710(1), (2)(a), Fla. Stat.
(4) § 605.1071, Fla. Stat.
(5) § 605.1070, Fla. Stat.
(6) § 605.0717(1)(b), Fla. Stat.
(7) § 605.0802, Fla. Stat.
(8) § 605.0802(2), Fla. Stat. (allowing a member to maintain a derivative action on his own by claiming that issuing a demand to other members to bring the suit in the name of the LLC would be futile or would cause irreparable injury to the company).
(9) § 605.0805(2), Fla. Stat. (LLC may be directed to pay plaintiff’s expenses in suit, even if only partly successful).
(10) § 605.0803, Fla. Stat.
(11) Keep in mind that Larry may challenge the efficacy of his purported withdrawal by arguing that he was never compensated for his interest, so the withdrawal was not effectuated until his final distribution, which occurred after Tom’s offending management decisions. § 605.1067, Fla. Stat. (member’s interest ceases upon payment of agreed value).
(12) E.g., Dinuro Investments, LLC v. Camacho, 141 So. 3d 731 (Fla. 3d DCA 2014).
(13) See id. at 736, 740.
(14) Id. at 740.
(15) § 605.04091(1)-(4), Fla. Stat.
(16) § 605.0105(3)(e)-(f), Fla. Stat.
(17) See Froonjian v. Ultimate Combatant, LLC, 169 So. 3d 151, 156 (Fla. 4th DCA 2015)
(18) § 605.0603(1)(c), Fla. Stat.
(19) Note that the LLC could also pay Tom’s costs if Tom wins against any or all of Larry’s direct claims. § 605.0304(1), Fla. Stat.
(20) Tom might be entitled to have his litigation expenses paid or awards indemnified by the LLC under § 605.0408(2)-(3), Fla. Stat., provided, for example, that his conduct was merely negligent as opposed to willful.
(21) In any event, the parties’ respective judgments will likely be limited to the amount of the final distribution the non-prevailing party received upon dissolution of the company. § 605.0712(3)(b), Fla. Stat.
Jared Wilkerson is a graduate of Florida Coastal School of Law now specializing in business litigation and contractual disputes in the northeast and central Florida regions.
Original Article published in the Association of Corporate Counsels 2nd Quarter newsletter. Full copy can be found here.