The “defacto” dissolution of a California LLC; it can result in member personal liability for a judgment against the dissolved LLC

California law provides generally that members of a limited liability company (LLC) are not personally liable for LLC “debts, obligations, or other liabilities.”   There are, of course, exceptions. These include:

  • a member’s liability under the equitable alter ego doctrine;
  • a member’s co-signing for a LLC debt or guarantying a LLC’s performance under a contract;
  • a member’s liability for his or her own wrongful acts – regardless of whether the member was acting as an agent for the LLC or not;
  • a member’s entering into contracts or business transactions without using or disclosing the complete legal name of the LLC; and,
  • a member’s removing assets from a LLC without the LLC receiving corresponding value to delay or defraud creditors.

The legal requirements for these exceptions are reasonably well understood under California law.

There is a further exception to the general rule member limited liability for LLC obligations, however—one which can result a member personal liability for a judgment against a dissolved LLC. Under section 17707.07 of the California Corporations Code, a judgment against a dissolved LLC is collectible against the dissolved LLC—to the extent it has undistributed assets (typically, an insurance policy), or, if the assets of the dissolved LLC were distributed to its members, against the members to the extent each member received distributions from the LLC upon dissolution. Until recently, there was little guidance from California courts on what a distribution “upon dissolution” actually meant.

By way of background, a dissolved California LLC remains in existence for lawsuits against it, whether such suits are brought before or after the LLC’s dissolution. If such a suit results in a judgment against a dissolved LLC which, at the time of judgment, has insufficient funds with which to pay the judgment, each former LLC member is personally liable for the judgment against the dissolved LLC up to the value of the assets he or she received as distributions from the LLC upon dissolution. Determining whether a member received assets “upon dissolution,” however, requires identifying when exactly the LLC’s dissolution actually occurred.

The final, and, in some circumstances, only, public filing a California LLC makes in connection with dissolution is to file with the California Secretary of State either a statement of dissolution or, as applicable, a certificate of cancellation. Such filing, however, is not the event that dissolves the LLC; it is not when the dissolution occurred.

Under the California Revised Limited Liability Company Act and its predecessor, a California LLC is said to dissolve upon (i) the happening of an event set forth in its articles of organization or operating agreement (for instance, a given date), (ii) after the passage of 90 days during which the LLC has no members, (iii) upon a judicial decree of dissolution, or (iv), and the most common occurrence—a vote of the members to dissolve. In practice, however, it is often the case that one of the foregoing dissolution formalities occurs well after the LLC distributes material assets to members. This can then mean that, upon a formal dissolution event, no assets remain to either distribute to members or pay a judgment against the dissolved LLC – including a judgment which first comes into existence after the LLC’s formal dissolution. In such circumstance the question arises of whether one who obtains a judgment against the dissolved LLC after its formal dissolution may collect that judgment against the LLC’s former members based on assets distributed to members in advance of any formal dissolution.

Representing the plaintiff the author recently tried to favorable judgment a case in the Madera County Superior Court presenting this precise issue. There, plaintiff, which was also an LLC, sued the defendant LLC and certain of its former members for monies which plaintiff’s own managing member had wrongly transferred to the defendant LLC to fund the defendant LLC. The defendant LLC, which had organized to assemble certain land and build a strip mall, encountered dismal market conditions in 2009 and, rather than develop, sold as much of its land as it could in a down market. It then distributed the sales proceeds together with its unsold land pro-rata among its members—including members who were unaware that its co-member had wrongfully transferred to the defendant LLC monies rightfully belonging to plaintiff. The members of the defendant LLC, however, did not formally vote to dissolve the defendant LLC until more than a year after these distributions, and did not file a certificate of dissolution until another year after that.

At trial, four years later, the defendants argued that, because the defendant LLC did not vote to dissolve until a year and three months after the land sale and distributions in question, its members received no distributions “upon dissolution” and were not personally liable for plaintiff’s judgment against the now dissolved and otherwise judgment proof LLC. The trial court ultimately agreed with plaintiff, however, and determined that dissolution in the context of “distributions upon dissolution” under California’s California Revised Limited Liability Company Act and its predecessor does not mean the last formal act of dissolution or a formal vote by its members to dissolve. Rather, dissolution reflects a process, and, that on our facts, the defendant LLC commenced a defacto dissolution when—rather than build a strip mall as originally planned—it instead sold what parcels it could into a depressed market and distributed the sales proceeds and balance of the land to its members as undivided tenants-in-common interests. The trial court held that plaintiff’s judgment – obtained four years after the LLC had distributed its assets and three years after its members voted to dissolve—was enforceable against the LLC’s former members to the extent each received distributions commencing with the 2009 land sales.

A “defacto” dissolution occurs when a California LLC ceases operating in the ordinary course of business

In October 2014, the California Court of Appeal in a case of first impression published a decision addressing this same fact pattern which the Madera County Superior Court addressed and reached the same conclusion. On October 7, 2014, the California Court of Appeal in CB Richard Ellis, Inc. vs. Terra Nostra Consultants, et al, held a defacto dissolution can in fact commence under California’s LLC statutory scheme (both that which existed before January 1, 2014, and under the California Revised Uniform Liability Company Act that became effective on January 1, 2014) without a formal vote of its members to dissolve. It determined that distributions to members in connection with a defacto dissolution in advance of or in the absence of one of the four formal events which the statutory scheme says dissolve an LLC support member personally liability for a later issued judgment against the dissolved LLC. It approved the following jury instruction which had been given in that case:

Dissolution of a limited liability company occurs when it ceases operating in the ordinary course of business, with the intention, on the part of its members, not to resume the ordinary course of its business. Dissolution of a limited liability company is not the same as cessation of all business activity. A limited liability company may continue to do business after it has dissolved for the purpose of winding up its affairs, paying its creditors and distributing remaining assets ….In determining whether a dissolution of [the LLC] …occurred, you may consider all evidence bearing on that issue, including, for example, the ordinary business of the limited liability company, the assets of the limited liability company both before and after a distribution, the continuation of the ordinary business and the cessation of its ordinary business.

The holding in CB Richard Ellis accordingly restricts an LLC’s ability to manipulate the appearance of the timing of commencement of dissolution—by delaying a formal member vote to dissolve and/or delaying the filing of dissolution documents so as to make it appear that the LLC did not distribute assets to members “upon dissolution.” Instead, California courts will look to all the circumstances and determine when it was that the LLC actually stopped operating in the ordinary course of business with the intention on the part of its members not to resume that ordinary course of business.  This means that an individual LLC member can be liable for a judgment against one’s dissolved LLC up to the value of money or assets distributed to such member from and after the date the LLC stopped operating in the ordinary course of business.

By Andrew (Drew) Piunti ©2014

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