We have seen in Part One how the jurisdiction in which you do business is the first factor to consider in the choice of the jurisdiction where to form an entity. In addition, the selection of the jurisdiction of formation also triggers the application of that jurisdiction’s corporate and contract law, which is also something to be considered. In Part Two we have seen how the requirements and costs of formation are similar but not identical (with some unexpected extra costs in certain jurisdictions) — so that this is also a factor that can guide your choice. We have also discussed the privacy expectation that you should have in the several jurisdictions.
Part Three deals with other two factors: liability protection for members/shareholders (i.e., whether or not they are protected from losing their interest for personal debts) and personal liability of shareholders/members and directors (i.e., whether they might be forced to pay for the entity’s debts or for malpractice).
Under this perspective, you are certainly better served when the court system is business-knowledgeable. Delaware courts are known for being experienced and business friendly; New York courts are also considered quite experienced.
Bear with me if this Part Three is rather technical. If you are risk-averse (that is: you are wondering if your personal creditors can take away your share of the business; if you can be called to pay for the company’s debt; and what is your responsibility as a director), these notes of mine can be a useful reading before choosing where to form your entity. If you are a “thrill-seeker” or you simply cannot stand legalese, just skip to Part Four of this series of articles. Part Four is where I discuss taxes.
[Read factors (1) and (2) in Part One and factors (3) and (4) in Part Two]
- Liability protection for members/shareholders – Which jurisdiction offers the best protection?
We deal here with the remedies available to personal creditors of shareholders or members. To clarify: what we will be discussing applies both if the shareholder/member is an individual and if the shareholder/member is a company.
The tools available to the personal creditors of a shareholder/member vary from jurisdiction to jurisdiction (we will discuss in the following New York, Delaware, Wyoming and Nevada as the most common jurisdictions where to form an entity).
Before considering the situation in these four jurisdictions, let’s discuss some general concepts about personal liability of owners of different types of entities in the U.S.
– LLC: generally speaking, the creditors of LLC members have, depending on the jurisdiction, the following remedies available: (i) charging orders (allowing collection on distributions to members or on sale of memberships); (ii) foreclosure on the membership interest and (iii) obtaining a court order for dissolution.
– Corporation: the creditors of shareholders have similar remedies: charging orders (in some jurisdictions), foreclosure, and order for dissolution (consider that dissolution often is not a direct action – it is a consequence of an action on the shares).
Additional explanation of charging orders is useful. A charging order is a court order that allows a lien to be placed against the debtor/member’s LLC “economic interest” in the LLC until the debt is satisfied, i.e., a lien against distributions that the LLC makes to the debtor/member. Consider that, for the broad way in which courts craft the order, it might be very difficult for the debtor/member to take away money from the company in any way (for example as salary or as a loan from LLC to relevant members).
It is often said that forming an LLC gives you almost everywhere in the U.S. a “charging order protection”, meaning that a personal creditor of a member cannot obtain the assets of the LLC or even his debtor’s LLC interest, but only a lien on the member’s economic interest. Said in another way, in almost all American jurisdictions, the charging order is the “exclusive remedy” that a creditor might employ to pursue the debtor/member’s interest. The reason behind the rule that the charging order is the exclusive remedy is the protection of the other members of the LLC (the members different from the debtor): we do not want to force them into a business relationship with someone (the creditor) who they did not bargain for.
To be fair, while it is often thought that charging orders are always the only remedy available to creditors of LLC members (being remedies like levies, garnishments, assignment orders, and the like excluded), it may be possible for a creditor to use other devices that are not technically “remedies,” such as the alter ego theory: this might result in the assets of an LLC being taken away. Also, because of the rationale behind the rule that we mentioned (protection of other members), when there is no other member to protect (either because we have a single-member LLC or all the members are debtors, e.g., personal guarantors towards a bank for a financing), the charging order protection does not apply and the creditors are entitled to a wider array of remedies.
While charging orders might be available in some jurisdictions also against corporations, they are never the “exclusive” remedy in case of corporations: personal creditors can enforce a judgment on the shares or can ask the liquidation of the corporation.
What’s about our 4 jurisdictions of reference?
New York: New York does not have charging orders protection for LLC: charging orders in NY are not the exclusive remedy for creditors of a multi-member LLC or single member LLC; courts have permitted foreclosure against a membership interest and dissolution notwithstanding the LLC statute. See N.Y. LLC. LAW § 607:
(a) On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the membership interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the membership interest. This chapter does not deprive any member of the benefit of any exemption laws applicable to his or her membership interest. (b) No creditor of a member shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.
In corporations creditors may foreclose on shares, or they can ask for dissolution.
Delaware: charging orders are the exclusive remedy for both single and multi member LLCs in Delaware. No foreclosure or dissolution is possible. Delaware LLC Act §18-703. In Delaware corporations, instead, foreclosure and dissolution are possible.
In Wyoming, the LLC has very clear statutory protection: the charging order is the exclusive remedy for both multi and single member LLCs. In corporations, judgment creditors can foreclose on the shares.
Nevada: there is even broader statutory protection granting charging orders as the exclusive remedy for multi and single member LLCs but also extending the protection to corporations. NRS 86.401 Nevada has made clear that charging orders are limited to distributions only. In Nevada a statute prohibits foreclosure on shares (this is similar to a “charging order protection” of LLCs).
- Personal liabilities of shareholders/members and directors.
Shareholders/members: As a general rule shareholders (corporations) and members (LLC) are generally liable only for their investments (i.e., loss of their investment in the entity and nothing else) but there are exceptions (i.e., in certain cases they can incur personal liability). You should consider those exceptions when choosing the jurisdiction. But before discussing the situations in which a shareholder/member can become personally liable for the LLC’s or corporation’s obligations, we want to highlight an obvious but important point: when the LLC or the corporation is owned by another entity (domestic or foreign), it will be this entity that may be subject to “personal” liability (i.e., the creditors of the subsidiary may be able to attach the assets of the parent company).
Personal liability (of members/shareholders or parent entity) arises typically under the following scenarios:
- “piercing the veil’ of the LLC/corporation;
- the member/shareholder has entered into a contract personally guaranteed by the member/shareholder;
- there has been an act or omission by the member/shareholder, such as their own negligence, fraud or illegal act;
- member/shareholder has consented to or has received a distribution violating a written agreement (for example with partners) or statute. Imagine a situation in which a lawsuit is pending and the shareholders quickly liquidate the company and distribute all of its assets – a court can order that shareholders to disgorge what they received.
Which is the liability of shareholders/members and directors in “our” jurisdictions?
New York has two peculiar rules. N.Y. BSC. LAW §630: the 10 largest shareholders/members are liable for wages and other compensation of employees. This is true for both for LLCs and corporations (on February 20, 2015, the law was changed to include LLCs.) In both LLCs and corporations, employees and managers having a duty to comply with sales tax payments are personally liable for unpaid sales taxes. In addition, in LLCs only, all members of the LLC are personally responsible for unpaid sales taxes. N.Y. Tax Law §1131(1), N.Y. Tax Law §1133.
Leaving aside the above, NY is very protective of shareholders. For example, in corporations, the cases in which shareholders bear personal responsibility as a consequence of a piercing of veil are really exceptional. It happens only when the plaintiff can establish (and the burden of proof is heavy) that 1) the principal of a corporation, with complete domination, has abused the corporate; and (2) the abuse was used to perpetrate a fraud, a wrong or an injustice on the plaintiff. See, e.g., ABN AMRO Bank v. MBIA, 17 N.Y.3d 208 (2011) and Matter of Morris v. New York State Dept. of taxation & Fin, 82 N.Y.2d, 135 (1993). See, e.g., G. Bundy Smith e T. J. Hall, The Wrongful Act Requirement for piercing the Corporate Veil, New York Law Journal, Volume 252 – No. 31, August 15, 2014.
Also Delaware offers a lot of protection to shareholders/members. §18-303 deals with liability to third parties (not to the company): (a) liabilities of an LLC, whether arising in contract, tort or otherwise, are solely liabilities of the LLC. No member or manager is obligated personally for any such liability solely by reason of being a member or manager. (b) A member or manager may agree to be obligated personally for liabilities of the LLC. In Delaware corporations can impose liability on shareholders through bylaws and charter provisions. The Supreme Court of Delaware held in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 555 (Del. 2014), that “a fee-shifting provision in a non-stock corporation’s bylaws can be valid and enforceable under Delaware law.”
Wyoming is also very protective of shareholders/members in avoiding personal liability: a statute specifically absolves members, except in case of fraud. For LLC: §17-29-304. (a) The liabilities of an LLC, whether arising in contract, tort or otherwise:(i) are solely liabilities of the company; and (ii) do not become the liabilities of a member or manager solely by reason of the member or manager acting as such. As for corporations, basically, in Wyoming, shareholders are committed only to the subscription. §17-16-204 deals with liability for pre-incorporation transactions. But once the corporation is formed, §17-16-622 states that a purchaser of shares is not liable to the corporation or its creditors except to pay the consideration for the shares. Unless in the articles of incorporation we specify otherwise, a shareholder is not personally liable for the acts or debts of the corporation except that he may become liable by his own acts or conduct.
In Nevada, LLC members are also well protected: NRS §86.371 deals with liability of members or managers for debts or liabilities of company: unless otherwise provided in the articles of organization or an agreement signed by the member or manager to be charged, no member or manager of any limited-liability company formed under the laws of Nevada is individually liable for the debts or liabilities of the company. This means that in Nevada, a member or manager can agree to assume liability (it is a kind of guaranty.) For corporations: NRS §78.747 says that except as otherwise provided by specific statute, no stockholder, director or officer of a corporation is individually liable for a debt or liability of the corporation, unless acting as the alter ego of the corporation (this is the “piercing the corporate veil” situation).
Directors: the general rule is that directors can be held personally liable for breaches of fiduciary duty but if otherwise acting in good faith and with reasonable business judgment, they are protected from personal liability for their service as directors. Good practice is for directors to obtain a D&O policy.
In New York, there is flexibility in shaping the responsibilities of directors. You should read carefully BCL 721, 722 and 723 when you draft your articles of incorporation because those sections tell you what you can change. In particular, BCL §§721-723 permit corporations to indemnify board members or officers who, by reason of board service, are sued in a civil or criminal proceeding. BCL §402(b) permits inclusion in the certificate of incorporation of a provision eliminating liability of directors to the corporation and shareholders for damages for breach of a duty owed to them. BCL §717(a)(2) permits board members to rely on the advice of professionals or persons whom they believe have expertise in the matter at issue in performing their corporate duties. Directors are free of personal liability for actions taken in reliance on such advice.
In Delaware, under 8 Del. C. § 102(b)(7), a corporation may adopt a provision in its certificate of incorporation exculpating its directors from monetary liability for an adjudicated breach of their duty of care. §141(e) is a general provision protecting directors for acting in good faith in reasonable reliance on professionals.
In Wyoming, the certificate of incorporation may contain:
(1) a provision eliminating liability of a director to the corporation/shareholders for money damages for any action taken, or any failure to take any action, except liability for: (i) The amount of financial benefit received but not entitled to; (ii) An intentional infliction of harm; (iii) A violation of W.S. 17-16-833 (responsibility for unlawful distribution); or (iv) An intentional violation of criminal law; and
(2) a provision permitting indemnification of a director for liability (as defined in W.S. 17-16- 850(a)(iii)) to any person for any action taken, or failure to take any action, as a director, except liability for: (i) Receipt of a unentitled financial benefit; (ii) An intentional infliction of harm; (iii) A violation of W.S. 17-16-833; or (iv) An intentional violation of criminal law.
Note that in Wyoming corporations themselves are subject to criminal sanctions (penalties) but it is possible to insert indemnification of directors in the by-laws.
In Nevada, directors are quite well shielded from responsibility: basically they are protected except for intentional misconduct, fraud or intentional violation of the law. NRS 78.138 7. Except as otherwise provided in specified cases, or unless the articles of incorporation (filed on or after October 1, 2003), provide for greater individual liability, a
director or officer is not individually liable to the corporation or its stockholders or creditors for any damages as a result of any act or failure to act in his or her capacity as a director or officer unless it is proven that (i) the act or failure to act was a breach of fiduciary duty; and (ii) the breach involved intentional misconduct, fraud or a knowing violation of the law.
For more information, Francesca Giannoni-Crystal
