As noted in this column Feb. 17, the law recognizes and encourages the use of limited liability entities - corporations, limited liability companies (LLCs), limited liability partnerships and limited liability limited partnerships - for the conduct of business.
As courts have said, treating limited liability entities as separate from their owners, officers and directors gives investors assurance they can invest in and act through the entity without being personally liable for its obligations. In other words, although you might lose your investment doing business through a limited liability entity, at least your house, car, wedding ring, etc., will be safe from the reach of creditors.
The law, however, also recognizes the idea that it wouldn't be fair to creditors if the owners of a limited liability entity could walk off with its money when it has unpaid debts. Here, the law governing corporations says creditors can sue a corporation's directors and officers if they authorize a distribution to shareholders that leaves the corporation insolvent and unable to pay its debts. (In a typical case, the directors and officers are also the shareholders receiving the distribution.)
In the case of LLCs - the most common type of limited liability entity used by small businesses - the law says owners of an LLC ("members") are liable to the LLC for distributions they receive that leave the entity insolvent.
You would think, then, that a creditor of an insolvent LLC could sue the LLC's members for money they received that caused the entity to become insolvent. But the Colorado Supreme Court, in a decision handed down in June, said no. Members who receive distributions from an LLC leaving the LLC insolvent are liable to the LLC - but not to its creditors, the court ruled.
"What kind of nonsense is that?" you might ask. Well, the court's reasoning went like this: "Hey, this is what the LLC statute clearly says, and we, as a court, have to enforce the statute as written."
So what are creditors of an LLC supposed to do when the members pocket all the money, leaving the LLC insolvent? Most likely, they will have to ask a court to appoint a receiver for the LLC with authority, in the name of the LLC, to sue the members in an effort to put the money wrongfully distributed to them back into the LLC's bank account. Then, if there's anything left after the costs of the receivership are paid, the receiver will pay the LLC's debts.
It wouldn't surprise me to see the Colorado General Assembly revisit this part of the LLC act.
Jim Flynn is a private attorney with Flynn Wright & Fredman LLC in Colorado Springs. Email him at email@example.com.