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Colorado Clarifies Rules for LLCs
The National Law Journal
In a ruling likely to make life easier for numerous businesses, including law firms, the Colorado Supreme Court said on June 10 that creditors of a limited liability company alleged to be facing insolvency could not go after its individual owners for payment on a debt.
The case, one of several that has sprung up as businesses face financial struggles in the recession, clarified case law in Colorado and reversed a decision of the Colorado Court of Appeals, according to Giovanni Ruscitti, founding partner of Berg Hill Greenleaf & Ruscitti in Boulder, Colo. Ruscitti, who represented the limited liability company in the case, talked to The National Law Journal about the significance of the court’s ruling.
Graham Fuller, of Stone & Rosen in Boulder, who represented the creditor in the case, declined to comment.
This article has been edited for length and clarity.
National Law Journal: Tell me a little bit about the background to this case.
Giovanni Ruscitti: There was an underlying arbitration matter between the entity that our individual clients were members in and a party they had a contractual relationship with. There was an adverse ruling against the Colorado LLC. And then, after a period of time, the plaintiff—they were called the “claimant” in the arbitration—filed a lawsuit in Colorado against the managers and members of the LLC.
Their theory was they wanted to have the managers and members liable for the debt of the corporation while the corporation was in the “zone of insolvency.” Essentially, what they were trying to do was pierce the LLC veil to collect debt.
The actual formal name was Boulder Partnership LLC. Prior to the arbitration case, Boulder Partnership sold some of its assets in the ordinary course of business—about 18 months before the arbitration hearing and award in the arbitration. Colborne Foodbotics LLC, the plaintiff, was trying to argue that when they did that, they were insolvent, and they knew they were likely to have an adverse award in the arbitration. So they were trying to say the members of Boulder Partnership should repay to the company the amount they received as part of the sale of the assets, so they could then be collected by the plaintiff in satisfaction of their arbitration award.
NLJ: What do you mean by “zone of insolvency”?
Ruscitti: Insolvency has different meanings. Generally speaking, it’s two perspectives: A balance approach, where liabilities exceed assets; or, from a cash-flow perspective, having the inability to pay debts as they come due. There was never a finding of insolvency. That was the allegation made by Colborne, the plaintiff. They jumped through several illogical hoops to say that the LLC was insolvent and, because it was, they should have the right to pierce through the corporation and go after the members.
NLJ: This case generated some interest outside Colorado. Why?
Ruscitti: The reason why this has a national flavor is our [LLC] act is based on the Uniform Act, which most states have adopted. It’s very similar. [The case] had appeal not only in Colorado but nationally—we found out because people from other states began following our case almost immediately.
NLJ: Why is this area of law unclear?
Ruscitti: LLCs are a relatively new breed in the corporate entity formation world. They’re a hybrid between corporations and partnerships. They’re attractive to entrepreneurs because they provide flexibility in ownership and management, and there’s some tax advantages. The problem was, it was a new type of corporate entity with no law in any state, including Delaware, one of the leading states in corporate law. That led to a typical flurry of litigation. When the recession hit, creditors started getting aggressive in their attempts to collect debts from LLCs—meaning, they started to go after owners and coming up with whatever theories they could.
NLJ: What was at stake in this case?
Ruscitti: To what extent can a creditor hold a member liable for debts of an LLC when the LLC was in this zone of insolvency. That was a specific issue. The reason that’s a hot topic is because most state LLC acts have some gaps or holes as to that specific issue. Other states have that issue going on at the same time, including Delaware.
The Delaware court ruled right before the Colorado court ruled, and reached the same conclusion—which was that when the LLC is in this zone of insolvency, creditors cannot bring claims against members over what are deemed to be statutory improper distributions that either were made to a member when the company was insolvent or which rendered it insolvent.
The reason this was important was that it was a byproduct of the economy. A lot of entities were in a distressed state. If you have a hard-line rule, like the Court of Appeals had in place, it opened up managers and members to all types of exposure that didn’t exist and shouldn’t exist, because it’s counter to the entire concept about corporate protection of owners.
NLJ: What effect did this case have on your other LLC clients?
Ruscitti: We’re located in Boulder, which is really a hotbed for emerging-growth tech companies. We have a lot of entrepreneurs here—a lot of high-level technology thinking occurs here. When a client comes to you, especially these emerging-growth companies that are well funded with venture capital and private equity firms, they want to make sure that they have that limited liability as the name entails. The Court of Appeals would have opened it up to other situations, so that I would not feel comfortable advising clients to organize here.
This ruling changes that. It not only provides precedent for other states grappling with this issue, but it invites LLC owners from other states to consider Colorado as a leading LLC state—much like Delaware—as maybe an attractive place to do business.
NLJ: How could this ruling apply to law firms in Colorado?
Ruscitti: The analysis would be identical. And looking at an LLC, now you know in Colorado that when you’re in this zone of insolvency, which is so hard to define, that you’ll have added protection that you might not otherwise have with other entity forms. It provides them assurance. It’s not a blank check to go out and engage in improper conduct, but it provides the type of assurances people want when they form a corporation, whether they’re lawyers or any type of entity.
This article originally appeared in The National Law Journal.