The question whether real estate developers should dissolve their limited liability companies ("LLCs") that they typically create for development projects has been a hot topic for the past several years in Washington. As we reported in the November 2008 edition of GroundBreaking News, the Washington Court of Appeals recently issued two important decisions, Chadwick Farms Owners Ass'n v. FHC LLC and Emily Lane Homeowners Ass'n v. Colonial Dev. LLC, which interpreted a more recent amendment to the Washington Limited Liability Company Act (the "LLC Act"). The end result was that (1) an LLC was open to a lawsuit for three years following dissolution even if the LLC had been canceled, and (2) once canceled and until the three-year period from the date of dissolution, the LLC could still be sued but could not defend that suit.
The decisions in Chadwick Farms and Emily Lane presented a multitude of interesting theoretical legal issues and ramifications for the legal community, of the kind that lawyers would discuss and debate among themselves over dinner and law professors would discuss with their law students. While the implications of these cases deserve attention, ultimately the fundamental issue for the LLC member is whether he or she has a personal liability for claims brought against the LLC. The issue of personal liability hinges on the proper dissolution/winding up of the LLC by the members, as discussed below. Chadwick Farms and Emily Lane for the most part never changed this.
In May, the Washington Supreme Court overturned the holding in Chadwick Farms (followed by Emily Lane), establishing with some hopeful finality that once an LLC is canceled, the LLC cannot sue or be sued. The developer, however, must rely on the proper dissolution/winding up of the LLC in order to avoid personal liability—and for this reason the fact that an LLC cannot be sued after cancellation is of little comfort. In order to understand this concept, it is first necessary to understand the process of ending an LLC. Essentially, the life cycle of a limited liability company has three primary stages: active, dissolved, and canceled.
Stage One: Active. The LLC is active once its certificate of formation has been filed with the Washington Secretary of State. The LLC can carry on its business purpose, and so long as the necessary initial and annual reports are timely filed with the state and the annual license fees paid, the members enjoy the limited liability protections of the LLC and the LLC can sue or be sued.
Stage Two: Dissolved. Dissolution is the step that starts the process of winding up and ending an LLC's life cycle. Typically, dissolution will start by (1) the failure (either intentional or unintentional) of the LLC to timely file the annual report or pay the annual license fee to the state (referred to as an "administrative dissolution"), (2) agreement of the members to voluntarily dissolve the LLC, or (3) the occurrence of certain events in the LLC's governing documents.
To make things confusing, an LLC in the dissolution/winding-up process is most commonly referred to as a "dissolved" LLC, which seems to imply that the LLC is no longer in existence. In reality, however, just the opposite is true: the LLC continues to exist as a legal entity—it is just in the winding-up phase. A dissolved LLC can therefore sue or be sued, and can carry on business for the purposes of winding up the affairs of the LLC, even if that means a gradual closure of the LLC's business.
During the dissolved stage, the LLC's members (or manager, if it is a manager-managed LLC) are responsible for winding up its business affairs. During this stage, the LLC must distribute its assets to its creditors and then to its members. In addition, a dissolved LLC must "pay or make reasonable provision to pay all claims and obligations, including all contingent, conditional, or unmatured claims and obligations, known to the limited liability company and all claims and obligations which are known to the limited liability company but for which the identity of the claimant is unknown." The provision of contingent, conditional, or unmatured claims (referred to as "provisional claims") is a commonly overlooked step by developers for dissolved LLCs, potentially a costly misstep that may unnecessarily expose the LLC's members to personal liability for claims against the LLC. Under the LLC Act, an LLC member that complies with the winding-up stage, including making allocations for provisional claims, is generally not liable for claims against the LLC and will avoid personal liability.
It is easy for an LLC in this stage to come out of the dissolved stage and reenter the active stage either by agreement of the members or by paying the annual fees and a reinstatement fee to the Washington Secretary of State.
Stage Three: Canceled. The final stage in the life cycle of an LLC is cancellation of the LLC's certificate of formation with the Washington Secretary of State. This is done either by the LLC's voluntarily filing a certificate of cancellation with the Washington Secretary of State or automatically by the Washington Secretary of State two years after the date of administrative dissolution. Either way, the effect is the same; and once an LLC has been canceled, it ceases to exist as a legal entity and cannot sue or be sued. But the courts have consistently held that an LLC cannot be used to fraudulently avoid member liability simply by canceling the LLC; rather, the members must properly wind up the LLC's affairs in accordance with the LLC Act, as discussed above.
Practically speaking, a former member of a canceled LLC should not be concerned about any suits against the LLC once it has been canceled by the Washington Secretary of State, because at this point all of the LLC's assets will in all likelihood have been completely distributed out of the LLC. In other words, an LLC would have no assets left from which a potential claimant could recover. In fact, under current law, an LLC that has been canceled cannot be sued, since it has ceased to exist and there is no longer any entity to sue. A former member of a canceled LLC need be concerned only about the member's personal liability, which would occur only as a result of a failure to properly wind up the affairs of the LLC in accordance with the LLC Act, as discussed above. It is therefore essential that the LLC member understand the importance of properly winding up an LLC in order to avoid the risk of personal liability. And because a canceled LLC also cannot sue, cancellation should not be taken lightly because the members could lose out on potential claims that the LLC might have against a third party.
Now that the importance of properly winding up an LLC has been addressed, let's look into some of the specifics of how a member can avoid personal liability. How does one properly provide for provisional claims in order to comply with the LLC Act? For developers, the end result is typically a written consent of the members that documents and details the members' analysis and provision for the "contingent, conditional, and unmatured" claims as required by the LLC Act. In addition to providing for the payment of known creditors, the consent should memorialize the members' review and analysis of these claims. If appropriate, a reserve for these claims should be established, and the purchase of an insurance policy should also be considered. The payment of known creditors, and if necessary establishment of a reserve and purchase of an insurance policy, all should be done before the final distribution of the LLC's assets to the members. A simple few-page consent in which the members analyze and make a good-faith provision for such claims can be essential in maintaining the limited liability protections of the LLC that its members expect.
One other way in which developers have sought to avoid personal liability is to maintain the LLC's active existence for a period that exceeds the statute of limitations under which potential claimants would be likely to bring a claim, usually two to five years. While this plan of attack would work in theory, generally speaking it would require the LLC to postpone distributing out its assets to its members until the end of this period. Most developers are generally not able or willing to risk the LLC's assets for such an extended period. Even so, it is still advisable to properly wind up the affairs of the LLC by adopting consent resolutions analyzing the potential claims, even if that good-faith analysis results in a determination that no reserve must be established or insurance purchased. These factors must be considered on a case-by-case basis.
To summarize, developers (like all other LLC members) can avoid personal liability by properly winding up an LLC in accordance with the requirements of the LLC Act, which includes providing for the payment of potential claims. This is a simple yet important step that will allow LLC members to maintain the limited liability protections of the LLC that they expect.