Business Litigation and Derivative Actions Involving Colorado Limited Liability Companies
Under Colorado law, there are various types of business entities that can be formed in order to conduct business inside and outside of the state. Common examples of these entities include general partnerships, limited partnerships, corporations, and limited liability companies. Business entities are frequently formed because they offer the ability to insulate one’s personal assets from the assets of the business, thereby allowing individuals to take risks and pursue business opportunities without jeopardizing their own personal assets.
Perhaps the most advantageous form of business entity in Colorado, and also one of the most commonly used, is the Limited Liability Company (“LLC”). The LLC form offers a flexible middle ground between general partnerships, which are the most basic form of a business venture and require no specific formalities and procedures to form; and a corporation, which requires a significant amount of formalities and procedures to both form and run.
In effect, an LLC combines the benefits of simple business entities, by being both easy and relatively simple to form; with the benefits of more complex entities, such as corporations, which insulate its members and managers from personal liability, something which general partnerships do not.
Additionally, another significant benefit of LLCs is that, for tax purposes, they are treated similar to partnerships and sole proprietorships such that they are not taxed at both the company and individual levels. Instead, LLCs are considered pass-through entities where any profits or losses pass directly to its owners thereby avoiding the double taxation elements that come with corporate entities.
Importantly, despite LLCs offering a relatively streamlined business entity form, dealing with lawsuits as members, managers, or shareholders of an LLC can quickly become a complicated process. This article focuses on litigation where a Colorado LLC is involved. Applicable statutes in Colorado include Colorado Revised Statutes (“C.R.S.”) §§ 7-80-101, et seq., which generally govern LLCs, including specific procedures for bringing lawsuits on behalf of an LLC.
Decision Makers and Agents of a Colorado Limited Liability Company
In forming an LLC, there are generally only two options for designating what type of management structure the company will have. That is, an LLC can either be created as a member managed company or a manager managed company.
Notably, the distinctions are just as they sound. A member managed company is where the actual members of the LLC – that is, the LLC owners – are responsible for running the company and making business decisions on behalf of the company.
In contrast, a manager managed LLC is where the owners of the LLC, instead of running the company themselves, designate managers to run the company for them. Importantly, whether an LLC will be a member managed company or a manager managed company must be specifically identifies in the LLC’s articles of organization. See C.R.S. § 7-80-204(e).
Where the LLC is designated as a member managed company, each member is considered an agent of the LLC regardless of the size of their ownership interest and, therefore, each member has the ability to bind the company for actions within the ordinary scope of the LLC’s business. This includes such things as entering into contracts on behalf of the LLC, hiring and firing employees of the LLC, and generally engaging in day-to-day operations on behalf of the LLC.
In contrast, where an LLC is designated as a manager managed company, the members are not considered agents of the LLC and, therefore, do not have the authority to bind the LLC in its day-to-day operations. Instead, this power is delegated to the appointed managers who, in effect, take the place of its members as agents of the LLC. Importantly, however, the specific scope and authority of both members and managers can be modified, granted, or otherwise changed in the LLC’s operating agreement. See C.R.S. § 7-80-405.
Duties and Rights of Decision Makers and Agents of a Colorado Limited Liability Company
Regardless of whether an LLC is a member managed company or a manager managed company, whoever is responsible for acting as an agent of the company owes certain duties to the LLC. Further, in addition to those duties, members and managers have certain rights they may exercise in relation to the LLC. In particular, those duties and rights include:
– A common law duty of care pursuant to agency principles which include obligations to use reasonable care in the performance of the agency relationship, to provide timely and accurate information to the LLC, to act competently in relation to the LLC’s business, and to act diligently in relation to the LLC’s business.
– A statutory duty to account to the LLC and hold as trustee for the LLC any property, profit, or befit derived by each member or manager in the conduct of winding up the LLC or derived from use of the LLC’s property by each member or manager, including the appropriation of an opportunity of the LLC.
– A statutory duty to refrain from dealing with the LLC in the conduct or winding up of the LLC as or on behalf of a party having an interest adverse the LLC.
– A statutory duty to refrain from competing with the LLC in the conduct of the LLC’s business before the dissolution of the LLC.
– A statutory duty of care in the conduct and winding up of the LLC, limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.
– A statutory duty that each member and manager shall discharge their respective duties to the LLC and exercise any rights in relation to the LLC consistent with the contractual obligation of good faith and fair dealing.
– A statutory right of members and managers to be reimbursed or indemnified by the LLC for any payments made or liabilities incurred by a member or manager in the ordinary course of business of the LLC.
– A statutory right of each member of the LLC to inspect and copy the financial records of the LLC upon reasonable demand and purpose reasonably related to a member’s interest in the LLC.
See C.R.S. §§ 7-80-404 to -408. Notably, Colorado statutes indicate that a duty is not violated by an LLC member or manager solely because a member’s or manager’s conduct furthers the member’s or manager’s own interest nor because a member of manager has lent money or transacted business with the LLC provided that those actions were taken in the same manner as though the LLC had been dealing with an independent entity. See C.R.C. § 7-80-404.
Additionally, and similar to how decision maker and agent roles may be modified, the statutory duties imposed on LLCs made by modified by the terms of the LLC’s operating agreement. Specifically, the duties managers and members owe to the LLC may be restricted, modified, or eliminated by the operating agreement as long as those modifications are not manifestly unreasonable.
In particular, an operating agreement may not unreasonably restrict the abilities of members to inspect the financial records of the LLC, may not waive the duty of members and managers to exercise their actions consistent with the obligation of good faith and fair dealing, or restrict and impose duties on persons other than the members of the LLC without the consent of those persons. See C.R.S. § 1-80-108.
In contrast, examples of duties and rights that can be waived, and frequently are, include waiving the duty of members of member managed LLC to not compete with the LLC, waiving the duty of care of member and managers in the conduct of winding up and dissolving the LLC, and waiving the obligations to refrain from dealing with the LLC as or on behalf of a party having an interest adverse to the LLC. See C.R.S. § 7-80-404(1)(c); C.R.S. § 7-80-404(2); C.R.S. § 7-80-404(1).
Bringing a Lawsuit, or Derivative Action, on Behalf of a Colorado Limited Liability Company
Where an LLC has a legal claim against another person or entity, that claim belongs to the company as opposed to the specific members or owners of the LLC. Accordingly, it is the company that must bring the lawsuit as opposed to the members or owners simply filing suit without consent of the company.
That is, under Colorado law, the decisions makers of the LLC, be it member managed or manager managed, have the first option of deciding whether or not to file a lawsuit to pursue any legal claims the LLC may have. If the LLC delays in filing a lawsuit or otherwise refrains from doing so entirely, then the members of the LLC have the ability to pursue claims on behalf of the company provided certain conditions are met.
Where the decision makers of the LLC refuse to bring a lawsuit or delay in bringing a lawsuit, and the members subsequently bring one on behalf of the LLC, those actions are called derivative actions and are governed by C.R.S. §§ 7-80-713 to -719. Put simply, derivative actions occur where a member stands in the shoes of the LLC and brings a lawsuit to pursue claims on behalf of the LLC where the LLC has otherwise failed to do so.
In order for a member to bring a derivative action on behalf of LLC, that member have proper standing to do so. In order to have standing, the member must have been a member of the LLC when the act or omission giving rise to the legal claim occurred. Additionally, the member must be similarly situated to such that he or she fairly and adequately represents the interests of other members of the LLC. See C.R.S. § 7-80-713.
If a member has proper standing, the member must also give a demand on the LLC before actually filing and proceeding with the derivative action. The purpose of the demand is to give the LLC’s decision notice of the claims the member is looking to pursue in order to enable LLC to investigate them and determine whether the LLC itself will bring an action.
Importantly, the demand must be given in writing and should indicate the member’s interest as well as state the claim with sufficient particularity that the LLC decision makers can identify the issue, perform an investigation into the issue, correct any problems if necessary, or otherwise pursue a lawsuit on behalf of the LLC. After giving a written demand, the member must wait 30 days before filing a derivative unless the LLC responds to the written demand sooner or unless irreparable injury would result if the 30 day period is allowed to run. See, e.g., C.R.C.P. 23.1.
If the LLC does decide to pursue legal action after receiving the written demand, then no derivative action is necessary since the decision makers will have filed and pursued a lawsuit on behalf of the company. If the LLC indicates it will not be pursuing the claim or otherwise fails to respond within the 30 day period, then the member may proceed with the derivative action on behalf of the LLC. See C.R.S. § 7-80-714.
Importantly, even though a member may have issued a demand and filed a lawsuit, an LLC may still have the lawsuit dismissed if it has already performed or, after the lawsuit is filed, subsequently performs an independent investigation into the claims and determines that it is in not in the best interest of the LLC to pursue the lawsuit.
Notably, any decision makers investigating the claims must be sufficiently independent from the factual basis of those claims so as not to impair the credibility of the investigation. Examples where the independence of an investigation may be questioned include scenarios where the people or persons charged with investigating the claim are the subject of the lawsuit, or have business, personal, or familial relationships with other individuals involved in the claims that would otherwise bias their judgment.
In such cases, making a demand on the LLC may, in effect, boil down to requesting that a decision maker investigate and sue themselves; something which, for obvious reasons, the decision maker has a vested interest in not doing. Accordingly, where these circumstances exist, the conflicts inherent in the investigation will raise serious doubts as to whether the investigation was sufficiently independent.
Where an investigation has been made and the decision makers have determined it is not in the best interests of the LLC to pursue a lawsuit, the burden is on the plaintiff to demonstrate that the decision makers were not independent, that the inquiry they conducted was inadequate, or that the determination not to continue the lawsuit was not make in good faith. See C.R.S. § 7-80-716; Young v. Bush, 277 P.3d 916 (Colo. App. 2012).
Further, if a derivative action has been filed before the investigation occurred, courts may stay the action in order to give the LLC time to investigate the claim. Similarly, after the investigation is complete, courts may allow the plaintiff an opportunity to engage in discovery to show the investigation was deficient for any of the above reasons.
Where a plaintiff is unable to show the LLC’s was investigation was deficient, the LLC’s determination will govern and the presiding court will dismiss the derivative action. Conversely, if the plaintiff is able to show the LLC’s investigation was deficient, the derivative action will continue. See C.R.S. § 7-80-715; Young v. Bush, 277 P.3d 916 (Colo. App. 2012).
Judicial Dissolution of a Colorado Limited Liability Company
Aside from derivative actions brought on behalf of an LLC and actions brought directly by LLC’s to pursue claims belonging to the company, lawsuit seeking to judicially dissolve the LLC can be brought as well.
More specifically, under Colorado law a member or manager of an LLC may bring a lawsuit to dissolve the company where it no longer reasonably practicable to carry on the business of the LLC. Notably, while there are no dispositive requirements for determining whether an LLC should be dissolved, some factors the courts look to in making such a decision include:
– Whether the management of the LLC is unable or unwilling to permit or promote the purposes for which the company was formed;
– Whether a member or manager has engaged in misconduct;
– Whether the members have clearly reached an inability to work with one another to pursue the company’s goals;
– Whether the is deadlock between the members;
– Whether the operating agreement provides of navigating around any such deadlock;
– Whether, due to the company’s financial position, there is still a business to operate; and
– Whether continuing the company is financially feasible.
See C.R.S. § 7-80-810; Gagne v. Gagne, 338 P.3d 1152 (Colo. App. 2014). Importantly, where a judicial proceeding is brought to dissolve an LLC, if no venue provisions are provided in the operating agreement, the lawsuit should be filed in the district court of the county where the LLC’s principal office is located. See C.R.S. § 7-80-811.
In dissolving the LLC, the court may appoint a custodian or receiver who has authority and control over the LLC’s assets or otherwise direct that the LLC be wound up or dissolved in conformance with a voluntary dissolution of the company. See C.R.S. § 7-80-803; C.R.S. § 7-80-811; C.R.S. § 7-80-812.
Lastly, a dissolved LLC may dispose of claims that creditors have against the LLC by providing notice to those creditors, either directly or by publication, an action to enforce those claims must be brought within two years of delivery of the notice. If a creditor fails to bring its claims within that time period then the creditor will no longer be able to pursue those claims against the LLC. See C.R.S. § 7-80-812; C.R.S. § 7-90-911; C.R.S. § 7-90-912.
© 2018 J.D. Porter, LLC. Author: Jordan Porter. Denver, Colorado.