Faulty Service on Defunct LLC Spells Trouble for Judgment Creditor – IL 1st Dist.

In a case whose procedural progression spans more than a decade, the First District in John Isfan Construction v. Longwood Towers, LLC, 2016 IL App (1st) 143211 examines the litigation aftershocks flowing from a failure to properly serve a limited liability company (LLC).

The case also illustrates when a money judgment can be vacated under the “substantial justice” standard governing non-final judgments.

The tortured case chronology went like this:

2003 – plaintiff files a mechanics lien suit against LLC for unpaid construction work on an 80-unit condominium development;

2005 – LLC dissolves involuntarily;

2005 – lien suit voluntarily dismissed;

2006 – plaintiff breach of contract action filed against LLC;

2009 – default judgment entered against LLC for about $800K;

2011 – plaintiff issues citations to discover assets to LLC’s former members and files complaint against the members to hold them liable for the 2009 default judgment (on the theory that the LLC made unlawful distributions to the members);

2014 – LLC members move to vacate the 2009 judgment. Motion is denied by the trial court and LLC members appeal.

Holding: The appeals court reversed the trial court and found that the 2009 default judgment was void.

The reason: Plaintiff’s failure to properly serve the defunct LLC under Illinois law. As a result, a hefty money judgment was vacated.

Q:           Why?

A:            A defendant must be served with process for a court to exercise personal jurisdiction over him.  A judgment entered against a party who is not properly served is void.  

Section 50 of the LLC Act (805 ILCS 180/1-50) provides that service of process on an LLC defendant must be made on (a) the LLC’s registered agent or (b) the Secretary of State if the LLC doesn’t appoint a registered agent or where the LLC’s registered agent cannot be found at the LLC’s registered office or principal place of business.

In the context of a dissolved LLC, the LLC Act provides that an LLC continues post-dissolution solely for the purpose of winding up.  This is in contrast to the corporate survival statute that provides that a dissolved (non-LLC) corporation continues for five years after dissolution (This means the defunct corporation can be sued and served for up to five years after dissolution.)  805 ILCS 5/5.05.

Here, the plaintiff sued the LLC’s former registered agent over a year after the LLC dissolved.  This was improper service under the LLC Act.  By failing to serve the Secretary of State in accordance with the LLC Act, the court lacked jurisdiction over the LLC.  (¶¶ 37-40)

The Court also rejected the plaintiff’s argument that the erstwhile LLC members waived their objection to jurisdiction over the LLC by participating in post-judgment proceedings.

Since a party who submits to a court’s jurisdiction does so only prospectively, not retroactively, the party’s appearance doesn’t activate an earlier order entered in the case before the appearance was filed. (¶¶ 40-42)

Another reason the Court voided the default judgment was the “substantial justice” standard which governs whether a court will vacate a judgment under Code Section 2-1301(e). 

The reason Section 2-1301 applied instead of the harsher 2-1401 was because the judgment wasn’t final.  It wasn’t final because at the time the judgment was entered, the plaintiff had a pending claim against another party that wasn’t disposed of.  ((¶¶ 46-47)

Under Illinois law, a default judgment is a drastic remedy and Illinois courts have a long and strong policy of deciding cases on the merits instead of on procedural grounds.  In addition, when seeking to vacate a non-final default order, the movant does not have to show a meritorious defense or diligence in presenting the defense.

Applying these default order guideposts, the Court found that substantial justice considerations dictated that the default judgment be vacated.  Even though the judgment was entered some five years before the motion to vacate was filed, it wasn’t a final order. 

This meant the LLC member movants did not have to show diligence in defending the action or a meritorious defense.  All the members had to demonstrate was that it was fair and just that they have their day in court and that they should be able to defend the plaintiff’s unlawful transfers allegations. (¶¶ 49, 51)

Afterwords: This case provides a useful summary of the key rules that govern how to serve LLC’s and particularly, dissolved LLC’s.  The case’s “cautionary tales” are to (i) serve corporate defendants in accordance with statutory direction; and (ii) always request a finding of finality for default judgments where there are multiple parties or claims involved.

Had the plaintiff received a finding of finality, the LLC members’ motion to vacate would have been untimely under Section 2-1401 – which requires a motion to attack a final judgment to be brought within two years and has a heavier proof burden than a 2-1301 motion.  Still, it wouldn’t have mattered here. The plaintiff’s failure to properly serve the LLC meant the judgment was void and could have been attacked at any time.

 

All About Charging Orders – When the Judgment Debtor Is an LLC Member

ChargeGetting a judgment against an LLC member can trigger a high-anxiety response.  That’s because the normal post-judgment collection rules set out in Code Section 2-1402 and Supreme Court Rule 277  don’t cleanly apply.  

Section 30-20 of the LLC Act (805 ILCS 180/30-20) states that a creditor’s exclusive remedy is to obtain a “charging order” against the LLC member’s “distributional interest.”  Illinois cases describe  Section 30-20 as a special remedy designed to allow a creditor of an LLC member to realize the value of the debtor’s distributional interest in the LLC and also protect both the LLC’s ability to function and the other members’ LLC interests.

The LLC Act defines “distributional interest” as a “member’s interest in distributions by the limited liability company.”  A distributional interest is not salary, wages, draws or reimbursement. To reach an LLC member’s wages, for example, a creditor should still utilize a third-party citation on the LLC and seek a turnover of any wages to be paid to the debtor.

To obtain a charging order, the creditor files an application or motion with the Court (“Motion for Charging Order”) and requests a charging order on the LLC member’s interest in the LLC.  The Motion is served on the debtor by regular mail and the creditor does not have to name the LLC as a party defendant. 

The court also isn’t required to have jurisdiction over the LLC for a charging order to issue against the member-debtor.  See, Bank of America, N.A. v. Freed, 1-11-0749 et al., 2012 WL 6725894 (Ill. App. Ct. Dec. 28, 2012) (LLC is not a necessary party to creditor’s charging order application).

The charging order impresses a lien (a hold) on the debtor’s LLC interest and any distributions coming due to the debtor can be paid to the creditor.  The lien on the distribution can also be foreclosed by the creditor filing a petition to foreclose the lien.  The debtor’s LLC interest can then be sold by the Sheriff or a private property – much like with any other asset sale.  Any sale proceeds the debtor’s distributional interest garners can be applied to the judgment amount.

To summarize, then, an LLC member’s judgment creditor should follow this four-step enforcement process: (1) file a motion for a charging order against the LLC member’s distributional interest; (2) serve the charging order on the LLC’s manager and registered agent (so they know to forward the distribution to the creditor), (3) (if the debtor doesn’t redeem and the judgment isn’t satisfied after turnover of the distribution) file a motion to foreclose the charging order (appoint someone to evaluate and sell the distributional interest); and (4) schedule either a public or private sale of the debtor’s distributional interest.  I also serve a third-party citation directly on the LLC and ask for a turnover order on any wages, draws or other payments (that aren’t distributions) to the debtor.

Post-Judgment Statutory Changes

Effective January 1, 2012, several statutes that govern Illinois judgment enforcement practice took effect.  The key statutory change as it relates to enforcing judgments against LLC members is Code Section 12-112.5.  This Section speaks directly to the charging order remedy and provides:

Sec. 12-112.5. Charging orders. If a statute or case requires or permits a judgment creditor to use the remedy of a charging order, said remedy may be brought and obtained by serving any of the various enforcement procedures set forth within this Article XII or by serving a citation pursuant to Section 2-1402. If the court does not otherwise have jurisdiction of the parties, the law relating to the type of enforcement served shall be used to determine issues ancillary to the entry of a charging order such as jurisdiction, liens, and priority of liens.

The comments to revised Section 5-112.5 make it clear that while a charging order is still the exclusive remedy for a creditor to impress a lien on an LLC member’s distributional interest, the creditor can use citation/supplementary proceedings under Code Section 2-1402 and Rule 277 to obtain that charging order in the first place.

Going forward, and in light of Section 112.5 and until there are more published cases that more thoroughly examine the interplay between Section 112.5 with LLC Section 30/20, judgment creditors of an LLC member should (1) serve a citation on the debtor, (2) serve a third-party citation on the LLC (via its registered agent or manager); and (3) file a motion for a charging order against the debtor’s LLC interest.

Once the charging order enters, the creditor can either receive distributions until the judgment is satisfied or try to more quickly monetize the debtor’s LLC distribution by filing a petition to foreclose the charging order lien.  A foreclosure sale buyer of the distributional interest will have rights to future distributions but does not get to exercise voting rights or make LLC business decisions.

 

LLC Member Not Liable For Fraud Carried Out On Behalf of LLC

The First District expansively construed Section 10-10 of the Illinois LLC statute (805 ILCS 180/10-10) to immunize LLC managers and members from personal liability for misdeeds carried out on the LLC’s behalf.

In Dass v. Yale, 2013 IL App (1st) 122520, the plaintiffs sued an LLC member (along with a general contractor and sales agent) for construction defects in their Chicago condominium.  They alleged the defendant LLC member made multiple misrepresentations in various written sales documents concerning the property’s roof and plumbing condition and past problems with leaking. 

After getting an uncollectable default judgment against the dissolved general contractor, the plaintiffs focused their case on the individual LLC member.  The Court granted the LLC member’s section 2-619 motion and the plaintiffs appealed.

Held: Affirmed.  Section 10-10 of the LLC Act provides that LLC members are not individually liable for actions taken on behalf of the LLC.

Rules/Reasoning:

Section 10-10 of the Illinois LLC Act plainly provides that liabilities of an LLC – arising in contract or tort – belong solely to the LLC and that LLC members or managers aren’t personally liable for LLC liabilities. 

Members of an LLC can only be personally responsible for LLC liabilities where (a) the LLC articles of organization explicitly provide for personal liability; and (b) the member(s) consents in writing to be personally bound by the articles’ section that imposes personal liability on the member(s). 

In addition, an LLC’s failure to follow corporate formalities in its business is not a basis for imposing personal liability on LLC members or managers. ¶37

Here, the plaintiffs’ fraud allegations against the defendant LLC member were premised on conduct he engaged in while carrying out his marketing efforts on behalf of the LLC.  The plaintiffs’ assertion that the defendant misrepresented the property’s condition and its construction materials alleged conduct occurring in the course of the LLC trying to sell the property.

 Since there was no evidence that the LLC’s organizing papers provided for personal liability or that the defendant consented in writing to liability, Section 10-10 of the LLC  Act clearly immunized the defendant from the plaintiffs’ fraud claims.  (¶¶38-39).

Two cases that figure prominently in the Dass analysis are Carrollo v. Irwin, 2011 IL App (1st) 102765 and Puleo v. Topel (368 Ill.App.3d 63) which, respectively, hold that LLC members aren’t individually liable for obligations occurring prior to LLC formation (Carrollo) or after LLC dissolution (Puleo).  

Dass, Carrollo and Puleo form a three-part case continuum on the issue of an LLC member’s liability for actions taken before, during and after an LLC’s formation and dissolution.  The synthesized holding of the three cases underscores that actions of LLC personnel will not give rise to personal liability; even for intentional torts (i.e., fraud). (¶¶ 39-44).  The LLC Act gives members of unformed LLCs more protection than officers of unformed corporations).

Take-away: A harsh result for plaintiffs trying to sue LLC members for acts taken under the auspices of the LLC.  Dass stands for clear proposition that until the legislature amends the LLC Act, LLC members and managers’ acts are protected – as long as they’re taken in connection with the carrying out the LLC’s business.

 Had the plaintiffs claimed that the LLC member committed fraud individually (and unrelated to his LLC duties), the result may have been different.