By John Hickey
People form corporations and limited liability companies for personal liability protection. Where partners in a partnership are personally liable for the partnership's obligations and liabilities, shareholders of corporations and members of limited liability companies usually are not personally liable for their company's obligations and liabilities. A recent Oregon case, however, shows that members of member-managed LLCs do not have the protection that many assumed they did.
The general assumption is that corporations and LLCs protect their owners from liability equally. Unless the owners signed a personal guarantee, a creditor may look only to the corporation or the LLC for payment of a company debt. If the corporation or LLC doesn't have the money, the creditor is out of luck.
But that protection does not extend to every debt of the corporation or LLC. For example, if an officer of a corporation or a manager of an LLC is negligent (fails to implement reasonable safety procedures) or makes fraudulent statements ("you don't need a guarantee from me because the company is good for it"), the officer or manager may be personally liable for his or her own conduct. In many such cases, the officer or manager and the company share liability.
Under the workers' compensation insurance laws, Oregon broadened the limited liability protections to cover individuals associated with the company who negligently cause injury to employees of the company. If a company has the required workers' compensation insurance, injured employees may only file a claim with the employer's workers' compensation insurer (e.g., injured employees may not sue their employer or coworkers for negligence).
The limitation on liability is called the exclusive remedy protection of the Oregon workers' compensation law. That protection extends to agents, employees, officers, and directors of a corporation — meaning that the people actually carrying out the business of a corporation are also shielded from personal liability. Although almost everyone assumed that the individuals carrying out the business of LLCs were equally protected, a recent case shows that the assumption was wrong.
Cortez v. Nacco
In Cortez, an employee of a member-managed LLC was hit by a forklift when it was backing up. The injured employee filed a claim for workers' compensation benefits and also sued the member-manager of the LLC (the owner who also managed the LLC). The member-manager argued that the exclusive remedy protection of the workers' compensation law extends to member-managers of LLCs just as it extends to officers and directors of corporations and that therefore the injured employee's claim should be dismissed.
The court disagreed and concluded that the exclusive remedy protection of the workers' compensation law does not extend to members of LLCs. The court looked to the specific language used in the law and refused to equate members of LLCs with officers or directors of corporations where the legislature did not specifically do so.
Business lawyers often debate whether forming a corporation is worth the expense and additional formalities since LLCs have more flexibility and can be cheaper to operate. An important difference highlighted by Cortez is the separation of ownership and operation. Corporations have three layers: the shareholders who own, the directors who manage, and the officers who carry out the directions of the directors. In LLCs the management and operation layers are often combined and performed by member-managers.
Even in a corporation where there is only one shareholder who is also the sole director and serves as all officers, that individual is acting as the corporation's director when he or she manages and as an officer when he or she carries out the business of the corporation and — if the corporation follows necessary formalities — is shielded from personal liability for claims by injured workers. In a member-managed LLC, the lines between owner, manager, and operator are blurred, and Cortez shows that the blurring opens member-managers to unexpected liabilities.
Business associations will undoubtedly push for a change in the law to lessen the risk to member-managers of LLCs. Even if they are successful, the real issue is whether there are other unexpected risks looming for owners of LLCs.
That does not mean that every member-managed LLC should become a corporation. In some cases, the benefits of an LLC may be worth the risk. However, member-managed LLCs should evaluate how they distinguish between ownership, management, and operation, and consider whether changes to the operating agreement or additional formalities would be beneficial.