Many clients come to me with complaints about their business partner and his or her misconduct in managing the co-owned LLC. Mismanagement that resulted in unnecessary debt for the LLC, liabilities, waste of the LLC’s assets and so forth. They invariably ask if they can sue the co-member for such misconduct and get damages. After all, their interest in the LLC is being “devalued” by such conduct and they should be made whole. The short answer is, that while you can sue the business partner for the harm caused to the LLC, the damages would be payable to the LLC and not to you, the member of the LLC. So while your interest in the LLC is in fact being devalued, you will not get damages paid directly to you. To make it more complicated, you cannot directly sue the business partner, you will have to start a lawsuit in the name of the LLC, on its behalf.
Mismanagement Damages go to the LLC
Members and managers of an LLC are responsible for the mismanagement of the LLC. Courts call that “fiduciary duties” of members and managers. And the law (Section 409 LLC Law) says:
A manager shall perform his or her duties as a manager, including his or her duties as a member of any class of managers, in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances.
If the LLC was harmed, the Member has to sue in the name of the LLC
You cannot go and sue the bad manager or managing member directly, even though your interest in the LLC was directly devalued by the co-member’s acts. You have to do it in the name of the LLC. This is called a derivative action, where you would sue the bad manager derivatively on behalf of the LLC. Consequently, any damages recovered will go to the LLC and not to your private bank account.
Courts have said (Serino v Lipper, 994 N.Y.S.2d 64):
It is black letter law that a stockholder has no individual cause of action against a person or entity that has injured the corporation. This is true notwithstanding that the wrongful acts may have diminished the value of the shares of the corporation, or that the shareholder incurs personal liability in an effort to maintain the solvency of the corporation
A plaintiff asserting a derivative claim seeks to recover for injury to the business entity,” while “[a] plaintiff asserting a direct claim seeks redress for injury to him or herself individually
Do Damages ever go to the LLC member Individually? Can an LLC member ever sue individually for damage to him/her?
Yes, if there was direct harm to her. For example, the other member froze her out of the business; or the other member denied her some sort of right she clearly has. But if the harm is just a consequence of the harm to the LLC, like that her interest in the LLC is “devalued”, there is no individual claim. This is sometimes hard to distinguish. Same court again:
In order to distinguish a derivative claim from a direct one, the court considers (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually). If there is any harm caused to the individual, as opposed to the corporation, then the individual may proceed with a direct action. On the other hand, even where an individual harm is claimed, if it is confused with or embedded in the harm to the corporation, it cannot separately stand.
Why would I bother then?
You may wonder why you would bother to sue if the damages would go to the LLC in any event. After all, then the money received may again be under the control of the other member if it is a majority member. Well, you do it to force the other member to come to an agreement on what you really want. A lot of LLC litigation is pursued to obtain a leg up in negotiating a favorable buyout or any other goal. So even if you will not get damages directly, you may get what you really want by bringing such a lawsuit and forcing the member to the negotiation table.