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A Lesson In Personal Liability For Owners Of A Soon-To-Be Formed Llc

  • Posted on: Apr 19 2017

The limited liability company (“LLC”) is a relatively new business form that combines features of a corporation (a separate legal entity and limited liability) and those of a partnership (pass-through taxation and contractual flexibility). This Blog previously wrote about the advantages and disadvantages of this business structure. (Here.)

In the past several years, the LLC has become the business structure of choice for entrepreneurs and small business owners. Unfortunately, many entrepreneurs and business owners enter contracts with third parties before the LLC is formed. When this happens, they expose themselves to personal liability.

The Law in New York

A person contracting in the name of a proposed (or non-existent) corporation is personally liable on the contract, unless the parties have agreed otherwise. Such liability is based upon the principle that one who acts for a non-existent principal is himself/herself liable on the contract in the absence of an agreement to the contrary. See, e.g., Clinton Invs. Co., II v. Watkins, 146 A.D.2d 861, 862-63 (3d Dept. 1989); Universal Indus. v. Lindstrom, 92 A.D.2d 150, 151 (4th Dept. 1983); Tarolli Lbr. Co. v. Andreassi, 59 A.D.2d 1011, 1012 (4th Dept. 1977). Whether a person is personally obligated on a pre-incorporation transaction depends on the intention of the parties.

It is important to note that ratification or adoption of the contract by the LLC (once formed) will not remove the liability of the individual; instead, it “gives rise to corporate liability in addition to any individual liability” so that the individual remains obligated unless there has been a novation (i.e., the substitution of a new contract for the old one) between the corporation and the third party. Universal Indus., 92 A.D.2d at 152.

The foregoing principles were at play in Eastern Consolidated Properties, Inc. v. Waterbridge Capital LLC, 2017 NY Slip Op. 02731 (1st Dept. April 6, 2017), where the Court held that a person who signs an agreement on behalf of an LLC prior to its formation can be held personally liable under the agreement.

Background

The case arose from the $92.25 million sale of 103 North 3rd Street in Williamsburg, Brooklyn to the investment firm Waterbridge Capital in 2014. Eastern Consolidated Properties, Inc. (“Eastern”) claimed that it was denied a commission from the transaction, and sued Waterbridge Capital LLC (“Waterbridge”) the following year.

Eastern alleged that, after Waterbridge agreed to pay it a 1% commission in connection with the transaction, Waterbridge’s chief executive, Joel Schreiber (“Schreiber”), verbally asked Eastern to accept a 1/2% commission because another broker claimed entitlement to a commission on the transaction. Eastern agreed to the revised agreement. Thereafter, WB Berry Street LLC (“WB Berry”), an affiliate of Waterbridge, acquired the property. The defendants refused to pay any commission.

Eastern sued for, among other things, breach of contract and quantum meruit. The defendants moved to dismiss, and Eastern cross moved to add Schreiber as a defendant. Justice Charles Ramos of the Supreme Court, New York County, Commercial Division, denied the defendants’ motion as to these causes of action and granted Eastern’s cross motion. The First Department unanimously affirmed the decision.

As to the cross motion, the Court found that Schreiber could be found liable under the principles discussed above:

Supreme Court properly granted plaintiff’s cross motion to add Schreiber as a party defendant. As a member of Waterbridge, Schreiber could not be held personally liable for an agreement made on Waterbridge’s behalf. However, at the time of the oral agreement, WB Berry was not yet formed. To the extent that Schreiber acted on WB Berry’s behalf before its formation, he is presumed personally liable as an agent of the nonexistent corporate principal.

Citations omitted.

Addressing the merits of the appeal, the Court found that Eastern adequately plead a breach of contract claim, stating that the agreement to pay Eastern half of the commission was valid “even if [the] claim was doubtful or would ultimately prove to be unenforceable.” The Court noted that the revised agreement was essentially a settlement agreement. As such, it was not necessary to determine whether Eastern was the “procuring cause” of the transaction, as the defendants contended.

Moreover, since the parties disputed the validity of the oral settlement agreement, the Court held that Eastern could seek, “in the alternative”, “to recover its full commission in quantum meruit, in order to prevent unjust enrichment.” This was especially so since Eastern alleged “that it performed valuable services in good faith, including providing confidential information concerning the property to Waterbridge, that the services were rendered with an expectation of compensation, and that they were accepted by defendants.”

Takeaway

All too often, entrepreneurs and business owners engage in too many activities during the formation of their LLC. While some of these activities are benign, others, such as entry into agreements with vendors, creditors and other third parties, are not. Eastern Consolidated serves as a good lesson for these individuals – do not enter into any contracts until the LLC is formed, especially if personal liability is to be avoided.

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