The intersection of procedural and corporate law takes on tactical immediacy when it comes to the question of access to federal courts. And it raises the question: should the diversity statute be amended to provide that litigants facing limited liability company (“LLC”) opponents need only be diverse from the LLC’s state of creation and principal place of business? The answer may take direction from fundamental concepts in civil procedure and business law. It also requires consideration of the conventional wisdom about who benefits from litigating in federal court and how that informs litigation strategy, as well as very recent legislative initiatives aimed at unveiling the beneficial owners of LLCs.
Federal v. State Court
Federal courts, with judges appointed for life, traditionally were considered above the political fray and their well-funded courthouses the province of sophisticated litigants. That characterization, whether true on the ground or not, leads potential litigants to make strategic choices based on assumptions as to whether they might fare better in state or federal courts.
In recent years, the conventional wisdom in many states is that plaintiffs facing corporate defendants, especially those bringing tort claims, would prefer state courts for many reasons. This reflects relatively recent procedural reforms in federal courts that seem to favor defendants, including more robust opportunities to have cases dismissed at the pleading, summary judgment, and even trial stages by judges characterizing contested issues as legal and not subject to jury decision-making. And even when juries are empaneled and empowered in federal courts, the jury pool from which they are drawn is the federal district (rather than a county as in state court), which can result in profound demographic differences in the makeup of the jury. Even if relatively few cases end up tried to a jury, this reality affects settlement bargaining. Moreover, because the federal courts are part of the national sovereign, transfer among federal districts, including the use of the Multi-District Litigation (MDL) statute, means that getting a case to federal court affords corporate defendants the potential ability to control where, geographically, a case will be processed.
Civil cases can be filed in a federal trial court either because the plaintiff’s complaint includes a claim based on federal law or because the opponents in the case are “diverse”—citizens of different states—and the amount in controversy exceeds $75,000. The statute authorizing diversity jurisdiction (28 U.S.C. § 1332), has long been interpreted to treat a partnership as a citizen of all states in which any partner is a citizen. A partnership comprising partners who are citizens of 30 states would be able to invoke diversity jurisdiction only against opponents from the other 20 states. By contrast, the diversity statute provides that “a corporation shall be deemed to be a citizen of every State and foreign state by which it has been incorporated and of the State or foreign state where it has its principal place of business[,]” without regard to the citizenship of its shareholders. Thus, the statute makes it possible for corporations (as opposed to partnerships) to claim diversity of citizenship against a wider array of opponents and thereby gain access to federal court.
This is true whether a corporation is a plaintiff or defendant; a corporation sued in a state court located in a state other than its state of incorporation or principal place of business, by opponents who are citizens of any state other than those, may remove the case to federal court and glean the perceived advantages of federal litigation. Plaintiffs’ attorneys wishing to preempt that possibility sometimes construct their lawsuits to prevent removal by, for example, including an in-state defendant to defeat diversity. Relatively recent amendments to the removal statutes apprehend this strategy and extend removal deadlines accordingly.
At the Intersection of Procedure and Business Law: The LLC’s Citizenship for Purposes of Diversity Jurisdiction
And here’s where the procedural law world and the business law world collide: what is to be done with relatively newer business organizational structures, like the LLC? The LLC, by design, is a hybrid entity that allows its owners to tailor its governance features, which may sport some features of partnerships and some of corporations. Since the dawn of LLCs, the perennial question has been, in any given instance, whether the law should treat the LLC by analogy to the partnership or to the corporation. This question is no less relevant when setting the parameters of diversity jurisdiction, and it necessarily dictates the ease with which an LLC may gain access to federal court by initial filing or removal.
From a business law perspective, the diversity jurisdiction rules for partnerships and corporations follow the historic legal fictions ascribed to those entities. The partnership, historically, was seen as an aggregate of its partners rather than a separate juridical entity. But even the common law lacked consistency because, for example, the partnership could own property in its own name. The revised Uniform Partnership Acts have evolved to take a more consistent view of the partnership as a separate entity from its partners. Yet, for purposes of diversity jurisdiction, procedural law still treats the partnership as an aggregate of its partners. By contrast, both business and jurisdictional law have always recognized the fiction that the corporation has a separate legal existence from its shareholders; thus, the diversity statute looks to the citizenship of the corporation itself rather than that of its shareholders.
Though the first LLC statute was enacted in Wyoming in 1977, in most states the LLC only became available in the mid-1990s. The concept of the LLC is that the owners (members) have limited liability like shareholders in a corporation, but can maximize freedom of contract to opt for governance that functions like a partnership, or a corporation, or some combination of both. Presently, for diversity purposes, the citizenship of the LLC is determined in the same way as a partnership: the LLC is a citizen of each of the states where its members are citizens. In essence, for the LLC, the law of civil procedure adheres to the aggregate theory, now largely anachronistic to partnership law, to determine the LLC’s citizenship.
Parenthetically, there is a symmetry between procedural law and tax law here– that is, the LLC and partnership both get “pass through” taxation and do not file taxes as entities separate from their owners, as a corporation does. This symmetry falls away, however, with an S corporation which, based on its election, is treated like a partnership for tax purposes, but not for purposes of diversity jurisdiction.
Given the hybrid nature of the LLC, it leaves open the question whether procedural law is hitting the right note by treating the LLC like a partnership and not like a corporation.
Calls for Reform and The Role of Ownership Transparency
There have been calls to amend the diversity jurisdiction statute to treat LLCs like corporations. One of the chief concerns in support of this proposal has been the lack of transparency concerning beneficial ownership of the LLC (that is, the individuals or entities who ultimately own or control the LLC), which presents significant hurdles for outsiders to determine the citizenship of the LLC members. Opponents of LLCs who wish to file in federal court may encounter layers of ownership that are not a matter of public record, which makes it difficult, if not impossible, to unveil its members.
Concern about this lack of ownership transparency is beginning to gain traction in federal and state legislation, mostly because anonymity is a useful aid in money laundering. At the federal level, the Corporate Transparency Act, which went into effect on January 1 of this year, requires entities (including LLCs), with only certain limited exceptions, to self-report their beneficial owners to the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCen”). The beneficial ownership information, however, will not be made available in a public database.
On the state level, there have been similar attempts to address transparency in ownership. Bills are pending in a number of states. In New York, the LLC Act was just signed into law, and it largely tracks the federal Corporate Transparency Act. In addition to money laundering, stated concerns were that the veil of anonymity made it difficult for a tenant to figure out who was their living, breathing human landlord, and for an employee to figure out who was their living, breathing human employer. Given these concerns, in the original version of the LLC Act, which had passed the New York State Assembly and Senate, there was a requirement that beneficial ownership information be made publicly available through a database. However, citing privacy concerns, the Governor signed the bill into law only after cutting from it the creation of a public database. Beneficial ownership will be self-reported in New York, but that information will be made available only to law enforcement.
The key takeway is that, even if the political will has not yet matched the trend, there is a growing awareness of the need for transparency in LLC ownership. There have been recent measures, although weakened ones, that begin to address these valid concerns. But the transparency concerns may not provide an animating justification for tinkering with the federal jurisdictional requirements for LLCs. It may be that what needs to be strengthened is the beneficial ownership reporting laws just now coming into effect, not the statute for diversity jurisdiction.
From a business law perspective, the shift, if any, may need to find its justification by analogizing the LLC more appropriately to the corporation than the partnership for citizenship purposes. And, although we describe the LLC as an “unincorporated entity,” the LLC does arguably have a separate juridical existence from its members by virtue of the fact that, like the corporation and unlike the general partnership, the LLC comes into technical legal existence upon filing paperwork and paying a fee to the state.
But from a procedural perspective, the broad expansion of LLCs’ access to federal court, particularly by authorizing removal in states where LLC members are citizens but the LLC itself was neither created nor headquartered, must be balanced against the potential unfairness of depriving plaintiffs of the perceived advantages of state court. By divesting plaintiffs’ choice of forum in such cases, the proposed amendment may impose a strategic disadvantage more damaging than any transparency advantage could expiate.
In sum, an amendment to the diversity statute to treat LLCs like corporations, or any interpretation of the existing statute that would have the same effect, must be evaluated through the lens of both business law and procedural law to get a full picture of the doctrinal and strategic implications, and importantly, to assess who will likely benefit from the shift.