Volume 14, Number 1 - September/October 2004

Diversity Juristriction for LLCs?
Basically, forget about it
    By Carter G. Bishop and Daniel S. Kleinberger

Is an LLC more like a corporation or a partnership?

In the early days of the modern U.S. limited liability company, lawyers and judges often had to examine that question. Although the question has different answers in different legal contexts, for most contexts, it is now settled.

Nowhere is the question more emphatically settled than in the context of federal diversity jurisdiction, whose purpose is to protect out-of-state parties from potential prejudice in local courts. In Belleville Catering Co. v. Champaign Marketplace, LLC, 350 F.3d 691, 692 (7th Cir. 2003), a case involving an Illinois corporation and a Delaware LLC, the Seventh Circuit bluntly chastised the lawyers for both parties for a jurisdictional statement that was "transparently incomplete and incorrect" and for an "insouciance toward the requirements of federal jurisdiction [which] has caused a waste of time and money."

Vacating the district court judgment (which had followed a jury trial) and remanding "with instructions to dismiss . . . for want of subject-matter jurisdiction," the court also admonished the lawyers that:

The costs of a doomed foray into federal court should fall on the lawyers who failed to do their homework, not on the hapless clients. . . . The best way for counsel to make the litigants whole is to perform, without additional fees, any further services that are necessary to bring this suit to a conclusion in state court, or via settlement. That way the clients will pay just once for the litigation. This is intended not as a sanction, but simply to ensure that clients need not pay for lawyers' time that has been wasted for reasons beyond the clients' control.

Belleville Catering at 694.

In some respects, the Belleville Catering decision is easy to understand. The Seventh Circuit had addressed the LLC diversity issue five years earlier, stating unequivocally and definitively that "the citizenship of an LLC for purposes of the diversity jurisdiction is the citizenship of its members." Cosgrove v. Bartolotta, 150 F.3d 729, 731 (7th Cir. 1998). Four years later, a district court in the Seventh Circuit had chided counsel that "it has been clear for more than four years that the place of organization and principal place of business of a limited liability company are irrelevant." Trowbridge v. Dimitri's 50's Diner L.L.C., 208 F. Supp. 2d 908, 910 (N.D. Ill. 2002)

But to fully understand the Seventh Circuit's ire requires understanding some important concepts of federal diversity jurisdiction, and to protect clients from Belleville Catering's long shadow requires knowing how those concepts apply to LLCs. This article will begin with a brief history and explanation of federal diversity jurisdiction and then focus on recent court pronouncements concerning diversity jurisdiction and noncorporate business entities. The article will conclude by considering whether those pronouncements make policy sense and then by explaining some key practical implications of the law as it stands for LLCs.

The federal courts, like the federal government in general, have only those powers conferred or contemplated by the Constitution. Article III, § 2, clause 1 provides that "The judicial power shall extend to all cases . . . between citizens of different states," and federal courts have had diversity jurisdiction since 1789 when the Judiciary Act made exceeding $500 the "amount in dispute" requirement. Some 20 years later, the Supreme Court decided that diversity meant complete diversity — that is, that diversity jurisdiction is not available if any party to a case has the same citizenship as any adverse party. Strawbridge v. Curtiss, 7 U.S. (3 Cranch) 267 (1806). Today, the "amount in controversy" requirement is to exceed $75,000, but the complete diversity doctrine remains in place. See 28 U.S.C. § 1332(a).

The diversity requirement pertains to a federal court's subject matter jurisdiction and therefore cannot be waived by the parties. Diversity can be challenged by any party and by the court itself at any time before final judgment (including during an appeal) but is determined "upon the state of things at the time of the action brought." Mollan v. Torrance, 22 U.S. (9 Wheat) 537, 539 (1824). This "time-of- filing" rule means that a party cannot cure a diversity problem by changing its citizenship after a lawsuit has begun.

A cure can be achieved by dismissing any nondiverse party from the lawsuit. Grupo Dataflux v. Atlas Global Group, LP, 124 S.Ct. 1920, 1924-25 (2004). However, this cure presupposes that the nondiverse party is not indispensable — that is, that "in equity and good conscience" dismissal will not unduly prejudice either the dismissed party or the remaining parties and will not unduly undermine the adequacy of the remedies available in the lawsuit. Fed. R. Civ. P. 19(b).

Diversity analysis turns on a litigant's state citizenship, and, for diversity purposes, domicile determines the state citizenship of U.S. citizens who are human beings. It was initially unclear, however, what citizenship means when applied to a party other than a human being. That was hardly surprising, given that the framers of the Constitution had in mind human beings when they provided for diversity jurisdiction. (Only 30 private corporations existed in the United States before 1790.)

The Supreme Court's first opinion on diversity jurisdiction for entities stated that "the term ‘citizen' ought to be understood as it is used in the Constitution, . . . . [t]hat is, to describe the real persons who come into court." Bank of the United States v. Deveaux, 9 U.S. (5 Cranch) 61, 86-91 (1809). Accordingly, "[t]hat invisible, intangible, and artificial being, that mere legal entity, a corporation aggregate, is certainly not a citizen; and, consequently, cannot sue or be sued in the courts of the United States, unless the rights of the members, in this respect, can be exercised in their corporate name." Therefore, the corporate plaintiff had the citizenship of each of the human beings that "composed" it.

In 1844, the Supreme Court reversed itself and declared a corporation to be a citizen of its state of incorporation, at least where the corporation did business in its state of incorporation. "[A] corporation created by and doing business in a particular state, is to be deemed to all intents and purposes as a person, although an artificial person, an inhabitant of the same state, for the purposes of its incorporation, capable of being treated as a citizen of that state, as much as a natural person." Louisville, C. & C.R. Co. v. Letson, 43 U.S. 497, 558 (1844).

In 1958, Congress narrowed the diversity aperture for corporations, declaring that "a corporation shall be deemed to be a citizen of any state by which it has been incorporated and of the state where it has its principal place of business." 28 U.S.C. § 1332(c)(1). The statute does not define "principal place of business," and many courts use the so- called "nerve center" test to make the determination.

By its terms, Section 1332(c)(1) applies only to "a corporation" and leaves unaffected a long line of cases (some decided before 1958 and some after) holding that, for diversity purposes, an unincorporated organization has the citizenship of each of its members or owners and that the organization's state of formation and principal place of business are irrelevant. For LLC purposes, the most important of these cases is Carden v. Arkoma Associates, 494 US 185, 195 (1990), which involved a limited partnership's suit against a lease guarantor and whose rationale was recently re-confirmed in Grupo Dataflux.

Carden held that, for diversity purposes, a limited partnership partakes of the citizenship of every one of its general and limited partners. A vigorous dissent argued that limited partners are not "real parties in interest" and are therefore irrelevant to the diversity analysis. The dissent relied heavily on Navarro Savings Ass'n. v. Lee, 446 U.S. 458 (1980), which had used the "real party in interest" analysis to hold that the trustees of a Massachusetts common law business trust could bring a diversity claim without regard to the citizenship of the trust beneficiaries.

The Carden majority rejected the "real party in interest" analysis, the dissent's reliance on Navarro, and the asserted analogy to a business trust. The majority acknowledged that it is "undoubtedly correct" that limited partnerships are "functionally similar" to other entities that have greater access to the federal courts, but rejected a functional approach as inappropriate given Congress' use of the word "corporation."

The majority opinion spent considerable time recapitulating and reaffirming precedent. From the standpoint of LLCs, the most instructive part of that discussion is the opinion's treatment of two cases, Chapman v. Barney, 129 U.S. 677 (1889) and Puerto Rico v. Russell & Co., 288 U.S. 476 (1933). Chapman concerned the United States Express Co., a New York joint stock company. Russell involved a Puerto Rico sociedad en comandita.

The Chapman court flatly rejected assertions that the Express Co. was a citizen of New York, and in doing so rejected any expansive reading of the notion of corporation:

[T]he express company cannot be a citizen of New York, within the meaning of the statutes regulating jurisdiction, unless it be a corporation. The allegation that the company was organized under the laws of New York is not an allegation that it is a corporation. In fact the allegation is that the company is not a corporation, but a joint-stock company — that is, a mere partnership.

Chapman, at 682.

In contrast, Russell held that a Puerto Rico sociedad en comandita had a juridical personality so complete under foreign law that there was "no adequate reason" for according the sociedad a different status than a U.S. corporation. Russell, at 480-82.

The Carden majority embraced Chapman and its formalist, per se rule, while essentially limiting Russell to its facts. The majority noted that a previous case, United Steelworkers v. R.H. Bouligny, had explained Russell as an exercise in "fitting an exotic creation of the civil law. . . into a federal scheme which it knew not." Carden, at 190 (quoting United Steelworkers v. R.H. Bouligny Inc., 382 U.S. 145, 151 (1965)). The majority also characterized Bouligny as specifically rejecting any analysis that looks to an entity's organization and structure.

In short, the Supreme Court's opinion in Carden states a rule remarkably similar to the approach used by the IRS in its 1997 "check-the-box" regulations on the tax classification of business entities: If it's a corporation, it's a corporation; if it's not, it's not. Carden thus dictates that, when federal diversity is the issue, LLCs are treated like any other unincorporated business organization. Corporate tests are irrelevant, and an LLC has the citizenship of each of its members.

In 1996, three unreported federal district court decisions suggested that the corporate tests do apply to LLCs, but since then every reported decision at both the district and circuit court levels has acknowledged that Carden controls. A recent Eight Circuit opinion is illustrative: "We recognize numerous similarities exist between a corporation and an LLC, but Congress is the appropriate forum to consider and, if it desires, to apply the same ‘citizenship' rule for LLCs as corporations for diversity jurisdiction purposes. This issue appears resolved by Justice Antonin Scalia's analysis in Carden." GMAC Commercial Credit LLC v. Dillard Department Stores Inc., 357 F.3d 827, 828 (8th Cir. 2004).

Is Carden good policy? The implication of the case is that a name (corporate or not) matters and function and structure do not, and the case can easily be criticized as the triumph of labels over substance. But this criticism disregards the decision's key "separation of powers" point. In the early days of the republic, Congress left open the question of the citizenship of entities. Since 1958, however, a statute has provided a rule applicable to a "corporation." Congress having legislated on the matter, it is for Congress, not the courts, to revise that term in light of contemporary business practices.

The Carden dissent should not attract those who advise or use LLCs. To make its "real party in interest" argument, the dissent must engage in a type of "veil piercing" that goes far beyond the majority approach (which attributes the citizenship of each partner to the limited partnership). The dissent must not only look through the limited partnership but must also attempt to conflate those who manage the entity with the entity itself. That is precisely the type of exercise attempted by creditors of an LLC when seeking to hold members liable for the debts of the entity.

In any event, Carden is the law and the case's applicability to LLCs is now beyond doubt and possibly even beyond "a nonfrivolous argument for the extension, modification, or reversal of existing law." Fed. R. Civ. P. 11(b)(2). This state of the law has some important practical consequences. In general:

• In any suit between an LLC and a third party (that is, not a member), diversity jurisdiction depends on the citizenship of each LLC member at the time the lawsuit is filed.
• In any suit between an LLC and a member, diversity jurisdiction is impossible.
• In an LLC-related suit among members of an LLC, diversity jurisdiction depends on whether the LLC is an indispensable party (even assuming the litigating members are diverse).
• In any derivative lawsuit brought on behalf an LLC, diversity jurisdiction depends on the citizenship of each LLC member at the time the lawsuit is filed and is impossible in all but very limited circumstances.