Limited liability companies, like partnerships both general and limited, are fundamentally creatures of contract law. The members agree with each other as to the business to be conducted by the LLC, and how that business will be conducted. The rights of members to manage the entity, to vote on members and managers, and to take most other actions in relation to the LLC are contractually determined by the LLC’s operating agreement. The LLC laws thus provide a framework to enable the informal governance of the LLC through agreement of the members. This situation is very different for corporations, which are largely required by the corporation statutes to follow a more formal system of governance through resolutions of variously the shareholder or directors.
Importantly, an LLC with more than one member, known as a Multiple-Member LLC (MMLLC), is effectively deemed to have an operating agreement even in the absence of a written agreement, i.e., the members have certain contractual understandings even if not reduced to writing. By contrast, an LLC with only one member, known as a Single Member LLC (SMLLC) does not have an operating agreement in the contractual sense for the simple reason that there is nobody for the single member to contract with. This difference between MMLLCs and SMLLCs can have dramatic implications, particularly when it comes to the situation where a bankruptcy case is commenced by a member.
Most states follow some version of the Uniform Limited Liability Company Act (ULLCA, or RULLCA as revised). The ULLCA is intentionally designed to allow the members to have a great deal of flexibility in the governance and operation of the LLC. Indeed, many (but not all) of the provisions of the ULLCA may be “toggled off” or “toggled on” by agreement of the members.
Fundamental to partnership law, and carried over into LLC law, is the concept of Pick Your Partner (PYP). The concept is simply stated as that every partner should have the right to choose who they are partners with, and no partner should be forced into an involuntary partnership with somebody they don’t want to be a partner with. Thus, ULLCA provides that no person may become a member of the LLC unless they are admitted as a member by a vote of the other members.
The effect of PYP is that there are no involuntary members. If a member sells their interest to a non-member, that non-member will not become a member of the LLC but will instead be nothing more than an assignee, or in this case a voluntary assignee of the interest. If a member loses their interest, such as to a judgment creditor or to an ex-spouse in a divorce proceeding, the party acquiring the interest will also not become a member and instead will be no more than an assignee of the interest, better known as an involuntary assignee in such a case.
An assignee of an LLC interest, whether voluntary or involuntary, has one and only one right in relationship to the LLC, which is to receive the distributions that would otherwise have been paid to the former member. An assignee has no other rights in relation to the LLC, such as the right to vote on admitting other members, choosing managers, or even any information rights. In practical terms, an assignee’s sole and exclusive right in relation to an LLC is to receive distribution checks and an annual K-1.
The charging order is a remedy that is almost uniquely limited in American law to partnerships and LLCs. Whereas a creditor may levy upon the debtor’s interest in corporate shares, thus causing those shares to be auctioned at a judicial sale with the buyer taking the full rights of a shareholder, a judgment creditor of an LLC member is restricted to the exclusive remedy of a charging order. The reason this remedy exists, and is the exclusive remedy for LLCs and partnerships, is to prevent interference with Pick Your Partner, i.e., to prevent the judgment creditor from becoming a member of the LLC against the will of the other members or otherwise interfering with the business of the LLC against the interests of these other members.
The effect of a charging order is to create a judicial lien upon the debtor/member’s right to distributions, i.e., to the debtor/member’s economic interest in the LLC. The charging order lien lasts until the judgment is satisfied, and requires that any distribution payments that would have been made to the debtor/member be made to the creditor holding the charging order as well. The creditor holding a charging order has no other rights, i.e., no voting rights, no information rights, and no other rights of a member.
As with any other lien, the charging order lien may be foreclosed (although some states’ laws prohibit this result). A foreclosure of a charging order lien means that the purchaser at the ensuing judicial sale will become an involuntary assignee of the interest as previously described. In this event, the purchaser as an assignee will receive distributions even after the judgment is satisfied (or whether or not the judgment is ever satisfied); however, as an assignee, the purchaser will also become liable for any taxable distributions of the entity, i.e., the purchaser will receive a K-1.
As mentioned, the reason for so-called charging order exclusivity is to prevent the non-debtor members of an LLC or partnership from being forced into an involuntary partnership with the creditor of the debtor/member or allowing such a creditor to interfere with the LLC’s business to the detriment of the non-debtor members. With a SMLLC, of course, there are no non-debtor members who might be forced into such an involuntary membership or who might be harmed by a creditor’s actions. Otherwise stated, charging orders are the exclusive remedy for creditors of an LLC to protect Pick Your Partner, but those concerns are nonexistent with a SMLLC.
In Olmstead v. FTC, 44 So.3d 76 (2010), the Supreme Court of Florida, after noting that the reasons for charging order exclusivity are not present in situation involving a SMLLC, held “that a court may order a judgment debtor to surrender all right, title, and interest in the debtor’s single-member LLC to satisfy an outstanding judgment.”
The Olmstead opinion provided the impetus for the Florida legislature to amend its LLC Act to provide for the special treatment of SMLLCs in what became known as the Olmstead Patch as ultimately found at Fla.Stat. § 605.0503(4) and (5):
(4) In the case of a limited liability company that has only one member, if a judgment creditor of a member or member’s transferee establishes to the satisfaction of a court of competent jurisdiction that distributions under a charging order will not satisfy the judgment within a reasonable time, a charging order is not the sole and exclusive remedy by which the judgment creditor may satisfy the judgment against a judgment debtor who is the sole member of a limited liability company or the transferee of the sole member, and upon such showing, the court may order the sale of that interest in the limited liability company pursuant to a foreclosure sale. A judgment creditor may make a showing to the court that distributions under a charging order will not satisfy the judgment within a reasonable time at any time after the entry of the judgment and may do so at the same time that the judgment creditor applies for the entry of a charging order.
(5) If a limited liability company has only one member and the court orders a foreclosure sale of a judgment debtor’s interest in the limited liability company or of a charging order lien against the sole member of the limited liability company pursuant to subsection (4):
(a) The purchaser at the court-ordered foreclosure sale obtains the member’s entire limited liability company interest, not merely the rights of a transferee;
(b) The purchaser at the sale becomes the member of the limited liability company; and
(c) The person whose limited liability company interest is sold pursuant to the foreclosure sale or is the subject of the foreclosed charging order ceases to be a member of the limited liability company.
Thus, to get at the assets of a debtor’s SMLLC in Florida, the creditor would have to bring a motion for charging order, prove to the satisfaction of the court that the charging order will not be paid in a reasonable amount of time, and then foreclose upon the charging order lien which will put the creditor in charge of the LLC.
The Olmstead Patch also provided an impetus for the Uniform Laws Commission to re-examine the issue of charging orders as applied to SMLLCs, and ultimately RULLCA § 503(f) was drafted to provide for its own RULLCA Patch as follows:
(f). If a court orders foreclosure of a charging order lien against the sole member of a limited liability company:
(1) the court shall confirm the sale;
(2) the purchaser at the sale obtains the member’s entire interest, not only the member’s transferable interest;
(3) the purchaser thereby becomes a member; and
(4) the person whose interest was subject to the foreclosed charging order is disassociated as a member.
The effect of § 503(f) is about the same as Florida law post-Olmstead, i.e., to get at the debtor’s SMLLC, the creditor files a motion for charging order and the forecloses upon the charging order lien. Upon foreclosure, the purchaser at the judicial sale (which might be the creditor by way of “credit bidding” a portion of the judgment) takes control of the SMLLC and, thus, its assets.
If a state’s courts follow Olmstead and do not recognize the exclusivity of the charging order remedy as to SMLLCs, but have not adopted a “patch” as described above, then the creditor may presumably take advantage of typical creditor remedies against the debtor’s interest in the SMLLC, such as by way of levy, garnishment, or a turnover order.
A creditor may also attempt to circumvent charging order exclusivity by having a receiver appointed for the debtor, which receiver could then take whatever action the debtor could take in relation to the SMLLC, such as to cause it to be wound up and dissolved, which would then trigger a liquidating distribution that would be picked up by the creditor’s charging order.
Another method to circumvent the charging order is by way of reverse veil piercing by way of an alter ego challenge, which is described more fully below.
Since the fundamental weakness of a SMLLC is that it only has one member, the obvious cure is for the entity to add at least one more member so that it becomes a MMLLC. This new member is referred to as a Late-Arriving Member (LAMB).
The question that arises is how late may a LAMB be added to thwart creditor challenges on the basis that the LLC is a SMLLC?
As mentioned, a charging order places a lien on the debtor/member’s interest. With a SMLLC, this means that the charging order places a lien on 100% of the membership interest. Attempts to divest the debtor/member of 100% of the membership would thus violate the charging order lien and not be enforceable. Therefore, once a creditor has taken a charging order, it becomes too late to add a LAMB.
In some states, such as California, the mere filing of a motion for a charging order is deemed to create a temporary lien on the debtor/member’s interest pending the hearing. Thus, in these states, the LAMB must be added prior to the creditor filing even just the filing of the charging order motion.
Prior to the charging order lien going into effect, but after the creditor’s claim has arisen, the creditor may attempt to argue that the addition of the LAMB is a voidable transaction. This may be a difficult argument to make if the LAMB is not an insider of the debtor insider and has paid reasonably equivalent value in exchange for the interest; however, even in this circumstance a creditor has a change of success in this challenge if there is evidence that the LAMB was added for the purpose of hindering, delaying or defrauding the creditor. See, e.g., UBS Financial Services, Inc. v. Lacava, 2018 Ohio 3055, 2018 WL 3689450 (Ohio App., Aug. 2, 2018) (debtor/member’s transfer of a SMLLC interest to his wife determined to be a fraudulent transfer; transfer avoided and punitive damages awarded).
Certainly, the best time to add a LAMB is prior to the time that any creditor’s claim has arisen.
An ancillary question is how much of an interest does the LAMB need to acquire so as to break up the SMLLC status? The opinion in In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003), muses in dicta that a fractional interest (less than 1%) might not be enough to break up single-member status:
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The harder question would involve an LLC where one member effectively controls and dominates the membership and management of an LLC that also involves a passive member with a minimal interest. If the dominant member files bankruptcy, would a trustee obtain the right to govern the LLC? Pursuant to Colo.Rev.Stat. § 7–80–702, if the non-debtor member did not consent, even if she held only an infinitesimal interest, the answer would be no. The Trustee would only be entitled to a share of distributions, and would have no role in the voting or governance of the company. Notwithstanding this limitation, 7–80–702 does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with “peppercorn” co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse. 11 U.S.C. §§ 544(b)(1) and 548(a).
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Id., at 541 fn. 9. However, for other reasons the percentage amount that a LAMB should take may be considerably higher. That now brings us to alter ego challenges against SMLLCs.
Alter ego challenges have been described to be “like lightning, it is rare, severe, and unprincipled.” F. Easterbook and D. Fischel, Limited Liability And The Corporation, U.Chi.L.Rev. (1985). There are many things such as undercapitalization or the failure to follow formalities that may be considered in an alter ego challenge, but most such successful challenges typically feature three key factors:
(1) There is a commonality of ownership between the person and the entity;
(2) There is a commonality of control between the person and the entity; and
(3) The alter ego relationship has caused some wrong (expansively interpreted) other than merely a creditor has not been paid.
The SMLLC inherently satisfies the first two key factors of an alter ego challenge: There is commonality of ownership and control. To prove alter ego, the creditor will only need to show that the alter ego relationship has caused some wrong other than the creditor has not been paid ⸺ although, what constitutes a “wrong” is an inquiry that is typically interpreted expansively in favor of creditors.
Because with a SMLLC the creditor essentially starts out on third base with an alter ego challenge, when SMLLCs first began to appear in the late 1990s, they were frequently disparaged by some planners as a “self-penetrating entity”.
Despite the common disparagement of SMLLCs as asset protection vehicles, the truth is that SMLLCs should not be treated substantially different than sole shareholder corporations, and sole shareholder corporations have a proven track record of creating a liability wall between the liabilities of the entity and its sole shareholder as to routine obligations, assuming a lack of other red flags such as undercapitalization, commingling of business and personal assets, and the like.
In other words, a SMLLC may provide protection against so-called traditional veil piercing, i.e., a creditor of the LLC itself attempting to penetrate the liability shield of the LLC so as to impute the liability to the single member. However, the SMLLC will not normally provide liability protection against so-called reverse veil piercing, i.e., attempts by a creditor of the single member to penetrate the legal separateness of the LLC so as to impute the member’s liability to the entity.
Just as adding another member (the LAMB) may operate to break up the single-member status of a SMLLC and convert it to a MMLLC for charging order purposes, adding a LAMB may also operate to block a creditor’s challenge based upon alter ego.
An issue here is that to negate claims of commonality of ownership, it may be necessary in particular jurisdictions to place the debtor/member into a minority ownership role, i.e., less than 50%. This means that the interest to be taken by the LAMB may be significantly larger to negate alter ego than would be necessary to negate single-member status for charging order purposes.
Similarly, a change of the manager may operate to block the commonality of control element of an LLC.
As with determining single-member status for charging order purposes, it is not clear when the commonality of ownership and control factors are to be tested, although this point is highly unlikely to be before the claim has arisen against the debtor/member.
The discussion heretofore has been about the treatment of SMLLCs outside of bankruptcy. Now let’s take a look at how SMLLCs fare in a bankruptcy proceeding, starting with the situation where the bankruptcy case involves the SMLLC itself.
The bankruptcy concept of substantive consolidation posits that if a person or entity is so closely related to another that the bankruptcy case cannot be equitably administered (recalling that bankruptcy is fundamentally a remedy arising in equity), then the bankruptcy court may join such persons or entities to the bankruptcy proceeding as are necessary for this purpose. This concept is similar ⸺ although not quite the same ⸺ as alter ego and veil piercing outside of bankruptcy.
Thus, whenever a SMLLC is placed into bankruptcy, there will always be a risk that single member may be substantively consolidated into the SMLLC’s bankruptcy case. Such consolidation is far from automatic, but instead depends on the totality of the relevant facts and circumstances of each case. Compare In re Clark (Gugino v. Clark’s Crystal Springs Ranch, LLC), 525 B.R. 107 (Bk.D.Idaho, 2014) (consolidating trust which owned SMLLC into bankruptcy proceedings) with In re Raymond (Butler v. Candlewood Road Partners, LLC), 529 B.R. 455 (Bk.D.Mass., 2015) (refusing consolidation of trust which owned SMLLC into bankruptcy proceedings).
Now let’s look at what happens if it is the single member of the SMLLC who is the debtor in a bankruptcy case.
Upon the commencement of a bankruptcy case, the debtor’s property (subject to exceptions not pertinent here) comes into debtor’s bankruptcy estate under 11 U.S.C. § 541(a). This would include the debtor’s interests in LLCs, and thus the debtor’s interest in an SMLLC.
With MMLLCs, how a debtor’s interest in an MMLLC will be treated involves an analysis of whether the interest is an executory contract under § 365, and this in turn requires an analysis of the MMLLC’s operating agreement. How this analysis shakes out in a given case will determine whether the administration will be held and administered by the trustee, or not, and (if so) whether the trustee may owe certain obligations to the MMLLC or be bound by certain provisions of the operating agreement.
None of the executory contract issues of MMLLCs are present for SMLLCs for the simple reason that there is nobody for the single debtor/member to contract with; instead, the SMLLC interest becomes a part of the debtor’s estate much like any other asset. In re Albright, 291 B.R. 538 (D.Colo., 2003).
The bottom line is that when a debtor commences a bankruptcy case, the trustee in administering the case becomes the owner and manager of the LLC:
“Because the Trustee became the sole member of Western Blue Sky LLC upon the Debtor’s bankruptcy filing, the Trustee now controls, directly or indirectly, all governance of that entity, including decisions regarding liquidation of the entity’s assets.”
In re Albright, 291 B.R. 538 at 541. So there you have it: An interest in an SMLLC goes right to the trustee’s ownership and control where the single member is in bankruptcy.
To summarize all of this, standing alone SMLLCs are poor asset protection tools. SMLLCs may not be protected by charging order exclusivity and they are prone to successful reverse veil piercing challenges. If most asset protection structures are considered walls against creditors, the SMLLC is merely a speed bump that may slow a creditor, but will not stop all but the least sophisticated creditors. Where the member ends up in a bankruptcy case, either voluntarily or involuntarily, the SMLLC is not even a speed bump since the SMLLC is taken into the bankruptcy estate and is owned and administered by the trustee.
Nonetheless, outside of bankruptcy, SMLLCs should not fare any worse than sole shareholder corporations when it comes to routine liabilities of the entity itself, and thus is preferable in at least some respects to a person conducting business as a sole proprietor.
For asset protection planning, SMLLCs still have significant uses, though subject to their limitations. A SMLLC in some situations may be suitable for holding assets that are unlikely to produce liabilities, where the SMLLC is owned by something that is itself unlikely to generate liabilities, such as a trust.
The far better practice, of course, is to simply avoid SMLLCs altogether whenever practical to do so, recalling the early and not completely facetious warnings that SMLLCs may be characterized as “self-penetrating entities”.