WARNING: Single-Member Limited Liability Companies May Be Hazardous To Your Financial Health
This warning label should appear on every limited liability company ("LLC") charter that the California Secretary of State issues to every person who opens a new LLC. For good measure, the Secretary of State should post this warning on every renewal notice it sends to the owners and managers of existing LLC's. A new case from the Florida Supreme Court, Olmstead v. Federal Trade Commission, points out the asset protection risks inherent in single-member LLC's. In this law letter, we'll explain why.
Background: How LLC's Protect Assets
LLC's are terrific vehicles for shielding assets from creditors. If investment real estate is titled in the name of an LLC, and the LLC is itself sued on a tort, contract or any other claim, and the plaintiff obtains a judgment against the LLC, the plaintiff may satisfy his or her judgment against the assets of the LLC, but it is highly unlikely that the judgment creditor will be able to access the assets of the members of the LLC. The rules are the same as in the corporate context: if the creditor can "pierce the corporate veil," or prove that the owners (the "members") are the "alter egos" of the entity, the creditor might be able to reach the assets of the members if the assets of the entity are insufficient to retire the creditor's judgment. See, California Corporations Code §17101.
"Piercing the corporate veil" is very difficult to do. The creditor would have to prove that the entity was undercapitalized when formed, and that its separate existence was disregarded by its owners. The failure of the owners of an LLC to hold meetings or write up minutes or resolutions may not be used to prove that the entity was disregarded. Corporations Code §17101(b). The bottom line is that if the owners maintain separate books and records for the LLC, and do not commingle business assets with the members' assets, a creditor of the entity will not likely be able to reach the assets of the members.
All of the foregoing is beneficial, but the ability of a creditor of the LLC to reach the assets of the members is usually not our concern. Because LLC's are formed to remove a valuable asset from the reach of the individual's creditors, we are far more concerned with the opposite case, i.e. where a creditor obtains a judgment against an individual who is a member of an LLC, is unable to satisfy his judgment against the individual's assets, and, as a last resort, attempts to access the assets of the LLC.
Reaching the assets of an LLC to satisfy a judgment against a member is very difficult, but it is not impossible. The difficulty stems from the "charging order" limitation that is embodied in §17302 of the Corporations Code.
All About Charging Orders
Before diving head first into LLC charging orders, it might be beneficial to take a side trip into the world of corporations and their shareholders. Let's assume that Mr. Brown is the sole shareholder of Widgets, Inc. He is involved in a traffic accident that has nothing to do with the operation of Widgets. He is sued, and the plaintiff obtains a multi-million dollar judgment against him. The plaintiff learns that all of Mr. Brown's liquid assets are located in a Swiss bank account that is controlled by a Cayman Islands company that is in turn owned by a foreign trust. But what about the assets of Widgets? Can the creditor access those assets? Very easily. Even though there is no liability on the part of Widgets, one of Mr. Brown's assets is that stock certificate representing 100% of all of Widgets' issued stock. The stock certificate is personal property, subject to attachment and seizure. Once the creditor gets control of the stock certificate, he controls Widgets, and all of its assets. He's home free.
But in an LLC, there usually are no attachable certificates. Not only that, but §17302 of the Corporations Code says that if a creditor of a member of an LLC cannot access the assets of the LLC! The creditor is limited to a "charging order."
A "charging order" is similar to a garnishment. It is served on the managers of the LLC, and it says, in effect "You have a member named Brown. We have a judgment against Brown. Any distribution of profits or revenues to which Brown is entitled should not go to Brown, but should go to us." But what if the person controlling the LLC is none other than Brown himself, who assures that there are no distributions? In that case, the creditor gets nothing. Section 17302(a) limits charging orders to members' assignable membership interests. If the LLC operating agreement prohibits the free assignment of an interest, the creditor may be without any remedy at all.
Section 17302(b) appears to give a creditor a bit more than a charging order. It provides that a creditor may "foreclose" on the economic portion of the membership interest. However, a "foreclosed" membership interest means little more than the membership interest can be sold. The foreclosed membership interest does not carry with it the management rights inherent in a membership interest in an LLC. But even the foreclosure of the membership interest is problematical. Section 17302(c) gives the other members of the LLC the right to buy out the debtor-member prior to foreclosure, and it does not specify the price or the terms. This provision gives practitioners a roadmap for drafting operating agreements. Each member of an LLC should have the right to buy out the interest of other members who are subject to charging orders or foreclosure, the price for which should be established by a formula.
Finally, Corporations Code §17302(e) makes it clear that the creditor remedies contained in that section are the exclusive remedies. That should mean that all of the other statutory remedies available to creditors – turnover orders, attachment, levy, etc – are unavailable.
Or does it?
All About Olmstead v. Federal Trade Commission
In Olmstead, 2010 WL 2518106 (July 6, 2010), the debtor was the member of a Florida LLC, which, like California, permits single-member LLC's. The creditor – the FTC – sought to obtain an order permitting the attachment and sale of the debtor's membership interest, similar to the attachment of a share of corporate stock. Florida has a charging order statute similar to California's. The key provision in the Florida charging order statute provides that an assignee of a membership interest in an LLC may become a member only if all of the other members consent.
Much to the surprise and chagrin of the debtor-member, the court ruled that this statute did not prevent the seizure of the member's interest. It reasoned that in every LLC where there is only one member, the interest must be assignable, for the simple reason that there is no other member who can possibly object. Moreover, there is a rationale for the charging order limitation that is not present if there is only one member. If there is more than one member, permitting a creditor of one member to access the underlying assets of the LLC would disrupt the investment and the business of the innocent non-debtor members. The "compromise" is to permit the creditors of the debtor-member to access the distributions owing to the debtor-member, leaving the underlying assets undisturbed. But that rationale disappears if there are no "innocent" non-debtor members.
Florida's statute is distinguishable in one key respect. Florida has no provision similar to Corporations Code §17302(e) which explicitly makes the charging order the sole remedy. But California practitioners should not rely on this distinction. At the very least, every LLC should have more than one member. The operating agreement should contain a "poison pill," giving each member the option to buy out the interest of a debtor-member prior to the foreclosure of the debtor-member's interest. The operating agreement should prohibit the free assignment of membership interests and give the manager the authority to withhold distributions to any member whose interest is or is about to become subject a charging order. The effect is the make the charging order – the creditor's sole statutory remedy – absolutely toothless.