By Gary Forster, JD, LLM
Limited liability companies (LLCs) insulate owners from “inside” business liabilities, similar to corporations, but, unlike corporate stock, member equity held in a protective LLC generally may not be reached. Also, an “outside” creditor of an LLC member cannot acquire voting equity in a protective LLC, nor reach LLC assets. Claims on LLC interests are generally limited to a charging lien. These asset protection measures are just a few of the reasons LLCs have largely become the business entity of choice.
LLC statutes offer so called “charging order” protection of LLC equity. The charging order (adopted from partnership law) establishes a creditor lien on distributions paid on “charged” LLC equity. Creditors of a member (holding the lien) are limited to LLC distributions paid to the debtor member.1 The charging order lien entitles the creditor only to company distributions (if any) payable to the debtor/member, but not to any liquidation, voting, or management authority.
In protective jurisdictions, the holder of a charging order owns only an economic interest (in distributions). Such a creditor may not sell ownership interest, force distribution of company assets, or vote on any company matters. The charging order limitation is what creates “outside asset protection” (as the “outside” creditor of an owner cannot get “in” to the assets of the LLC). This “outside” limitation on creditors (if properly implemented in a protective jurisdiction) generally prevents involuntary equity transfers. LLCs therefore insulate owners (members) from both company “inside” operational liabilities (similar to corporations) and “outside” protection of LLC equity (not offered by corporations).
All 50 states and several foreign jurisdictions have passed LLC organizational statutes. However, the level of protection varies from state to state (and country to country). For instance, several states limit collection rights on LLC equity “exclusively” to a charging lien. Other states actually permit attachment and foreclosure of LLC equity. Several factors must be considered in forming the most protective entity for a proposed business or investment arrangement.
Several states have adopted the Uniform Limited Liability Companies Act (ULLCA), which authorizes a creditor to foreclose LLC economic interests (subject to a charging order).2 Under the act, a charging order constitutes a lien on the debtor’s distributional interest, which may be foreclosed. The purchaser at the foreclosure sale permanently obtains the debtor’s distributions rights. Worse, a creditor with an ULLCA charging order may seek judicial dissolution of the LLC.3
Although ULLCA statutes allow the foreclosure of distribution rights, the real exposure is the judicial propensity to disregard any limitation on creditor remedies. In several cases, the judge permitted attachment of the debtor’s membership interest, exposing LLC managerial control and assets. This has happened in Colorado, Idaho, Maryland and Florida, regarding single-member LLCs.
The foreclose right could be a trap for unaware residents of states with compromised LLC statutes. The use of a ULLCA-based LLC (not limiting the creditor “exclusively” to a charging order) is ill-advised. Superior charging order protection is available in other states (and countries). The states and commonwealths that have adopted ULLCA (or the Revised Uniform Limited Liability Company Act - RULLCA), which also includes foreclosure rights) are as follows: Alabama, California, Connecticut, Florida, Hawaii, Idaho, Illinois, Indiana, Iowa, Minnesota, Montana, Nebraska, South Carolina, South Dakota, Utah, Vermont, Washington, D.C., Washington, West Virginia, Wyoming, and the Virgin Islands.
LLC statutes that limit creditors exclusively to a charging order generally eliminate exposure of member equity. Protective LLC organizational statutes preclude collection rights beyond a charging order. Several states have implemented protective LLC charging order provisions. Note that a few states have adopted the ULLCA but revised the charging order language to preclude foreclosure. Such states include Arizona, Arkansas, Connecticut, Delaware, District of Columbia, Florida (for multimember LLCs), Idaho, Illinois, Kentucky, Louisiana, Maryland, Minnesota, Mississippi, Nebraska, Nevada, New Jersey, North Dakota, Oklahoma, Rhode Island, Texas, Virginia, and Wyoming.
North Carolina is one of the first states where a court explicitly acknowledged the charging order limitation. In Herring v. Keasler, a court of appeals prevented a creditor from seizing and selling the debtor’s North Carolina LLC interest.
Florida initially adopted exclusivity language for its limited partnership but failed to so limit creditors of LLC members (to the charging order) in its LLC statute. The prior Florida LLC statute was dismantled by the Florida Supreme Court in 2010 (Olmstead v. FTC, 44 So.3d 76 (FL 2010)), to expose equity in the single-member Florida LLC (and arguably all Florida LLCs). The Florida LLC statute was then revised to protect equity in multimember LLCs. Although the revised Florida statute specifically protects multimember equity, it explicitly exposes equity in single-member Florida LLCs.
Several states, such as Delaware, Nevada, and Alaska, expressly protect equity in single-member LLCs (apparently addressing the bankruptcy and state court trend to expose equity to creditors of a sole member). California is the first state to suggest that the issuance of equity to a second member must have substance (as a condition to the LLC being considered a protective multimember LLC). In Curci Investments LLC v. Baldwin,4 the court allowed for “outside” reverse veil piercing to reach LLC assets (to satisfy a judgment against the 99% member).
The Pennsylvania Limited Liability Company Act establishes the charging order as the sole remedy available to creditors of a member. The creditor may lien equity for distributions and foreclose the lien (creating a salable interest). Moreover, a creditor may force the foreclosure sale of equity in a single member Pennsylvania LLC.5
Other courts have rejected the reverse-veil piercing theory. The Glick court noted that neither Illinois nor Delaware law recognize outside reverse piercing theory.6
In Greenhunter Energy Inc. v. Western Ecosystems Technology Inc.,7 the Wyoming Supreme Court upheld a ruling permitting the creditor of a corporation’s wholly owned subsidiary to “pierce the corporate veil” (of the subsidiary). The ruling made the parent company responsible for the debts of its subsidiary. Veil piercing is an extraordinary remedy typically reserved for fraudulent conduct. In Greenhunter, the Wyoming Supreme Court acknowledged that the two companies (parent and subsidiary) maintained separate bank accounts and business records. The court, however, took the unprecedented step of considering consolidated federal tax returns as suggesting an alter ego relationship. The court permitted the plaintiff to pierce through the subsidiary (to reach the parent’s assets).
Other factors may also be considered. If stability is a concern, Delaware is a traditional choice and Nevada similarly relies on Delaware’s long-standing body of favorable corporate law. If privacy is a concern, Delaware (which requires almost no public disclosure) is the best domestic option.
The types of assets to be owned by the LLC should also be considered. It makes little sense (for instance) to rely on the protections of a Nevada LLC to own real estate in California. The practical reality is that any litigation is likely to occur in the state where assets are located and local courts tend to apply local law.8
Choosing the appropriate entities for an asset protection structure is essential. Entity selection requires constant study of legal trends and pitfalls as well as the counsel versed in the area.
1 Sergeant v. Al-Alseh, 137 So.3d 432 (Fla. 4th DCA 2014).
2 The National Conference of Commissioners on Uniform State Laws (also known as the Uniform Law Commission - ULC) provides states with nonpartisan guidance to critical areas of state statutory law.
3 Uniform Limited Liability Act (1996) Section 503(e)(3), drafted by the National Conference of Commissioners on Uniform State Loans.
4 Curci Investments LLC v. Baldwin, 14 Cal. App.5th 214 (Cal. Ct. App. 2017)
5 Pa. Stat Sections 8853(h), 8853(c), 8853(f)
6 In re Glick, 568 B.R. 634 (Bankr. N.D. Ill. June 8, 2017).
7 Wyoming Supreme Court Case No. 5-14-0036 (Nov. 7, 2014).
8 See Wells Fargo v. Barber, et al., 85 F.Supp. 3d 1308 (M.D. Fla. 2015); But see JP Morgan Chase Bank N.A. v. McClure, et al., 393 P.3d 955 (Co. 2017), where the Colorado Supreme Court determined that a member’s interest exists in the state of LLC formation (for purposes of enforcing a charging order); and Arayos LLC v. Ellis, 2016 WL 1642676 (S.D. Alabama 2016), where the court ruled that it has no authority to act on an LLC interest if the LLC was organized in another state; and Sergeant v. Al-Alseh, 137 So.3d 432 (Fla. 4th DCA 2014), where the court ruled that it lacked the authority to enforce collection of stock certificates located outside Florida.
Gary Forster, JD, LLM, is managing partner and co-founder of the law firm ForsterBoughman in Maitland, Fla. He can be reached at firstname.lastname@example.org.
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