Corporate & Securities. Creditor Remedies against Members of LLCs

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1 ALBANY AMSTERDAM ATLANTA AUSTIN BOSTON CHICAGO DALLAS DELAWARE DENVER FORT LAUDERDALE HOUSTON LAS VEGAS LONDON* LOS ANGELES MIAMI NEW JERSEY NEW YORK ORANGE COUNTY ORLANDO PALM BEACH COUNTY PHILADELPHIA PHOENIX SACRAMENTO SAN FRANCISCO SHANGHAI SILICON VALLEY TALLAHASSEE TAMPA TYSONS CORNER WASHINGTON, D.C. WHITE PLAINS Strategic Alliances with Independent Law Firms** MILAN ROME ZURICH Creditor Remedies against Members of LLCs LLC members and other persons dealing with LLCs will be interested in a recent Florida Supreme Court case that was decided on June 24, The court s decision in Olmstead v. FTC appears to eliminate part of the asset protection feature of single-member LLCs and calls into question the remedies available to creditors of members in multiple-member LLCs. The case involved a $10 million judgment obtained by the FTC against individuals for having "operated an advance-fee credit card scam." The assets of the debtors were frozen and placed in receivership. Among the assets placed in receivership were the membership interests of the judgment-debtors in several single-member LLCs. The FTC obtained a court order compelling the debtors to surrender to the receiver all of their right, title and interest in their LLCs. The debtors argued that the FTC s sole and exclusive remedy was to procure a charging order against their membership interests in the LLCs. The case was appealed to the Eleventh Circuit of the U.S. Court of Appeals, which in turn asked the Florida Supreme Court to rule on the question of whether, pursuant to the Florida LLC Act, a court may order a judgment-debtor to surrender all right, title and interest in the single-member LLC to satisfy an outstanding judgment. The court rephrased this question to eliminate any reference to a provision of the Florida LLC Act, and a majority of the justices (in a 5-2 decision) answered it in the affirmative. Another way of stating the question before the court was whether the charging-order provision contained in the Florida LLC Act constitutes the exclusive remedy of a judgment creditor who wants to execute a levy and sale upon a debtor s membership interest in a single-member LLC. The court essentially ruled that the charging-order remedy is not the exclusive remedy available to a judgment creditor proceeding against a debtor s membership interest in a single-member LLC. Prior to this decision, it was generally believed that the sole remedy of a judgment creditor of a member of a Florida LLC was to procure a charging order against that member s interest in the LLC. With a charging order, a judgment creditor in Florida is entitled to receive distributions otherwise payable to the member, if any. However, the creditor cannot foreclose against or otherwise obtain ownership or control of the membership interest itself, nor can it compel the LLC to make distributions to the debtor to be applied to the creditor s debt. If the creditor has the right to foreclose on the membership interest, then it has essentially the same recourse that extends to creditors foreclosing on the stock held by a shareholder in a corporation, which could include the right to vote the stock, after foreclosure. If the debtor has a sufficient voting interest, this would enable the creditor to cause the corporation to take actions that would monetize the debtor s stock so that the debt could be satisfied. In the case of an LLC membership interest, foreclosing on that interest could include acquiring whatever voting or management rights the debtor possesses under the

2 operating agreement of the LLC (or under the applicable voting and management provisions of the LLC Act in the absence of an operating agreement or when the operating agreement is unclear). Historically, the charging order remedy was intended to protect the personal and contractual relationships among the partners of a partnership (which by definition has more than one owner), including any specific voting and management rights contractually agreed upon by the partners. The rationale was (and continues to be) that if a creditor of a particular partner could take over the partner s voting and management rights, this would disrupt the relationship among the partners and violate the rights and expectations of the innocent partners. This has sometimes been called the pick your partner principle and was codified in partnership acts as early as the 19th century. When states began adopting LLC statutes about 30 years ago many historical partnership concepts were carried over to LLCs because of its hybrid nature. The tension between the corporate and partnership attributes continues in the LLC statutes of all states today, but most experts and practitioners would agree that LLCs are first and foremost creatures of contract, and in this respect resemble partnerships more than corporations. The flexibility afforded by having a contract govern a business entity s affairs is one of the characteristics that has made LLCs so popular. Many commentators have argued in recent years that the rationale or justification for the charging order remedy breaks down in the case of single-member LLCs, which only emerged during the last 15 to 20 years. Because the provisions for single-member LLCs were grafted onto existing LLC statutes that were predicated on the idea of a partnership-type entity having at least two owners, single-member LLCs were in many ways a square peg being pounded into a round hole. The charging order is a good example, as it was intended to balance the rights of creditors and non-debtor members alike. These commentators and other experts have also pointed out that a statutory provision limiting judgment creditors to the charging order remedy is subject to abuse because the debtor can invoke a distribution policy designed solely to frustrate the debtor s creditors. In fact, many legal and financial advisers openly advocate the use of single-member LLCs as debtor-protection vehicles, and herald their utility for keeping non-business assets beyond the reach of creditors. The ability to organize LLCs for a purpose other than a business objective (or for no specific purpose) has fueled the use of LLCs for housing personal assets that would otherwise be within the scope of general levy and sale rules available to judgment creditors. The court reasoned in Olmstead that while the Florida LLC Act does not authorize the transfer to a judgment creditor of all an LLC member's interest in an LLC, another Florida statute (specifically F.S. Section , which enables the levy and sale rights of judgment creditors) does authorize such a transfer, including stock in corporations. Therefore, according to the court, the issue before it should turn on whether the charging order provision in the LLC Act (F.S. Section (4)) displaces the general levy and sale remedy. F.S. Section (4) states in relevant part: On application... by a judgment creditor of a member, the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment... This section further provides that such a charging order would give the creditor only the rights of an assignee, which, in effect, means that the creditor would be entitled only to distributions, if any, made by the LLC with respect to the membership interest subject to the charging order. The court went on to note that Section deals with the right of assignees or transferees to become members of an LLC and the nature of an assignee s rights and duties. Section (1) sets forth the basic premise that, absent a contrary provision in the articles or operating agreement, an assignee of a limited liability company interest may become a member only if all members other than the member assigning the

3 interest consent. The court concluded that the provision in section (4) with respect to charging orders must be understood in the context of this basic rule. It said that the limitation on assignee rights in section (1) could have no logical application to the transfer of rights in a single-member LLC due to the absence of any other members who can give their consent to the transfer. Therefore, according to the court, the assignee of the membership interest of the sole member in a single-member LLC becomes a member and takes the full right, title, and interest of the transferor without the consent of anyone other than the transferor. This finding led to the conclusion that the general levy and sale remedies available to judgment creditors should apply to the debtor s transferable interest in the LLC. The court also contrasted the charging order provisions in Florida s partnership and limited partnership statutes, which expressly provide that a charging order remedy is the exclusive remedy of a judgment creditor, to the LLC charging order provision, which does not contain the word exclusive. The court said that the absence of an express exclusive reference further supports a finding that the LLC Act s charging order provision does not supersede the judgment levy and sale statute. In a lengthy dissenting opinion, Justice Lewis said the majority s comparison of the partnership and LLC statutes was irrelevant to the analysis and that such reasoning would be a disaster for multi-member LLCs. Unfortunately, the attention given to the absence of the exclusive language in the LLC statue (in both the majority and dissenting opinions) could undermine the protection that members in a multi-member LLCs have historically enjoyed against general levy and sale remedies. While the majority s opinion was specifically targeted to single-member LLCs, its off-handed handling of the exclusivity language comparison of the LLC and partnership statutes could be an invitation for creditors to claim that the absence of expressly stated exclusivity provisions in the LLC statute means that the charging order is not the exclusive remedy in the case of a multi-member LLC. Such a result would be plainly inconsistent with the long standing pick your partner principle underlying the Florida LLC Act, as well as the partnership statutes upon which it was based. Moreover, the Olmstead decision will likely lead to the same unfortunate result in the many other states lacking the express exclusive remedy language in their LLC statutes, since the rationale of this opinion will undoubtedly be seized upon by judgment creditors in those states. It is up to the legislature to squarely address and resolve this issue not only in Florida but in other states in which the exclusivity language is absent from the LLC statutes. Efforts are already under way by certain sections of The Florida Bar to propose a legislative fix to the potential problems cause by the Olmstead decision. The drafting committee that has been rewriting the entire LLC Act during the last two years has discussed this issue at great length and has considered conforming the LLC charging order provisions to the charging order provisions of the limited partnership statute (which contains the exclusivity language noted by the majority opinion in Olmstead). The committee has struggled with the question of whether this language should apply equally to single-member LLCs and decided to defer action until the release of the Olmstead decision. It has been suggested that one solution is to change the statute to provide that judgment creditors are not restricted to charging orders in cases involving single-member LLCs, but that the exclusivity rule would continue to apply to multi-member LLCs. Many commentators and other legal analysts have suggested this kind of solution in Florida and elsewhere. However, there is no way to predict whether this course of action will be selected under the new Florida LLC Act. Furthermore, this kind of bifurcated treatment would probably encourage the use of nominal or dummy members to qualify LLCs as a multi-member LLCs. At least one task force has also been organized within The Florida Bar for the sole purpose of considering options for a legislative response to the Olmstead decision.

4 Members of LLCs should evaluate the risks and possible exposure caused by this decision and consider whether corrective action may be warranted. In the case of a multi-member LLC, a possible solution may be to amend the operating agreement to provide for the buy-out of the debtor member s interest if it is levied upon by a creditor, or by providing for the conversion of the interest to a non-voting interest in such event (or otherwise limiting the management and voting rights attaching to the interest). This would minimize the danger of the creditor or its designee from interfering in the management structure of the LLC or meddling with the personal relationship among the members. In some cases more drastic measures may be justified, such as converting to a limited liability partnership (LLP) or a limited partnership or limited liability limited partnership (LLLP), as these statutes do contain the exclusivity language. Some business owners may decide it is necessary to organize their LLCs in another jurisdiction that has an LLC statute with exclusivity language, or to convert an existing Florida LLC into an LLC organized in such a state. Whether any of these measures is called for or appropriate in a given situation will depend on many factors, such as the original purpose for using an LLC, the primary objectives of its owner(s), the risk associated with a judgment creditor proceeding against the interest of a member, whether the operating agreement already contains safeguards (such as a buy-sell provision governing that event), and an evaluation of any other options that may be available to the owner(s). For most multi-member LLCs, one should not overlook the fact that the Olmstead decision was specific to single-member LLCs. Those LLC members whose business or wealth preservation objectives are specifically predicated on the types of remedies available to judgment creditors should re-evaluate (with their professional advisers) their business and estate planning structures in order to minimize or manage the risks that have been laid bare by this decision. Pending the expected legislative fix, existing owners of LLCs holding significant assets and other persons contemplating the organization of such LLCs would be well advised to consult their attorneys to discuss these issues further. They can then determine whether any curative or preventative actions are necessary, and properly evaluate the other choice of entity planning considerations that would apply (including income, estate and gift tax planning points). This GT Alert was prepared by Gregory M. Marks. Questions about this information can be directed to Mr. Marks at (marksg@gtlaw.com), or to your Greenberg Traurig attorney.

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