May the creditor of the sole member of a single member California LLC satisfy the debt from the LLC’s assets?
A 2010 Florida Supreme Court case provides the rationale for a creditor to execute upon the assets of a single member California LLC in order to satisfy the personal obligation of the member.
- NATURE OF A LIMITED LIABILITY COMPANY; SINGLE MEMBER LLC’S ARE PERMITTED IN CALIFORNIA
“A limited liability company is a hybrid business entity that combines aspects of both a partnership and a corporation. It is formed under the Corporations Code and consists of “members” who own membership interests. Members may by individuals, corporations, partnerships, or other limited liability companies.
The company has a legal existence separate from its members. It provides members with limited liability to the same extent enjoyed by corporate shareholders, yet allows members to actively participate in management and control [citations omitted].” Witkin, 9 Summary of California Law, §136 (10th ed., 2005).
A California Limited Liability Company may be formed with only one member. Corp. Code § 17050(b).
- LLC’S, INCLUDING SINGLE MEMBER LLC’S, ARE PROMOTED AS ASSET PROTECTION DEVICES
“All states permit a limited liability company (SMLLC) to be formed with only one member and asset protectionists seek shelter for clients under its protective liability umbrella to shield assets from the obligations of its only member.” Reverse Piercing: A Single Member LLC Paradox, Carter G. Bishop, South Dakota Law Review, Vol. 54, p. 199, 2009.
The underlying assets of the LLC are protected because the creditor can only reach the member’s economic interest. Absent the member’s consent, the creditor does not obtain any right to control the assets or affairs of the LLC. “A transfer of the membership interest to an unsecured creditor who purchases at a foreclosure sale generally allows the creditor to assume ownership of only the right to receive future distribution when and if made. Unfortunately, unless the transferor debtor consents to admit the transferee as the substitute member, the transferor generally continues as the only member with control over the timing of the distributions. Thus, while the debtor member no longer owns a financial interest in the SMLLC, that member nevertheless guards the entity holding the assets and is in a position to favor its own economic interests over those of the creditor owner of the entire economic interest….”ibid. at 199.
- THE CHARGING ORDER IS ONLY PARTIALLY EFFECTIVE AS A CREDITOR’S TOOL
LLC’s are treated as separate entities in California. A member’s LLC interest, like a partner’s interest in a partnership, is not subject to execution or attachment unless the LLC is also a debtor. See, Evans v. Galardi, 16 Cal. 3d 300, 310-311, 128 Cal. Rptr. 25, 546 P 2d 313 (1976). Creditor remedies for reaching LLC assets are set forth in Corporations Code§ 17302. Under this section, and the corresponding provisions of the Code of Civil Procedure, the sole remedy available for direct attack on a member’s interest is the charging order and its associated remedies. Corp. Code § 17302; CCP § 708.310. The reason for this limitation on creditors is to prevent a claim against a member from disrupting or interfering with the business of the LLC.
The charging order acts as a lien against the interest of the debtor member, and directs that all distributions attributable to the member be made instead to the creditor. The lien arises once the motion for a charging order is granted and relates back to the date the motion was served. CCP § 708.320(a). The charging order, however, acts solely against the economic interest of the member and reaches only the member’s proceeds or surplus distributions. The creditor holding a charging order has no right to participate in management and has no claim to specific LLC assets. This limitation restricts the effectiveness of the charging order as a creditor’s tool.
- REMEDIES ASSOCIATED WITH THE CHARGING ORDER
Under Corporations Code § 17302, there are two supplemental remedies which may be used in conjunction with the charging order. The issuance of the charging order is generally required before these other remedies may be employed and each is “progressively more drastic, … consistent with the underlying rationale of the charging order which is to minimize the disruption of a partnership business.” 1 P. Spero, Asset Protection, Partnerships § 9.02(1) (2001).
The creditor must first obtain a charging order which in effect garnishes all distributions available to the member whose interest is charged. The issued charging order should be served on both the debtor member and the LLC. See CCP § 708.320(a).
The second available remedy is appointment of a receiver to collect the funds due to the debtor member and conserve LLC property. This remedy is sometimes requested at the same time as the motion for a charging order. While the receiver can conserve the LLC’s property and prevent fraudulent transfers of its property, he or she can neither seize the property nor participate in LLC management.
If issuance of the charging order and appointment of a receiver are ineffective in satisfying a creditor’s claim, the final remedy is foreclosure upon and sale of debtor’s LLC interest. See Corp. Code § 17302(b). This remedy, however, is only available under restricted conditions, imposed to prevent the creditor of one member from unduly interfering with the LLC’s business. Even if the creditor is allowed to proceed with foreclosure, the purchaser at the foreclosure sale obtains only the member’s economic interest and not the member’s share of the LLC’s underlying assets.
- FORECLOSURE OF A MEMBER’S LLC INTEREST IN CALIFORNIA
Two California cases, Crocker Nat’l Bank v. Perroton, 208 Cal. App. 3d 1, 255 Cal. Rptr. 794 (1989) and Hellman v. Anderson, 233 Cal. App. 3d, 852 (1991), describe the limited circumstances under which a creditor with an unsatisfied charging order may foreclose upon and sell a debtor’s partnership interest. While Perroton and Hellman deal with partnerships, rather than LLC’s, the same rules and procedures apply.
In Perroton, decided in 1989, the court determined that a judgment creditor holding an unsatisfied charging order against a limited partner could proceed with foreclosure of the partner’s interest, but only after obtaining the consent of the non-debtor partners.
In Hellman, a general partnership case decided two years later, the restrictions on foreclosure and sale were further relaxed. The Hellman court held that even if consent of the non-debtor partners is unavailable, the foreclosure sale can go forward if sale of the debtor’s interest would not disrupt the partnership business. The court further held that the burden of proof to show that the foreclosure sale would disrupt partnership business was on the debtor partner.
The Hellman court concluded that, “since the interest acquired by the purchaser of a partnership interest is limited by operation of law to the partner’s share of profits and surpluses, with no acquisition of interest in partnership property or management participation, the foreclosure and sale of the partnership interest will not always unduly interfere with the partnership business to the extent of requiring consent of the nondebtor partners. In some cases, foreclosure would appear to have no appreciable effect on the conduct of partnership business. Thus, the effect of foreclosure on the partnership should be evaluated on a case-by-case basis by the trial court in connection with its equitable power to order a foreclosure.” ibid at 852.
- THE FLORIDA SUPREME COURT HELD IN 2010 THAT THE ASSETS OF A SINGLE MEMBER LLC ARE NOT PROTECTED FROM THE MEMBER’S PERSONAL CREDITORS
In a much anticipated ruling (see, Bishop & Kleinberger: The Single Member LLC as Disregarded Entity, Business Law Today, August 2010) , the Florida Supreme Court, after deliberating for over one year, determined that the charging order was not the exclusive remedy available to the creditor of a single member LLC, and that the creditor could execute upon the assets of the LLC in order to satisfy the sole member’s debt. Olmstead v. FTC, Supreme Court of Florida, June 24, 2010. While the court’s analysis discussed the Florida LLC statutes in detail, at the end of the day, the decision was a practical one, based on the common sense notion that if there is only one member in the LLC, there are no other members whose interests can be adversely affected, and there is no one else from which to seek or obtain consent to foreclose. As stated in Olmstead, “The limitation on assignee rights … has no application to the transfer in a single member LLC. In such an entity, the set of ‘all members other that the member assigning the interest’ is empty. Accordingly, an assignee of the membership interest of the sole member in a single-member LLC becomes a member – and take the full right, title, and interest of the transferor – without the consent of anyone other than the transferor.”
- HELLMAN AND OLMSTEAD, READ TOGETHER, PROVIDE CALIFORNIA CREDITORS WITH A COMPELLING ARGUMENT THAT THEY SHOULD BE ALLOWED TO SATISFY A MEMBER’S DEBT FROM THE ASSETS OF A SINGLE MEMBER LLC
Under Hellman, the court stated that consent of the remaining entity members would not be required in order to foreclose upon the underlying assets of the entity if the court determined that the foreclosure would not adversely effect the entity’s business, suggesting a case-by-case analysis in “connection with [the court’s] equitable power.” This practical approach suggests, in line with Olmstead, that if there are no other members whose interests can be adversely affected, that the consent requirement should be disregarded, and a creditor of the single member should be allowed to satisfy its claim from the assets of the single member LLC.