When a creditor obtains a judgment against a debtor, the debtor’s assets are sometimes held in membership interests in a limited liability company, which presents challenges for the creditor seeking recovery. The LLC Law provides for a charging order in such instances, which is a narrow remedy. Direct pursuit of the LLC’s assets is not typically available, unless the creditor can meet the high burden of reverse veil-piercing. In some states, a creditor may pursue a more direct recovery against the debtor-owned LLC when the debtor is the sole member of the LLC. Moreover, it may be difficult to obtain document discovery, and recent developments in Louisiana have seriously limited a creditor’s rights in such instances. As a result, it will be difficult for the creditor to investigate and determine that its charging order is being followed. The entire complexion of this may change if that debtor files a federal bankruptcy petition. In sum, the law on this issue presently is generally friendly to debtors and their LLC interests, while it can be the bane of a creditor’s lawyer’s existence. Even when aggressively pursued, the rights of a creditor to recover from a debtor’s membership interests in an LLC are likely to yield mixed results.
The Charging Order Statute
A creditor’s primary remedy against an LLC owned by the debtor is a limited one: the charging order. A charging order gives the creditor the right to receive payment from the LLC under limited circumstances. In Louisiana, La. R.S. 12:1331 provides:
On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the membership interest of the member with payment of the unsatisfied amount of judgment with interest. To the extent so charged, the judgment creditor shall have only the rights of an assignee of the membership interest. This Chapter shall not deprive any member of the benefit of any exemption laws applicable to his membership interest.
The charging order permits the creditor to have “only the rights of an assignee of the membership interest.” Id. This means that the creditor is not entitled to exercise management authority or otherwise to direct the affairs of the LLC. Section 1332 further defines this concept when it states “[a]n assignee of an interest in a limited liability company shall not become a member or participate in the management of the limited liability company unless the other members unanimously consent in writing.” The creditor is therefore not entitled to the ordinary rights of an LLC member, such as the right to manage the company, to vote the membership interests or to withdraw from the LLC and demand payment. The creditor is only entitled to receive distributions that would otherwise be paid to a holder of a membership interest.
The LLC Laws adopted by most states contain language deeming it an exclusive remedy. For example, Texas’ statute states that “the entry of a charging order is the exclusive remedy by which a judgment creditor of a member or of any other owner of a membership interest may satisfy a judgment out of the judgment debtor's membership interest.” Louisiana’s LLC Law does not contain such an exclusivity provision.
The narrow right of a creditor to obtain a charging order allows the target LLC latitude to manage its business so as to prevent the creditor from receiving distributions. Cash distributions are often discretionary under the governing rules and regulations of an LLC, and therefore, such distributions may be deferred indefinitely. The LLC’s other members are sympathetic to the plight of their co-member who is locked in conflict with a third party creditor, and they are often willing to take actions sufficient to deny recovery to the creditor. This may even include characterizing distributions as “salary” or other compensation to avoid having to distribute funds to the creditor. Such manipulation of the LLC governance could arguably give rise to direct claims against the LLC or even the co-members. Certain other remedies may be available to the creditor as well, such as garnishment. Ultimately, however, the creditor’s rights will be difficult to vindicate.
The Judgment Creditor’s Right to Information
The next pivotal question is whether a creditor can monitor the charging order and make sure that he is receiving the full “rights of an assignee of the membership interest.” Recent case law in Louisiana has narrowed the ability of a creditor to monitor the activity of the LLC.
The provision that courts have relied upon to determine a creditor’s right to information in this context is La. Rev. Stat. § 12:1319(B). It provides that members of an LLC are entitled, by virtue of their membership interest, to review and inspect certain company documents, upon reasonable request. These documents include:
Courts in Louisiana have interpreted the provisions of Section 1319(B) to mean not only that members are entitled to review these documents, but also the reverse proposition: That people who are not members are prohibited from obtaining these documents. Khoobehi Props., LLC v. Baronne Dev. No. 2, L.L.C., 16-506 (La. App. 5 Cir. 3/29/17), 2017 La. App. LEXIS 530, *13. Louisiana courts have widely concluded that this right to information is exclusive to members.
This issue came up before the Louisiana Court of Appeals for the Fourth Circuit in the judgment creditor context in the Channelside case. In Channelside, the creditor had obtained a judgment against a Florida corporation that had a membership interest in a Louisiana LLC. The LLC was a non-party to the original suit. The creditor obtained a charging order against the Florida corporation’s membership interest in the LLC, then sought document discovery as to the internal business of the LLC. The trial court partially granted and partially denied opposing motions to quash and to compel a records deposition and subpoena duces tecum issued to the LLC, for the production of financial documents and tax returns. The appellate court found the "specific provisions of the Louisiana LLC Act are controlling in this case over the more general statutory provisions governing discovery." See Channelside Servs., LLC v. Chrysochoos Grp., Inc., 2015-0064 (La. App. 4 Cir. 05/13/16), 194 So.3d 751, 759, writ denied, 2016-1079 (La. 10/12/16). The court held that in accordance with the provisions of the LLC Law, an assignee of a membership interest in an LLC "is expressly restricted from inspecting the records" of the LLC. Id. at 773. As a result, the creditor was denied the opportunity to see financial information of the company against which it held a charging order. The Louisiana Third and Fifth Circuit Courts of Appeal have issued similar decisions following Channelside in the past year, and the Louisiana Supreme Court declined to take up the issue on writs in each instance.
If the target LLC makes no distributions to the judgment creditor on account of a charging order, the creditor has very little ability to investigate whether the charging order is being followed, due to the limitations of the LLC Law on record access. The most effective way to discover this information in support of the charging order may be through aggressive questioning at one or more judgment debtor examinations of the debtor who holds the membership interest.
Rights Against Single Member LLCs
If the judgment debtor is the sole member of his or her LLC, there is an argument that the creditor may obtain managerial control of the LLC through the foreclosure process, at least in Louisiana and other nonexclusive remedy states. The analysis is different in the single member LLC context, because there are no other members whose consent would be required for the creditor to be admitted as a full member.
In LLCs that have multiple members, courts have reasoned that it would be an unjust imposition on the other members if a creditor could simply step in the shoes of an LLC member and exercise control over the business. One Delaware court stated “it is far more tolerable to have to suffer a new passive co-investor one did not choose than to endure a new co-manager without consent” Eureka VIII LLC v. Niagara Falls Holdings LLC, 899 A.2d 95, 115 (Del.Ch.6/06/06). This is codified in LLC Laws, which provide that a person holding the rights of an assignee can exercise managerial rights only if all of the other LLC members have consented to admission. See La. Rev. Stat. § 12:1332. Following this procedure, a judgment creditor who is granted a charging order could obtain full member rights if and when the other LLC members vote to admit him. Although this, of course, rarely happens.
In Florida, the Supreme Court held that in the context of single member LLCs, a judgment creditor who has a charging order against a single member LLC may take full membership rights in the LLC. The court reasoned that there are no other members who could object to the judgment creditor taking a complete assignment of the membership interest. A Florida bankruptcy court observed the effects of the ruling on creditor’s rights:
Before Olmstead, if a Florida judgment creditor levied on a debtor's ownership in a single-member LLC, the most the judgment creditor could get was a statutory charging order . . . . In the instant case, that result would not have threatened the Debtor, because the Debtor did not receive any “profits or distributions” from the Middle Tier, single-member LLCs. Pursuant to the holding of Olmstead, after June 24, 2010, Inervest became entitled to cause the Debtor to surrender its “right, title and interest” in, and to, all of the Middle Tier LLCs. The Debtor would have lost control of the subsidiaries, and subsequently all the real property owned by the subsidiaries. In order to prevent that outcome, the Debtor filed the instant case.
In re Davis Heritage GP Holdings, LLC, 443 B.R. 448, 458 (Bankr. N.D. Fla. 2011) (J. Killian). This interpretation of the law gave creditors extraordinarily greater leverage against a debtor’s interest in wholly owned LLCs. Not long after the Florida Supreme Court’s decision, however, the Florida legislature amended the applicable law to limit the rights of a judgment creditor to a charging order, or foreclosure. Sec. 608.433, Fla. Stat.
Few other states have definitively addressed this issue. A Texas appellate court, for example, recently rejected the Olmstead argument in a somewhat similar fact pattern involving partnerships. In Pajooh v. Royal West Investments LLC, Series E, 518 S.W.3d 557, 563 (Tex.App.-Hous. 1 Dist., 2017). It is difficult to predict how the Louisiana Supreme Court would address this issue. Nevertheless, Louisiana law could be favorable to the Olmstead argument because it is one of the states in which the LLC Law does not expressly designate the charging order as an exclusive remedy.
Effect of Bankruptcy Filing
Bankruptcy courts are more open to allowing creditors, or a trustee, to exercise control over debtor membership interests. Bankruptcy courts look to Section 541 of the Bankruptcy Code and applicable state LLC Law on this question. It should suffice to say, for purposes of this article, that as a matter of bankruptcy law, Section 541 establishes the scope of property of the debtor’s bankruptcy estate, and it is often construed broadly. Applying this broad principle to the rights of a trustee vis-à-vis a debtor’s 100 percent interest in an LLC, courts have often found that the trustee may step into the shoes of the debtor to manage the LLC. In the Chapter 7 setting, bankruptcy courts that have discussed the rights of a Chapter 7 Trustee flowing from a debtor’s pre-petition membership interest have generally held that where the debtor held a 100 percent membership interest, the Chapter 7 Trustee obtains full management rights. In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003); In re A-Z Electronics, LLC, 350 B.R. 886 (Bankr. D. Idaho 2006); In re Garrison-Ashburn, LC, 253 B.R. 700 (Bankr. E.D. Va. 2000); see also In re Mohawk Traveler Transportation, LLC, Bankr. E.D.La. 11-13269.
In fact, the decision in Albright suggests that in the bankruptcy context, the courts will take the matter one step further and will grant the trustee such membership rights if the debtor held an overwhelming majority interest in the LLC, and some third party has a “peppercorn” interest which may, presumably, be disregarded in order to better effectuate creditors’ rights.
Lugenbuhl’s bankruptcy team represents a wide array of constituencies, including acting as counsel for numerous corporate and partnership Chapter 11 debtors, as well as committees, trustees, secured and unsecured creditors, bondholders and equity holders. More information about Lugenbuhl’s bankruptcy practice is available here.
The content of this article is not intended to serve as an exhaustive review of the laws, statutes or issues related to bankruptcy, creditor/debtor rights and insolvency/reorganization cases and is not intended to provide legal advice. The opinions expressed through this article may not reflect the opinions of the firm, individual attorneys or clients.