If you’re looking for a way to protect your assets from creditors and lawsuits you should consider creating a Limited Liability Company (LLC). An LLC is a business entity that combines the benefits of a business partnership and a corporation and protects your assets while still allowing you to retain control over them. Desirable characteristics of LLC include that it can be formed by a single member, does not have to have a business purpose, and does not require a separate tax return or annual filings to maintain its existence. LLCs can be a wonderful tool… but not all LLCs are created equal.
Arizona asset protection enjoys a competitive advantage over the laws of many other states because the drafters of the Arizona LLC law omitted creditor friendly portions of the Uniform Laws that allowed creditors to foreclose their charging order liens to realize on the underlying assets owned by the LLC. This puts Arizona LLCs among the country’s elite LLCs for asset protection. This enhanced protection is commonly known as the “charging order as the exclusive remedy,” and until recently was thought to be absolute in states like Arizona. However, this enhanced protection is now being eroded by developing case law, and even in an LLC-friendly state such as Arizona the yellow flag of caution must be out for a Single Member LLC (SMLLC) as protection of its assets from its member’s creditors.
THE BATTLE BETWEEN CREDITORS AND SMLLCS
In the 2003 Colorado bankruptcy case Ashley Albright, the Court allowed a bankruptcy trustee to stand in the shoes of the debtor and control the assets of the debtor’s SMLLC. First thought to be an aberration limited to its facts, in fact that decision was correctly decided and a warning to all SMLLCs. The true lesson of that case is stay out of bankruptcy court if you expect to protect the assets in a SMLLC because the bankruptcy trustee steps into the place of the debtor and can control the assets inside the SMLLC if there are no other members to protect.
Then in 2005, in an Arizona bankruptcy case case, In re Ehmann, a decision since vacated when the parties settled, Judge Haines articulated a theory that if a limited partner had a passive role in the governance of a family limited partnership, the bankruptcy trustee could under some circumstances succeed to the interest of the debtor limited partner, formulating a theory about the impact of the executory nature of the limited partnership interest. While not particularly interesting because it broke no new intellectual ground –the bankruptcy trustee always had that bundle of rights, the case is interesting and instructive because the general partner governed the limited partnership to the detriment of the bankruptcy trustee giving rise to a right to dissolve the partnership and reach the underlying assets, the case is nevertheless instructive. The case is important because it is the vanguard case signaling that the remedy of judicial dissolution can be used by creditors in a variety of circumstances where no other remedies exist.
The next important case is the recently published Florida Olmstead case where the Florida Supreme Court failed to decide the question certified to it by the Federal District Court about the remedies available against a SMLLC, but rather held that a charging order was not the exclusive remedy against a single member limited liability company because single member limited liability companies lacked other members whose interests needed to be protected.
The Florida Supreme Court refused to interpret the state statute and instead chose to fashion a remedy designed to protect creditors against artificial barriers in collection procedures.
It has been suggested elsewhere that a strict reading of exclusive remedy statutes (such as the one in Arizona) invites judicial activism to shape remedies as did the Florida Supreme Court which has now given it’s imprimatur to the creditor friendly theory.
Although SMLLCs are good asset protection entities protecting a member’s other assets from claims by creditors of the SMLLC (commonly called inside out protection), even that protection is limited if the member has signed a guarantee or can be held directly responsible as the actor giving rise to the claim.
The importance of the omission in Arizona law of the right to foreclose the charging order means a judgment creditor is entitled to a lien against a member’s interest in an LLC, but the creditor is only entitled to receive distributions that would otherwise be made to the member. If the LLC makes no distributions, then the creditor receives nothing except the satisfaction of making life difficult for the debtor. In states that follow the Uniform Laws or have their version of the charging order statute, the creditor may foreclose its lien on the member’s interest and force its way into the governance of the LLC; this is not the case in Arizona.
In single member limited liability companies, this means the creditor may have an absolute right to distributions from the SMLLC, but the debtor retains control over the assets of the SMLLC and the timing of distributions. This is a most undesirable result from the point of view of the debtor.
WHAT DOES THIS MEAN FOR YOU?
The battle will continue over the distinction between economic rights and governance rights in SMLLCs. How much deference to a plain reading of the statute can asset protectors expect from judges in cases with difficult fact patterns will continue to present a quandary to most. Practitioners have long argued peppercorn theories of additional members, but the modern genre of reverse piercing and judicial dissolution arguments in an increasingly hostile judicial environment require you to stand up and take notice rather than relying only on statutory constructions. It will be increasingly important that documents are well drafted in a state with favorable laws and that the ownership and governance provisions of your operating agreements be given particularly attention to achieve your specific goals. Most importantly specific facts must be analyzed because beginning with the best structure is the key to long term success.
If you think a custom crafted LLC will benefit you, give me a call.