Warning: Single Member LLCs Lack Asset Protection if the Member Files for Bankruptcy

by Richard Keyt, Arizona LLC attorney

One of the primary reasons to form an Arizona limited liability company is to shield the members from the debts and obligations of the company. If formed and operated properly (i.e. the company complies with applicable laws), the Arizona LLC should protect the members from the company’s financial problems. This member protection applies to protect the members from a type of creditor I call the bottom up creditor.

The Bottom Up Creditor

A bottom up creditor is a creditor that has a claim and/or gets a judgment against the LLC arising from the acts or omissions of the company rather than from the acts or omissions of a member, manager or employee. The general rule that the members of the LLC are not liable for the company’s debts and obligations works well with claims by bottom up creditors. See my diagram that illustrates the bottom up creditor problem.

The Arizona limited liability company gives good asset protection for its members, whether the LLC has one or many members. A single member, LLC, however, does not give its member any asset protection from a “top down creditor” if the member files a bankruptcy petition.

The Top Down Creditor

A top down creditor is potentially more serious for an LLC member because the creditor is not coming from the bottom up through the LLC to get to assets of a member. Instead, the top down creditor first sues and gets a judgment against the member because of the member’s acts or omissions, rather than the acts or omissions of the LLC, its managers or employees. For example, a member of an LLC who runs a red light and kills or injures somebody is liable for the harm he or she caused. If the victim or the family of the victim sues the member and gets a judgment against the member for the damages caused by the member running the red light, the LLC does not provide any protection for the member against the creditor.

An LLC or other entity never protects you from harm that you cause. When you cause the harm, you have a top down creditor problem. See page 2 of my diagram for a pictorial illustration of the top down creditor problem.

Adverse Single Member LLC Case Law

Olmstead vs. Federal Trade Commission

This Florida Supreme Court case involved the attempt by the Federal Trade Commission to enforce collection of a $10 million judgment it got against Shawn Olmstead and Julie Connell for their involvement with entities that operated an advance-fee credit card scam. The issue before the court was:

“Whether, pursuant to Fla. Stat. § 608.433(4), a court may order a judgment-debtor to surrender all, ‘right, title, and interest’ in the debtor‘s single-member limited liability company to satisfy an outstanding judgment.”

Olmstead argued that the issue should be answered in the negative because the only remedy available to a creditor who has a judgment against a member of a Florida single-member LLC is a charging order.  The court said:

“we rephrase the certified question as follows: ―Whether Florida law permits a court to order a judgment debtor to surrender all right, title, and interest in the debtor‘s single-member limited liability company to satisfy an outstanding judgment. We answer the rephrased question in the affirmative.”

The reason the court allowed the creditor to get to the assets of the single member Florida LLCs is because the court ruled:

“that there is no reasonable basis for inferring that the provision authorizing the use of charging orders under section 608.433(4) establishes the sole remedy for a judgment creditor against a judgment debtor‘s interest in single-member LLC.

Arizona LLC law is different from Florida’s LLC law.  Arizona’s LLC member charging order protection is contained in Arizona Revised Statutes Section 29-655 which states:

“A. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the member’s interest in the limited liability company with payment of the unsatisfied amount of the judgment plus interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the member’s interest.

B. This chapter does not deprive any member of the benefit of any exemption laws applicable to his interest in the limited liability company.

C. This section provides the exclusive remedy by which a judgment creditor of a member may satisfy a judgment out of the judgment debtor’s interest in the limited liability company.”

Because of this statute, an Arizona court should not reach the result of the Florida Supreme Court in Olmstead vs. FTC.  See “Olmstead Decision Does Not Make All Single Member LLCs Useless.”

Single Member LLCs When the Member is in Bankruptcy

Because of relatively recent bankruptcy cases, it is clear that a single member limited liability company (regardless of the state in which it was formed) will not provide any asset protection when the member is a debtor in bankruptcy court. As of May 25, 2008, federal bankruptcy courts in Idaho, Maryland, Idaho and Colorado have exercised powers over single member LLCs without any using any of the legal theories commonly used by courts. The courts did not pierce the veil or reverse veil pierce. Nor did they impose a constructive trust or a resulting trust. The alter ego theory was not used.

In each case, the courts treated the single member LLCs differently than they would have been treated if the LLCs had multiple members.

In re: Ashley Albright, 291 B.R. 538 (Bkr. D Colo. 2003)

In a case called “In re: Ashley Albright,” a Colorado bankruptcy court ruled for the first time that the assets of a single member limited liability company could be used to pay Ashley Albright’s creditors. She filed for bankruptcy, not her LLC. The court based it’s ruling on Colorado’s LLC statute. Colo. Rev. Stat. § 7-80-703 provides:

Rights of creditor against a member. 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 the judgment with interest thereon and may then or later appoint a receiver of the member’s share of the profits and of any other money due or to become due to the member in respect of the limited liability company and make all other orders, directions, accounts, and inquiries which the debtor member might have made, or which the circumstances of the case may require. To the extent so charged, except as provided in this section, the judgment creditor has only the rights of an assignee of the membership interest. The membership interest charged may be redeemed at any time before foreclosure. If the sale is directed by the court, the membership may be purchased without causing a dissolution with separate property by any one or more of the members. With the consent of all members whose membership interests are not being charged or sold, the membership may be purchased without causing a dissolution with property of the limited liability company. . . .

The bankruptcy court stated,

The Debtor argues that the Trustee acts merely for her creditors and is only entitled to a charging order against distributions made on account of her LLC member interest. However, the charging order, as set forth in Section 703 of the Colorado Limited Liability Company Act, exists to protect other members of an LLC from having involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a co-manager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties’ interests affected. (emphasis added).

The court issued the following order:

The Trustee, as sole member, controls the Western Blue Sky LLC and may cause the LLC to sell its property and distribute net proceeds to his estate. Alternatively, the Trustee may elect to distribute the LLC’s property to the bankruptcy estate, and, in turn, liquidate that property himself.

Beware of the “Peppercorn” Membership Interest

Before adding a second member to your single member LLC just to solve the single member bankruptcy problem, consider the implications of the following statement by the Albright bankruptcy court:

To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with “peppercorn” co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse.

A-Z Electronics, LLC, 350 B.R. 886 (Bkrtcy. D. Idaho 2006)

The second adverse bankruptcy case was In re A-Z Electronics, LLC based on Idaho’s LLC statute. This case did not involve the state of formation’s charging order statute. Nor did the bankruptcy court allow creditors of the debtor in bankruptcy to obtain assets of A-Z Electronics, LLC. Instead, the court dismissed a Chapter 11 petition for bankruptcy signed by Ron Ryan as the managing member (and only member) of the LLC because he did not have the authority to act on behalf of the LLC. The court said that because:

  1. Ron Ryan was a debtor in personal Chapter 7 bankruptcy when he signed the bankruptcy petition on behalf of A-Z Electronics, LLC, he did not have the authority to sign, and
  2. Because Ron Ryan was the sole member of the LLC, all of his interests in the LLC become the property of the bankruptcy estate and the bankruptcy trustee was the only party that could manage the LLC and file a petition for bankruptcy.

The bankruptcy court said:

Where a single member files bankruptcy while the other members of a multi-member LLC do not, . . . the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of contributions to which that member would otherwise be entitled.

The case stands for the proposition that when a person who is the only member of an LLC files for personal bankruptcy, the bankruptcy trustee steps into the shoes of the debtor and can exercise management powers over the LLC to the same extent the single member could do.

In re Modanlo, 2006 WL 4486537 (D. Md. 2006) (slip copy)

In re Modanlo is a Maryland bankruptcy court case that involved an LLC formed in Delaware. The filing of the bankruptcy petition by the only member of a Delaware LLC caused the automatic dissolution of the LLC under Delaware law. Notwithstanding the automatic dissolution of the LLC, the bankruptcy trustee could, under Delaware LLC law, revive the company by amending the LLC’s Operating Agreement and appointing himself as the new manager of the company. The court rejected the sole member/debtor’s argument that the bankruptcy estate only held an economic interest in the LLC and that the trustee could not participate in the LLC’s management or become a member.

Citing Albright favorably, the court said that because there were no other members to protect, the purpose of preventing a creditor from becoming a substituted member of the LLC does not apply when the LLC is a single member LLC. The court held that “using principles of statutory construction and adopting the reasoning of the bankruptcy court in In re Albright, sections 18-702 (assignment of limited liability company interest) and 18-704 (right of assignee to become member) of the Delaware LLC Act do not apply to single member LLCs.

Cognex Corp. v. VCode Holdings, Inc., 2006 WL 3043129 (D. Minn., Oct. 24, 2006)

This case involved a lawsuit for a declaratory judgment against Acacia Research Corporation and its wholly-owned subsidiary VData, LLC, relating to intellectual property rights. The court found that the officers/managers of the parent corporation and its subsidiary LLC were substantially the same. The court said there was “no reasonable way” to distinguish when the officers/managers of Acacia Research Corporation were operating for its benefit instead for the benefit of the subsidiary LLC. The court allowed Cognex’s lawsuit against VData LLC, as the alter ego of Acacia Research Corporation to proceed.

Conclusion to Be Drawn from these Cases

All of these cases involving bankruptcy courts and single member LLCs involve whether the bankruptcy trustee succeeds to all of the management rights of the LLC. So far, the three bankruptcy courts have said Yes! One of the consequences of allowing the bankruptcy trustee to exercise management powers over the LLC is that the trustee will be able to dissolve the LLC and distribute its assets to the bankruptcy estate and make the assets available to pay creditors. When that happens, there is ZERO asset protection for the bankrupt member.

How to Solve the Single Member LLC Dilemma

If you are the only member of a single member LLC and you want to maximize asset protection from top down creditors, your options include the following:

1.  Never file for bankruptcy. This is the best solution, but if you have a creditor problem, you may not be able to prevent your creditors from putting you into an involuntary bankruptcy.

2.  Add a second member so your LLC is a multiple member LLC. This may work, but adding a member also has its potential problems:

a. No court case has said what the minimum amount of an LLC the second member must own. You could go with 1%, but a court might say that’s a “peppercorn” interest and it will be disregarded because it is not large enough to be considered a second member. We don’t know yet how much the second member must own.

b. If you do add a second member, be sure that the member pays fair market value for the interest the second member acquires. Remember the Ashley Albright court’s warning about adding a “peppercorn” co-member and bankruptcy avoidance provisions and fraudulent transfer law. If 1% of your company is worth $10,000 and you give 1% to your child for $1,000, you could have a fraudulent transfer.

c. The second member must be a “real” member for all purposes. This means that the member is entitled to financial statements, access to books and records, the right to vote on certain matters affecting the company, a right to get a share of the profits equal to the membership percentage owned, and other rights of a member in an LLC. If the second member is sham member or a member only on paper, the court will disregard the second member’s interest and find that you have a single member LLC.

d. Your new multi-member company will need a good comprehensive Operating Agreement that governs the rights and obligations of all of the members. Some of the problems inherent with having members other than just you are:

(i) What happens to the second member’s interest if he or she dies or gets divorced and the wrong person acquires the interest? Your Operating Agreement should give you an option to purchase the second member’s interest if the second member dies, gets divorced and does not retain all of the interest, defaults under the Operating Agreement, makes an assignment of assets for the benefit of creditors, files for bankruptcy and perhaps for other reasons.

(ii) Your second member decides to sell or give his or her interest in your company to a third party. What if you have a dispute with your second member and the second member sells the interest to his next door neighbor for $100? Your Operating Agreement should contain a right of first refusal provision that gives the LLC an option to match the terms and conditions of a proposed disposition or transfer of the second member’s interest in the LLC.

(iii) If your second member is sued and a creditor gets a judgment against the second member, the creditor will serve your LLC with a charging order and may seek to become a member of your LLC and exercise the rights of a member. Your Operating Agreement should have a provision in it that gives the LLC the right to purchase the interest of a member who has creditor problems.

(iv) If your second member files for bankruptcy, you may have the bankruptcy trustee step into the shoes of your second member and exercise the rights of a member of your company. This is the nightmarish In re Ehmann situation. The Ehmann case is an Arizona bankruptcy case where the bankruptcy trustee wanted to step into the shoes of a minority LLC member and the court allowed it.

If you add one or more members to your single member LLC and you do not have all the members sign a comprehensive Operating Agreement, you may be creating one or more future problems of the type listed above just to avoid the remote possibility that you might be in bankruptcy court one day as a debtor.

If protection from top down creditors who might get a judgment against you is more important than the risk that one or more of the problems listed above might happen to your LLC, then you could add a second member.

Related Article

For more on this important topic, read my article called “Do Single Member LLCs Provide any Asset Protection?

Multi-Member LLCs Need a Good Comprehensive Operating Agreement

As an LLC attorney who has formed 3,000+ Arizona limited liability companies, I urge people who have multi-member LLCs to always adopt a good comprehensive Operating Agreement. Arizona law does not require that an AZ LLC have an Operating Agreement, but it is foolish and risky to go into business with somebody without one. I have seen far too many LLCs with member problems that could have been solved with a good comprehensive Operating Agreement.

To hire me to prepare a comprehensive Operating Agreement for your multi-member Arizona limited liability company, see my Operating Agreement Preparation Service.