Law & Legal & Attorney Bankruptcy & consumer credit

The Trouble With Single-Member LLCs – PART 2

The decision in In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003), has been followed by other bankruptcy courts, such as in In re Modanlo, 412 B.R. 715 (D. Md. 2006), which cited Albright favorably for the proposition 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. "[U]sing the principles of statutory construction and adopting the reasoning of the bankruptcy court in Albright…" the sections of the Delaware LLC Act regarding assignment of LLC interests and rights of assignees to become members "do not apply to single member LLCs." Modanlo, 412 B.R. at 730.

One cannot simply substitute in someone else who is a stranger without affecting those (personal) relationships among [multi-member LLC] members. That reasoning, however, is substantially undermined, if not meaningless, in the context of single member limited liability companies. By definition, there can be no remaining members of a single member LLC … whose personal relationships (among members) could be compromised by being forced to accept substitute performance from a stranger…

Modanlo, 412 B.R. at 727.

The same reasoning was followed in In re A-Z Electronics, LLC, 350 B.R. 886 (Bankr. D. Idaho 2006), where an Idaho bankruptcy court dismissed a chapter 11 petition signed by the single member of the debtor LLC because he did not have authority to act on behalf of the LLC based on his own chapter 7 bankruptcy filing. The court stated that in a multi-member LLC, when a single member files bankruptcy, the bankruptcy estate is entitled only to receive the debtor members' share of profits or other compensation and the return of contributions to which the debtor member would be entitled. However, when the debtor is the only member of the LLC, 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.

Based on this growing line of cases, two arguments could be made by a Seattle Bankruptcy Attorney representing a Washington judgment creditor seeking to collect assets held by a debtor's single-member LLC:

First, the provisions of the Washington LLC act regarding assignment of membership interests, charging orders, and limitations on assignees or judgment creditors becoming managers of the LLC do not apply to single-member LLCs because there are no other members to protect. A Seattle Bankruptcy court accepting this argument might allow the judgment creditor to execute on and sell the entire LLC interest including the debtor member's bundle of LLC rights (management and right to receive profits). While there is no appellate decision providing precedent for this, it happens as a matter of course in KingCounty, where the sheriff routinely levies on and sells debtors' membership interests in single-member LLCs under writs of execution.

Second, Washington's LLC act permits appointment of a receiver in appropriate cases after entry of a charging order. A receiver could be appointed in the case of a single-member LLC to prevent the member debtor from controlling the LLC assets to his or her own advantage such as by preventing any disbursement under the charging order. By statute, upon appointment of a receiver, the single member of the LLC would be divested of his or her management rights. The receiver would be entitled to manage the LLC, and either sell its property and distribute the proceeds to the judgment creditor after payment of all partnership debts, or manage the LLC property and distribute the profits to the judgment creditor until the judgment was fully satisfied.

A common response to this potential problem by Seattle Tax Attorneys is to add a new member or two to the LLC so that it is no longer a single-member LLC. While this may be appropriate in some cases, if it is done with intent to hinder, delay, or defraud creditors, or for less than fair consideration, the addition of token or "peppercorn" members to the LLC could be avoided by a bankruptcy trustee or as a fraudulent transfer by a state-court creditor. See Albright, 291 B.R. at 541, n.9. This would especially be true where the new member did not buy into the LLC for fair value, was a family member or other entity controlled by the debtor (such as a self-settled trust), or the addition of a new member was done at a time when the original member was faced with a lawsuit, preparing to file bankruptcy, or in financial difficulty.

What to do if you are forming a new LLC or have an existing single-member LLC? First, make sure your LLC has more than one member. If you have an existing single-member LLC, you can add one or more new members, but be sure they are actual members and not just token members added merely as a roadblock for your creditors. The new member should also pay reasonably equivalent value for the membership interest. If the LLC's value is $100,000 and you add a new 10% member, the new member should pay $10,000. If you add a new member for no consideration or considerably less than the value of his or her percentage interest, a creditor or bankruptcy trustee could potentially avoid that transfer. Of course, whenever forming a new LLC or adding new members to an existing single-member LLC, you should hire an experienced Seattle Attorney to prepare a good operating agreement to best protect the members and the LLC assets from potential creditor claims.

On the other side of the equation, if you are a creditor trying to collect from a debtor who has placed his or her assets in an LLC, your Seattle Bankruptcy Lawyer should investigate the nature of the LLC to determine if it is a single-member LLC or has had new members added recently. If so, then the LLC assets may be fair game.

Finally, if you are a single-member LLC owner in financial difficulty or contemplating bankruptcy, you should consult with an experienced Seattle Bankruptcy Lawyer to help you determine how a bankruptcy filing will affect you and determine how, if possible, to protect your LLC interest.

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