The limited liability company (LLC) is a hybrid--a combination of the best elements from the corporation and the partnership. The LLC derives a non-liquidation benefit from its partnership heritage.
Many states, in enacting LLC statutes, have followed the Revised Uniform Limited Partnership Act (RULPA) limited partnership (LP) heritage in enacting rules preventing foreclosure of an owner's interest and forced liquidation of the business to satisfy a personal debt liability of the owner. In short, these states now prohibit foreclosure and forced liquidation of an LLC.
The unfavorable outcome that can occur in a corporation cannot occur in the LLC because a creditor with a charging order does not become a member of the LLC and, accordingly, has no voting or management rights. However, this conclusion must be tempered by several facts.
Not all states follow the RULPA view with respect to LLC interests. Instead, some still take the "liquidation view," under which the creditor can, in fact, foreclose on the partnership interest. In short, the creditor can force a liquidation of the partnership, so that the partner's personal debt can be paid from his or her share of the liquidated assets.
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The following states have LLC statutes that follow the RULPA view prohibiting foreclosure and liquidation:
| States Prohibiting Foreclosure on an LLC Interest |
| Arizona |
Idaho |
Minnesota |
| Arkansas |
Illinois |
Nevada |
| Connecticut |
Louisiana |
Oklahoma |
| Delaware |
Maryland |
Rhode Island |
| Virginia |
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Other states are likely to follow the general partnership view--liquidation. Note that the Uniform Limited Liability Company Act, which has been adopted in some states, reflects the general partnership view.
You should consider forming an LLC in one of the states listed above, even if that is not the state where the business will be conducting its operations (see our discussion of a choice-of-state analysis). In these states, the protection afforded to your business interest, against the claims of any personal creditors, is significant.
Note that, under the RULPA view incorporated into the LLC statutes in the states listed above, courts are not given the power to make any orders, except the mere granting of a charging order. In fact, the courts that have interpreted the RULPA charging order provision have concluded that the charging order is the only remedy available to the personal creditor. This should also extend to LLCs in the states listed above.
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As we've seen, a personal creditor of an LLC owner who obtains a charging order against the owner's LLC interest will not have an effective remedy in states that apply the RUPLA charging order concept in their LLC statutes.
This also may be the result in a federal bankruptcy proceeding. However, the federal bankruptcy courts have other powers that come into play. Further complicating the exercise of these powers is the fact that the bankruptcy code does not yet have specific provisions that apply to LLCs. This often leads to uneven results across the states in bankruptcy cases.
The LLC operating agreement is likely to be deemed an "executory contract" in bankruptcy parlance. The trustee appointed by the bankruptcy court can, under the federal bankruptcy code, exercise powers over the debtor's interests in an executory contract. This power can be used to sell or assign the owner's rights under the agreement. This right should only apply to the extent a creditor with a charging order could exercise these rights. Thus, an LLC statute with a RULPA charging order provision should work to prevent the bankruptcy trustee from usurping, or assigning, any management rights in the LLC, or naming an assignee of the interest as a full-fledged owner.
In other words, the trustee should have no greater rights than could be exercised by a creditor with a charging order under state law. However, because of a lack of express provisions in the bankruptcy code related to LLCs, this result is not assured. It is possible that bankruptcy courts in some states could reach a different conclusion.
For this reason, a properly drafted LLC operating agreement may contain a clause that expels, or gives the LLC the power to expel, an owner who files a bankruptcy action. This clause, if it is exercised to trigger expulsion, severs the filing member from the contract and allows the remaining owners to regroup and continue the LLC without bankruptcy court interference. (Note that this is the default rule under the Delaware LLC statute--one more reason to consider forming your LLC in Delaware.)
The right to expel might include the requirement that it can only be exercised if the bankruptcy court concluded the trustee had the power to exercise or transfer the management rights of the owner. In the event of an expulsion, management and voting rights could, under the agreement, be vested in the existing voting/managing owners, or if none exist, in the owners who originally held nonmanager/nonvoting interests.
The expulsion clause may further provide for a diminished payout (e.g., equal to book value, rather than fair market value) to an owner who is so expelled. The clause also can provide that the bankruptcy action amounts to a material breach of the agreement by the debtor/owner, entitling the LLC to recover damages from the owner. Further, the clause can provide that this diminished amount be reduced further on account of the damages caused to the LLC by the breach. These provisions reduce any amount that would be paid into the debtor/owner's bankruptcy estate and could persuade the trustee to abandon the executory contract.
Because of the fairly severe consequences an expulsion clause itself can cause, it is wise to seek professional guidance in this matter. For example, an expulsion clause may be more appropriate in a family owned LLC, where expulsion and a diminished payout would not, in reality, diminish the family's overall wealth.
As you may have guessed, trustees sometimes challenge these clauses. A court may uphold the clause, however, if applicable state law incorporates the RULPA charging order concept, and thus prevents a judgment creditor from assuming all the rights of an owner, and allows the remaining owners the power to reject admitting the creditor as full-fledged owner. Thus, it is essential that the LLC be formed in a state that incorporates the RULPA charging order concept, and that the operating agreement contain a clause along the lines described above.