LLC Interests and a Member’s Bankruptcy, Part I

[The other articles in this seven-part series are here:  Part II, Part III, Part IV, Part V, Part VI, Part VII.]

The law of limited liability companies is a blend of concepts taken from the law of corporations and the law of partnerships. One of the differences between corporations and partnerships deals with the rights of the creditor of a shareholder of a corporation versus the rights of a creditor of a partner.

The usual rule for corporations is that a shareholder’s stock is property that, like any other property of the shareholder, can be reached by the shareholder’s creditors. For example, the shareholder’s creditor may be able to force a sale of the stock to satisfy a judgment against the shareholder, and the person who buys the stock will receive all the rights of a shareholder, including the right to receive dividends (i.e., economic rights) and to vote in elections of directors (i.e., noneconomic rights).

In contrast, the usual rule for closely held businesses organized as general partnerships is that the creditor of a partner can reach the partner’s economic rights in the partnership (for example, by obtaining a “charging order,” which is an order from a court directed to the partnership to pay to the creditor amounts that would otherwise be paid to the partner) but cannot reach the partner’s noneconomic rights, e.g., the right to participate in the management and operation of the partnership itself.

In this arena, multi-member LLCs, at least in Indiana and in most other states, have a stronger resemblance to partnerships than to corporations. (Things are sometimes different for single-member LLCs, so we’ll limit this discussion to multi-member LLCs.) The creditor of a member of a limited liability company can obtain a charging order, but generally cannot acquire the right to participate in the management of the LLC unless all the members of the LLC consent or if the LLC’s operating agreement otherwise permits the creditor to become a member.  That feature of LLCs, combined with the limited liability afforded members of LLCs, makes a limited liability company a potentially useful vehicle for asset protection.

However, the law of limited liability companies is not the only consideration in determining the ultimate utility of LLCs for protecting assets.  If the member of the LLC files for bankruptcy protection, the law of bankruptcy also kicks in, and a lot of things change when that happens.  For these purposes, the specific question is, what happens to a member’s rights in an LLC when the member files a bankruptcy petition?  Different bankruptcy courts have answered that question differently, and a recent bankruptcy decision from the Southern District of Indiana, In re Lee, 524 B.R. 798 (S.D.Ind. 2015) answers it in a way that potentially undermines the utility of Indiana LLCs for asset protection purposes.

More about that in Part II.


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