Creditor Collection Action Against Member LLC Interest

I shy away from debtor-creditor conflicts as they are messy affairs; however, a corporate lawyer needs to have a basic understanding of collection fundamentals when creating business entities. One of the main reasons for forming an LLC is liability protection of the members from the debts of the LLC. But what about the reverse, a claim by a creditor of a member against the assets of the LLC?

The Uniform Limited Liability Company Act (upon which the LLC laws of all states are based), provides the following in Section 504 entitled "Rights of Creditors":

(a) On application by a judgment creditor of a member of a limited liability company or of a member's transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment. The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor and make all other orders, directions, accounts, and inquiries the judgment debtor might have made or which the circumstances may require to give effect to the charging order.

The comments to Section 504 further state that "A charging order is the only remedy by which a judgment creditor of a member or a member's transferee may reach the distributional interest of a member or member's transferee."

Why is this important? Two reasons: (a) it means a creditor of an LLC member cannot vote a member's LLC interest nor otherwise attempt to manage the LLC and (b) the creditor cannot force liquidation of the LLC assets to satisfy a judgment it holds against a member. Basically, once a judgment creditor seizes an LLC membership interest through a judicial charging order, the creditor is left to sit on its hands waiting for the LLC members to vote a member asset distribution. Only then does the creditor collect anything from the LLC.

A bankruptcy court in Colorado carved out an exception to the above rule in the case of single-member LLCs. In the 2003 case of In re Ashley Albright, the sole member of an LLC went into bankruptcy. The bankruptcy trustee asserted that he as trustee now controlled the LLC and could cause the LLC to liquidate its property for the benefit of the bankruptcy estate. The court held that a charging order remedy given in the state LLC statute only acts to protect other members of the LLC. With no other members to protect in this case, the court granted the bankruptcy trustee complete control of the LLC and its property. See also In re Modanlo, 2008 U.S. App. LEXIS 3685 (4th Cir.), affirming In re Modanlo, 2006 Bankr. LEXIS 4524 (Bankr. D. Md); But see In re KRSM Properties, LLC, 318 B.R. 712 (9th Cir. Bank App. 2004) rejecting the Ashley Albright holding.

Forced Member Capital Contributions

Your LLC has been formed and competing in the business world. Oops, things have not gone as smoothly as the business plan predicted. The LLC needs an additional infusion of capital to survive. Perhaps your LLC has been wildly successful and needs an additional capital infusion to grow. You basically have two options at this point for equity investment in the LLC: (a) sell an LLC ownership interest to a new member (or existing member) that dilutes all other members or (b) require all existing LLC members to kick in new capital in amounts proportionate to their ownership interest. It's often difficult to bring new members into an existing LLC. There's a limited market for closely held small business interests. The problem with option (b) above is what happens when less than all members vote for new capital contributions. Unless the operating agreement provides for forced member contributions with a less than unanimous vote, many state LLC statutes prohibit the practice. Below are a few sample statutes.

• California Corporate Code Section 17200(b): "Unless the articles of organization or operating agreement provide otherwise, no member shall be required to make any additional contribution to the limited liability company." Link.
• Florida Business Code Section 608.4211: "(2)A promise by a member to contribute to the limited liability company is not enforceable unless it is set out in writing signed by the member. * * * (4) Unless otherwise provided in the articles of organization or the operating agreement, the obligation of a member to make a contribution or return money or other property paid or distributed in violation of this chapter may be compromised only by consent of all the members." Link.
• New York LLC Act Section 502(b): "Unless otherwise provided in the operating agreement and except as provided in section six hundred five of this chapter, the obligation of a member to make a contribution or to return money or other property paid or distributed in violation of this chapter may be compromised only by consent of all the members." Link.

Thus, when forming an LLC, remember that in most states an LLC member cannot be required to make capital contributions absent the member's consent unless a written operating agreement sets out such a right on the part of the LLC. If your operating agreement will allow the majority of the LLC members to force a minority of members to make additional capital contributions after formation, then you should also address what remedies are to be available to the LLC in the event of a breach of this duty (i.e., penalties? attorney fees? forced sale of LLC interest?).

Initial LLC Member Contributions

Many an LLC operating agreement merely lists dollar values that members are to make as an initial capital contribution. But what happens if one member never makes the agreed contribution? Planning is required to put the aggrieved members in a solid position should this situation come to pass. Here are a few basic drafting points for inclusion in an operating agreement that can tighten up this area:

• Delineate initial capital contributions between cash and non-cash contributions;
• For contributions of property other than cash, make a specific list of the items to be contributed (i.e., HP copier, Dell desktop computer, conference table, etc.);
• State a specific deadline by which initial capital contributions are to be made;
• Provide for interest to accrue on any unpaid balance of the initial capital contribution (perhaps also provide for a penalty when a delinquency occurs);
• Provide for attorneys fees to the party collecting upon a member's failure to make the required capital contribution.

Here is sample language of the foregoing:

Section 7 Capital Contributions.

1. Each Member shall contribute or shall have contributed, as an initial capital contribution ("Initial Capital Contribution") to the LLC the amounts set forth below. Any non-cash contributions to be made by the Members and their valuations are set forth in Attachment 1 hereto. Below are the cash contributions.
   
   

   Member Name	Initial Capital Contribution
   Stan Jordan	$ 30,000
   Bob Lobe	$ 30,000
   Tom Stroud	$ 20,000

   
   
2. The Members shall complete their initial capital contributions to the LLC within 10 days of the date of this agreement unless another date is agreed upon in writing by all LLC Members.
3. Interest shall accrue against a member upon any unpaid capital contribution at a rate of 6% per annum, compounded annually, commencing from the due date of the initial capital contribution.
4. Indemnification of Attorneys Fees and out-of-pocket costs. Should a member breach Section 5.3 of this agreement, any other member may sue for enforcement and shall be indemnified by the breaching member for its reasonable attorneys fees and out-of-pocket costs which in any way relate to, or were precipitated by, the breach of Section 5.3 of this agreement.

Language for attorneys fees can be much more detailed than the above sample but it should give you an idea of the minimum specificity one desires in operating agreement on the topic of initial member contributions.

Passive Investors In An LLC

I received a user question from my commercial site yesterday regarding how to structure the admittance of passive investors into an existing single person LLC. In a basic, member-managed LLC, the members serve three rolls when compared to corporations: shareholder, board director, and corporate officer. In order to curtain the authority of certain members (and enhance the authority of others), I have seen LLCs adopt corporate style bylaws then name certain of its members as "officers" of the LLC. That muddies the waters IMHO. This situation can be handled within the framework of the operating agreement.

The first step is to switch the LLC from one managed by all members to one that has managers. For an existing LLC, this quite often entails amendment of the LLC articles of organization which is not a complicated task. Most states have pre-printed forms for amending the articles. Remember that LLC managers can also be members. The operating agreement is then amended allowing the members to name managers (or one manager if that be your desire). The passive members are not named as managers. The tricky part comes with spelling out the level of authority of the manager and those acts for which a vote of the LLC members is required. The amount of authority that can be delegated to the managers by the members in an operating agreement is quite extensive. Section 404 of the Uniform Limited Liability Company Act (upon which all states have modeled their LLC acts) sets forth 10 acts which require unanimous consent of all members. The comments to Section 404 give further insight into the relationship between managers and members:

In a manager-managed company, the members, unless also managers, have no rights in the management and conduct of the company's business unless otherwise provided in an operating agreement. If there is more than one manager, manager disputes as to any matter relating to the company's business may be resolved by a majority of the managers unless the matter relates to a matter specified in subsection (c) (unanimous member consent required). Managers must be designated, appointed, or elected by a majority of the members. A manager need not be a member and is an agent of the company with the apparent authority to bind the company in the ordinary course of its business.

Here is a sample member-managed LLC operating agreement setting up boundaries of manager authority by reserving certain decisions for the members. As you might expect, there are tax implications to being a passive LLC member. For example, here is an article discussing the deductibility of LLC losses by a passive member.

LLC Articles of Organization

I've noticed occasional confusion between two LLC forms: (a) Articles of Organization and (b) the Operating Agreement. Here are two sample LLC articles of organization from the states of California and Florida. The articles of organization is the document filed with the state (usually in the office of the secretary of state) that initiates the legal existence of your LLC (usually the same day the articles are filed). Almost every state has a pre-printed form for articles of organization. They ask for rather basic information: LLC name, registered agent, location of headquarters, location of business, the LLC managers, and some ask for the LLC members. For links to articles of organization forms for all 50 states (that have forms), click on your state from this page. In two or three states (Arizona being the most notable), those who form an LLC are required to publish this fact in a newspaper in general circulation in the state shortly after the LLC is formed. In other states, the filing of the articles of organization is all that is legally required to legally bring an LLC into being.

Then what is the purpose of the operating agreement? This is the contract between members recording agreement upon such issues as ownership, voting, admission of new members, division of profits and losses, et alia. It is analogous to a partnership agreement. In single members LLCs, it is not uncommon for there to be no operating agreement. Why have an operating agreement in a single member LLC? In most states, a list of members is only filed with the state annually. An LLC operating agreement definitely sets out who are the members and who has the authority to act on behalf of the LLC. It is standard procedure for banks and other lenders / suppliers doing new business with an LLC to ask for a copy of the operating agreement regardless of the number of members.