Holding property in a limited liability company, or LLC, can provide a certain level of asset protection to individuals as opposed to holding such property in their individual capacity. However, that is not to say that a good asset protection plan is as simple as transferring property to a formed LLC and calling it a day. Often, asset protection plans incorporate the use of LLCs in tandem with other vehicles, namely certain trusts. Regardless of whether the LLC is used on a stand-alone basis or in conjunction with a trust, individuals and practitioners should be thorough in the preparation of the LLC’s operating agreement, making sure certain provisions are included to ensure the intended asset protection is provided. This article will provide a nonexhaustive list of certain provisions to consider incorporating into an LLC operating agreement to provide for asset protection.
Generally[1]
The crux of any asset protection strategy is generally to control assets without owning them in your individual name. In most states[2], the only remedy available to a personal creditor of an LLC member is obtaining a charging order, or a right to receive the member’s right to distributions from the LLC. In a minority of states, the creditor may foreclose on the member’s LLC ownership interest or obtain a court order for the LLC to be dissolved.
Eliminating Mandatory Distribution Clauses
LLC operating agreements often contain a mandatory distribution clause wherein the manager or member is required to make distributions of profits at certain regular intervals. By having a clause that eliminates mandatory distributions, the manager or member can then make discretionary distributions, operating similarly to a spendthrift trust. Giving the manager absolute discretion as to distributions from the LLC will prevent the creditor from “intercepting” the debtor-member’s share of distribution.
Poison Pill Provisions
A “poison pill” provision permits the LLC’s manager to redeem any LLC units lost or threatened to be lost to a creditor at a substantially reduced price. This provision is especially important in states where judicial foreclosure may be an alternative remedy to a charging order. For example, the operating agreement could provide that when LLC interests are charged by a charging order, the LLC has the right, but not the obligation, to redeem those interests for a fixed dollar amount or for a percentage of the interest’s last determined value. This “poison pill” provision protects the LLC and its other members, whose percentage interest in the LLC is augmented for a nominal amount. The debtor-member remains liable to the creditor and is removed from the LLC.
Restricting Transfers of Membership Interest
Restricting the transfer of LLC membership interests by members prevents new parties from obtaining an ownership interest in the LLC without following certain procedures, such as obtaining approval from the other current members of the LLC. The LLC operating agreement should always clearly articulate who becomes a member (rather than merely an assignee) upon a transfer of LLC interests, and whose consent is required to transfer membership interest, such as by unanimous vote of members, majority vote of members, and/or manager’s consent. Often, even if the court gives a creditor interests in an LLC, such creditor becomes merely an assignee without any management rights. As such, while some operating agreements state that any unapproved transfer is void ab initio (which is sometimes invalidated by the court), others say that any unapproved transferee becomes a mere assignee rather than member. Note that it may be prudent practice to include both provisions, the latter being a backstop in the instance the court invalidates any attempt to declare the unapproved transfer void.
For example, a provision could provide that membership interests could be assigned, but such assignment would include only financial, not governance, rights. The operating agreement could also provide for a right of first refusal, where the LLC and/or other members would have the right for a specified amount of time to match any third party offer to acquire a transferring member’s membership interest. Such provision would prove especially beneficial should a debtor member decide to sell his or her interest to pay his or her debt. Additionally, the operating agreement should be clear that any member or creditor who has a charging order against the LLC is not entitled to vote or otherwise govern the LLC in any manner. Carve out provisions are also a valuable option to consider including in the operating agreement. These provisions exempt certain transactions from the transfer restrictions. These generally include transfers to trusts, family members, other members of the LLC, and controlled entities or affiliates of a member.
Decanting Clause
A decanting clause, while typically used in trust agreements, can be applicable to LLCs. This clause can be used as a defense to potential fraudulent conveyance claims that could arise upon the transfer of any assets out of the LLC. Furthermore, inclusion of a decanting provision will provide for flexibility in the case of administrative changes.
Creditors Have No Voting Rights
While stated previously, the operating agreement should unambiguously articulate that a creditor has no voting, governance, or management rights in the LLC whatsoever. A charging order is merely a lien on the interests of the member, not a transfer of an LLC interest. Operating agreements should clearly state that only members have governance rights and contain provisions limiting who may become a member. In other words, a creditor is just a creditor, with no management or other rights with respect to the company, and the operating agreement should provide for as much.
No Partition of Assets
The operating agreement should provide for the waiver of an action for partition. This deters a creditor of the LLC from partitioning the LLC’s assets to receive payment. The property held by the LLC belongs to the LLC, not its individual members. Holding ownership interests in an LLC is much easier and more efficient than holding fractional interests in real property. The operating agreement should facilitate the member’s indirect ownership interests in real property without the fear of a partition action by a creditor of an LLC member.
Rights of Members in Bankruptcy
A trustee appointed by a bankruptcy court can, under the federal bankruptcy code, exercise powers over the debtor’s interest in an executory contract. The operating agreement may be considered an executory contract in bankruptcy when “the obligation of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other.”[3] The trustee may argue that the bankruptcy code gives the trustee the right to step into the shoes of the debtor-member before the filing of bankruptcy. Thus, in a state where the LLC statute provides a charging order as an exclusive remedy, the trustee in bankruptcy should only have the same rights as a creditor with a charging order. This result could work to prevent the bankruptcy trustee from attempting to influence management rights, sale rights, or other privileges of a member in good standing.
As the bankruptcy code does not directly address LLCs, the court may not accept this interpretation. It is therefore prudent to consider including expulsion provisions in the operating agreement. Such a provision could provide other members of the LLC the option to expel a member who files for bankruptcy or has nay of their interest subject to creditors’ rights, whether charging order or otherwise. Successfully expelling the member would release the remaining members and the LLC from bankruptcy and the reach of the trustee of the bankruptcy estate. The expulsion clause could further be tailored so that the value of the expelled member’s interest is substantially reduced, further dissuading the trustee form contesting the position that the operating agreement is an executory contract. Like a “poison pill” provision mentioned herein, these provisions provide the debtor-member little to no relief and as such should be discussed with the LLC members during the creation of the operating agreement.
Multi-Member vs. Single-Member LLCs
Practitioners should also be aware of any state law related to asset protection and the number of members of an LLC. While some states do not limit creditors to only a charging order if the interest is held in a single-member LLC, others do. Some courts have allowed creditors to “pierce the veil” of a single-member LLC under the notion that charging order protections are intended to benefit the non-debtor members, but when there are no other members, there is no relevant interest to protect.
Conclusion
LLCs are used in almost every asset protection plan, whether alone or in conjunction with other entities and/or trusts. While state statutes generally provide a certain level of protection, individuals and their trusted practitioners should always consider the inclusion of certain provisions, including but not limited to those contained within this article, in the LLC operating agreement in order to provide the greatest level of asset protection.
[1] See Gray Edmondson’s previous articles on charging orders here: https://www.esapllc.com/a-tale-of-two-charging-orders/; https://esapllc.com/charging-orders-se-property-holdings-llc-2022/
[2] In considering which state’s laws apply to a charging order, see Gray Edmondson’s article here: https://esapllc.com/where-should-you-form-your-new-llc-creditors-rights-2023/
[3] In re Robert L. Helms Const. and Dev. Co., Inc, 139 F.3d 702 (9th Cir. 1998).