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Single Member LLCs and Charging Order and Foreclosure Protection

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Introduction: Uninformed commentators give unfounded advice when making the overly board statement that single member LLCs (“SMLLC”), as well as multi-member LLCs with a husband and wife as the sole members, do not afford asset protection under charging order and foreclosure statutes. The thoughtful answer is that it depends on the state and, more importantly, the skill of the attorney drafting the LLC operating and corresponding trust, if any, agreements.

Types of LLC liabilities: There are two types of LLC liabilities. First, those originating from the LLC’s operations and unconnected to LLC members (“inside-out liabilities”). Second, liabilities originating from an individual member’s actions and not connected to the LLC (“outside-in liabilities”).

Criminal Behavior, Civil Fraud, Knowing Tortious Acts with Inside-Out and Outside-In Liabilities: No court will allow an individual to avoid liability while committing criminal acts, civil fraud, or engaging in tortious conduct through an LLC or any other entity. Further, if an individual engages in these activities outside the LLC and wants to shelter that individual’s LLC membership interests from the his or her individual liabilities, a Court will bend over backwards not to provide protection.

In Olmstead v. Federal Trade Commission, 44 So.3d 76 (2010), the Florida Supreme Court succinctly opined that the appellants (husband and wife, which is most states is regarded as an SMLLC), owners of an LLC, had, through certain other entities, run a credit card scam, defrauding numerous consumers. The judgments against these members were assessed against the LLC. The court analyzed the charging order statute and foreclosure laws to supplement the decision, but even without that analysis, the result would have been the same.

Thus, inside-out and outside-in liabilities may not be avoided if criminal activities, civil fraud, or knowingly tortious acts are being perpetuated by the member either inside or outside the LLC.

Inside-Out Liabilities: Liabilities of the SMLLC may not be enforced against the SMLLC’s sole member (including husband and wife members), unless the SMLLC creditor can prove the SMLLC (i) is being operated as an alter ego of the member; (ii) did not have adequate capital to conduct its business; or (iii) was used to conduct a fraud. Thus, a correctly managed SMLLC will not have inside-out liability against its member. This alone is sufficient reason to form an LLC.

Outside-In Liabilities for SMLLCs in 45 States (Excluding Wyoming): The seminal case on an SMLLC outside-in liabilities is In re Albright, 291 B.R. 538 (D. Colo. 2003), a Chapter 7 bankruptcy case. The Court followed the general rule that:

A charging order protects the autonomy of the original members and their ability to manage their enterprise. In a SMLLC, there are no non-debtor members to protect and, therefore, the charging order serves no purpose.

Thus, absent a specific statute to the contrary, which on five states (including Wyoming) have, the sole member’s outside-in liability (including husband and wife members) may be satisfied against SMLLC assets.

Outside-In Liabilities for SMLLCs in Remaining States (Including Wyoming): There are five states recognizing charging order protection to the SMLLC and, consequently, its sole member (or husband and wife members) for the member’s individual debts:

  • Wyoming;
  • Delaware;
  • South Dakota;
  • Alaska; and
  • Nevada.

SMLLCs formed in these five states maintain charging order protection for outside-in liabilities, but what of about law suits outside the state of formation and their enforcement.

SMLLCs formed in Wyoming with operations outside Wyoming: The question is whether a foreign state will honor Wyoming’s law in the formation and operation of an LLC. Article IV, Section 1 of the U.S. Constitution requires that each state give

“full faith and credit” to the “public acts, records and judicial proceedings of every other state.”

The “internal affairs doctrine” is a choice of law rule providing that

The internal affairs of a corporation are governed by the corporate statutes and case law of the states in which the corporation is incorporated.

The Restatement (Second) of Conflict of Laws provides that this doctrine recognizes the needs of business systems to maintain certainty, predictability, and uniformity and to protect the expectation of the parties. This doctrine, however, is limited to the internal affairs of the entity, which leaves two questions: (i) what are “internal affairs”; and (ii) is charging order protection an internal affair.

Internal affairs generally involve voting, fiduciary responsibilities, and potential conflicts between owners and managers. This would not include issues surrounding the rights of third parties, such as creditors and SMLLC charging order protection, unless the third parties are parties to the LLC’s governing agreements.

Thus, would a California court recognize Wyoming SMLLC charging order protection on an outside-in liability assertion arising in the California activities of a Wyoming LLC. We do not know but consider a Utah case involving a Delaware LLC operating in Utah. American Institutional Partners LLC v. Fairstar Resources Ltd, C.A. No. 10-489-LPS, 2011 WL 1230074 (D. Del. March 31, 2011) involved creditors who had obtained judgments against debtors in Utah. The creditors sought to foreclose on membership interests in LLCs owned by the debtors. The judgments did not originate from activities by the LLCs at issue; thus, this was an outside-in liability case. The sole issue was which state’s collection law applied.

The LLCs at issue were formed in Delaware; however, their principal place of business and operations were in Utah and their management resided there. The Court applied Utah charging order and foreclosure law; thus, if the LLC was an SMLLC, foreclosure could occur; otherwise, charging order protection would apply. If Delaware law had applied the sole remedy would have been the limited benefit of the charging order whether the LLC was an SMLLC or a multi-member LLC. The Delaware Court upheld the Utah decision under the doctrine of res judicata, but there were serious indications of procedural failures by the debtors’ attorneys that may have precluded the result, leaving the efficacy of the final determination at issue in other matters.

The facts of Fairstar leave a great deal of uncertainty regarding what circumstances would lead to the application of the formation state’s laws to LLCs operating locally. For example, would a Delaware LLC operated solely to hold membership interests in an LLC solely tied to Utah be subject to Delaware or Utah charging order and foreclosure law. What if the holding company solely had Utah members and managers. What if members and managers were from several states. What if the holding company had other LLC interests operating in other states.

Wyoming LLCs held by a Wyoming Trust: W.S. 4-10-507.1 deals directly with full faith and credit and the enforcement of judgments against Wyoming LLCs held by a Wyoming DAPT. Succinctly, the judgment of another court is not enforceable unless a Wyoming court determines that the time, manner, and mechanism (emphasis added) for enforcing the judgment is consistent with the Wyoming trust code and the trust agreement; thus, the necessity of a good attorney.

The DAPT should own a Wyoming LLC holding company that owns underlying Wyoming operating entities.

The DAPT beneficial owners should give the underlying holding LLC and underlying operating LLCs multi-member status and if not, domiciling the money from the enterprises in Wyoming will force ultimate litigation in Wyoming. This will then impose Wyoming charging order protection as the sole remedy.

Conclusions

  1. An individual member of an SMLLC (including a husband and wife) is protected against the liabilities of the SMLLC, i.e., inside-out liabilities, if the SMLLC is operated properly. This applies in all states. This alone is reason enough to form an LLC.
  2. An SMLLC desiring charging order protection as the sole remedy against a membership interest on outside-in liabilities in a state that does not statutorily recognize this should provide a second member and make sure that member received a substantial and participating interest in the LLC. Alternatively, form a Wyoming LLC as the SMLLC and let the creditors go through the difficulties of establishing all the legal requisites to the judgment. Why not try if you are already at no. Most creditors give up easily.
  3. An LLC regarded as an SMLLC due to husband and wife owners should consider executing statutory individual property classifications recognizing each of their interests separately as individual property. This may overcome the antiquated assumption that the husband and wife are one and the one is the husband.
  4. Form a Wyoming LLC with a Wyoming holding company owned by an irrevocable trust with beneficial owners. Maintain all deposits in Wyoming banks. The creditors will not obtain a favorable judgment on foreign judgments sought to be enforced in Wyoming.
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