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Arizona Limited Liability Company Law

Warning: Single Member LLCs Lack Asset Protection if the Member Files for Bankruptcy

by Richard Keyt, Arizona LLC attorney

One of the primary reasons to form an Arizona limited liability company is to shield the members from the debts and obligations of thecompany. If formed and operated properly (i.e. the company complies with applicable laws), the Arizona LLC should protect the membersfrom the companys financial problems. This member protection applies to protect the members from a type of creditor I call the bottomup creditor.

The Bottom Up Creditor

A bottom up creditor is a creditor that has a claim and/or gets a judgment against the LLC arising from the acts or omissions of thecompany rather than from the acts or omissions of a member, manager or employee. The general rule that the members of the LLC arenot liable for the companys debts and obligations works well with claims by bottom up creditors. See my diagram that illustrates thebottom up creditor problem.

The Arizona limited liability company gives good asset protection for its members, whether the LLC has one or many members. A singlemember, LLC, however, does not give its member any asset protection from a top down creditor if the member files a bankruptcypetition.

The Top Do wn Creditor

A top down creditor is potentially more serious for an LLC member because the creditor is not coming from the bottom up through theLLC to get to assets of a member. Instead, the top down creditor first sues and gets a judgment against the member because of themembers acts or omissions, rather than the acts or omissions of the LLC, its managers or employees. For example, a member of an LLCwho runs a red light and kills or injures somebody is liable for the harm he or she caused. If the victim or the family of the victim suesthe member and gets a judgment against the member for the damages caused by the member running the red light, the LLC does notprovide any protection for the member against the creditor.

An LLC or other entity never protects you from harm that you cause. When you cause the harm, you have a top down creditor problem.See page 2 of my diagram for a pictorial illustration of the top down creditor problem .

Adverse Single Member LLC Case Law

Olmstead vs. Federal Trade Commission

This Florida Supreme Court case involved the attempt by the Federal Trade Commission to enforce collection of a $10 million judgmentit got against Shawn Olmstead and Julie Connell for their involvement with entities that operated an advance-fee credit card scam. Theissue before the court was:

Whether, pursuant to Fla. Stat. 608.433(4), a court may order a judgment-debtor to surrender all, right, title, and interest in the debtors single-member limited liability company to satisfy an outstanding judgment.

Olmstead argued that the issue should be answered in the negative because the only remedy available to a creditor who has a judgmentagainst a member of a Florida single-member LLC is a charging order. The court said:

we rephrase the certified question as follows: Whether Florida law permits a court to order a judgment debtor to surrender all right, title, and interest in

Beware of the Single Member LLC

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the debtors single-member limited liability company to satisfy an outstanding judgment. We answer the rephrased question in the affirmative.

The reason the court allowed the creditor to get to the assets of the single member Florida LLCs is because the court ruled:

that there is no reasonable basis for inferring that the provision authorizing the use of charging orders under section 608.433(4) establishes the soleremedy for a judgment c reditor against a judgment debtors interest in single-member LLC.

Arizona LLC law is different from Floridas LLC law. Arizonas LLC member charging order protection is contained in Arizona RevisedStatutes Section 29-655 which states:

A. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the members interest in the limited liability company with payment of the unsatisfied amount of the judgment plus interest. To the extent so charged, the judgment creditor has only the rightsof an assignee of the members interest.

B. This chapter does not deprive any member of the benefit of any exemption laws applicable to his interest in the limited liability company.

C.This section provides the exclusive remedy by which a judgment creditor of a member may satisfy a judgment out of the judgment debtors interest in the limited liability company .

Because of this statute, an Arizona court should not reach the result of the Florida Supreme Court in Olmstead vs. FTC. See OlmsteadDecision Does Not Make All Single Member LLCs Useless.

Single Member LLCs When the Member is in Bankruptcy

Because of relatively recent bankruptcy cases, it is clear that a single member limited liability company (regardless of the state in whichit was formed) will not provide any asset protection when the member is a debtor in bankruptcy court. As of May 25, 2008, federalbankruptcy courts in Idaho, Maryland, Idaho and Colorado have exercised powers over single member LLCs without any using any of thelegal theories commonly used by courts. The courts did not pierce the veil or reverse veil pierce. Nor did they impose a constructive trustor a resulting trust. The alter ego theory was not used.

In each case, the courts treated the single member LLCs differently than they would have been treated if the LLCs had multiple members.

In re: Ashley Albright, 291 B.R. 538 (Bkr. D Colo. 2003)

In a case called In re: Ashley Albright, a Colorado bankruptcy court ruled for the first time that the assets of a single member limitedliability company could be used to pay Ashley Albrights creditors. She filed for bankruptcy, not her LLC. The court based its ruling onColorados LLC statute. Colo. Rev. Stat. 7-80-703 provides:

Rights of creditor against a member . On application to a court of competent jurisdiction by any judgment creditor of a member, thecourt may charge the membership interest of the member with payment of the unsatisfied amount of the judgment with interestthereon and may then or later appoint a receiver of the members share of the profits and of any other money due or to become dueto the member in respect of the limited liability company and make all other orders, directions, accounts, and inquiries which thedebtor member might have made, or which the circumstances of the case may require. To the extent so charged, except as providedin this section, the judgment creditor has only the rights of an assignee of the membership interest. The membership interestcharged may be redeemed at any time before foreclosure. If the sale is directed by the court, the membership may be purchasedwithout causing a dissolution with separate property by any one or more of the members. With the consent of all members whosemembership interests are not being charged or sold, the membership may be purchased without causing a dissolution with propertyof the limited liability company. . . .

The bankruptcy court stated,

The Debtor argues that the Trustee acts merely for her creditors and is only entitled to a charging order against distributions madeon account of her LLC member interest. However, the charging order, as set forth in Section 703 of the Colorado Limited LiabilityCompany Act, exists to protect other members of an LLC from having involuntarily to share governance responsibilities withsomeone they did not choose, or from having to accept a creditor of another member as a co-manager. A charging order protects theautonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, becausethere are no other parties interests affected. (emphasis added).

The court issued the following order:

The Trustee, as sole member, controls the Western Blue Sky LLC and may cause the LLC to sell its property and distribute netproceeds to his estate. Alternatively, the Trustee may elect to distribute the LLCs property to the bankruptcy estate, and, in turn,liquidate that property himself.
http://www.keytlaw.com/Cases/in-re-albright.pdfhttp://www.assetprotectionlawjournal.com/2010/12/articles/asset-protection-strategiesalt/olmstead-decision-does-not-make-all-single-member-llcs-useless/


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Beware of the Peppercorn Membership Interest

Before adding a second member to your single member LLC just to solve the single member bankruptcy problem, consider theimplications of the following statement by the Albright bankruptcy court:

To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with peppercorn co-members,bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse.

A-Z Electronics, LLC, 350 B.R. 886 (Bkrtcy. D. Idaho 2006)

The second adverse bankruptcy case was In re A-Z Electronics, LLC based on Idahos LLC statute. This case did not involve the state of formations charging order statute. Nor did the bankruptcy court allow creditors of the debtor in bankruptcy to obtain assets of A-ZElectronics, LLC. Instead, the court dismissed a Chapter 11 petition for bankruptcy signed by Ron Ryan as the managing member (andonly member) of the LLC because he did not have the authority to act on behalf of the LLC. The court said that because:

1. Ron Ryan was a debtor in personal Chapter 7 bankruptcy when he signed the bankruptcy petition on behalf of A-Z Electronics, LLC,he did not have the authority to sign, and

2. Because Ron Ryan was the sole member of the LLC, all of his interests in the LLC become the property of the bankruptcy estateand the bankruptcy trustee was the only party that could manage the LLC and file a petition for bankruptcy.

The bankruptcy court said:

Where a single member files bankruptcy while the other members of a multi-member LLC do not, . . . the bankruptcy estate is only entitled to receive theshare of profits or other compensation by way of income and the return of contributions to which that member would otherwise be entitled.

The case stands for the proposition that when a person who is the only member of an LLC files for personal bankruptcy, the bankruptcytrustee steps into the shoes of the debtor and can exercise management powers over the LLC to the same extent the single membercould do.

In re Modanlo, 2006 WL 4486537 (D. Md. 2006) (slip copy)

In re Modanlo is a Maryland bankruptcy court case that involved an LLC formed in Delaware. The filing of the bankruptcy petition by theonly member of a Delaware LLC caused the automatic dissolution of the LLC under Delaware law. Notwithstanding the automaticdissolution of the LLC, the bankruptcy trustee could, under Delaware LLC law, revive the company by amending the LLCs OperatingAgreement and appointing himself as the new manager of the company. The court rejected the sole member/debtors argument that thebankruptcy estate only held an economic interest in the LLC and that the trustee could not participate in the LLCs management orbecome a member.

Citing Albright favorably, the court said that because there were no other members to protect, the purpose of preventing a creditor frombecoming a substituted member of the LLC does not apply when the LLC is a single member LLC. The court held that using principles of statutory construction and adopting the reasoning of the bankruptcy court in In re Albright, sections 18-702 (assignment of limitedliability company interest) and 18-704 (right of assignee to become member) of the Delaware LLC Act do not apply to single memberLLCs.

Cognex Corp. v. VCode Holdings, Inc., 2006 WL 3043129 (D. Minn., Oct. 24, 2006)

This case involved a lawsuit for a declaratory judgment against Acacia Research Corporation and its wholly-owned subsidiary VData, LLC,relating to intellectual property rights. The court found that the officers/managers of the parent corporation and its subsidiary LLC weresubstantially the same. The court said there was no reasonable way to distinguish when the officers/managers of Acacia ResearchCorporation were operating for its benefit instead for the benefit of the subsidiary LLC. The court allowed Cognexs lawsuit against VDataLLC, as the alter ego of Acacia Research Corporation to proceed.

Conclusion to Be Drawn from these Cases

All of these cases involving bankruptcy courts and single member LLCs involve whether the bankruptcy trustee succeeds to all of themanagement rights of the LLC. So far, the three bankruptcy courts have said Yes! One of the consequences of allowing the bankruptcytrustee to exercise management powers over the LLC is that the trustee will be able to dissolve the LLC and distribute its assets to thebankruptcy estate and make the assets available to pay creditors. When that happens, there is ZERO asset protection for the bankruptmember.

How to Solve the Single Member LLC Dilemma

If you are the only member of a single member LLC and you want to maximize asset protection from top down creditors, your optionsinclude the following:
http://delcode.delaware.gov/title6/c018/sc07/index.shtmlhttp://delcode.delaware.gov/title6/c018/sc07/index.shtmlhttp://www.id.uscourts.gov/decisions-bk/A-Z_Electronics.pdf


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1. Never file for bankruptcy . This is the best solution, but if you have a creditor problem, you may not be able to prevent your creditorsfrom putting you into an involuntary bankruptcy.

2. Add a second member so your LLC is a multiple member LLC. This may work, but adding a member also has its potential problems:

a. No court case has said what the minimum amount of an LLC the second member must own. You could go with 1%, but a courtmight say thats a peppercorn interest and it will be disregarded because it is not large enough to be considered a second member.We dont know yet how much the second member must own.

b. If you do add a second member, be sure that the member pays fair market value for the interest the second member acquires.Remember the Ashley Albright courts warning about adding a peppercorn co-member and bankruptcy avoidance provisions andfraudulent transfer law. If 1% of your company is worth $10,000 and you give 1% to your child for $1,000, you could have afraudulent transfer.

c. The second member must be a real member for all purposes. This means that the member is entitled to financial statements,access to books and records, the right to vote on certain matters affecting the company, a right to get a share of the profits equal tothe membership percentage owned, and other rights of a member in an LLC. If the second member is sham member or a memberonly on paper, the court will disregard the second members interest and find that you have a single member LLC.

d. Your new multi-member company will need a good comprehensive Operating Agreement that governs the rights and obligationsof all of the members. Some of the problems inherent with having members other than just you are:

(i) What happens to the second members interest if he or she dies or gets divorced and the wrong person acquires the interest?Your Operating Agreement should give you an option to purchase the second members interest if the second member dies, getsdivorced and does not retain all of the interest, defaults under the Operating Agreement, makes an assignment of assets for thebenefit of creditors, files for bankruptcy and perhaps for other reasons.

(ii) Your second member decides to sell or give his or her interest in your company to a third party. What if you have a disputewith your second member and the second member sells the interest to his next door neighbor for $100? Your OperatingAgreement should contain a right of first refusal provision that gives the LLC an option to match the terms and conditions of aproposed disposition or transfer of the second members interest in the LLC.

(iii) If your second member is sued and a creditor gets a judgment against the second member, the creditor will serve your LLCwith a charging order and may seek to become a member of your LLC and exercise the rights of a member. Your OperatingAgreement should have a provision in it that gives the LLC the right to purchase the interest of a member who has creditorproblems.

(iv) If your second member files for bankruptcy, you may have the bankruptcy trustee step into the shoes of your second memberand exercise the rights of a member of your company. This is the nightmarish In re Ehmann situation. The Ehmann case is anArizona bankruptcy case where the bankruptcy trustee wanted to step into the shoes of a minority LLC member and the courtallowed it.

If you add one or more members to your single member LLC and you do not have all the members sign a comprehensive OperatingAgreement, you may be creating one or more future problems of the type listed above just to avoid the remote possibility that youmight be in bankruptcy court one day as a debtor.

If protection from top down creditors who might get a judgment against you is more important than the risk that one or more of theproblems listed above might happen to your LLC, then you could add a second member.

Related Article

For more on this important topic, read my article called Do Single Member LLCs Provide any Asset Protection?

Multi-Member LLCs Need a Good Comprehensive Operating Agreement

As an LLC attorney who has formed 3,000+ Arizona limited liability companies, I urge people who have multi-member LLCs to alwaysadopt a good comprehensive Operating Agreement. Arizona law does not require that an AZ LLC have an Operating Agreement, but it isfoolish and risky to go into business with somebody without one. I have seen far too many LLCs with member problems that could havebeen solved with a good comprehensive Operating Agreement.

To hire me to prepare a comprehensive Operating Agreement for your multi-member Arizona limited liability company, see my OperatingAgreement Preparation Service .

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