Nevada Once Again Leads the Way in Debtor-Friendly Legislation
In his recent article describing the benefits of using a Nevada LLC as an asset protection tool, Jacob Stein wrote all of the following:
The laws of the 50 states aren’t uniform when it comes to shielding or exposing a debtor’s assets from the claims of creditors. For example, some states fully expose a debtor’s residence to a creditor. Other states, such as Florida and Texas, provide a complete homestead exemption. But no state beats Nevada when it comes to consistently and aggressively enacting legislation designed to assure that a debtor’s assets remain with the debtor and out of the clutches of creditors.
We repeatedly recite the mantra to all who will listen that investment real estate, be it commercial real estate, apartment building or raw land, should not be owned by the individual, but should be titled in a limited liability company (“LLC”). The laws of most states follow a pattern that prevents a creditor of a member of an LLC from reaching the assets of the LLC. Most states — including California — limit the creditor of a member to a charging order, an order issued by a court and directed to the manager of the LLC ordering that any distributions of LLC income or profits that would otherwise be distributed to the debtor-member be instead distributed to the creditor. But if there are no distributions, the charging order is ineffective and the creditor gets nothing. If the LLC is controlled by the debtor-member or someone friendly to the debtor-member, it’s not too difficult to withhold distributions until the creditor tires of the hunt or to make distributions to one or more other members who are friendly to the debtor.
The rationale for treating creditors of members of LLC’s this harshly is as follows: Let’s assume that ten investors pool their resources and start a business, forming an LLC. The LLC purchases real estate and other business assets. Later, one of the members of the LLC develops a problem with creditors. It would disrupt the operations of the business and impact the investment of the other nine members if the creditors of one member were permitted to seize the assets of the LLC. So the law tracks a middle ground: The creditors of the debtor-member cannot seize the assets of the LLC, but they are permitted to intercept any distributions of profits or gains that might be made to the debtor-member, by means of a charging order.
Which brings us to the bottom-line question: If the charging order limitation is grounded in the protection of the other members, should the charging order limitation apply at all if the LLC has only one member, viz., the debtor-member? No state statute excludes single-member LLC’s from the purview of the charging order limitation. Nevertheless, most careful practitioners counsel their clients to have more than one member in their LLC’s if at all possible.
The Courts Speak
In 2003, the United States Bankruptcy Court for the District of Colorado addressed the issue head-on. In In re Albright, the Court ruled that, where a Colorado LLC had only one member, the Colorado charging order limitation did not apply, because
“the charging order limitation serves no purpose in a single member limited liability company, because there are no other parties’ interests affected.”
In light of the fact that this was the decision of a trial court, little credence was given to it. Last year, however, the first appellate court had the opportunity to squarely address the issue. In Olmstead v. Federal Trade Commission, WL 2518106 (July 6, 2010), the Florida Supreme Court was confronted with the efforts of a creditor of a 100% owner of a Florida LLC. Of course, the issue was whether the creditor was limited to a charging order. Florida’s governing statute is somewhat unusual in that the operative restriction provides that:
“Unless otherwise provided in the articles of organization or operating agreement, an assignee of a limited liability company interest may become a member only if all members other than the member assigning the interest consent.”
Florida Stats. 608.433(1).
The Florida Supreme Court held that this statute could not apply, because in the single-member LLC, there are no other members who could withhold or give their consent. Many states, notably California and Nevada (see California Corporations Code §17302(e)) are explicit in providing that the charging order is the only remedy available to a creditor of a debtor-member. Florida has no such provision, and this distinction may render Olmstead inapplicable, or at least distinguishable, from those states that have such a provision.
The Nevada Response
In what appears to be a direct response to the Florida Supreme Court’s decision in Olmstead, in June, 2011, Nevada amended its governing statute to add the following highlighted clause:
This section…[p]rovides the exclusive remedy by which a judgment creditor of a member may satisfy a judgment out of the member’s interest of the judgment debtor, whether the limited liability company has one member or more than one member.
In Nevada, at least, the issue is settled.
Will California Defer to the Nevada Statute?
Let’s assume that a real estate investor forms a Nevada LLC. The LLC owns a parcel of investment real estate in California. The investor is the sole member of the LLC. Because the LLC is conducting business in California, the LLC registers as a foreign limited liability company with the California Secretary of State. The investor defaults on a promissory note having nothing to do with the operation of the Nevada LLC. The judgment creditor seeks to satisfy his judgment against the assets of the LLC. Is the creditor limited to obtaining a charging order and waiting — perhaps forever — until there are distributions to the debtor-member? If the action were brought in Nevada, we know the result. But what if the action were brought in California?
California Corporations Code §17450(a) provides:
The laws of the state or foreign country under which a foreign limited liability company is organized shall govern its organization and internal affairs and the liability and authority of its managers and members.
A cursory reading of this statute might lead one to conclude that a California court should defer to Nevada’s statute. After all, the issue of whether a creditor of a member is limited to a charging order or may have other remedies available would appear to be an issue involving the “liability” of the “members.” But a creditor might argue that this statute, on its face, is intended to apply to the internal relations of the members and managers, not the liability of a member to third parties.
There is a bottom line here: If a person desires to form an LLC and has no other person to act as a co-member, the LLC should be formed under Nevada law. If a California court defers to the Nevada statute, so much the better. If the attempt fails, the debtor is no worse off than if he or she had formed the LLC under California law in the first place.
Still More Good News from Nevada
One of the basic distinctions between an LLC and a corporation — at least from a debtor-creditor standpoint — is that a creditor of a shareholder of a corporation can seize the shareholder’s shares, usually by means of a “turnover order.” If the debtor is the controlling — or sole — shareholder of the corporation, the seizure of the stock means that the creditor has a straight shot at all of the corporation’s assets. But there is no possibility of a turnover order for a membership interest of an LLC, especially in those states such as California and Nevada that specify that the charging order is the only remedy that a creditor of a debtor-member has. It is for this reason that we often convert closely-held corporations into limited liability companies.
But this distinction no longer obtains in Nevada, which is now the first state to provide a charging order limitation to the shareholders of Nevada corporations! See N.R.S. 78.746. The limitation exists only for those Nevada corporations that have no more than 75 shareholders (close corporations), and does not apply at all to the subsidiaries of public companies or to professional corporations. But for every other shareholder of every other Nevada corporation, it’s nice to know that the legislature is always there, vigilant in protecting their assets.