Bankruptcy Can Upend the Asset Protection Benefits of the LLC
The limited liability company is widely used as the business entity of choice for a number of reasons, including its asset protection benefits. If a creditor of an LLC member attempts to seize the LLC member's interest (or the assets of the LLC for that matter), the creditor will have to deal with the charging order roadblock.
The charging order is found in most state LLC statutes and in Minnesota at Minn. Stat. §322B.32. In general, the charging order limits a judgment creditor's remedies against the LLC member by prohibiting the judgment creditor from seizing or selling the LLC member's LLC interest and, by extension, seizing or selling the LLC's assets. The creditor simply becomes an assignee with respect to the LLC.
Most state LLC statutes give the judgment creditor few options or rights. The primary right of the judgment creditor is to receive any (cash) distributions from the LLC that might otherwise be made by the LLC to the LLC member. The judgment creditor does not have a right to be an LLC member, to vote on business matters, to inspect LLC books and records, or to receive LLC financial information. These limitations on a judgment creditor's rights presume there has not been a fraudulent transfer under state or federal law.
The charging order remedy was created to avert business disruption by preventing the judgment creditor from meddling in LLC business affairs. In most cases it has been successful in doing so. However, if the LLC member files for federal bankruptcy protection, different rules may apply.
In Re: Ehmann 319 B.R. 200 (Bankr. D. Ariz. 2005), a debtor who owned an interest in an Arizona LLC (Fiesta Investments, LLC) filed for Chapter 7 bankruptcy liquidation. The trustee in bankruptcy brought a lawsuit against the LLC claiming that the bankruptcy trustee was a (substitute) LLC member and that the assets of the LLC were being wasted, misapplied or diverted for improper purposes. The court sided with the bankruptcy trustee. It held that the bankruptcy trustee had all the rights and powers with respect to Fiesta Investments, LLC that the debtor held at the commencement of the case, and that the appointment of a receiver to dissolve and liquidate the LLC in order to satisfy the creditors of the LLC member/debtor might be appropriate.