Multi-member limited liability companies provide some asset protection in state court collections because the creditor’s collection is limited to a charging lien against asset distributions, if any, to the debtor. Bankruptcy trustees are not limited to charging liens, and moreover, a bankruptcy trustee needs to liquidate interests in property and cannot wait for distributions.
A recent Chapter 7 bankruptcy case involved a debtor who owned part of the membership interests in a limited liability company which, in turn, owned free and clear a range of over 140 acres. The Chapter 7 trustee sought to enforce a provision of the LLC operating agreement that required the LLC to dissolve itself if any member filed bankruptcy. The trustee wanted the dissolution so that the ranch would be sold and the trustee could claim the debtor’s share of the cash sale proceeds.
The court held that Section 541 of the Bankruptcy Code invalidated the LLC’s automatic dissolution; the Code invalidates contract provisions that provide for the termination of a debtor’s property interest conditioned upon the debtor’s bankruptcy. The trustee complained that without the dissolution he could not access the value of the debtor’s interest in the underlying property. The court recognized that trustees have difficulty realizing value in a debtor’s interest in an LLC.
The court also noted that a debtor’s LLC interest consist of two parts: an economic interest and management or voting rights. If the LLC agreement is an” executory contract” (depends upon how LLC agreement is drafted) then, absent dissolution, the trustee can sell only the debtor’s economic interest which essentially amounts to the debtor’s right to distributions. The trustee in this event can sell an interest which is essentially the same as a state court creditor’s charging lien.
The result of all this is that a multi-member LLC is effective both in state court and in bankruptcy liquidations for asset protection.