Issues for Single Member LLC’s as Asset Protection Vehicles

For a period of time, asset protection planners were quite concerned (and rightly so) about whether single member limited liability companies would be treated the same as multi-member LLC’s if a member’s creditor sought to reach the member’s interest in the LLC. While there was general agreement that in the case of multi-member LLC’s a creditor’s sole remedy was to obtain a charging order, such was not the case with single member LLC’s. Indeed, there was much commentary and analysis in the asset protection world following the Olmstead and Albright cases, where courts decided that single members of LLC’s were not entitled to the same protections as LLC’s with more than one member.

Some states then took action to clarify their positions on single member LLC’s and provide that the charging order remedy is the sole remedy for creditors of LLC members irrespective of whether the LLC is owned by one or several members. In an amendment to the Michigan Limited Liability Company Act in 2012, the legislature made it clear that single member LLC’s will be treated no differently than multi-member LLC’s if creditors come calling. So, if that is the situation today, why can’t asset protection planners in Michigan feel comfortable that a single member LLC is as protected from creditors as one with multiple members.

The issue that persists is what happens if the single member ends up in bankruptcy court. Remember that in a bankruptcy the trustee succeeds to all of the debtor’s property. However, there is a very complicated legal analysis to determine whether a single member’s interest in an LLC should be part of the bankruptcy estate. Members argue that the bankruptcy estate is subject to state LLC law which prevents creditors and transferees from seizing the membership interest. The trustee counters that it is neither a creditor nor a transferee but instead it steps into the shoes of the debtor by operation of the bankruptcy code.

The next level of analysis questions how stepping into the shoes of the debtor helps the creditor.  The trustee can get no more than whatever rights the member has. If the Operating Agreement provides that a transferee has nothing more than a right to distributions and if a member cannot force a dissolution, then arguably the trustee would be similarly limited.

Note that if the LLC is owned by a single member, the terms of the Operating Agreement are essentially meaningless since the single member has the unilateral power to change it. And this is where the risk of trustee access to the single member LLC is greatest. The trustee will simply argue that irrespective of the terms of the Operating Agreement the single member could change it at any time and, therefore, so can the trustee who has now stepped into the debtor’s shoes. With this power the trustee can force a dissolution and access the assets of the LLC. A very different result is present when there are other members and the Operating Agreement must be respected.

Even if the Operating Agreement provides for automatic loss of voting power for a bankrupt member, which would presumably prevent the trustee from acting, the bankruptcy code invalidates so-called ipso facto clauses. Moreover, it just seems illogical that a single member LLC  Operating Agreement provides that upon the member’s bankruptcy the member loses rights to dissolve the company. If so, who would be in a position to make decisions for the LLC? How can an LLC exist without members or, more specifically, members who have the power to manage the LLC.

Further complicating the matter is the bankruptcy code provisions limiting the ability of a trustee from assuming executory contracts. In the LLC arena this means that a member of an LLC has a right to expect she will be dealing with the other members with whom she entered into the Operating Agreement. The members did not bargain for a stranger to come into the mix. And so, in multi-member LLC’s the executory contract argument can be used to subdue a trustee’s claim in the right circumstances. However, the single member LLC does not have the same argument.

The area is fraught with complexity and no clear answer emerges from the case law but prudence would suggest that a single member LLC formed for asset protection may fare poorly if the member ends up in bankruptcy.