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The Bankruptcy Protector

March 21, 2022

Recovery from a Member’s Interest in an LLC

By Jody A. Bedenbaugh

In my last post on this Blog, I explored a potential avenue for a debtor to maximize value from the sale of its membership interest in a limited liability company (“LLC”) in bankruptcy, notwithstanding restrictions on sale in the LLC’s operating agreement and applicable state law.  In this post, I discuss the ways in which a creditor may recover from its debtor’s membership interest.  To set the stage, consider this common scenario: in making a real estate development loan, a lender extends credit based in part on a developer guarantor’s personal net worth, much of which is attributable to his interests in closely held LLCs.  If that loan defaults and the lender looks to its guarantor for payment, can it recover those interests in the LLCs?  Underlying state law provides the answer.  In South Carolina, the law currently governing LLCs is the Uniform Limited Liability Company Act of 1996, S.C. Code Ann. § 33-44-101 et seq (the “LLC Act”).  The LLC Act sets forth a specific process for recovering a debtor’s economic interests in an LLC, as described below. 

Charging Lien

As a first step in collecting on a member’s LLC’s interest after obtaining a judgment against the member, the LCC Act provides that the court may enter a charging lien on a member’s distributional interest to satisfy a judgment and appoint a receiver for the share of distributions due or to become due.  S.C. Code Ann. § 33-44-504(a).  “Distributional interest” means “all of a member’s interest in distributions” by the LLC.  S.C. Code Ann. § 33-44-101(6).  As result of its charging lien, if the LLC makes a distribution to the judgment debtor member, the lender would be entitled to receive the distribution and apply it to the judgment debts.  However, the judgment debtor member retains his membership interest and, until dissociated as discussed below, the right to manage the LLC.  The judgment creditor has no right to direct the actions of the LLC (i.e., no ability to compel the LLC to sell its property) and, absent further order from the court, no right to direct that a distribution be made upon the sale of any of its property.

Foreclosure on the Charging Lien

Under S.C. Code Ann. § 33-44-504(b), a court may order a foreclosure of the charging lien.  At any time prior to the foreclosure sale, the debtor or another member may “redeem” the distributional interest by paying the amount due to the judgment creditor.  If the interest is not redeemed and is sold at foreclosure, the purchaser at the foreclosure sale has the rights of a “transferee.”  Under S.C. Code Ann. §§ 33-44-502 and 33-44-503, a transfer of a distributional interest does not entitle the transferee to exercise any rights of a member (such as the right to participate in management) and only entitles the transferee to receive the distributions to which the transferor would be entitled.  In addition, upon dissolution and winding up of the LLC, the transferee receives the amount of property distributable to the transferor. 

Judicial Dissolution

Following foreclosure of the charging lien, another option is to force dissolution of the LLC.  Under S.C. Code § 33-44-503(e), a transferee may seek a judicial determination that it is equitable to dissolve and wind up the business.  Upon dissolution, pursuant to S.C. Code § 33-44-806, the LLC’s assets are distributed to members after payment of the LLC’s creditors.

Dissociation of the Member

Finally, with regard to the judgment debtor’s right to manage the LLC, pursuant to S.C. Code Ann. § 33-44-601(7)(iv), 90 days after the appointment of the receiver for the member’s distributional interest, if the order is not appealed, the member is “dissociated” as a member.  The member would at that point lose his or her right to manage the LLC, other than to participate in the winding up of the LLC.  See S.C. Code Ann. § 33-44-603(3).

Receivership

S.C. Code Ann. § 33-44-504(e) provides that Section is the exclusive remedy by which a judgment creditor may satisfy a judgment out of the distributional interests in an LLC.  Courts have recognized that this “exclusive remedy” provision refers to the remedies under the LLC Act and does not abrogate a judgment creditor’s other remedies with respect to a judgment debtor, such as the appointment of a receiver, or the powers of a receiver or bankruptcy trustee.  The appointment of a receiver in this context is often a more effective and efficient method for recovery of property from a judgment debtor.

Bankruptcy

The potential loss of a member’s economic interest can be sufficient pressure to lead to a bankruptcy filing by the member.  To the extent the charging lien has been granted prior to the bankruptcy, the judgment creditor should have a secured claim in the amount of the value of its interest.  The debtor or trustee may assert the lien is avoidable as a preference if it was granted within 90 days of the filing.  Further, if a receiver has been appointed and the 90 day time period in section 33-44-601(7)(iv) has run, resulting in the member’s dissociation, the creditor may be able to assert that the debtor member has lost the requisite authority to manage or sale the LLC, notwithstanding his or her bankruptcy filing.       

Conclusion

Given the limitations and various hoops through which a judgment creditor must jump under the LLC Act, I expect some judgment creditors will view the process as slow and somewhat cumbersome.  On the other hand, the ultimate effectiveness of the procedures to strip a member’s economic interest in the LCC and potentially lead to the LLC’s dissolution could certainly cause a member to question the effectiveness of “asset protection” under the LLC Act.  In these ways, the collection provisions of the LLC Act strikes a balance between the interests of the creditor, the debtor, the LLC, and the other members.   

      Nelson Mullins attorneys are experienced in handling bankruptcy matters of all sizes and are well equipped to advise debtors, trustees, purchasers, LLC members and other stakeholders on both the legal and practical aspects of the sale of LLC membership interests in a bankruptcy case.



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