On April 4, 2003, the United States Bankruptcy Court for the District of Colorado rendered its decision in In re: Ashley Albright, Debtor, Case No. 01-11367 ABC, Chapter No. 7 (2003 Bankr. LEXIS 291). In the case of single-member LLCs, the Albright decision seriously weakens an important LLC business organization law feature often referred to by LLC practitioners as business asset protection. In the case of multi-member LLCs, the decision significantly strengthens this feature. As discussed below, the decision has important implications not only in entity formation practice generally but also for the VC/PE community.
First, a word about LLC business asset protection. Since as early as 1890, limited partnership statutes have contained provisions known as charging order provisions. Under these provisions, the judgment creditor of a limited partner debtor in default may obtain an order from a competent court requiring that if the partner's limited partnership determines to make interim or liquidating distributions of its cash or other assets to the partner, it must pay these distributions to the creditor, not the partner, to the extent of the unsatisfied judgment. Many decisions have held and a number of limited partnership statutes, including that of Delaware, expressly provide that charging order provisions are the exclusive remedy of such creditors and that creditors of limited partners who are debtors in default may not force the sale of limited partnership assets in satisfaction of the debt even if the limited partner is the limited partnership's majority owner.
LLC statutes did not begin to appear until many decades after the emergence of limited partnerships, but, with the exception of the LLC acts of Nebraska and Pennsylvania, all U.S. LLC statutes, based as they are on limited partnership law, contain charging order provisions. By contrast, no U.S. corporate statute contains such a provision. The statutory business asset protection that charging order provisions provide to LLC members is a major factor in making the LLC form preferable to the corporate form for most businesses from the viewpoint of nontax choice of entity.
In Albright, the debtor, Ashley Albright, owned a parcel of real estate. She formed a single-member LLC under the Colorado LLC Act, appointed herself as its sole manager, and transferred the real estate to the LLC as its sole asset. Some time later she filed for bankruptcy under Chapter 11 and thereafter transferred to Chapter 7. Under Chapter 7, the bankruptcy trustee took title to all of her property rights including her LLC membership interest, and on the basis of his ownership of this interest, the trustee sought to require the LLC to sell the real estate and to distribute the proceeds to him to help in paying the debtor's obligations. The debtor contended that the trustee's only remedy was under the charging order provision of the Colorado Act and that he thus had no legal basis for taking these actions.
Rejecting the debtor's contention, the Albright court held that as the transferee of the debtor's membership interest, the trustee succeeded to control of the LLC and thus had the right to cause the LLC to sell the real estate. In addition, in a dictum, the court noted that the rationale of charging order provisions as originally enacted in limited partnership statutes was to protect innocent nondebtor limited partners from losing the value of their investment in their limited partnership as a going concern because of a debtor partner's debt. The court rightly commented that this rationale made no sense in the case of a single-member LLC, in which, by definition, there is no nondebtor member to protect.
The Albright court's decision, while hardly surprising in light of the equities and the above dictum, was based on a serious misunderstanding of the Colorado LLC Act and of LLC law in general. LLC members, like limited partners, have two quite distinct types of ownership rights - namely, management rights, including voting and agency rights that give them control over their LLC; and economic rights consisting of the right to receive allocations of LLC profits and losses and to receive distributions of LLC cash and other assets. Section 7-80-102(1) of the Colorado LLC Act makes quite clear that a member's "membership interest," as defined in that act, consists only of the member's economic rights and not the member's management rights. Numerous other provisions of the act are to the same effect.
Accordingly, the court was dead wrong in holding that the trustee's succession to Ms. Albright's membership interest in her LLC under the Bankruptcy Act gave him control over the LLC and thus the right to compel the LLC to sell her real estate. In so holding, the court disregarded the plain meaning of the charging order provisions of the Colorado LLC Act as interpreted in numerous LLC and limited partnership cases. Apparently, the debtor never sought to rely on this "plain meaning" argument. On the other hand, the court's dictum about the inapplicability of the traditional rationale for charging order provisions in the case of single-member LLCs was unquestionably correct.
The author suspects that not only in Colorado but also in all other states, the practical effect of the Albright decision, despite its formal incorrectness, will be to weaken substantially the already somewhat dubious statutory business asset protection allegedly afforded to single-member LLCs. The Colorado court's decision will not be dispositive in other states, but it (or at least the above dictum) will be persuasive.
There is also, however, a bright side in the Albright decision for LLC members and practitioners. In another dictum in that decision, the Albright court noted that if Ms. Albright's LLC had had even a "peppercorn" second member - i.e., a second member with even a minute investment in the LLC - the court would have ruled in her favor on the basis of the Colorado LLC Act's charging order provisions. This dictum significantly strengthens the LLC business organization law feature of business asset protection in the case of multi-member LLCs.
The main lessons of Albright for the VC/PE community are these:
John Cunningham is of counsel to the Concord, New Hampshire law firm of Ransmeier & Spellman, P.C. He specializes in the law and taxation of limited liability companies and is the author of Drafting Limited Liability Company Operating Agreements (Aspen Law & Business), the leading LLC formbook and practice manual.
1: The business asset protection feature of LLC statutes and their limited liability feature must be sharply distinguished. LLC business asset protection operates to protect an LLC's assets when a controlling member is subject to a judgment in the member's personal capacity. LLC limited liability protects the personal assets of LLC members when claims are brought against the LLC.