Membership in an LLC gives you two basic rights: the right to receive a portion of the company’s profits and the right to vote on issues regarding the management of the company. Today’s case, called First Bank v. S&R Grandview, LLC, deals with the right of a bank to take over some control of the LLC as payment for the debts of the LLC member. In other words, if the bank can take over your right to profits, does that allow it to take over your right to vote as well?
Like corporations, LLCs exist only because the state legislature passed a law allowing them to exist. That means that the rules for how LLCs function are included in state statutes.
One of the functions of an LLC is, as implied by the name, that it limits liability. Usually this means that the investors, who are called members, are not responsible for the debts of the LLC. The most they can lose is their investment. But limited liability also works the other way: the LLC is not responsible for paying the personal debts of its members.
So if a member in a profitable LLC owes you money, is there no way to get at those profits? There is, by a device called a charging order. Basically the creditor can get a court order, requiring the LLC to turn over the debtor’s share of profits directly to the creditor as they are paid out. It is equivalent to the process of garnishing someone’s wages.
The question, previously unresolved, is whether by charging an LLC member’s share of profits, the creditor also gains control of the member’s ability to vote on LLC matters.
There is some logic on either side. On the one hand, if the creditor is hoping to get repaid from the profits of a company, it makes some sense that the creditor gets to have a say in whether the company is run in a profitable manner. The member whose ownership has been charged has some incentive to run the company into the ground in order to spite his creditors.
On the other hand, just because a state agency gets to garnish the wages of a store manager doesn’t mean that the agency should come in and run the store. The right to be repaid is not the same as the right to run the debtor’s life in every detail.
Donald Rhine owed a significant amount of money to the plaintiff, First Bank. After First Bank got a judgment against Rhine, it tried to collect on the judgment by charging Rhine’s membership in the defendant S&R Grandview, LLC. In addition to collecting the money it had loaned by taking Rhine’s share of S&R’s profits, First Bank also sought to prevent Rhine from participating in the management of S&R until the debt was repaid. It requested that his membership rights “lie fallow” while the debt was outstanding.
The key statutory provision that First Bank relied on stated that a creditor which has charged a membership interest in an LLC “has the rights of” an assignee. A separate section of the statutes stated that a member who has made an assignment of all his rights loses the ability to participate in management of the LLC. (Note that all of these rules are part of the old LLC statute. Major revisions to the LLC rules, which I blogged about here, have changed much of this language, although not the underlying rule.)
First Bank argued that because it “had the rights of” an assignee, that meant an assignment had actually taken place. Therefore, Rhine had lost his ability to participate in management of the LLC in any way.
The court disagreed. Its basic decision was that there is a difference between having the rights of an assignee and actually being an assignee, which is pretty closely splitting the hairs. More importantly, the court looked at the public policy aspect of the question. It held that economic rights to receive a payout from the LLC are quite different from management rights. Especially since many LLCs are small businesses between individuals who know each other personally, injecting an outside third party into running that business would be unreasonable.
The Bottom Line
If you are in debt to a bank or any other creditor, and you are a member of an LLC, the bank can take away your right to get money from the LLC. But it can’t take away your right to manage the company, by voting or in any other way. Debtors are not slaves and still retain their rights, including economic rights.
If you are in debt and a member of an LLC, or if you are considering forming an LLC with another person who might be over his head in debt, you should consult an attorney to protect your rights. If you do not have an attorney, feel free to contact me.