LLC Protection for Members' Personal Debt in Delaware
In Delaware, like in most states, the general rule is that the money or property of an Delaware limited liability company (“LLC”) cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Example: Larry and LaVerne have formed a Delaware LLC called Sports Memories, LLC, to operate their sports memorabilia business in Wilmington. The business has been quite successful and has $50,000 in its own bank account. Unbeknownst to Larry, LaVerne has a gambling problem and owes $100,000 to the Lady Luck Casino. While the casino can attempt to collect its debt from LaVerne’s personal assets (such as her personal bank accounts and personal property) it cannot take money or property owned by the LLC to satisfy Laverne’s personal gambling debts. For example, it cannot get any of the money held in the LLC’s bank account.
However, there are other ways that creditors of an LLC owner might try to collect against the LLC for the owner’s debt. These include:
1) obtaining a charging order requiring that the LLC pay the creditor all the money due from the LLC’s payments to the debtor-owner
2) foreclosing on the debtor-owner’s LLC ownership interest, or
3) getting a court to order the LLC to be dissolved and all its assets sold.
States laws vary widely on what creditors are allowed to do so you need to check the laws of your state. This article covers what actions creditors in Delaware are allowed to take against an LLC for an LLC owner’s personal debt.
Charging Order- Exclusive Remedy
Delaware, like all states, permits personal creditors of an owner of an Delaware LLC to obtain a charging order against the debtor-owner’s membership interest. A charging order is an order issued by a court directing an LLC’s manager to pay to the debtor-owner’s personal creditor any distributions of income or profits that would otherwise be distributed to the debtor-member. Like most states, creditors with a charging order in Delaware only obtain the owner-debtor’s “financial rights” and cannot participate in the management of the LLC. Thus, the creditor cannot order the LLC to make a distribution subject to its charging order. Very frequently, creditors who obtain charging orders end up with nothing because they can’t order any distributions. Thus, they are not a very effective collection tool for creditors.
Example: The Lady Luck Casino gets a Delaware court to issue a charging order in the amount of $100,000 against LaVerne’s 50% ownership interest in the Sports Memories LLC. This means that any distributions of money or property the LLC would ordinarily make to LaVerne must be given to the Casino instead until the entire $100,000 is paid. However, if there are no distributions there will be no payments.
The charging order remedy without any right to order distributions is so weak many creditors don’t even try to use it.
Foreclosure and Dissolution Not Allowed
Delaware’s LLC law says that the charging order is the exclusive legal procedure that personal creditors of Delaware LLC members can use to get at their LLC ownership interest. Thus, unlike some other states, Delaware does not permit an LLC owner’s personal creditors to foreclose on the owner’s LLC ownership interest or get a court to order the LLC dissolved and its assets sold. This makes Delaware a particularly friendly state for people who want to form LLCs to protect assets from personal creditors.
What About Single-Member LLCs?
The reason personal creditors of individual LLC owners are limited to a charging order is to protect the other members (owners) of the LLC. It doesn’t seem fair that they should suffer because a member incurred personal debts that had nothing to do with their LLC. Thus, personal creditors are not permitted to take over the debtor-member’s LLC interest and join in the management of the LLC, or have the LLC dissolved and its assets sold without the other members’ consent. This rationale disappears when the LLC has only one member (owner). As a result, the LLC laws and court decisions in some states make a distinction between multi-member and single-member LLCs ("SMLLCs") and don't limit personal creditors of owners of SMLLCs to the same remedies as multi-member LLCs.
To date, Delaware has not made a distinction in how it handles cases involving single and multi-member LLCs. Thus it appears that creditors of SMLLCs in Delaware are limited to the charging order remedy as described above. However, even when the LLC law states that charging orders are the exclusive remedy, courts in some states have applied a different rule for SMLLCs, particularly in cases where the SMLLC owner has filed for personal bankruptcy. It's possible that a court in Delaware would do the same; this is an unsettled and evolving area of law. In a Maryland bankruptcy case that involved a Delaware SMLLC, the Maryland bankruptcy court held that Delaware LLC charging order protection did not apply to a SMLLC and allowed the creditor to step into the shoes of the sole LLC member (In re Modanlo, 2006 WL 4486537 (D. Md. 2006)).
If you are concerned about your LLC's liability protection from personal creditors, you should consider creating a multi-member LLC with two or more members. If you create a two member LLC, the second member must be a legitimate co-owner of the LLC. If the second owner is added merely on paper as a sham, the courts will likely treat the LLC as a single-member LLC. To avoid this, the co-owner must pay fair market value for the interest acquired and otherwise be treated as a "real" LLC member--that is, receive financial statements, participate in decision making, and receive a share of the LLC profits equal to the membership percentage owned.
For more information on LLCs and the limited liability protections they offer, see Limited Liability Protection and LLCs: A 50-State Guide.