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Creditors’ Rights Trump Ownership Restrictions in LLC Operating Agreements

A recent South Carolina Supreme Court decision affirms the supremacy of creditors’ foreclosure rights, and sounds a cautionary note for LLCs. The state’s high court said that LLCs can’t use an operating agreement to force a creditor to sell a distributional interest it obtained via judicial foreclosure. 

The ruling came in Levy v. Carolinian, LLC, a case involving an LLC that owns an oceanfront hotel. One of the members, who owned about a quarter of the LLC, found himself on the wrong end of a judgment for $2.5 million. Creditors obtained a charging order – essentially a lien – against their debtor’s distributional interest in the LLC. The creditors then foreclosed on its charging lien and purchased the member’s distributional interest at public auction.

One of the advantages of an LLC is that operating agreements can restrict the sale or transfer of a member’s interest, often with a provision that requires the approval of other members, or that sets buyout terms. In this case, the LLC’s operating agreement forbade the transfer of a member’s interest – even involuntarily – without the consent of members representing at least 67 percent of the voting shares.

The LLC members hoped that provision would close the door on the creditor, and asked the courts to force the creditor to sell the distributional interest it purchased at foreclosure sale back to the company per the terms of operating at a price considerably less than what was paid at the public auction.

Court sides squarely with creditors

While the LLC won at the trial court level, the state Supreme Court came down firmly on the side of the creditors, ruling that a distributional interest in an LLC must be treated as property, and is subject to foreclosure. An LLC cannot use an operating agreement to protect a member’s interest from a creditor’s judgment.

LLCs retain some protections, however. While the LLC is stuck with the creditor as an owner of the former member’s distributional interest, it doesn’t have to grant the new owner voting powers or any management authority. Thus, current voting members can continue to make all business decisions for the LLC. But the new owner must receive a proportional share of any profit distributions and, eventually, the full value of the shares when the LLC is liquidated.

LLC takeaways

For LLCs, the takeaways from the decision are this:

  • Pick your business partners wisely. An outsider can join your business if a member’s property becomes subject to a judgment, and if a member gets into debt trouble, the other LLC members have limited options.
  • Once an LLC member gets into debt trouble, there is no easy way to keep the member’s interests out of the judgment process. By law, the LLC can redeem a distributional interest at the charging order stage, but that may be expensive if it’s a large judgment.
  • The LLC also could have rescued its distributional interest at the foreclosure auction, which would have been expensive, but may have been better than allowing an outsider to gain an ownership interest. In this case, the LLC was outbid at the public auction.

Creditor takeaways

For creditors, the takeaways are:

  • A debtor’s interest in an LLC can be foreclosed upon to satisfy a judgment and, in the future, there will be no ambiguity on this right.
  • The ownership interest, however, won’t give the creditor any say in the LLC’s decisions, nor the ability to the LLC to make profit distributions. This means the creditor has obtained ownership of an asset that may not yield any short-term value.

Finally, there are issues that the court didn’t clarify. It’s not clear if the creditor has the right to sell the newly won interest or the level and extent it may examine the LLC’s books. It’s also unclear what rights the non-voting owner has to challenge potential improper business practices such as voting members giving themselves excessive salaries for managing the business while shortchanging profit distributions.

These are questions that likely will be settled by another court in the future. In the meantime, the South Carolina Supreme Court has affirmed that creditors have a clear path to foreclosure on LLC distributional interests.

Mark Goddard is a shareholder at Turner Padget, where he focuses on business and corporate litigation, complex insurance defense matters, and probate litigation. He has extensive trial and arbitration experience, and has taken over 25 cases to verdict in venues throughout South Carolina. He may be reached at (843) 213-5542 or by email at mgoddard@turnerpadget.com

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