Charles and Ellerie Cleveland ("Debtors") had two Nevada LLCs. From PFG Advisors, LLC, the Debtors ran their insurance agency. That company leased the office building from the Debtors' other company, PFG Properties, LLC, which owned the building. The Debtors owned 100% and were the managers of each of the LLCs.
In planner's parlance, the LLCs were thus "Single Member LLCs" or "SMLLCs" for short, since they had no other members than the Debtors.
By at least 2012, the Debtors' financial situation had taken a turn for the worse, and their office building in PFG Properties, LLC, was foreclosed upon. Shortly thereafter, on February 21, 2013, the Debtors themselves personally filed for Chapter 7 bankruptcy in the U.S. Bankruptcy Court for the District of Nevada. The Court appointed Lenard Schwartzer as the Bankruptcy Trustee.
The Debtors fully disclosed their 100% interests in the two LLCs, and claimed that those interests were exempt under Nevada law. The Trustee then filed objections to the claims of exemption, seeking to take ownership of the assets of the two LLCs. The Bankruptcy Court found that:
. . . although those interests are otherwise property of the bankruptcy estate the Trustee has no right to sell or otherwise take ownership of any assets of those companies . . .
Not happy in with this result, the Trustee then appealed that finding to the U.S. District Court.
Apparently, and this is conjecture on my part, what the Debtors and the Trustee were fighting about here were the account receivables of the Debtor's insurance agency, which was in PFG Advisors, LLC. By and large, insurance agencies don't have much in the way of hard assets, but over the years they can develop future income streams known as "tail commissions".
I deduce this from a cryptic statement by the Court that the Trustee originally challenged the Debtor's claimed exemptions as to 75% of the commissions payable to PFG Advisors, LLC (which would track the 25% federal limitation on collections against "wages", which can of course include commission income). At some point, the Trustee apparently decided that going after 100% of the commissions was a losing argument, and so abandoned that attack.
Now back to what the U.S. District Court did clearly tell us in its Opinion.
The Trustee argued that that the Bankruptcy Court was wrong when it held that he had no right to sell or take possession of the assets of the LLCs. First, the Trustee noted that LLC interests are not exempt under Nevada law. Second, the Trustee argued that when the Debtors filed for bankruptcy, the LLC interests became property of the Debtor's bankruptcy estate, such that the Trustee "stepped into their shoes" and could exercise control over those companies and their assets.
For their part, the Debtors agreed that the LLC interests were part of their bankruptcy estate, but argued that the Trustee's sole remedy under Nevada law was a Charging Order against their interests in the LLCs, i.e., the Trustee could attack any distributions made to the Debtors from the LLCs, but didn't have any power to go after the assets of the LLCs.
The District Court agreed with the Trustee, and ruled against the Debtors on this point:
Numerous bankruptcy courts have held, and the Court agrees, that where a debtor has a membership interest in a single-member LLC and files a petition for bankruptcy under Chapter 7, the Chapter 7 trustee succeeds to all of the debtor's rights, including the right to control that entity, and a trustee need not take any further action to comply with state law before exercising such control. See, e.g., In re First Protection, Inc., 440 B.R. 821, 830 (B.A .P. 9th Cir.2010); In re B & M Land & Livestock, LLC, 498 B.R. 262, 267 (Bankr.D.Nev.2013); In re Albright, 291 B.R. 538, 541 (Bankr.D.Colo.2003). Furthermore, the Court agrees that "[s]tate law does not control the administration of property interests that are part of the bankruptcy estate." In re B & M, 498 B.R. at 268. Accordingly, [Trustee] is not limited to a charging order under Nevada law, and succeeds to all of [Debtors'] rights in the LLCs, including the right to control those entities.
But the Debtors also argued -- and this is how they won at the Bankruptcy Court level -- that this result should not happen where the LLC renders "personal services" In other words, where an LLC was used for a professional practice like a law firm or medical practice, or (as here) a state-licensed insurance agency, the Trustee should not be allowed to take over and run the business, because the Trustee is not qualified or licensed to do so.
The District Court skirted this issue by pointing out that even if the Trustee could not run an LLC that was providing such professional or personal services, that didn't preclude the Trustee from taking possession of, and selling, the assets of the LLC. Thus, the Bankruptcy Court was wrong, and the Trustee walked away the winner.
ANALYSIS
This decision is critically important in the area of Charging Orders for two reasons.
First, this decision is another in an increasingly-long line of cases that basically says that a single-member LLC affords no protection to the assets of the entity when its sole member lands in a Chapter 7 bankruptcy proceeding. Known as "Albright relief" after the first case (In re Albright, 291 B.R. 538 (Bk.D.Colo., 2003) to recognize the power of the Trustee to invade the LLC and sell its assets, the cases so far are consistently coming down in favor of the Trustee and against debtors and their single-member LLCs.
Second, and more importantly, this decision is critically important to the development of charging order law as it is the first to directly consider the issue of a Debtor's single-member LLC that provides "personal services".
Among those of us who practice in this area, there has long been intense speculation as to what happens to a single-member LLC that provides professional or personal services.
Think of the issue this way: Let's say that a famous painter sets up her business in an LLC. The customers of the LLC don't just wanting any old paintings, but they want the valuable paintings that are done by this particular painter.
Nobody wants the paintings of the Bankruptcy Trustee; therefore, the Bankruptcy Trustee can't really take over the business of the LLC, because the Bankruptcy Trustee can't provide the unique products that only the famous painter can create.
So, in the case of the famous painter, there has been speculation that a Court should not allow the Trustee to take over the business and run it for the benefit of creditors, but instead the Trustee should be limited to a Charging Order that would restrict the Trustee to taking no more than the distributions made to the famous painter by the LLC.
The Court here really doesn't answer the personal services issue directly, but instead tells us -- more importantly -- that it doesn't really matter because, whether or not the LLC is being used to provide personal services, that doesn't prevent the Trustee from taking possession of, and selling, the assets of the business.
Thus, to go back to our famous painter, let's say that before she declared Chapter 7 bankruptcy, our famous painter had sold 14 paintings through her LLC that she had not yet been paid for. In that case, the Trustee could take possession of the LLC's receivables, and collect the money (presumably, subject to the 25% federal limitation on wage garnishment).
But let's say that the day after our famous painter files for Chapter 7 bankruptcy, she paints another valuable painting and the LLC sells it. That new sale might be considered to be the painter's post-petition earnings, and the Trustee would probably not have a right to it.
The same result should be true for professional practices. While a Trustee cannot lawfully control a professional practice (state law prevents this), nothing prohibits a Trustee from taking the assets of a single-member LLC and selling them.
The bottom line is something that we've known for a while now: Single-member LLCs really make lousy asset protection vehicles, particularly in bankruptcy.
Having said that, it is very important to distinguish SMLLCs from Multiple-Member LLCs (MMLLCs), which have at least two substantial members. The reason is that if there is a debtor-member and a non-debtor-member, then Charging Order protection arises to protect the interests of the non-debtor-member against being forced into what would amount to an involuntary partnership with the debtor-member's creditor. So, as long as an LLC has at least one substantial non-debtor member (unlike this case), then it is unlikely that a Trustee will be able to get at the LLC's assets, but instead will be stuck with a Charging Order against the debtor-member's rights to distribution.
Of course, this doesn't mean that the Trustee doesn't get anything, but instead is limited to whatever is distributed from the LLC (and that may be further limited to 25% of net earning if those distributions are treated as anything like "wages" for purposes of the federal wage garnishment restrictions).
Note also that in asset protection planning, SMLLCs can still be used so long as their owner is something like a Trust that is unlikely to incur liabilities, and thus creditors. In this instance, they are typically not used for creditor protection purposes, but rather to facilitate the more efficient management of the trust assets.
But when directly used by individuals as asset protection devices, single-member LLCs have so far proven to be just one thing:
And that is a singular failure.
CITE AS
In re Cleveland, 2014 WL 4809924 (D. Nev. Sept. 29, 2014). Full Opinion at https://chargingorder.com/opinion-2014-nevada-cleveland-charging-order.html
This article at http://onforb.es/1xhIAy5 and http://goo.gl/itbmIT
