NATIONAL BUSINESS INSTITUTE

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1 NATIONAL BUSINESS INSTITUTE SEMINAR ON LLC STATUTORY PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS THURSDAY, APRIL 26, PM 3:30 PM INSTRUCTOR: JOHN M. CUNNINGHAM 1 OVERVIEW I. INTRODUCTION... 2 II. LLC STATUTORY PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS OVERVIEW... 5 A. LLC Pick-Your-Partner Provisions and Charging Order Provisions... 5 B. Chief Points of Comparison Between Limited Liability Provisions, Pick-Your-Partner Provisions and Charging Order Provisions C. Provisions in Corporate Statutes Equivalent to LLC Pick-Your-Partner Provisions and Charging Order Provisions; State Case Law III. IV. DEFINITIONS OF LLC STATUTORY TERMS AND TERMS OF ART RELEVANT IN UNDERSTANDING PICK- YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS DLLC ACT PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS; RELATED PROVISIONS A. Section (Admissions of Members) B. Section (Limited Liability) C. Section (Allocations of Profits and Losses) D. Section (Allocations of Distributions) E. Section (Right of Members to Interim Distributions) F. Section (Distribution Upon Resignation) G. Section (Nature of LLC Interest; Members Have No Interest in LLC Property) H. Section (Rights of Assignees of LLC Interests) I. Section (Charging Orders) J. Section (Right of Assignees to Become Members) K. Section (Distributions in Liquidation of the LLC) John Cunningham is of counsel to the law firm of McLane, Graf, Raulerson & Middleton, Professional Association. His telephone number is (603) His address is john.cunningham@mclane.com. He is the principal author of Drafting Limited Liability Company Operating Agreements, the leading U.S. formbook and practice manual, published by Wolters Kluwer Law & Business. He publishes a blog on LLC formation practice entitled John Cunningham on LLC Operating agreements. This blog may be accessed at The author of this outline wishes to express his gratitude to Allan Donn of the law firm of Wilcox & Savage, P.C., and to Professor Frances Fender of the University of Arkansas School of Law for sharing with him their ideas about the subject matter of this outline and commenting on earlier versions of the outline. However, Mr. Cunningham alone is responsible for any errors in the outline.

2 V. THE IMPORTANCE OF PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS IN NON- TAX CHOICE OF ENTITY; HYPOTHETICAL EXAMPLE OF THEIR OPERATION VI. VII. CHARGING ORDER PROVISIONS PROBABLY AREN T AVAILABLE TO SINGLE-MEMBER LLCS UNDER MOST OR ALL LLC ACTS THE FEDERAL INCOME TAX CONSEQUENCES OF CHARGING ORDERS; CONSEQUENCES FOR CREDITORS VIII. CHARGING ORDERS AND MEMBER BANKRUPTCIES A. Federal Bankruptcy Code 365(a) and (c) B. Dealing with 365(c)(1)(A) in Drafting Operating Agreements IX. WHEN SHOULD CREDITORS FORECLOSE ON THE LLC INTERESTS OF MEMBER-DEBTORS-IN-DEFAULT? 23 A. General Guidelines B. The Case of XYZ X. MISCELLANEOUS PLANNING AND DRAFTING ISSUES IN ADDRESSING ISSUES UNDER PICK-YOUR- PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS XI. XII. STATUTORY CONVERSIONS OF CORPORATIONS TO LLCS IN ORDER TO OBTAIN PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROTECTIONS FOR CORPORATE SHAREHOLDERS LEGAL GROUNDS FOR SEEKING TO OVERCOME PICK-YOUR-PARTNER AND CHARGING ORDER PROVISIONS XIII. CHARGING ORDER MULTI-JURISDICTIONAL ISSUES XIV. BIBLIOGRAPHY XV. CONCLUSIONS I. INTRODUCTION 1) Greetings. Good afternoon. I m John Cunningham, the instructor in this seminar. 2) My law practice. a) I m of counsel to the law firm of McLane, Graf, Raulerson & Middleton, Professional Association. b) I am the in-house consultant for the lawyers of the firm on issues of LLC law, tax and practice. c) My practice for my clients is focused on: i) Business entity formations and, in particular, on LLC formations; and ii) The conversion of corporations and other non-llcs to LLCs. d) I serve as an expert witness in litigation involving LLC issues. 3) Purpose of seminar; expansion of its scope; primacy of this outline. a) Charging order provisions. As its advertised title indicates, this seminar focuses on LLC statutory business asset protection provisions, found in all LLC statutes except that of Pennsylvania, called charging order protections. (However, Pennsylvania case law provides for charging order provisions under the Pennsylvania LLC Act.) 2

3 b) Pick-your-partner provisions. However, in preparing for the seminar, I ve become convinced that I can only meaningfully explain charging order provisions if I discuss these provisions in tandem with the other major types of LLC statutory business asset protection provisions namely, the provisions referred to in this seminar as pick-your-partner provisions. c) Slides vs. outline. Thus, the seminar will based primarily on this outline, which focuses equally on pick-your-partner provisions and charging order provisions, not on the Power Point slides that I provided to NBI and that NBI recently posted on its website, which focus only on charging order protections. If you have downloaded those slides, I would suggest that you discard them. And if you want to review this outline, you may download it from my blog on drafting LLC operating agreements. The link is. The link to the blog is 4) The importance of the subject matter of this seminar. a) What are pick-your-partner provisions and charging order provisions? In essence: i) Pick-your-partner provisions. Pick-your-partner provisions provide that LLCs may not admit new members and members may not transfer their management rights to other persons except with the consent of all members. ii) Charging order provisions in general. Charging order provisions provide that creditors may not levy on the property of LLCs in satisfaction of creditor judgments against LLC members but that they may obtain liens on members right to distributions of LLC profits. iii) Charging order provisions foreclosures on LLC interests. Charging order provisions vary widely on the issue whether creditors may levy on debtormembers LLC interests (i.e., their rights to allocations of LLC profits and to distributions of profits and other assets). b) Protections provided by pick-your-partner provisions. Pick-your-partner provisions protect: i) Debtor-members from losing their LLC management rights; ii) Other members from having to accept creditors as unwanted new substitute members; and iii) The members and the LLC from the possibility that creditors will be able to force the LLC to force the sale of LLC assets in satisfaction of their claims against members. c) Protections provided by charging order provisions. Charging order provisions provide creditors of debtor-members with the right to obtain distributions that would other be made to debtor-members. However: i) They also prevent creditors from levying on LLC assets in satisfaction of their claims against debtor-members; and ii) They may (depending on the LLC act in question) prevent creditors from levying on member s LLC interests. 3

4 d) Importance of seminar subject matter. There are at least four important reasons why you need to understand LLC pick-your-partner provisions and charging order provisions: i) Non-tax choice of entity. You need this understanding for non-tax choice of entity purposes i.e., in order to advise your business entity formation clients whether they should form their businesses as LLCs or as non-llc entities such as corporations. Most LLC members are likely to want the strongest possibly protection from the possibility that their creditors will be able to levy on their membership rights or their LLC interests. ii) Choice of LLC act. You need it for purposes of choosing the best LLC act for an LLC you are forming (and, specifically, choosing an act an antiforeclosure act if that will be in your client s best interest). For example, the DLLC Act does not permit foreclosures on members LLC interests. The New Hampshire LLC Act does, and the Massachusetts LLC probably does. iii) Conversions of corporations, etc., to LLCs. You need it in order to be able to advise your corporate and other non-llc clients as to whether they should convert to LLCs. iv) Advising LLCs and their members when members incur unsatisfied judgments. You need it in order to advise LLC members and clients in situations in which creditors obtain unsatisfied judgments against members or appear likely to obtain them. e) This seminar is merely introductory. i) In order to understand the pick-your-partner and charging order provisions of your LLC act, you need substantial knowledge. (1) Above all, you need to understand the theory and the practical implications of the provisions themselves. (2) However, in order to obtain this knowledge, you must first identify all of the terms of art underlying these provisions and learn their definitions and practical implications. (3) Finally, you must know all of the relevant cases construing the relevant statutory provisions and terms of art. ii) No 90-minute seminar can address the above knowledge comprehensively. Instead, the goal of this seminar is to provide you with an intensive introduction. 5) My writings and counseling of clients about pick-your-partner provisions and charging order provisions. a) I m the principal author of Drafting Limited Liability Company Operating Agreements, the leading U.S. LLC formbook and practice manual, published by Wolters Kluwer Law & Business. Chapter 4 of the third edition of this book, which will appear in approximately June of this year, extensively discusses LLC pick-your-partner provisions and charging order provisions. 4

5 b) I m the author of the above blog on LLC formation practice entitled John Cunningham on LLC Operating Agreements. The blog discusses pick-yourpartner provisions and charging order provisions from time to time. c) In addition, in my business entity formation and conversion practice, I frequently advise clients about issues relating to these provisions. d) I often teach national teleconference seminars about LLC pick-your-partner provisions and charging order provisions. 6) Questions about the seminar. I will welcome your questions about the seminar subject matter at the end of the seminar and by phone or after the seminar. My contact information is in the first footnote in the outline. 7) The Delaware Limited Liability Company Act as the reference LLC act in this seminar. a) LLC statutory law doesn t exist abstractly in a Platonic heaven; it exists only in the concrete namely, in the 51 U.S. LLC statutes and in the cases interpreting them and it can be adequately understood only by reference to these statutes and cases. b) The reference LLC act in this seminar will be the Delaware Limited Liability Company Act (the DLLC Act ), since: i) The DLLC Act is generally viewed by LLC lawyers as the preeminent U.S. LLC statute; ii) The DLLC Act has deeply influenced many other LLC statutes; and iii) The pick-your-partner provisions and charging order provisions of many non- Delaware LLC acts are closely similar to those of the DLLC Act. 8) The importance of mastering the pick-your-partner provisions and charging order provisions of your own LLC act and the relevant case law. However, as discussed further below, there is significant variation in the charging order provisions of the 51 U.S. LLC acts, particularly as to the rights of creditors to foreclose on LLC interests. Thus, in order to handle LLC matters, you must develop a detailed familiarity those provisions under your LLC act and with the relevant case law. II. LLC STATUTORY PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS OVERVIEW A. LLC PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS 1) The two main types of statutory rights of LLC members. The default provisions of all LLC statutes provide LLC members with two main kinds of rights: a) A right to participate in the management of the business and affairs of the LLC (often referred to by LLC lawyers as the members management rights which is not a statutory term but which is useful shorthand for the above phrase); and b) LLC interests (designated as membership interests, distributive interests or transferable interests under some LLC statutes). 5

6 i) The term LLC interest is clumsy, since it really refers to rights i.e., rights to allocations and distributions and not merely to interests. (At least in some situations, interests may not be the same as rights.) 2) Additional rights under operating agreements. All LLC acts permit members in their operating agreements to provide members with a virtually infinite variety of other rights, among the most important of which are: a) A right to a redemption or cross-purchase (a buy-out ) of their membership rights upon dissociation from the LLC by reason of death, disability or other specified causes. (A redemption is a purchase by an LLC of a member s membership rights. A cross-purchase is a purchase of these rights by one or more other members.) b) A right to salaries and bonuses for services to and for the LLC; and 3) What rights do management rights include? I know of no authority on the critical pick-your-partner issue of how to define the rights comprised in members management rights. However, it is reasonable to assume that these comprise the following types of rights: a) Voting rights; b) Information rights (i.e., the right to information about the LLC and in the possession of the LLC); c) Fiduciary rights (i.e., the right to require managers and other members to act with care and loyalty); d) Dispute resolution rights; e) In the case of LLC members who are managers, agency rights; f) In the case of LLC members who are managers, the right to decide LLC management matters and to conduct the LLC s business; and g) Any other rights to participate in the business and affairs of the LLC that are provided in the operating agreement (which may include, for example, rights to participate in member or manager meetings). 4) LLC statutory grants of management rights to members are implicit, not express. No LLC acts of which I m aware expressly provide members with management rights in single provision. Rather, they provide these rights through a combination of numerous narrower provisions, such as those providing members with voting rights and information rights. 5) The two rights comprised in LLC interests. As noted, members LLC interests include two rights, both of which are economic: a) The right to receive allocations of LLC profits and losses; and b) The right to receive distributions of LLC cash and other assets. 6) LLC statutory grants of LLC interests are implicit, not express. I am aware of no LLC acts that expressly provide members with LLC interests. However, all such acts of which I am aware do so by clear implication. See, e.g.: 6

7 a) DLLC Act , which provides that members LLC interests are personal property ; b) DLLC Act (a), a default rule which provides that members may freely assign their LLC interests; and c) DLLC Act (d) (second sentence), which provides that LLCs may admit members without granting them LLC interests (and which thus implies that, unless the LLC agreement provides otherwise, members normally do receive LLC interests upon being admitted as members). 7) The three main types of asset protection provisions in LLC acts. LLC statutes contain three main types of asset protection provisions: a) Limited liability provisions, b) Pick-your-partner provisions, and c) Charging order provisions. 8) Limited liability provisions. All LLC acts contain limited liability provisions. These provisions protect LLC members and managers from claims against the LLC. I will discuss these provisions in this seminar only from time to time and only briefly. 9) The two types of pick-your-partner provisions; the persons bound by them. a) All LLC statutes contain default pick-your-partner provisions. These provisions provide, in essence, that although LLC members may freely transfer their LLC interests. There are two kinds of pick-your-partner provisions: i) The first type bars LLCs from granting management rights to additional members without the consent of all existing members. ii) The second type bars LLC members from transferring their management rights to other members or to other persons except with the consent of all other members. b) Not only LLCs and their members but also the courts are bound by pick-yourpartner provisions. By their terms, the above provisions bar only LLCs and members from transferring management rights to non-members. However, the courts uniformly treat them as also barring the courts from ordering LLCs and members to transfer these rights. 10) The policy basis for pick-your-partner provisions. The basis of LLC statutory pickyour-partner provisions is a fundamental English and American legislative and judicial policy of partnership law known as the delectus personae or pick-yourpartner policy. This policy is based on a belief that the survival and success of partnerships depends critically on the compatibility of their partners and that, accordingly, the law should protect that compatibility. ( Delectus personae is a Latin phrase meaning choice of the person. The phrase is an ancient legal shorthand for the principle that partners must be free to choose compatible co-partners.) 7

8 11) Charging order provisions in general. As noted, all LLC statutes except that of Pennsylvania also contain charging order provisions, and a Pennsylvania court has construed the Pennsylvania LLC Act as containing these provisions. 12) Exclusive vs. non-exclusive charging order provisions; anti-foreclosure charging order protections vs. pro-foreclosure charging order provisions. a) The charging order provisions of all LLC acts provide that creditors who hold unsatisfied judgments against LLC members ( member-debtors-in-default ) and who want to obtain the right to receive distributions of profits that would otherwise be made to the members may apply to a court for a charging order that will so provide. i) Under the charging order provisions of many LLC acts, charging orders are the exclusive means available to creditors for obtaining a right to distributions otherwise payable to debtor-members; but under some LLC acts, charging orders are not the exclusive means to achieve this purpose, and other means, such as garnishment or attachment may be available. b) Furthermore, all charging order provisions effectively bar creditors from levying on LLC assets to satisfy their judgments. c) However, as to creditors who want to obtain not only a member-debtor-indefault s right to LLC distributions but also the member s right to allocations of LLC profits and losses i.e., creditors who want to obtain the member s entire LLC interest their right to do so varies from state to state: i) The charging order provisions (which I will refer to here as pro-foreclosure provisions ) of some LLC acts (e.g., that of New Hampshire) expressly or impliedly permit these creditors to foreclose on these LLC interests; but ii) The charging order provisions of other LLC acts ( anti-foreclosure provisions ) expressly or impliedly bar these foreclosures. 13) The policy underlying charging order provisions. The policy underlying charging order provisions is less clear than that underlying pick-your-partner provisions. a) Protection of LLC assets. It is clear that charging order protections are intended to protect LLC assets from creditors of member-debtors-in-default. This was the original basis for charging order provisions under English partnership law. b) Balancing of creditor and debtor interests. It also appears that these provisions are intended to strike a balance between: i) The interests of credits of member-debtors-in-default in satisfying their judgments against these debtors; and ii) The interest of innocent non-debtor members: (1) In levying on LLC property (under all charging order provisions); and (2) In preventing creditors from obtaining the right to LLC profits (under antiforeclosure charging order provisions). 8

9 c) Policies underlying anti-foreclosure and pro-foreclosure provisions in charging order provisions. The policy considerations that have influenced state legislators to choose anti-foreclosure and pro-foreclosure statutes are less clear. However: i) LLC interests as core LLC membership rights. Anti-foreclosure statutes arguably reflect a legislative view that the combination of allocation rights and distributions constitutes a core membership right that must be protected from creditor. ii) Impact of foreclosure on LLC interests on LLC members management rights. Most LLC acts contain default rules providing that if members transfer their entire LLC interests, they are thereby automatically dissociated as members. In many charging order cases, a key reason why members may want to opposing a court s permitting a foreclosure of their LLC interests is that this will also cause the loss of their LLC management rights. 14) Distributions to which creditors that hold charging orders against the LLC interests of member-debtors-in-default are entitled. The distributions to which creditors with charging orders against the LLC interests of member-debtors-in-default will be entitled will depend on the provisions of the governing LLC act and of the relevant LLC operating agreement. However, in general: a) Interim distributions. These creditors will be entitled to interim distributions in accordance with the relevant provisions of the governing LLC act, the operating agreement and the history of interim distributions to the member by the LLC. b) Distributions in liquidation of the membership rights of a member. These creditors will receive any distribution to which the debtor-member is entitled under the governing LLC act or operating agreement upon the member s dissociation as a member of the LLC, including distributions in connection with buy-sell arrangements in the form of redemptions and cross-purchases. c) Distributions in liquidation of the LLC. Upon the liquidation of the LLC, a creditor that forecloses on a member s LLC interest will be entitled to distributions provided under the provisions of the governing LLC act that govern these distributions. 15) Partnerships and statutory trust statutes also contain pick-your-partner provisions and charging order provisions but are generally less advantageous for conducting businesses. General and limited partnership statutes and, in the states that have them, statutory trust statutes also contain pick-your-partner provisions and charging order provisions. However, these statutes contain other statutory provisions that make them less useful to most businesses, and especially to smaller businesses, than LLC statutes. Thus, in this outline, I will focus on pick-your-partner provisions and charging order provisions only as they appear in LLC statutes. 9

10 B. CHIEF POINTS OF COMPARISON BETWEEN LIMITED LIABILITY PROVISIONS, PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS In order to understand pick-your-partner provisions and charging order provisions adequately, you must know the chief points of comparison among limited liability provisions, pick-your-partner provisions and charging order provisions. to 1) Limited liability provisions. Limited liability provisions protect the personal assets of LLC members from claims by third parties against their LLCs. 2) Pick-your-partner provisions. In general, pick-your-partner provisions protect members from having to accept unwanted third parties as co-members. In particular, they protect non-debtor members from having to accept creditors of debtor-members as new co-members. 3) Charging order provisions. a) The charging order provisions of all LLC acts permit creditors to obtain the distribution rights of debtor-members. b) The charging order protections of all LLC act prevent creditors of LLC members from levying on LLC property in satisfaction of their claims. c) The charging order provisions of the LLC acts of some states prevent creditors from levying on the LLC interests of debtor-members; the charging order provisions of other states do not. C. PROVISIONS IN CORPORATE STATUTES EQUIVALENT TO LLC PICK-YOUR- PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS; STATE CASE LAW 1) Why business corporation acts generally lack pick-your-partner provisions. The business corporation statutes of most states contain no provisions equivalent to LLC statutory pick-your-partner provisions or charging order provisions. This is because, historically, the purpose of business corporation statutes has been to mobilize large amounts of capital for corporate business purposes. This purpose may normally be achieved only if corporate shares are freely transferable by persons acquiring them. 2) Close corporation statutes and provisions; state case law. A number of states have provisions in specialized close corporation statutes or close corporation provisions in their general business corporation statutes that have the same effect as LLC statutory pick-your-partner provisions; and one or more states have case law to the same effect. 3) Corporate charging order provisions. However, as indicated above, there appears to be only one business corporation statute i.e., that of Nevada that contains charging order protections. 4) Non-tax choice of entity. If your state has statutory close corporation provisions or case law that prevent creditors from levying on the shares of shareholder-debtors, this may significantly complicate your work in choosing between the corporate form and the LLC form in non-tax choice of entity. 10

11 III. DEFINITIONS OF LLC STATUTORY TERMS AND TERMS OF ART RELEVANT IN UNDERSTANDING PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS The LLC statutory terms and terms of art set forth below are relevant in understanding pick-your-partner provisions and charging order provisions. 1) Shares. Shares are units of ownership of corporations. Shares confer on shareholders (i) management rights; (ii) rights to allocations of corporate profits; and (iii) certain distribution ( dividend ) rights. 2) Membership rights. Most LLC acts have no defined term for the totality of members membership rights, including both their economic and their non-economic rights. In this outline, I will use the term membership rights to denote this totality. 3) LLC interest. Under DLLC Act (6), an LLC interest is the right of a member to receive allocations of LLC profits and losses and distributions of LLC cash and other assets (including interim and liquidating distributions). 4) Management rights. Under the default rule of DLLC Act (a) (second sentence), members may not transfer their right to participate in the management of the business and affairs of the limited liability company except with the consent or vote of all of the other members. LLC lawyers usually refer to rights of the kind identified in (a) as members management rights. As indicated, these may include many different types of rights. 5) Allocation. An allocation is an accrual on the books of an LLC of a member s share of LLC income. Members of LLCs taxable as partnerships and S corporations are liable for federal income taxes and in some cases for Social Security Taxes on their annual shares of LLC income. a) Under the default rules of many LLC statutes, an LLC s profits and losses are allocated among the members in proportion to their respective contributions of cash, property and services to the LLC. 6) Distribution in general. Unless the LLC agreement provides otherwise, distributions generally mean transfers of LLC cash and other assets to members because of their status as members and not because of their services to the LLC. 7) Interim distribution. An interim distribution is an operating distribution by an LLC to a member i.e., a distribution that is not a liquidating distribution. a) Under the default rules of many LLC acts: i) The members have the right to interim distributions only if the operating agreement so provides. ii) These distributions must be allocated among the members in proportion to their respective contributions of cash, property and services to the LLC. 8) Distribution in liquidation of LLC membership. A distribution in liquidation of a member s membership sometimes referred to as a redemption distribution is a distribution by the LLC to the member under the DLLC Act or an LLC agreement in extinguishment of the member s membership rights. 11

12 a) Under the default provisions of many LLC acts, an LLC must make distributions to dissociated members of their accrued allocations but is not required to make any distribution in redemption of these members. (Indeed, I am aware of no LLC act that requires LLCs to return to dissociated members, upon their dissociation, the contributions these members have made to the LLCs.) 9) Distribution in liquidation of the LLC. A distribution in liquidation of the LLC is a distribution of the LLC s assets to the members after its winding up and in connection with its liquidation. a) Under mandatory provisions in most or all LLC acts, LLCs that have been wound up must use their cash and other assets to pay their creditors. b) Under default rules in their acts, LLCs must use any excess cash and other assets: i) First to pay members amounts covering their accrued allocations; ii) Then to return their contributions; and iii) Finally, in proportion to their right to allocations. 10) Foreclosure, levy and execution. A foreclosure order in an charging order case means an order by a court transferring the ownership of a member s LLC interest to a creditor. Under the default rules of many LLC acts, the foreclosure will trigger the member s dissociation. Under the laws of many states, the meaning of the terms levy and execution is the same as that of the term foreclosure for charging order purposes. 11) Assignment. Under most LLC acts, an assignment of an LLC interest means its transfer by an LLC member to a non-member. Under most or all LLC acts, assignees of LLC interests have only the right to receive allocations and distributions; they have no other membership rights. IV. DLLC ACT PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS; RELATED PROVISIONS The provisions of the DLLC Act set forth below in italics include the principal pick-yourpartner provisions and charging order provisions in that act and various provisions relevant in understanding these provisions. Also set forth below are brief comments on the provisions that may be useful to you in interpreting and applying them. As you will note, most of the provisions below are also contained in most other LLC acts. A. SECTION (ADMISSIONS OF MEMBERS) Admission of members [Effective Aug. 2, 2010] (a) In connection with the formation of a limited liability company, a person is admitted as a member of the limited liability company upon the later to occur of: (1) The formation of the limited liability company; or (2) The time provided in and upon compliance with the limited liability company agreement or, if the limited liability company agreement does not so provide, when the 12

13 person s admission is reflected in the records of the limited liability company. (b) After the formation of a limited liability company, a person is admitted as a member of the limited liability company: (1) In the case of a person who is not an assignee of a limited liability company interest, including a person acquiring a limited liability company interest directly from the limited liability company and a person to be admitted as a member of the limited liability company without acquiring a limited liability company interest in the limited liability company, at the time provided in and upon compliance with the limited liability company agreement or, if the limited liability company agreement does not so provide, upon the consent of all members and when the person s admission is reflected in the records of the limited liability company; (2) In the case of an assignee of a limited liability company interest, as provided in (a) of this title and at the time provided in and upon compliance with the limited liability company agreement or, if the limited liability company agreement does not so provide, when any such person s permitted admission is reflected in the records of the limited liability company [.] COMMENT. Section (b)(i) is a pick-your-partner provision: It provides, in essence, that, after its formation, an LLC may not admit a person as a member except with the consent of all existing members. B. SECTION (LIMITED LIABILITY) Liability to 3rd parties. (a) Except as otherwise provided by this chapter, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company. (b) Notwithstanding the provisions of subsection (a) of this section, under a limited liability company agreement or under another agreement, a member or manager may agree to be obligated personally for any or all of the debts, obligations and liabilities of the limited liability company. COMMENTS. 1) Section (a) is the limited liability provision of the DLLC Act. 2) A detailed discussion of LLC limited liability provisions is beyond the scope of this outline. However, readers should be aware that these provisions are subject to several importance exceptions. For example: a) LLCs are subject to veil-piercing on essentially th e same grounds as corporations and other limited liability entities. 13

14 b) LLC members and managers who act negligently on behalf of their LLCs will be personally liability for their negligence. c) LLC members and managers who breach their fiduciary duties toward the members and the LLC will be personally liable for these breaches. C. SECTION (ALLOCATIONS OF PROFITS AND LOSSES) Allocation of profits and losses. The profits and losses of a limited liability company shall be allocated among the members, and among classes or groups of members, in the manner provided in a limited liability company agreement. If the limited liability company agreement does not so provide, profits and losses shall be allocated on the basis of the agreed value (as stated in the records of the limited liability company) of the contributions made by each member to the extent they have been received by the limited liability company and have not been returned. COMMENTS. 1) This section provides, in essence, that unless the LLC agreement provides otherwise, LLCs must allocate their profits and losses among members in proportion to the agreed values of their respective contributions of cash, property and services to the LLCs. 2) Under the default rules of the DLLC Act and many other LLC acts, LLCs must also allocate interim distributions among the members in proportion to their contributions. D. SECTION (ALLOCATIONS OF DISTRIBUTIONS) Allocation of distributions. Distributions of cash or other assets of a limited liability company shall be allocated among the members, and among classes or groups of members, in the manner provided in a limited liability company agreement. If the limited liability company agreement does not so provide, distributions shall be made on the basis of the agreed value (as stated in the records of the limited liability company) of the contributions made by each member to the extent they have been received by the limited liability company and have not been returned. COMMENTS. 1) As noted above, this section provides that unless the operating agreement provides otherwise, LLCs must allocate interim distributions among the members in proportion to their respective contributions. 2) It is important to understand the difference between allocations of profits and losses and allocations of interim distributions. 14

15 E. SECTION (RIGHT OF MEMBERS TO INTERIM DISTRIBUTIONS) Interim distributions. Except as provided in this subchapter, to the extent and at the times or upon the happening of the events specified in a limited liability company agreement, a member is entitled to receive from a limited liability company distributions before the member s resignation from the limited liability company and before the dissolution and winding up thereof. COMMENTS. This section appears to provide, in essence, that members have no right to interim distributions from their LLCs except as expressly provided in the LLC agreement. F. SECTION (DISTRIBUTION UPON RESIGNATION) Distribution upon resignation. Except as provided in this subchapter, upon resignation any resigning member is entitled to receive any distribution to which such member is entitled under a limited liability company agreement and, if not otherwise provided in a limited liability company agreement, such member is entitled to receive, within a reasonable time after resignation, the fair value of such member s limited liability company interest as of the date of resignation based upon such member s right to share in distributions from the limited liability company. COMMENTS. 1) This section provides, in essence, that an LLC must distribute to members who resign all amounts allocated to them before their resignations. 2) By implication, this section would appear to imply that if members are dissociated for any reason other than resignation, they will not be entitled to the above distributions upon their dissociation. G. SECTION (NATURE OF LLC INTEREST; MEMBERS HAVE NO INTEREST IN LLC PROPERTY) Nature of limited liability company interest. A limited liability company interest is personal property. A member has no interest in specific limited liability company property. COMMENTS. 1) The first sentence of arguably implies that members are entitled to LLC interests by virtue of being members and that in the absence of LLC agreement provisions to the contrary, these interests, like non-llc property, are freely transferable. 2) The second sentence of arguably suffices by itself to prevent creditors of LLC members from levying on LLC property in satisfaction of members debts. Thus, may be viewed as merely confirmatory of

16 H. SECTION (RIGHTS OF ASSIGNEES OF LLC INTERESTS) Assignment of limited liability company interest [Effective Aug. 2, 2010] (a) A limited liability company interest is assignable in whole or in part except as provided in a limited liability company agreement. The assignee of a member s limited liability company interest shall have no right to participate in the management of the business and affairs of a limited liability company except as provided in a limited liability company agreement or, unless otherwise provided in the limited liability company agreement, upon the affirmative vote or written consent of all of the members of the limited liability company. (b) Unless otherwise provided in a limited liability company agreement: (1) An assignment of a limited liability company interest does not entitle the assignee to become or to exercise any rights or powers of a member; (2) An assignment of a limited liability company interest entitles the assignee to share in such profits and losses, to receive such distribution or distributions, and to receive such allocation of income, gain, loss, deduction, or credit or similar item to which the assignor was entitled, to the extent assigned; and (3) A member ceases to be a member and to have the power to exercise any rights or powers of a member upon assignment of all of the member s limited liability company interest. Unless otherwise provided in a limited liability company agreement, the pledge of, or granting of a security interest, lien or other encumbrance in or against, any or all of the limited liability company interest of a member shall not cause the member to cease to be a member or to have the power to exercise any rights or powers of a member. COMMENT. 1) Pick-your-partner rule. DLLC Act (a) (second sentence) provides in effect that unless the operating agreement provides otherwise, the assignee of an LLC interest may become a member only with the consent of all existing members. 2) Member dissociation upon transfer of entire LLC interest. DLLC Act (b)(3) provides that upon the assignment (i.e., the transfer) of a member s entire LLC interest, the member will cease to be a member of the LLC i.e., in standard LLC parlance, will be dissociated from the LLC. Thus, if a creditor of a member forecloses on the member s LLC interest in a foreclosure permitted by the applicably charging order provisions: a) The member will cease to be a member; but b) Since the member will thus lose the member s management rights, these rights will become unavailable to the creditor. 16

17 I. SECTION (CHARGING ORDERS) Member s limited liability company interest subject to charging order. (a) On application by a judgment creditor of a member or of a member s assignee, a court having jurisdiction may charge the limited liability company interest of the judgment debtor to satisfy the judgment. To the extent so charged, the judgment creditor has only the right to receive any distribution or distributions to which the judgment debtor would otherwise have been entitled in respect of such limited liability company interest. (b) A charging order constitutes a lien on the judgment debtor s limited liability company interest. (c) This chapter does not deprive a member or member s assignee of a right under exemption laws with respect to the judgment debtor s limited liability company interest. (d) The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or of a member s assignee may satisfy a judgment out of the judgment debtor s limited liability company interest. (e) No creditor of a member or of a member s assignee shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company. (f) The Court of Chancery shall have jurisdiction to hear and determine any matter relating to any such charging order. COMMENTS. 1) DLLC Act (a) provides creditors with the right to seek charging orders, but it also makes clear that the only right they will obtain under that order is the right to receive distributions otherwise payable to the relevant debtor-member; it does not make them assignees of the member s LLC interest. 2) DLLC Act (d) provides that a charging order is the exclusive means by which a creditor may satisfy a judgment out of the judgment debtor s LLC interest. The quoted terms clearly imply that by reason of , creditors may not foreclose on debtor-members LLC interests in satisfaction of their judgments and may not garnish or attach these interests. 3) DLLC Act (e) confirms the implication in other DLLC Act provisions e.g., (second sentence) that creditors may not levy on LLC property in satisfaction of their judgments. See Delaware Legislature synopsis accompanying amending : The current amendments to this section clarify the nature of a charging order and provide that a charging order is the sole method by which a judgment creditor may satisfy a judgment out of the limited liability company interest of a member or a member s assignee. Attachment, garnishment, foreclosure or like remedies are not available to the judgment creditor, and a judgment creditor does not have a right to become or to exercise any rights or powers of a member (other than the 17

18 right to receive the distribution or distributions to which the member would otherwise have been entitled, to the extent charged). J. SECTION (RIGHT OF ASSIGNEES TO BECOME MEMBERS) Right of assignee to become member [Effective Aug. 2, 2010] (a) An assignee of a limited liability company interest may become a member: COMMENT. (1) As provided in the limited liability company agreement; or (2) Unless otherwise provided in the limited liability company agreement, upon the affirmative vote or written consent of all of the members of the limited liability company. 1) DLLC Act (a)(2) is a default pick-your-partner provision that provides, in effect, that a member of an LLC that transfers an LLC interest to another person may transfer the member s management rights to the person only with the consent of all other members. 2) DLLC Act (a)(2) must be read in tandem with (b)(1). The former section addresses transfers of membership rights by members to other persons. The latter addresses grants of membership rights by LLCs to new members. K. SECTION (DISTRIBUTIONS IN LIQUIDATION OF THE LLC) Distribution of assets. (a) Upon the winding up of a limited liability company, the assets shall be distributed as follows: (1) To creditors, including members and managers who are creditors, to the extent otherwise permitted by law, in satisfaction of liabilities of the limited liability company (whether by payment or the making of reasonable provision for payment thereof) other than liabilities for which reasonable provision for payment has been made and liabilities for distributions to members and former members under or of this title; (2) Unless otherwise provided in a limited liability company agreement, to members and former members in satisfaction of liabilities for distributions under or of this title; and (3) Unless otherwise provided in a limited liability company agreement, to members first for the return of their contributions and second respecting their limited liability company interests, in the proportions in which the members share in distributions. COMMENT. Section (1) provides a hierarchy that LLCs must follow (except to the extent that the default rules of the section provide otherwise) in making liquidating distributions to 18

19 its creditors and members. Presumably, under (a)(1), a creditor holding a charging order would have priority with respect to these distributions over LLC members. V. THE IMPORTANCE OF PICK-YOUR-PARTNER PROVISIONS AND CHARGING ORDER PROVISIONS IN NON-TAX CHOICE OF ENTITY; HYPOTHETICAL EXAMPLE OF THEIR OPERATION 1) Under the laws of most states, creditors can levy on corporate shares. Only a few corporate statutes contain pick-your-partner provisions and only one that of Nevada provides charging order provisions. Thus, under most corporate statutes, creditors can levy on corporate shares held by shareholders against whom they have unsatisfied judgments and if these shareholders control these corporations, creditors can effectively acquire this control, since every share carries both rights to allocations and distributions of corporate profits and other assets and voting and other management rights. 2) Pick-your-partner provisions and charging order provisions may prevent levies. By contrast, unless they are altered in LLC operating agreements: a) The pick-your-partner provisions in the LLC acts of most or all states prevent creditors of LLCs from levying on the management rights of LLC memberdebtors-in-default; and b) Charging order provisions in the LLC acts of many states (i.e., the antiforeclosure states) prevent them from levying on the LLC interests of these members. 3) Impact of pick-your-partner provisions and charging order provisions on non-tax choice of entity. a) Hypothetical example. The above advantages of LLC statutory law over corporate law are of tremendous importance in non-tax choice of entity i.e., in choosing between LLCs and corporations on non-tax grounds in entity formations. To illustrate: i) On January 1, 2000, Mary Jones forms MJ, a new Delaware company whose purpose is to manufacture and sell widgets. She is MJ s CEO and its 51% owner of the company. Her husband James is the 49% owner. Her lawyer, Arthur Able, is a traditionalist who is very competent in forming corporations but not in forming LLCs. Thus, he forms MJ as a Delaware corporation, not as an LLC. ii) MJ prospers and, by January 1, 2012, it has assets worth $10 million. MJ pays out all of its annual net profits as compensation to Mary. iii) On that date, while driving her car on non-mj business, Mary accidentally but negligently runs over and kills Smith, a brain surgeon, and incurs a judgment of $20 million, which vastly exceeds her auto liability insurance. iv) Smith s estate levies on Mary s MJ stock, takes control of MJ, sells its assets, and distributes 51% of them to itself. 19

20 v) Mary loses her most valuable asset her MJ stock; and she loses her job and her salary. James loses his interest in MJ s going concern value. b) Corporation vs. LLC. If Arthur Able had formed MJ as a Delaware LLC, not as a Delaware corporation: c) The pick-your-partner provisions of the DLLC Act would have prevented Smith s estate from levying on Mary s management rights. Thus, she would have retained control of MJ and Smith s estate would not have been able to force the sale of MJ s assets. d) Mary would have retained her job with MJ and her MJ salary. e) James would have retained his interest in MJ s going concern value. f) Under the DLLC Act charging order protections, Smith s estate would have been able to obtain a charging order against Mary s LLC interests, but, since MJ had no history of making distributions and since Smith s estate could not compel these distributions, this charging order would be of no practical value to it unless MJ was liquidated while the charging order was still in effect. g) Under the DLLC Act charging order provisions, Smith s estate could not levy on Mary s LLC interest. Thus, if it settled its claim against Mary, it would never be able to obtain any liquidating distribution from MJ. 4) Pick-your-partner provisions, charging order provisions, ethical violations and malpractice. In light of the above considerations, a plausible argument could be made that in forming MJ as a corporation: VI. a) Arthur Able violated Rule 1.1 of Delaware s Rules of Professional Conduct, which requires lawyers to be competent in handling client matters and thus could be subject to sanctions by Delaware s professional ethics authority; and b) His incompetence also constituted negligence and thus could make him liable to Mary in a malpractice suit. CHARGING ORDER PROVISIONS PROBABLY AREN T AVAILABLE TO SINGLE-MEMBER LLCS UNDER MOST OR ALL LLC ACTS 1) No restriction of pick-your-partner provisions and charging order provisions to multimember LLCs. By their terms, the legal benefits of the pick-your-partner provisions and charging order provisions in the LLC acts of most states are not restricted to multi-member LLCs; thus, arguably, they also protect single-member LLCs and their members. 2) Probable unavailable of pick-your-partner and charging order protections to singlemember LLCs. However, as noted, the purpose of pick-your-partner provisions and charging order provisions is to protect innocent non-debtor members of LLCs from claims against member-debtors-in-default. Thus, since, by definition, single-member LLCs against whose members creditors hold unsatisfied judgments have no innocent non-debtor members, it is doubtful whether these provisions protect single-member LLCs and their members, and a number of cases have so held. 20