The Olmstead decision and the problem of single member LLCs

Larry Ribstein —  27 June 2010

The Florida Supreme Court’s decision in Olmstead v. FTC on the surface is a highly convoluted case that outwardly appeals only to the sort of people who think about LLCs in the shower. Since I qualify, I suppose it falls to me to explain what this is all about. Bear me out, because this matters to you if you are a business lawyer, even if you’re not an LLC jock.

Here’s the setup: The FTC got a $10 million judgment against Shawn and Julie Olmstead, and sought to collect from the Olmsteads’ Florida single member LLCs. The Florida LLC act (Fla. Stat. Section 608.433(4)), like other LLC acts, lets an LLC member’s creditors reach only the member’s interest in the LLC, via something borrowed from partnership law called a “charging order.” LLC acts typically define this interest to include only the member’s economic rights, including the right to distributions (e.g., Fla. section 608.402(23)). A single member LLC often has the sort of property, like the debtor’s residence, which does not generate any distributions. Anyway, the debtor, as the sole member, controls whether the distributions are made. Thus, the charging order basically gives the creditor only the right to sit and wait for the debtor to decide to get generous and distribute the LLC’s assets to his creditors.

The charging order remedy was designed to protect partners’ governance rights. In the traditional partnership these are substantial, which is understandable since each partner has personal liability for the debts of the business. If a single partner’s creditor could take over the partner’s governance rights, this could disrupt the traditionally close and co-equal partnership relationship. Notably, partnerships are defined as having two or more members.

The charging order carried over to LLCs, which have been based from the beginning largely on the partnership model. Limited liability arguably reduced the need to be careful about usurping members’ governance rights, but didn’t make enough of a difference to make the charging order clearly inappropriate.

The real problem came with single-member LLCs (“smllcs”). I argued from the beginning (The Loneliest Number: The Unincorporated Limited Liability Sole Proprietorship, 1 J. Asset Protection 46 (May/June 1996)) that the move from the multiple-owner partnership model to permitting single-member LLCs was questionable, or at least should be undertaken with great care. The charging order illustrates the problem: it was designed specifically to accommodate the rights of both creditors and non-debtor members, and therefore is arguably unnecessary if there are no non-debtor members. Moreover, charging orders are more subject to debtor opportunism in smllcs because they invite a distribution policy designed solely to frustrate the debtor’s creditors.

Indeed, it gets worse: single member LLCs have been widely used specifically as debtor-protection vehicles. This was especially invited by enabling LLCs, unlike partnerships, to be formed for non-business purposes, which might include owning homes. This may have been particularly true in Florida, which is both a notorious debtor-protection state, particularly given the size of its homestead exemption, and which, perhaps not so coincidentally, trails only Delaware in the number of LLCs (see Kobayashi & Ribstein, Jurisdictional Competition for LLCs).

I wrote about this problem five years ago, bemoaning this misuse of LLCs, warning of trouble down the road, but cautioning that the fix lay with the legislature, not the courts (apart from the few cases where careless debtors left the opportunity for a veil-piercing or fraudulent conveyance argument.). See Reverse Limited Liability and the Design of Business Associations, 30 Del. J. Corp. L. 199 (2005). By then one court had ignored this advice and held that the charging order provision didn’t prevent a bankruptcy court from giving the bankruptcy estate the debtor’s governance rights despite the inconsistency with supposedly applicable state law. In re Albright, 291 B.R. 538 (D. Colo. 2003).

Now we come to Olmstead. Here the 11th Circuit recognized the ferment in LLC law and did what seemed ex ante at least to be the right thing – certified to the applicable state court the question of whether the court may order the debtor to surrender all of his rights, including governance, to a creditor under the above statute. As a theoretical matter, I wish more federal courts would do this instead of mucking up uncorporation law to the extent they have in diversity cases – an issue I expect to treat at length some day.) The problem is that the state court in this case was Florida. (Bush v. Gore! Don’t get me started.)

The court started out by rejecting the certified question! Finding itself unduly constrained by the charging order provision, the court asked whether “Florida law” requires the surrender of all membership rights. The majority noted the policy issue that co-member consent to transfer of governance rights was not called for in single-member LLCs. But that still left the clear statutory language. The court dealt with this by reasoning that applying the charging order provision would effectively abrogate the general execution statute which makes various types of property, including corporate stock, subject to attachment and execution. The LLC, said the court without any basis or citation, is “a type of corporate entity.” Anyway, the LLC statute, while specifying the charging order remedy, didn’t say explicitly that was the “exclusive” remedy (as it had in other uncorporate statutes). This gave the court enough of a hook to apply the general attachment statute.

Two of the seven justices dissented. They noted the unanimity of academic opinion in opposition to the majority approach, citing among others my article noted above, from which the dissenters drew a nice long quote. The dissenters also discussed, among other things, the obvious problem that the majority had usurped the legislature’s role stomping on the Florida LLC act; that by relying on non-exclusivity it had unsettled creditor remedies for all LLCs and not just the single-member ones they were worried about; that exclusivity is the only reasonable reading where the statute applies only one remedy; and that the court’s remedy could support transferring management rights even where the judgment is for less than the value of the interest.

The dissenters also suggested alternative approaches for dealing with smllcs that did less violence to the statutory language: dissolving the LLC when a charging order effectively emptied out the whole economic interest; or dealing with the problem in bankruptcy, where the whole economic interest is transferred to the bankruptcy estate whether or not it equals or exceeds a particular judgment.

Now it’s back in the legislature’s court – and not just Florida, since this opinion is likely to be cited under any of the many statutes that resemble Florida’s. One possible fix is to change the statute to provide that creditors are not restricted to charging orders in smllcs. That might not work completely because it invites using nominal members with very small governance interests. More drastically, legislatures also might remove the temptation for asset protection by reinstating the business purpose requirement for LLCs, or at least qualifying the use of the charging order for LLCs used primarily for protecting assets from creditors.

The important lesson here, as I first argued five years ago, is that legislatures need to understand the functions of particular business associations and stay true to those functions when legislating. In the case of smllcs, legislatures fell like lemmings for the single member variation without recognizing and adjusting for the violence it did to LLCs’ partnership model. (This may have been an example of the lawyers who advocated this shift leading a race to the bottom, but I’ll save that question for another day.) As I recently discussed in Rise of the Uncorporation, p. 186:

The basic problem is that business association statutes should not have allowed nonbusiness and one-member LLCs because the statutes were not designed for these situations. The charging order provisions exist to protect ongoing businesses with multiple members. Opening up the statutes to relationships that do not fit the rules of the business association rendered them incoherent. It should not be surprising that this led to unintended consequences. The result is the chaos engendered by Albright and now Olmstead, where neither creditors nor members of any LLCs can be sure what their rights are.

In other words, courts and lawyers need to start really understanding the nature and function of uncorporation statutes. They could start by reading the aforementioned book.

Larry Ribstein

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Professor of Law, University of Illinois College of Law

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  1. Creditors and SMLLCs. Olmstead v. FTC (Fla. 2010) « Unincorporated Business Entities Law - June 28, 2010

    [...] There has been extensive discussion of this on LNET-LLC, under the thread Olmstead Case Decided.  Prof. Larry Ribstein also discusses Olmstead on Truth on the Market. [...]