Your partner’s creditor - by Thomas Kearns

The law recognizes that people will go into a business with certain people and not others. This is called the “pick your partner” rule. Generally, the law will not permit a stranger to enter into an existing partnership unless the other partners consent or there is a prior agreement allowing the stranger to join. This remains the general rule in modern LLC law—unless there is an agreement to the contrary. A member in an LLC can only assign its economic interest, and not its full membership interest, to a stranger to the other members of the LLC.

A recent court opinion, however, highlights that in certain circumstances a court will order a member in an LLC who is in debt to a creditor to turn over its full ownership of the member’s LLC interest to the member’s creditor. The Appellate Division in 79 Madison LLC v. Ebrahinzadeh ruled, in the context of a single member LLC, that the creditor could take actual ownership of the LLC interest. Traditionally, creditors have been entitled only to a “charging order” meaning that the creditor would be limited to only the distributions related to the interest but not actual ownership. Since the 79 Madison case involved a single member LLC, the issue of the role of the creditor (and now new member) in management and the LLC’s voting provisions was not addressed.

The best way to protect yourself from having to deal with a creditor as a new partner in these circumstances is to have a robust written LLC agreement in place before the trouble starts. The LLC agreement can give the other LLC members a right to purchase the debtor/member’s interest in the LLC in the event of an involuntary transfer like the transfer ordered by the 79 Madison court. These clauses often permit the other members to purchase the involuntarily transferred interest at a discount to make up for the aggravation and distraction involved.

Another possibility is to make sure that the LLC agreement expressly limits the uninvited creditors so that they have no say in management of the business, no right to inspect books and records other than basic financial statements, and no vote on LLC matters. One advantage of modern LLC law is the flexibility that it gives businesspeople. The downside of LLCs is that many key issues need to be addressed in the LLC agreement itself, which many businesspeople would prefer not to be troubled by, particularly in the early, honeymoon stage of the business.

The 79 Madison case is a reminder that attention should be paid to the governing LLC agreements at the outset of the business and that all LLC agreements should be periodically reviewed to update them to address changes in the LLC statute and case law.

Thomas Kearns is a partner with Olshan Frome Wolosky LLP, New York, N.Y