New Jersey LLC Statute Limits Creditors Rights

A recent amendment to New Jersey’s limited liability company law changes the rights of creditors seeking to collect a judgment from a member of a limited liability company, eliminating the creditor’s right to foreclose the member’s interest.

Foreclosure of LLC Member Interests Eliminated

This particular aspect of the Revised Uniform Limited Liability Company Act (RULLC) is one of the more controversial provisions of the newly enacted statute because it eliminated a key asset protection aspect of LLCs.  Under the prior statute, a creditor’s right was limited to a “charging order.”  The amendment to the statute simply restores the prior law.

Under most state limited liability company statutes, a creditor has the right obtain a charging order that provides that when an LLC distributes money to its members, the debtors share goes to the party holding the charging order.  It only works if any money is actually distributed to the members.

The RULLC was based on a model act devised by the Uniform Law Commission and contained a provision that allowed judgment debtors to foreclose an interest under certain circumstances.  What that meant was that if the judgment creditor was being paid, it had a right to seek a foreclosure of the interest, meaning that it would be sold at a judicial auction.

New Jersey Amends RULLC

The Uniform Law Commission proposes uniform acts for adoption by the states in various areas in an attempt to promote uniformity among the states.  There are dozens of uniform acts, ranging from the almost universally adopted Uniform Commercial Code to laws from adoptions to wage withholdings.  The RULLC has been slow to gain acceptance in individual states, and one of the reasons was this particular provision permitting the foreclosure of an interest.

Careful drafting of an operating agreement for an LLC can make life very difficult for creditors of the individual members.  A charging order gives the creditor no rights other than to receive the debtor’s distributions when they are made – and if they are made.  And there is the rub as far as creditors are concerned.  They fall into the class of interest holders known as transferees – people or entities that have a right to receive distributions payable to an individual member – but which have no rights in the management of the company whatsoever.

The statute as revised, N.J.S.A. 42:2C-43, provides that a judgment creditor may “charge the transferable interest of the member with payment of the unsatisfied amount of the judgment with interest” and that such an order is “the sole remedy of the judgment creditor.”  It goes on to state that the creditor has not right to interfere with the management, force dissolution or seek to foreclose the interest.

Charging Order is Creditor’s Sole Remedy

Some operating agreements contain provisions that terminate distributions if a charging order is entered against a member.  In addition, because the creditor with a charging order has no rights, there is no legal obstacle to amending the operating agreement to make the interest worthless.

Not that the judicial sale of a member’s interest would necessarily have improved the situation.  Whoever purchased that interest at the sale of a foreclosed interest would have been in the same weak position.  But the idea was that the creditor could convert that interest in a cash payment.

The underlying concept behind ownership of a limited liability company is that no one should become an owner unless all of the other members agree.  This concept, borrowed from partnership law, makes the interest in a limited liability company personal to the member.  The law is that a membership interest cannot be transferred, only the economic benefit.

This is one of the principal areas in which LLCs and partnerships differ from corporations.  In a corporation, it is presumed that shares can be transferred because no management rights are associated with one’s status as a shareholder.  Restrictions on transfer that are common in closely held corporations are put in place through agreements between the shareholders.

In a limited liability company, only the economic interest can be transferred without the approval of the other members (unless they have specifically made an agreement to the contrary.)  And the RULLC is very specific when it comes to the rights – or lack of rights – that transferees or assignees have in a limited liability company.   There is not only no right to participate in management, but generally no right to receive any information about the business and no duties are owned to the transferees.

Asset Protection for LLC Members

The real value of the asset protection available in the LLC form seems to lie in the case of single member LLCs.  The foreclosure of the interest of a single member would be a powerful tool to collect a debt against the sole owner of a limited liability company.  There have been cases in other states in which the members have been forced to make capital contributions or have lost control of the LLC because they no longer retained an economic interest in the entity.

Using the limited liability company as an asset protection tool is no assurance that the judgment creditor of an individual member can never reach their interest in an LLC, but collecting against that interest is at best difficult.  Careful drafting may not make it impossible to collect a debt by pursuing an individual LLC member’s interest in the business, but it can make it a formidable task and ultimately put the LLC member is a much stronger position.