Debunking the Myth of LLC Poison Pills

The celebrated psychologist Sy Kosis is sued for malpractice. After a trial, Sy’s patient has a $1 million uninsured judgment against him and then begins turning over every stone to find Dr. Kosis’ assets. It turns out that Sy owns a 25% interest in a LLC that owns an apartment building. Can the creditor grab Sy’s interest in the LLC?There are many reasons why individuals create business entities, among the most important being liability protection. Not only are the members protected from liability of the LLC, but the assets of the LLC are also protected from the creditors of the members. For the most part, the creditors of a member cannot attach the assets of the LLC to fulfill a judgment against that member individually. The judgment creditor’s remedy is generally limited to a charging order. That means that Sy’s LLC can be ordered to make distributions to Sy’s injured patient until the judgment is paid in full.

Charging orders provide a remedy by granting the creditor the right to distributions that would be paid to that member. However, the judgment creditor does not get management or voting rights in the LLC. Further, the creditor will only receive distributions if and when the manager of the LLC determines that it is in the best interest of the company to make a distribution. If the manager sees fit, he may decide to reinvest capital available for distribution instead of distributing it to the members (and the creditor).

In some jurisdictions, courts can order the charging order to be foreclosed, forcing the charged membership interest to be sold to the judgment creditor. Foreclosing on a charging order makes the judgment creditor the permanent owner of the economic right. The creditor may then sell the right to a third party. Alternatively, other jurisdictions, including Delaware and Nevada, have revised their statute to make charging orders the exclusive remedy of a judgment creditor of a member, thus preventing foreclosure of charging orders.

To avoid situations where a creditor forecloses and becomes a member, a LLC Operating Agreement can be prepared with a so-called “poison pill” provision, which permits the LLC to redeem (i.e., purchase) the charged LLC’s interest. In Sy’s LLC, suppose the Operating Agreement provides that when a membership interest is “charged” by a “charging order” the LLC can repurchase it for $1,000 or some nominal sum. California Corporations Code Section 17100(c) makes any such provision enforceable in most instances.

Theoretically, a “poison pill” provision may sound appealing. However, in practical situations it does very little for the member whose interest is charged. Only the remaining members benefit. The remaining members get to pick up Sy’s interest for a bargain purchase price, and they do not have to be in business with Sy’s patient. Talk about taking advantage of someone else’s adversity! But look at poor Sy – he still owes his debt to the extent that the predetermined purchase price for his membership interest does not satisfy the debt. In other words, after the LLC redeems Sy’s membership interest for $1,000, Sy’s creditor will still pursue him for the remaining $999,000.

While Sy still faces the judgment creditor, the remaining members of the LLC have benefited by purchasing Sy’s interest for $1,000! Why in the world would Sy be happy about that? Most writers explain that LLC members would be willing to enter into such an arrangement in a family situation where the remaining members are agreeing to “take care” of the member whose interest is purchased at a bargain price. First of all, that means that some degree of fraud is occurring, but even overlooking the likelihood of a creditor figuring out the plan and overturning it, what happens to Sy if the other members change their mind about “taking care” of him? Or what if they file bankruptcy, get divorced, or die? Would the heirs of the other members be willing to “take care” of Sy? Not so much.

Single member LLCs are often given a bad name, because with only one member, a “poison pill” provision can’t be added to a Operating Agreement. In other words, there’s no other members to purchase the interest of a member who faces a charging order. However, as the “poison pill” provision is by and large a myth of asset protection, single member LLCs should be formed without hesitation. See, Do Single Member LLC Provide Limited Liability Protection?