Asset Protection: Is Your LLC Creditor-Protected?

Background

In the recent case of Golfwood Square, LLC v. O’Malley, 2018 WL 4370875 (Ill.App., Unpublished, Sept. 11, 2018), the Appellate Court of Illinois held that a creditor could reach assets of a subsidiary LLC to satisfy debts of its parent company’s owner. This is an important case to review in evaluating how to operate an LLC to obtain creditor protection. In many ways, this case can be seen as an example of what not to do.

Facts

In 2012, Golfwood Square, LLC obtained a judgment against Michael O’Malley (“O’Malley”) in the amount of $915,000.  Golfwood Square, LLC obtained a 2013 charging order against O’Malley’s interests in Shefield Street Group, LLC (“SSG”), allowing Golfwood Square, LLC a right to receive any distributions from SSG which otherwise would be payable to O’Malley (at all times, O’Malley owned 100% of SSG). Generally, a creditor receiving a charging order has only the right to distributions payable to its debtor. The creditor cannot compel a distribution or exercise any management rights over the entity. Rather, the creditor merely is required to sit back and wait until any distributions are actually made, if at all, to the debtor. This case shows that creditors, in certain circumstances, may be able to receive more than typically available under a charging order.

The sole asset of SSG was a 90% interest in 3 Squared, LLC (“3 Squared”) which initially owned a condominium in Chicago. The other 10% of 3 Squared was owned by O’Malley’s business manager. In 2014, 3 Squared sold the Chicago condo and received approximately $224,000 net of the remaining mortgage.

After this sale, in addition to certain other expenditures, 3 Squared used the $224,000 as follows:

  • $22,000 to the 10% member;
  • $13,500 to pay for legal services rendered in 2015, apparently for O’Malley’s other business entities;
  • $10,500 to repay a loan owed by an entity owned by O’Malley’s girlfriend to repay loans it owed;
  • $20,658.43 to pay American Express bills incurred by another O’Malley entity; and
  • $1,500 to pay tax obligations of another of O’Malley’s entities.

3 Squared was left with approximately $144,000. In 2017, Golfwood Square, LLC sought to require this remaining amount be paid to it in satisfaction of the judgment against O’Malley. The legal basis for this request relied upon Illinois statutory law which allows the court to “make all other orders necessary to give effect to the charging order.” 1 The court ruled in favor of Golfwood Square, LLC and was affirmed by the Illinois Appellate Court.

Analysis

Mentioned in the Court’s opinion are a number of relevant facts:

  • 3 Squared’s operating agreement stated that, after sale of “the asset of the Company,” the LLC would be dissolved and the net proceeds, after payment of liabilities, to the members;
  • O’Malley testified that 3 Squared had “no direct liabilities” and, once the condo was sold, “3 Squared basically doesn’t exist any longer;”
  • O’Malley admitted having “unfettered access” to 3 Squared’s account;
  • SSG has no operating agreement, no employees and does not operate any business. O’Malley admitted that “on a daily basis [SSG] doesn’t do anything;”
  • Although O’Malley owned no direct interest in 3 Squared, his business manager obtained her 10% in 3 Squared via an assignment from O’Malley rather than SSG; and
  • 3 Squared’s 2014 tax return showed that it distributed the sale proceeds directly to O’Malley.

Although there were legal arguments about whether this case was properly a veil piercing case versus a case under Illinois charging order statutes,  the facts appear to have ultimately controlled the outcome. It seems quite likely that in states without a statute corresponding to the relevant Illinois statute, courts likely would reach the same result on similar facts. In essence, this could have been a veil piercing case.

Clearly, O’Malley did not operate his entities in a way which would have given any credibility to the legitimacy of his right to limit Golfwood Square, LLC under a charging order. O’Malley caused 3 Squared to pay off the 10% member, then used the remaining funds to make payments for his personal benefit. Tax returns substantiated this result. In addition, SSG had no business purpose, had no operating agreement, and did nothing. It was clear that, as argued by Golfwood Square, LLC, O’Malley used 3 Squared as “his personal piggy bank.” The Court agreed and affirmed the trial court’s order compelling O’Malley to turn over all remaining funds in 3 Squared to Golfwood Square, LLC.

There seem to be a number of steps O’Malley could have taken to protect the value of charging order protection. Some of those include, but are not necessarily limited to:

  • Follow formalities of SSG by, for example: (1) having a written operating agreement; (2) distributing funds not directly from 3 Squared to O’Malley, but through SSG; and (3) assigning interests in 3 Squared to O’Malley’s business manager from SSG rather than O’Malley, individually;
  • Engage in some formal business activity in SSG other than merely holding interests in 3 Squared or, at least, document an intention to reinvest proceeds from the condo sale into another investment under SSG or 3 Squared;
  • Have employees paid through SSG. O’Malley had a business manager, whom he gave interests in 3 Squared; and 2
  • Document the payments made for O’Malley’s benefit from 3 Squared as bona fide loans by properly reflecting the disbursements as loans on the books of 3 Squared or SSG, prepare written promissory notes, make periodic payments on the loans, etc.

Conclusion

There is no way to know what combination of the steps above, or other steps, would have changed the outcome of the case. Of course, the primary step O’Malley could have taken would be to avoid using an LLC account to pay personal expenses. However, since the Court specifically pointed out the non-existence of many of these items, it seems reasonable to conclude that the Court would have found differently if some of these items had been present.

This case should serve as an example of what not to do. LLC’s can be great asset protection vehicles, preserving investment assets from the claims of creditors. Under the law of many states, creditors generally are limited to a charging order against an LLC member’s interests which allows the creditor only to receive any distributions to the member, but not to require distributions or manage the entity. However, when LLC formalities are not followed, when the LLC is treated like the member’s back pocket, when the terms of operating agreements are not followed, etc., that creditor protection is compromised. It simply is not enough to form an LLC. Proper operation of the entity is critical to preserving asset protection.

S. Gray Edmondson, J.D., LL.M.

Gray practices in the areas of tax, business, and estate planning. View Full Profile.

Footnotes

  1. See 805 ILCS 180/30-20(b)(2)
  2. Could some or all of that business manager’s compensation have come from SSG?