LLC Charging Order Protection Against Creditor Causes Debtor to Lose Even More Money: How Can That Be?

In the recent case of Garcia v. Garcia, the guarantor of a loan (Morris) is sued by the bank to honor his guarantee obligation of about $1.5 million. The debtor was not able to pay under the guarantee, so the bank obtained a charging order against the debtor member’s 50% LLC interest. The bank wanted access to the funds in that LLC, but the third-party manager of the LLC refused to pay any distribution to the debtor member. As a result, the debtor member filed Chapter 7 bankruptcy. Under California law, since the bank was not going to be able to have the guarantee obligation honored by the debtor, the bank was able to foreclose on its charging order. This means the bank became the replacement economic owner of the debtor’s 50% LLC membership interest in the LLC. This makes the bank an “assignee” of the LLC, which entitles the bank to 50% of the profits and distributions of the LLC.

Even though the bankruptcy succeeded in having the debtor’s financial obligations discharged, it did not erase the assignee status held by the bank with respect to the LLC. The LLC’s manager eventually sold LLC assets and liquidated the LLC, which entitled the bank to millions in liquidation proceeds. The bank is happy since that amount exceeded what the debtor otherwise owed the bank. The bank therefore profited from the LLC’s accumulated asset value and the debtor was never able to share in such value.

It is yet undetermined whether the debtor has a cause of action against the manager of the LLC, but this matter is a very interesting case in light of the common perception that an LLC’s charging order protections only help debtors.

Is there a takeaway from this? An offshore LLC could have been used, which can add extra asset protection because charging orders being foreclosed upon are not recognized under the LLC laws of numerous offshore jurisdictions. Consequently, an offshore manager likely would not have distributed liquidation proceeds to a creditor-bank assignee. This could have prevented the bank from profiting off of the LLC, especially if the LLC funds were not held in the form of US situs property or US financial accounts.

Cite: Garcia v. Garcia, 2018 WL 2316522 (Cal.App. Distr. 5, Unpublished, May 22, 2018)