Banking and Finance Law Report : Banking & Finance Lawyer & Attorney : Porter Wright Morris & Arthur Law Firm : Bankruptcy, Commercial Lending

This article is Part Two in a seven-part series on how to structure sales and what to do when your customer fails to pay. You can find Part One of this series here: Structuring Sales to Ensure Payment. Please subscribe to this blog by entering your email in the box on the left, or check back weekly for additional articles in the series. 

With the recent economic slowdown in many sectors and the parade of corrupt corporate executives on the evening news, corporate managers are more sensitive than ever to signs of troubled business practices and how those practices affect outstanding receivables.  Many distressed businesses display early warning signs of impending trouble, including some or all of the following:

• Lack of a sound business plan- The company may not have a plan or may have expanded past the vision of it original business plan.

• Ineffective management style- The management of a small company that has experienced rapid growth may not be able to delegate authority effectively. 

• Poor lender/vendor relationships- The company may not respond quickly or fully to its vendor’s request for financial information or may actively hide information from its vendors.

• Change in market conditions- The market for the company’s product may have changed, leaving the company with a shrinking market share and lower sales. The company’s technology or marketing may be obsolete to compete in the current marketplace (remember 8-track tapes?).

• Over-diversification of products- The company may enter non-traditional markets too quickly in an effort to increase flagging sales but without the necessary resources or knowledge to compete successfully in the new market.

• Geographic expansion- The company expands its footprint too quickly, straining managerial and financial resources. These signs should alert the vendor that the company may be a candidate for default on existing obligations.  The prudent vendor should heed these signs and take immediate action to protect its interests in the event the company defaults on its obligations or seeks protection from its creditors under the Bankruptcy Code.  Consider shortening payment terms, going to credit card payment or cash on delivery, a consignment sale format or taking a security interest in the customer's assets of obtaining a guaranty from a financially reliable insider.

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Substitute House Bill 48, an amendment to Ohio's Limited Liability Company Act, discussed in our December 9, 2011 post, Charging Order Protections for Multi-Member and Single-Member LLCs (SMLLCs), has been passed by the Ohio General Assembly and signed into law by Governor Kasich. This act amends ORC 1705.19 to expressly provide that a charging order is the "sole and exclusive remedy" of a creditor seeking to satisfy judgment against the LLC membership interest of a debtor and to prohibit any creditor of a member of an LLC from having any right to obtain possession of, or to exercise legal or equitable remedies with respect to, the property of the LLC. It also specifically limits the rights of a judgment creditor who has obtained a charging order against a debtor's membership interests to those of an assignee of a membership interest, as laid out in ORC 1705.18. The amendment will become effective May 4, 2012.

The act contains no exception for SMLLCs and makes a charging order a judgment creditor's exclusive remedy to reach the membership interests of its debtor. Because of this, it is likely that Ohio courts will interpret the statute to provide SMLLCs with the same charging order protections as multi-member LLCs, leaving creditors unable to recover judgments by forcing the sale of their debtors' SMLLC assets and distributing proceeds.

Bankers should take necessary precautions to avoid relying on unreachable assets of the debtor's SMLLC as security for the credit they extend. In most cases, the straight-forward solution is prepare loan documentation reflecting the SMLLC as a borrower.

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In the course of their business, bankers routinely encounter single member limited liability companies ("SMLLCs"), entities commonly used in real estate and small businesses. Despite the prevalence of SMLLCs, there is a fundamental legal uncertainty as to whether the assets of an SMLLC share the same level of protection from its member's creditors as is provided to the assets of a multi-member LLC through the charging order remedy.

Depending on state law, bankers may or may not be able to reach the assets of their debtors' SMLLCs through a charging order. Furthermore, changes to Ohio law have recently been discussed in the Ohio Legislature which attempt to remove any uncertainty and would prevent bankers and other creditors from reaching assets of a SMLLC through a charging order.

The following analysis discusses recent case law from around the country examining a judgment creditor's ability to reach the assets of an SMLLC in which its debtor holds the sole membership interest. The LLC charging order is a remedy through which a creditor who has won a judgment may reach its debtor's membership interest in an LLC. State LLC statutes generally require the unanimous consent of all members (other than the assigning member) in order for the assignee of an LLC membership interest, such as a creditor who has attached its debtor's membership interest, to participate "as a member" in the management of the LLC. To protect this approval right of the other members in a multi-member LLC, a charging order entitles a creditor only to the debtor's share of distributions and assets upon dissolution, and not to the right to participate in the management of the LLC. This prevents the judgment creditor from selling the LLC's assets and distributing the proceeds to itself.

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