New Utah Court Case Undermines Asset Protection Benefits of LLC
A common asset protection planning tool is the limited liability company (LLC). In many states, LLCs provide what is sometimes referred to as “front door” and “back door” liability protection. Front door liabilities arise from the conduct of the LLC. Creditors generally look to LLC assets first, such as liability insurance coverage and unencumbered assets. If LLC assets prove insufficient, creditors may try and seize the personal assets of the Members. If properly established and operated, the assets of the individual Members are shielded from the debts and liabilities of the LLC and cannot be attached.
Back door liabilities occur when a creditor has a judgment against a Member (Owner) of the LLC. In this situation, the creditor may wish to seize the ownership interest and potentially move through the back door and into the LLC and liquidate assets of the LLC to cover the debt. Many states limit a creditor’s right in these circumstances to a charging order. With a charging order, the creditor does not receive the voting and management rights of the LLC Member, only the right to distributions of profits, if any. The argument has always been that if the LLC is profitable but chooses not to distribute profits, the creditor will receive no money and could be liable for taxes on those undistributed profits making it undesirable to move down this path.
A recent 10th circuit court of appeals case originating in Utah has cast serious doubt on whether back door liability protection really exists. The long running case of Earthgrains Baking Co., v. Sycamore involves the efforts of Earthgrains Baking to collect on a multi-million dollar judgement against Leland Sycamore and the Sycamore Family Bakery. Leland Sycamore created “Grandma Sycamore's” which he sold to Metz Baking Company (“Metz”) in 1998. The sale encompassed all marks, goodwill, and trade secrets associated with Grandma Sycamore's, but Leland retained a limited license to sell the bread in several states—not including Utah. Metz merged into the Sara Lee Corporation (“Sara Lee”) and all rights under the agreement transferred to Sara Lee.
Leland contributed the money from the Grandma Sycamore's deal into Sycamore Family LLC, a Nevada LLC. The LLC's founding members were Leland, his wife Jeri, and their four children. Leland and Jeri each held 48% of the membership interests while the children received 1% a piece. The LLC's business operations were limited to holding and managing the family's assets, including a multimillion-dollar mansion in Provo, Utah.
In 2008, Leland bought a bakery, which became the Sycamore Family Bakery, by obtaining a $2,112,500 line of credit from Wells Fargo Bank. The LLC (not Leland) secured the line of credit by pledging the Sheffield Property as collateral. In exchange, Leland gave the LLC a promissory note for $2,112,500. Leland's new business soon breached the Sara Lee license by selling homemade bread products under the Sycamore name in Utah. Several cease-and-desist letters followed, nevertheless Leland persisted. In 2009, Sara Lee sued Leland and the Sycamore Family Bakery. EarthGrains subsequently acquired Sara Lee’s interest and thereafter stood in its shoes. In 2012, a jury awarded EarthGrains $2,333,129 in damages, $2,324,429 of which was attributed to Leland. The district court doubled the award against Leland. The district court also tripled the remaining damages attributed to the Sycamore Family Bakery—bringing the total damages award to $4,674,958, plus interest—and awarded EarthGrains $1,091,336.40 in attorney's fees.
Following two years of non-payment on the judgment, the district court rejected the application of Nevada law and entered a charging order against Leland’s 48% interest. The LLC made no distributions to Leland for another four years thereafter. The district court found the LLC in contempt of court and appointed a receiver to inventory the distributions proportionately owed to EarthGrains based on the distributions made to other LLC members after the entry of the charging order. Following submission of its report, the receiver asked the district court for permission to liquidate some of the LLC's assets to satisfy these distributions. The district court entered an order adopting the receiver's recommendations.
On appeal, the LLC argued that the district court exceeded its authority under the Utah Revised Uniform Limited Liability Company Act (“Utah LLC Act”). Relying on language in the Utah LLC Act that allows a court to “make all other orders necessary to give effect to the charging order” the 10th Circuit Court of Appeals upheld the decision of the district court. The Court of Appeals determined that “Utah law permitted the district court to require the LLC to liquidate its assets to afford the sum it owed EarthGrains based on actual and imputed distributions made since the charging order's entry.”
In writing about this decision, Jay Adkisson, a noted legal commentator, stated that in this case the “so called charging order protection has been eviscerated in a way that most creditor rights’ attorneys could only have dreamed about.” When it comes to asset protection, there is no such thing as a magic pill. It is a series of building blocks that gradually increase the protection, none of which are fool proof and none of which should be abused. Consideration should be given to the use of other vehicles, such as irrevocable trusts, in conjunction with LLCs of this nature. How this case is applied and extended going forward is still to be seen. But the playing field has, most definitely, changed.
This post is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.