16 Jun The Six Paragraphs in Your LLC That Decide Whether a Lawsuit Reaches Your Business
I have seen this play out more than once. A business owner gets sued. Not the business. Him, personally. A car accident. The injured party’s attorney comes after everything: his personal bank accounts, his brokerage accounts, and his 50 percent interest in a company.
I remember one occasion where his business partner called me in a panic. “Can they take his share of the company? Can they force a sale? Can they become my partner?”
The answer to all three questions came down to six paragraphs in their operating agreement that neither of them had read since the day they signed it.
What is a Charging Order and Why it Matters to You
When a creditor wins a judgment against an LLC member personally, the creditor’s primary remedy in most states is something called a charging order. A charging order gives the creditor the right to receive any distributions that would otherwise go to the debtor-member. It does not give the creditor the right to vote, participate in management, force distributions, or become a member of the LLC.
In theory, this is powerful protection. The creditor gets a lien on distributions, but can’t touch the business itself. In practice, the protection is only as strong as the operating agreement that supports it.
Where the Operating Agreement Makes or Breaks You
If your operating agreement gives the managers discretion over distributions, a charging order creditor can be frozen out. The company simply stops making distributions, or makes them in non-cash form, or reinvests profits in the business. The creditor has a right to distributions that never come. This is the scenario that makes LLC asset protection genuinely powerful.
But if your operating agreement requires mandatory distributions, say, to cover tax obligations or to meet a minimum payout schedule, the creditor is guaranteed a stream of cash. The protection disappears. The operating agreement you signed for convenience just funded your creditor’s recovery.
Similarly, if your operating agreement allows members to freely transfer their interests, a creditor may argue that the charging order protection doesn’t apply, because the interest is freely transferable and should be treated like any other asset. Transfer restrictions in the operating agreement are not just about keeping unwanted partners out. They’re about keeping the charging order remedy as the exclusive creditor remedy.
The Foreclosure Risk in Some States
Not every state limits creditors to charging orders. Some states allow a creditor to foreclose on the debtor’s LLC interest entirely, effectively taking ownership. Some states provide strong charging order protection for multi-member LLCs but weaker protection for single-member LLCs. Other states have their own variations.
If your LLC is organized in a state with weak charging order protection, or if your operating agreement doesn’t contain the provisions needed to support the charging order defense, you may have less protection than you think. The legal structure of the entity matters, but the drafting of the operating agreement matters more.
Indemnification and Insurance Provisions
Beyond charging order protection, your operating agreement should contain clear indemnification provisions that protect members and managers from personal liability arising from company activities. If a manager makes a business decision in good faith that results in a loss, the operating agreement should specify that the company will indemnify the manager against claims and legal costs.
Without these provisions, a manager facing personal liability from a business dispute may not have any contractual right to have the company pay for their defense. I’ve seen situations where one member sues another, and the defending member’s legal fees come entirely out of pocket because the operating agreement was silent on indemnification. A two-paragraph clause could have prevented $200,000 in unreimbursed legal costs.
The Six Provisions Every Operating Agreement Needs
For lawsuit protection specifically, your operating agreement should contain these six elements: restrictions on the transfer of membership interests without consent; discretionary, not mandatory, distribution provisions; a clear statement that a creditor of a member is limited to a charging order as their exclusive remedy; indemnification of members and managers acting in good faith; a provision specifying the state law that governs the agreement, ideally a state with strong charging order protection; and a prohibition on any member voluntarily or involuntarily assigning their membership interest to a third party without the consent of the remaining members.
If your operating agreement doesn’t have all six, it has a gap. And gaps get expensive when someone files a lawsuit.
Would Your Operating Agreement Protect You in a Lawsuit?
For advisors: Have a client dealing with this? I do quick consult calls for advisors working through complex planning situations.
Schedule a call: https://lgarzalaw.com/schedule-online/
For business owners and families: At Garza Law, we are selective in choosing our clientele. We work with a select group of families every year to help them protect their legacy. If what you read here raised questions about your own situation, you can apply here: