Many LLC operating agreements contain transfer restrictions on LLC member interests. Those restrictions sometimes include the LLC’s right to repurchase the interest if a member makes a transfer in violation of the operating agreement. What’s the result if such a repurchase right applies to a transfer resulting from the foreclosure of a charging order by a member’s judgment creditor? The South Carolina Supreme Court earlier this month ruled that a foreclosure sale was valid and trumped the operating agreement’s repurchase right, and that the repurchase right could not be enforced. Levy v. Carolinian, LLC, No. 27442, 2014 WL 4347503 (S.C. Sept. 3, 2014).
Background. Shaul and Meir Levy obtained a $2.5 million judgment against Bhupendra Patel, a member of Carolinian, LLC, a South Carolina LLC. The Levys later obtained a charging order against Patel’s interest in the LLC, and subsequently foreclosed the lien of the charging order.
Following the foreclosure sale, the LLC asserted that it was entitled under the operating agreement to purchase Patel’s interest from the Levys. Section 11.1 barred the members from voluntarily or involuntarily selling, transferring, or otherwise conveying their interest without a two-thirds vote of the other members, and declared that any attempted conveyance of a member’s interest without the requisite consent would be null and void. Section 11.2 provided for the repurchase: “If a Member attempts to transfer all of a portion of his Membership Share without obtaining the other Members’ consent as required in Section 11.1, … such Member is deemed to have offered to the Company all of his Member Share….” Id. at *2.
The LLC contended that because Patel’s interest was conveyed without the members’ consent, the Levys were deemed to have offered their interest to the LLC and it was entitled to purchase the interest. The Levys objected that they were not parties to the operating agreement and were not required to obtain any consent to foreclose their statutory charging order.
The Levys filed suit for a declaratory judgment that they were the rightful owners of Patel’s interest. The trial court found that as transferees the Levys became subject to Article 11 of the operating agreement, and that the LLC could therefore force the Levys to sell Patel’s interest to the LLC. Id.
Supreme Court. The court began by reviewing the South Carolina LLC Act, S.C. Code Ann. § 33-44-101 to -1208 (the Act). The Act provides at Section 504 that:
The court pointed out that while an LLC is generally free to modify the default provisions of the Act by its operating agreement, the agreement may not restrict the rights of a person “other than a manager, member, and transferee of a member’s distributional interest.” Levy, 2014 WL 4347503, at *3 (quoting S.C. Code Ann. § 33-44-103(b)).
But, said the court, the Levys did not become transferees until after the foreclosure sale, so the LLC’s operating agreement could not restrict their rights by requiring consent of the members before the foreclosure sale. At that time the Levys were merely judgment creditors. The LLC could not invoke the purchase right under Section 11.2 after the foreclosure, because that right was only applicable where consent was not obtained prior to the transfer. The Supreme Court accordingly reversed the trial court: “[W]e further find that Carolinian may not now invoke the provisions of Article 11 to compel the Levys to sell the distributional interest they acquired through the foreclosure sale.” Id. at *4.
Comment. Levy is not about an attempt to avoid a charging order or an attempt to prevent foreclosure of a charging order, and it’s not a dispute about a pre‑foreclosure redemption. (The operating agreement and the Act both allowed redemption of a member’s interest that is subject to a charging order, but the LLC was unwilling or unable to redeem Patel’s interest prior to the foreclosure.) Levy is about an attempt by an LLC to require in its operating agreement that unwanted acquirors of a member’s interest, on demand by the LLC, must sell back the interest to the LLC (presumably at a fair price, although the opinion never mentions the price that Article 11 apparently describes).
The operating agreement’s buyback is an aspect of the “pick your partner” principle – the idea that, like partners in a partnership, members in an LLC should not be forced to associate and do business with another member they don’t know and don’t want to be associated with. This principle is embodied in the distinction between an LLC member, who will have voting and management rights as well as economic rights, and an assignee (also called a “transferee”) that has only economic rights unless admitted as a member. Consistent with this principle, most LLC statutes only allow an assignee to be admitted as a member on the unanimous vote of the members, or as otherwise allowed by the operating agreement. E.g., S.C. Code Ann. § 33-44-503.
Of course the buyback provision of the Carolinian operating agreement goes further than merely keeping the purchaser at the foreclosure sale out of management. Buying back the purchaser’s interest completely ousts the purchaser from the LLC, so it would not even have economic rights, let alone management rights.
The court’s analysis, however, focused in a literalistic way on the language of the operating agreement. The court’s analysis ran as follows: the Levys did not become transferees until after the foreclosure, consent for the sale was required by the operating agreement before the foreclosure, and therefore the Levys were not bound by the need for consent. But a transferee of a member’s interest takes no less and no more than the economic rights of the transferor. If the transferor’s LLC interest was subject to a repurchase right under certain circumstances before the transfer, then it would continue to be subject to the repurchase right after the transfer. The court ignored this basic principle of property rights. The repurchase right did not affect the rights of a third party; it applied to a transferee, the purchaser at the foreclosure sale.