CHARGING ORDERS IN BUSINESS TRANSACTIONS First Run Broadcast: August 9, 2016 Live Replay: January 3, 2017 1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) A charging order is an order to an LLC or partnership to pay any distributions payable to an LLC member or partner instead to his or her creditor until a debt is satisfied. Charging orders are frequently used when an LLC member or partner has pledged his or her interest to a creditor and is in default of the loan. They differ substantially from liens on corporate stock because charging orders do not allow the creditor to foreclose on the LLC or partnership interest, only to claim distributions from the entity. The creditor does not succeed to any other rights of the LLC member voting, management, information and is totally dependent on the entity to make decide to make distributions. This program will provide you with a real-world guide to the uses and limitations of charging orders in transactions and tips on enhancing their effectiveness. Use and limitations of charging orders in business transactions Differences in rights of a creditor of a corporate shareholder v. the rights of a creditor of a partner/llc member What does a creditor get with a charging order and what rights does the debtor retain? Tax consequences of charging orders Recent cases involving charging orders bankruptcy, asset protection, single-member LLCs Charging orders and the race to the bottom Enforcement of one state s charging order statute in another state What can be done to enhance effectiveness of charging orders? Speaker: Allen Sparkman is a partner in the Houston and Denver offices of Sparkman Foote, LLP. He has practiced law for over forty years in the areas of estate, tax, business, insurance, asset protection, and charitable giving. He has written and lectured extensively on choice-of-entity, charitable giving and estate planning topics. He is the Colorado reporter for the books "State Limited Partnership Laws" and "State Limited Liability Company Laws," both published by Aspen Law & Business. He has also served as president of the Rocky Mountain Estate Planning Council. Mr. Sparkman received his A.B. with honors from Princeton University and his J.D. with high honors from the University of Texas School of Law.
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CHARGING ORDERS A RECONSIDERATION* Allen Sparkman Sparkman + Foote LLP 4800 Post Oak Blvd., Suite 4100 Houston, TX 77506 713.401.2922 (office) 713.859.7957 (mobile) sparkman@sparkmanfoote.com Society expects accountability in many areas. Creditors expect that people who owe them money will be accountable for their debts. A person who is injured by another person s negligence or misconduct expects the other person to be accountable. Persons who seek professional advice whether medical, legal, accounting, or other expect to receive competent advice tailored to their particular problem and that the professional advisor will stand behind his or her advice. Often, if not in most cases, the owners, customers, and suppliers of businesses expect the people who are managing the business to be accountable for managing the business well. Despite these understandable expectations, changes in the law in the last several years with respect to a creditor s ability to reach a debtor s interest in a partnership or limited liability company have made accountability ephemeral or non-existent in many cases. This article takes the position that charging order statutes should be substantially modified to provide more real relief to creditors. This article considers outright repeal but, as discussed below, if charging order statutes were repealed and nothing more were done, creditors might be no better off. 1 A creditor who has an unsatisfied judgment against a member or partner faces a very different situation than a creditor who has an unsatisfied judgment against a corporate shareholder. Generally, 2 subject to shareholder agreements, a judgment creditor may foreclose *The author thanks Jay Adkisson and Professor Dan Kleinberg for their comments on a draft of this article. Any mistakes are the author s. 1 See infra, notes 10-12 and accompanying text. 2 As discussed infra, notes 40-42 and accompanying text, Nevada has extended its charging order provisions to include certain corporations. 1
on corporate stock, and a purchaser of the stock at a foreclosure sale obtains all rights with respect to the stock voting, information rights, and rights to any dividends declared and paid. In the case of a partnership or LLC, foreclosure is not available as an initial remedy of a creditor who has an unsatisfied judgement against a partner or member. Every LLC, partnership, or limited partnership statute provides, however, that a creditor of a member or partner may obtain a charging order against the member s or partner s interest. A charging order is an order to the LLC or partnership to pay any distributions that would otherwise be payable to the debtor member to be paid to the creditor until the creditor s debt is satisfied. Even after a charging order is obtained, the creditor may not be able to foreclose on the charged interest even if distributions under the charging order prove to be inadequate to make the creditor whole. Disalvo Properties, LLC v. Bluff View Commercial, LLC 3 held that foreclosure was not available to the holder of a charging order issued against a membership interest of a Missouri LLC because foreclosure is not authorized by the Missouri LLC statute. The court s holding was influenced by the silence of the Missouri LLC statute with respect to foreclosure compared to the Missouri limited partnership statute, which does authorize foreclosure. As discussed below, 4 some states, including Delaware, Nevada, and Wyoming, have amended their LLC charging order statutes to prohibit foreclosure. The charging order originated in Section 23 of the English Partnership Act of 1890 and was intended to protect the partnership business from disruption by creditors of an individual partner. 5 As to the situation that prevailed before the development of the charging order, commentators have noted: When a creditor of a partner took action against partnership assets, the result was often chaos: When a creditor obtained a judgment against one partner and he wanted to obtain the benefit of that judgment against the share of that partner in the firm, the first thing was to issue [a writ of execution], and the sheriff went down to the partnership place of business, seized everything, stopped the business, drove the solvent partners wild, and caused the execution creditor to bring an action in Chancery to take an account and pay over what was due by the execution debtor. A more clumsy method of proceeding could hardly have grown 3 2015 WL 3759402 (Mo. App. June 16, 2015. 4 Infra, notes 33-42 and accompanying text. 5 Daniel S. Kleinberger, Carter G. Bishop, and Thomas Earl Geu, Charging Orders and the New Uniform Limited Partnership Act Dispelling Rumors of Disaster, 2004 Prob. & Prop. 30 (July/August 2004) 1. 2
up. Brown, Janson & Co. v. A. Hutchinson & Co., 1 Q.B. 737 (Eng. C.A. 1895) (Lindley, J.). 6 Law v. Zemp 7 provides a good overview of the development of charging orders. The court cites commentary discussing Brown, Janson & Co. v. Hutchinson & Co. as well as other judicially crafted remedies that included: (1) seizure of some or all of the partnership property under writ of execution; (2) sale of the debtor partner's interest in the property; (3) acquisition of the debtor partner's interest in the property by the purchaser at the execution sale, subject, however, to the payment of partnership debts and prior claims to the firm against the debtor partner; (4) compulsory dissolution and winding up of the partnership, and (5) distribution to the execution purchaser of the debtor partner's share of any property remaining after the winding up process was completed. 8 The court further noted that in the end, the main consequence of such remedies was a devaluation of all of the partnership interests, including those from which the judgment creditor initially hoped to collect. 9 If the charging order regime was not in effect, the problem noted in the quote would not arise under modern partnership and LLC statutes. A partner s or member s interest is defined as personal property, 10 and the partner or member has no ownership interest in the assets of the partnership or LLC. 11 Accordingly, one policy question that should be addressed is whether all charging order statutes should be repealed. If that were to happen, a creditor who obtains a judgment against a partner or member presumably would be able under the generally applicable civil remedies laws to levy on the partner s or member s interest and have it sold. Whether this would be more attractive to creditors is open to question because, 6 Id. at 2. 7 P.3d, 278 Or. App. 852 (2016). 8 278 Or. App. at 857, citing J. Gordon Gose, The Charging Order Under the Uniform Partnership Act, 28 Wash. L. Rev. 1, 2 (1953). 9 Id. 10 Revised Uniform Partnership Act ( RUPA ) 502; RUPA is available at www.uniformlaws.org/shared/docs/partnership/upa_final_97.pdf. Revised Uniform Limited Liability Company Act ( RULLCA ) 501. RULLCA is available at www.uniformlaws.org/shared/docs/limited%20liability%20company/ullca_final_06rev.pdf. 11 RUPA 203; Revised Uniform Limited Partnership Act ( RULPA ) 701. RULPA is available at www.uniformlaws.org/shared/docs/limited%partnership/ulpa7685.pdf. RULLCA does not contain a provision stating that a member has no ownership interest in the assets of the LLC. A comment to RULLCA 501 states: This Act does not include ULLCA 501(a), which provided: A member is not a co-owner of, and has no transferable interest in, property of a limited liability company. That language was a vestige of the aggregate notion of the law of general partnerships, and in a modern LLC statute would be at least surplusage and perhaps confusing as well. 3
under all partnership and LLC statutes, the purchaser of the interest would be only an assignee unless admitted as a partner or member. As an assignee, the purchaser would have no right to vote, no rights to information, 12 and would be entitled to receive distributions only when the governing persons of the partnership or LLC decide to make them. Accordingly, the purchase price of an interest sold at a foreclosure sale likely would be significantly depressed. Creditors often find charging orders to be cold comfort. In general a charging order is unattractive to creditors. It makes the creditor holding the charging order dependent entirely on whether the partnership or LLC makes any distributions. There is no guarantee that the partnership or LLC will ever make distributions, and as an assignee or transferee, the holder of the charging order (even after foreclosure) has no right to obtain information about the partnership or LLC, or to require the payment of distributions. Even while starving a creditor, the partnership or LLC can probably find means other than distributions for compensating the judgment debtor and other partners or members. A 2002 case from North Carolina demonstrates the very limited usefulness of a charging order to a creditor. 13 A bank obtained a judgment against a debtor (Keasler) and (through an assignee) attempted to execute on Keasler s LLC interests. The court denied the request for 12 RUPA 503(a)(3); a transferee under RUPA does have the right to seek a judicial determination that it is equitable to windup the partnership, 503(b)(3), and in a dissolution and winding up, a transferee is entitled to an account of partnership transactions only from the date of the latest account agreed to by all of the partners. 503(c); RULPA 702(a)(3) with exceptions substantially the same as in RUPA. 702(c); RULLCA 502(a)(3); in a dissolution and winding up, a transferee has a right to an accounting of the company s transactions only from the date of dissolution. 502(c). Texas is an outlier in that its LLC statute provides information rights to assignees. TEX. BUS. ORG. CODE 101.109(a)(3), (4). Some statutes also provide information rights to assignees who are the personal representative of a deceased member. RULLCA 401(e) states: A member or dissociated member may exercise rights under this section through an agent or, in the case of an individual under legal disability, a legal representative. Several state statutes provide similarly. For example, TEX. BUS. ORG. CODE 153.113 states that the executor, administrator, guardian, conservator, or other legal representative of a deceased or incapacitated limited partner may exercise all of the limited partner s rights and powers to settle the limited partner s estate or administer the limited partner s property. The Colorado limited partnership statute, the Delaware limited liability company statute, and the Delaware limited partnership statute have a similar rule. C.R.S. 7-62-705(1); DEL. CODE ANN., tit. 6, 17-705 (limited partnerships), 18-705 (limited liability companies). TEX. BUS. ORG. CODE 152.213(a) provides that on request and to the extent just and reasonable, each partner and the partnership shall furnish complete and accurate information concerning the partnership to the legal representative of a deceased partner or a partner who has a legal disability or to an assignee. Except for the Texas provision extending this information right to assignees, Colorado and Delaware provide similarly. C.R.S. 7-64-403(3); DEL. CODE. ANN., tit. 6, 15-403(a). 13 Herring v. Keasler, 563 S.E.2d 614 (N.C. App. 2002). 4
seizure and sale of the LLC interest, but granted the assignee a charging order that provided that the LLC must deliver to the assignee any distributions and allocations Keasler would be entitled to receive on account of his membership interest, but that the creditor-assignee would not obtain any rights in the LLC except as an assignee without the ability to require any distributions or satisfaction of the judgment. After the North Carolina Court of Appeals decision, the assignee s counsel observed: The bad thing about having a charging order is that, at most, you get your principal and your interest but only if the LLC works out until your judgment is paid. The charging order is worth less than selling the interest because you bear all the risk that the business will go bust before the judgment is paid. So its worth much less than what you could get by selling it under an order.... If you re a member and manager of an LLC, you never have to give yourself a distribution or you don t have to do it until the judgment runs out. [The defendant] owns at least seven or eight LLCs that were formed years after the judgment with his assets, and I can t get to them. If they were shares in a corporation, we could sell them. 14 It is sometimes suggested that a creditor who obtains a charging order against a member of an LLC or a partner of a partnership will be taxable on the debtor s distributive share of income to the extent charged whether or not any distributions are made to the creditor. 15 Those who argue that the creditor would be taxable usually base their arguments on Rev. Rul. 77-137 16 and Evans v. Commissioner. 17 The argument for creditor taxability appears weak, however. Both Rev. Rul. 77-137 and Evans involved voluntary transfers in which the assignor assigned all of the assignor s economic interest to the assignee. In Rev. Rul. 77-137, the assignor agreed to exercise all of the assignor s residual rights in the partnership in favor of the assignee. In Evans, the assignor had assigned all of his economic interest in a partnership to his wholly-owned corporation. The court found that the assignor had a fiduciary duty to exercise his residual rights in favor of the assignee corporation. 14 Quoted in Leimberg s Asset Protection Planning Email Newsletter, Archive Message #24, available at http://leimbergservices.com (subscription only). 15 The discussion in this and the following paragraph is based on an article by Christopher M. Riser, Tax Consequences of Charging Orders: Is the K. O. by K-1 K. O. d by the Code? published in the Asset Protection Journal, Winter, 1999, available at www.riserlaw.com/home/publications/taxconsequencesofcharging orders. 16 1977-1 C. B. 178. 17 497 F. 2d 547 (7 th Cir. 1971). 5
What is the interest of a judgment creditor who has obtained a charging order against the interest of a partner or LLC member? A judgment creditor who obtains a charging order is something less than an assignee. 18 Without further agreement between the debtor and judgment creditor, or without an additional equitable order by the court, the judgment creditor who has obtained a charging order will have no right except the right to future partnership or LLC distributions, to the extent of the judgment plus interest, and the debtor partner or member will retain all of the rights as a partner or member that the debtor had before the issuance of the charging order except the right to future distributions to the extent of the charging order. Indeed, in the view of at least one court, the right of a judgment creditor to distributions is so weak as to be subordinate to subsequent liens by the creditors of a partnership. 19 An assignee is not a proper party to a suit affecting the assignor s retained (non-economic rights) as a partner. 20 Based on the authorities discussed in the two immediately preceding paragraphs, the author doubts that a debtor member or partner can rely on a creditor being dissuaded from seeking a charging order because of expected tax consequences. Charging Order Developments When the U.S. Bankruptcy Court for the District of Colorado considered the bankruptcy of the sole member of Western Blue Sky LLC, a Colorado LLC a few years ago, the court, stating that the rationale of the charging order cases did not apply to a single-member LLC, held that the bankruptcy trustee of the member became the substitute member of Western Blue Sky. 21 The court ruled that the bankruptcy trustee could therefore cause the LLC to sell its real estate 18 Expressed colorfully by the court in Bank of Bethesda v. Koch, 44 Md. App. 350, 354, 408 A. 2d 767, 769 (1979): [A charging order] is nothing more than a legislative means of providing a creditor some means of getting at a debtor's ill-defined interest in a statutory bastard, surnamed partnership, but corporately protecting participants by limiting their liability as are corporate shareholders. Since the statutory offspring is unique, the rights of creditors against partnerships were necessarily peculiar as well; hence the charging order is neither fish nor fowl. It is neither an assignment nor an attachment. But unlike many such questionable offspring, it resembles both progenitors in some of the characteristics. 19 Shirk v. Caterbone, 201 Pa. Super. 544, 193 A. 2d 664 (1963). 20 Dixon v. American Industrial Leasing Corporation, 157 W. Va. 735, 205 S. E. 2d 4 (1970). 21 In re: Ashley Albright Case No. 01-11367 ABC, 2003 Bankr. LEXIS 291 (April 4, 2003), 291 B.R. 538 (D.Colo. 2003). 6
and distribute the proceeds to the trustee. 22 Based on Albright, many thought that if a client does not have other available family members who are suitable for membership in the client s LLC, the client could consider gifting a small portion (such as one percent) to a friendly charity to avoid single-member status. The court in Albright stated that, although so-called peppercorn members would be disregarded, the existence of a second real member, no matter how small the second member s interest, would have forced the bankruptcy trustee into a charging order situation. 23 Although Albright was criticized by some commentators, 24 Albright reached the correct result based on the historic rationale for charging orders. Notwithstanding such rationale, as discussed below, 25 without any readily apparent policy discussion, some states have statutorily extended charging order protection to single-member LLCs. In Olmstead v. Federal Trade Commission, 26 the FTC had obtained a $10 million judgment against Shaun and Julie Olmstead 27 and sought to collect it from the assets of the Olmsteads Florida single member LLCs. The Florida Supreme Court considered a question certified to it by the Eleventh Circuit: whether Florida law permits a judgment debtor to surrender all right, title, and interest in the debtor s single-member limited liability company ( LLC ) to satisfy an outstanding judgment. The court considered whether the charging order provisions of the Florida Limited Liability Company Act are exclusive, and concluded that they are not. As a result, the court concluded that the Florida LLC Act does not preclude a member s judgment creditor from executing on a member s full interest and not merely obtain a charging order against the member s right to LLC distributions as, when, and if made. 28 However, the court did not hold that the FTC could execute on the member s noneconomic interests or what the effect of such execution would be. 29 22 Id. 23 Id. 24 See, e.g., Thomas E. Rutledge and Thomas Earl Geu, The Albright Decision-Why an SMLLC is Not an Appropriate Asset Protection Vehicle, 5 Business Entities (Sept./Oct. 2003). 25 Infra, notes 32-39 and accompanying text. 26 44 So. 3d 76 (Fla. Sup. Ct. 2010). 27 FTC v. Olmstead, 528 F.3d 1310 (11 th Cir. 2008) 28 44 So. 3d at 76-78. 29 The paragraph above is based on J. William Callison, Charging Order Exclusivity: A Pragmatic Approach to Olmstead v. FTC, 66 Bus. Law. No. 2, 2011, available at http://ssrn.com/abstract=1755174. 7
After the Olmstead decision, Florida amended its LLC statute to provide, with an exception for LLCs that have only one member, that a charging order is the sole and exclusive remedy by which a judgment creditor of a member or member s transferee may satisfy a judgment from the judgment debtor s interest in a limited liability company or rights to distributions from a limited liability company. 30 In the case of an LLC that has only one member, the Florida statute provides that if the judgment creditor establishes to the satisfaction of the court that distributions under the charging order will not satisfy the judgment within a reasonable time, the court may order the sale of the judgment debtor s interest. 31 At the foreclosure sale, the purchaser obtains the member s entire limited liability company interest, not merely the rights of a transferee, the purchaser becomes the member, and the person whose interest was sold ceases to be a member. 32 Although charging orders generally have been an unattractive remedy to creditors, some states such as Delaware, Kansas, Nevada, and Wyoming have amended their statutes to make charging orders even less useful to creditors by providing that the sole remedy of a creditor against a member of an LLC (whether multi-member or single member) and a partner of a partnership is a charging order. 33 Delaware and Kansas do not go as far as Nevada and Wyoming. Although the Delaware and Kansas statutes provide that the charging order is the exclusive remedy available to a creditor, they do not prohibit the court from issuing orders as do the statutes of Nevada and Wyoming. In 2010, the Wyoming legislature adopted a pure asset protection amendment to its limited liability company act. 34 This amendment provides that, even in the case of a singlemember LLC, only a charging order is available to creditors of the single member. 35 As applicable, the Wyoming LLC Act now provides: 30 XXXVI FLA. STAT. ANN. 605.0503(3). 31 XXXVI FLA. STAT. ANN. 605.0503(4). 32 XXXVI FLA. STAT. ANN. 605.0503(5). 33 DEL. CODE ANN. tit. 6, 18-703(d) (2013) provides: The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or a member's assignee may satisfy a judgment out of the judgment debtor s limited liability company interest and attachment, garnishment, foreclosure or other legal or equitable remedies are not available to the judgment creditor, whether the limited liability company has 1 member or more than 1 member. KAN. STAT. ANN. 17-76-113; NEV. REV. STAT. 86.401; and WYO. STAT. 17-29-503. Nevada provides similarly (that the charging order is the exclusive remedy for a creditor) for a corporation (NEV. REV. STAT. 78.746) and for partnerships (NEV. REV. STAT. 87A.480). 34 Wyoming L. 2010, ch. 94, 1. 35 Wyo. Stat. 17-29-503 (entitled Charging Orders ) provides: 8
This section [17-29-503] provides the exclusive remedy by which a person seeking to enforce a judgment against a judgment debtor, including any judgment debtor who may be the sole member, dissociated member or transferee, may, in the capacity of the judgment creditor, satisfy the judgment from the judgment debtor s transferable interest [36] or from the assets of the limited liability company. Other remedies, including foreclosure on the judgment debtor s limited liability interest and a court order for directions, accounts and inquiries that the judgment debtor might have made are not available to the judgment creditor attempting to satisfy a judgment out of the judgment debtor s interest in the limited liability company and may not be ordered by the court. 37 Wyoming statutes do not provide a similar limitation for Wyoming partnerships and, in fact, specifically contemplate the right of a creditor to foreclose on a partner s transferable interest in a Wyoming partnership. 38 A transferable interest in a Wyoming partnership is defined as the partner s interest in distributions. 39 In 2011, the Nevada legislature took the Wyoming LLC limitation even further in SB 405. Nevada SB 52: (a) On application by a judgment creditor of a member or transferee, a court may enter a charging order against the transferable interest of the judgment debtor for the unsatisfied amount of the judgment. A charging order requires the limited liability company to pay over to the person to which the charging order was issued any distribution that would otherwise be paid to the judgment debtor. (b) Reserved. (c) Reserved (d) The member or transferee whose transferable interest is subject to a charging order under subsection (a) of this section may extinguish the charging order by satisfying the judgment and filing a certified copy of the satisfaction with the court that issued the charging order. (e) A limited liability company or one (1) or more members whose transferable interests are not subject to the charging order may pay to the judgment creditor the full amount due under the judgment and thereby succeed to the rights of the judgment creditor, including the charging order. (f) This article does not deprive any member or transferee of the benefit of any exemption laws applicable to the member s or transferee s transferable interest. (g) This section provides the exclusive remedy by which a person seeking to enforce a judgment against a judgment debtor, including any judgment debtor who may be the sole member, dissociated member or transferee, may, in the capacity of the judgment creditor, satisfy the judgment from the judgment debtor s transferable interest or from the assets of the limited liability company. Other remedies, including foreclosure on the judgment debtor s limited liability interest and a court order for directions, accounts and inquiries that the judgment debtor might have made are not available to the judgment creditor attempting to satisfy a judgment out of the judgment debtor s interest in the limited liability company and may not be ordered by the court. 36 Wyo. Stat. 17-29-102(a)(xxii) defines the term transferable interest for the purposes of a Wyoming LLC as: the right, as originally associated with the person s capacity as a member, to receive distributions from a limited liability company in accordance with the operating agreement, whether or not the person remains a member or continues to own any part of the right. 37 Wyo. Stat. 17-29-503(g) (emphasis added). 38 Wyo. Stat. 17-21-504. 39 Wyo. Stat. 17-21-502(a). 9
Amended Nev. Rev. Stat. 78.746 to provide that, on application to a court of competent jurisdiction by any judgment creditor of a stockholder of a Nevada corporation, the court may charge the stockholder s stock with payment of the unsatisfied amount of the judgment with interest. This amendment does not apply to A corporation that has 100 or more stockholders; A corporation that is publicly traded or that is a subsidiary of a publicly traded corporation; or A professional corporation as defined in Nev. Rev. Stat. 89.020. Amended Nev. Rev. Stat. 86.401 similarly for a member s interest in an LLC formed under Nevada law. Amended Nev. Rev. Stat. 87A.480 similarly for a Nevada partnership interest. The amendments to Nevada s LLC and partnership statutes do not contain the limitations in the amendment to Nevada s corporate statute. In all cases, Nevada statutes now provide that the creditor so charging has only the rights of an assignee, and go on to say: No other remedy, including, without limitation, foreclosure on the stockholder s stock [member s interest or partnership interest] or a court order for directions, accounts, and inquiries that the debtor or stockholder [,member, or partner] might have made, is available to the judgment creditor attempting to satisfy the judgment out of the judgment debtor s interest in the corporation [, LLC, or partnership], and no other remedy may be ordered by a court. 40 The term rights of an assignee is defined in each of the sections to be the rights to receive the share of the distributions or dividends paid by the corporation [, LLC, or partnership] to which the judgment debtor would otherwise be entitled. The term does not include the rights to participate in the management of the business or affairs of the corporation [, LLC, or partnership] or to become a director of the corporation. 41 The Nevada limited liability company act amendment 42 states specifically that it applies to a single-member LLC the same as to a multi-member LLC. Research has not disclosed any policy justification for the application of charging order protections to single-member LLCs, 40 Nev. Rev. Stat. 78.746. 41 The limitations on the rights of an assignee are set forth elsewhere, but similarly, in the Nevada limited liability company act and the Nevada partnership laws. 42 Section 69 of SB 405. 10
much less for making the charging order the exclusive remedy of a creditor of a debtor member, including a single member, and prohibiting foreclosure even in the case of a single-member LLC. Even less justification exists for extending the charging order regime to corporations, as Nevada has done thereby redoing decades of corporate law. Arguably the remedies of piercing the veil and fraudulent conveyances are still available for LLCs in Wyoming 43 and corporations and LLCs in Nevada, but the Wyoming and Nevada laws are draconian changes to the detriment of any contract, tort, or other creditor of an owner of a single- or multi-member Wyoming LLC or Nevada corporation or LLC. At least contract creditors have the opportunity to protect themselves up front. 44 The author is unaware of any policy discussion supporting the actions of some states in making charging orders so exclusively the only remedy available to creditors that courts were 43 Wyoming recently amended its LLC statute to impose new requirements that must be met before the veil of a Wyoming limited liability company may be pierced. Wyo. Stat. Ann. 17-29-304(2016) now provides in new subsections (c) and (d); (c) for purposes of imposing liability on any member or manager of a limited liability company for the debts, obligations or other liabilities of the company, a court shall consider only the following factors no one (1) of which, except fraud, is sufficient to impose liability: (i) Fraud; (ii) Inadequate capitalization; (iii) Failure to observe company formalities as required by law; and (iv) Intermingling of assets, business operations and finances of the company and the members to such an extent that there is no distinction between them. (d) In any analysis conducted under subsection (c) of this section, a court shall not consider factors intrinsic to the character and operation of a limited liability company, whether a single or multiple member limited liability company. Factors intrinsic to the character and operation of a limited liability company include but are not limited to: (i) The ability to elect treatment as a disregarded or pass-through entity for tax purposes; (ii) Flexible operation or organization including the failure to observe any particular formality relating to the exercise of the company s powers or management of its activities; (iii) The exercise of ownership, influence and governance by a member or manager; (iv) The protection of members and managers personal assets from the obligations and acts of the limited liability company. The 2016 amendment also deleted 17-209-304(b), which had provided that neither a failure to observe formalities as to the operation and management of a limited liability company nor an election to be treated as a disregarded entity for federal income taxes was sufficient to justify setting aside limited liability. The legislative fact sheet accompanying the amendment indicates that the changes were in response to Greenhunter Energy, Inc. v. Western Ecosystems Technology, Inc., 337 P.3d 454 (Wyo. 2014). Although the court in GreenHunter did make some unfortunate references to the tax status and attributes of the single-member LLC at issue in that case, the court appeared to place much more weight on the sole member s total control of the LLC s finances, including deciding to contribute funds to pay some of the LLC s debts and not others. For a discussion of veil-piercing cases, including GreenHunter, and the factors that courts appear to apply notwithstanding their analysis, see Sparkman, infra, note 44. 44 For a discussion of whether it makes a difference in a veil-piercing case that the claim arises out of a contract or a tort, see Allen Sparkman, Will Your Veil be Pierced? How Strong is Your Entity s Liability Shield? Piercing the Veil, Alter Ego, and Other Bases for Holding an Owner Liable for debts of an Entity, available at http://ssrn.com/abstract=267620 (forthcoming, Hastings Business Law Journal). 11
denied the power to appoint receivers or issue orders. Much less is there any known policy supporting Nevada s extension of such changes to non-public corporations with fewer than 100 shareholders and which are not professional corporations. Is there any conceivable reason for these restrictions other than to frustrate creditors who have legitimate judgements against partners, members, or shareholders? The charging order provisions of RUPA, 45 RULPA, 46 and RULLCA differ substantially from the charging order provisions of Nevada and Wyoming law. RUPA 504(a) permits a court to enter a charging order against a partner s transferable interest. RUPA 504(a) also authorizes the court to appoint a receiver and make all other orders, directives, accounts, and inquiries the judgment creditor might have made or which the circumstances of the case may require. Further, RUPA 504(b) provides that the court may order foreclosure at any time and that the purchaser at a foreclosure sale has the rights of a transferee. RULLCA 47 503(a) authorizes a court to issue a charging order against the transferable interest of the judgment debtor for the unsatisfied amount of the judgment. RULLCA 503(b) provides that, to the extent necessary to effectuate the collection of debts pursuant to a charging order in effect under subsection (a), the court may: Appoint a receiver of the distributions subject to the charging order, with the power to make all inquiries the judgment debtor might have made; and Make all other orders necessary to give effect to the charging order. RULLCA 503(c) provides: Upon a showing that distributions under a charging order will not pay the judgment debt within a reasonable time, the court may foreclose the lien and order the sale of the transferable interest. The purchaser at the foreclosure sale only obtains the transferable interest, does not thereby become a member, and is subject to Section 502. 48 45 Supra, note 7. 46 Supra, note 8. 47 Supra, note 7. 48 The Revised Prototype Limited Liability Company Act ( Prototype LLC Act ) makes different policy choices. The Prototype Act is an ongoing project of the LLCs, Partnerships and Unincorporated Entities Committee of the Business Law Section of the American Bar Association. The most recent version was published in The Business Lawyer (Nov. 2011). Prototype LLC Act 503(a) authorizes charging orders and provides that to the extent so charged and after the limited liability company has been served with the charging order, the judgment creditor has only the right to receive any distribution or distributions to which the judgment debtor would otherwise be entitled in respect of the limited liability company interest. Prototype Act 503(f) provides that the judgment creditor 12
RULPA 703 is substantially the same as CUPA 504. As noted in footnote 44, the Prototype LLC Act made policy choices differing from those made by RUPA, RULPA, and RULLCA by not allowing foreclosure of an interest subject to a charging order or allowing a court to issue orders in support of a charging order. In a discussion with the author, Robert Keatinge, 49 who was actively involved in the drafting of the Prototype LLC Act, noted two potential areas of concern if a holder of a charging order was allowed to foreclose on the charged interest. First, some states, such as Delaware, allow an assignee to bring a derivative action. 50 Mr. Keatinge doubts that the Delaware statute would allow the holder of an interest acquired in a foreclosure to bring a derivative action and further noted that such a holder likely would not be subject to any fiduciary duties, perhaps not even the obligation of good faith and fair dealing. Second, from the point of view of the other members or partners, they would have to deal with someone they didn t want to deal with who just wanted to be paid as quickly as possible and who had no real interest in the long-term success of the LLC s or partnership s business. Mr. Keatinge s first area of concern can be dealt with by appropriate statutory amendments. The concerns he expressed about the other members or partners could be shall have no right to foreclose, under this Act or any other law, upon the charging order, the charging order lien, or the judgment debtor s limited liability company interest. No judgment creditor of a judgment debtor shall have any right to obtain passion of, or otherwise exercise legal or equitable remedies with respect to, the property of a limited liability company. Court orders for actions or requests for accounts and inquiries that the judgment debtor might have made, are not available under this Act to the judgment creditor attempting to satisfy the judgment out of the judgment debtor s limited liability company interest and may not be ordered by a court. The comments to 503(c) and (f) of the Prototype Act state: Subsection (c). The priority of the lien as to other creditors will be determined under applicable law and is not addressed in this [Act]. The lien cannot be foreclosed upon as other liens. This removes a significant amount of issues presented by other statutes that attempt to provide rights of redemption and other pre and post foreclosure remedies. These rights were seen as clumsy and not effective as to assisting in the collection of the debt while maintaining the integrity of the LLC and avoiding the intrusiveness of some statutes regarding creditor s rights to obtain overly broad court orders that have the effect of interfering with the day to day activities of the LLC. This lack of right to foreclose is reinforced in paragraph (f) of this section. Subsection (f). This provision is derived from Delaware 18-703(e) and 101.112(f) of the Texas Business Organization Code. This provision attempts to eliminate the problems encountered by overly broad court orders. This provision was not intended, nor should it be interpreted, to prevent a court from enforcing its charging order in the event of a violation of the charging order by the judgment debtor or the limited liability company.` 49 Mr. Keatinge is Of Counsel with Holland & Hart LLP in Denver, Colorado. 50 6 DEL. CODE, 18-1001. 13
dealt with, as Professor Dan Kleinberger has suggested, by the contractual provisions that have been developed and tested over more than 100 years of corporate law. 51 The opinion in Law v. Zemp 52 illustrates some of the problems created for creditors by charging order statutes that provide that a charging order is the exclusive remedy and prohibit the court from issuing other orders. In that case, Robert Law, acting on behalf of a trust, obtained a money judgment against Ronald Zemp, which Zemp did not pay. 53 Law then obtained charging orders against Zemp s interest in four Oregon limited partnerships and in one Oregon limited liability company. 54 When it granted the charging orders, the trial court also imposed four additional obligations on the limited partnerships and the limited liability company: (1) the companies were prohibited from making any loans until the judgment was paid; (2) the companies and their members were prohibited from transferring, modifying, or encumbering any partnership or membership interest without approval from the court or from Law until the judgment was paid; (3) the companies were required to open their books and certain tax records for inspection by Law; and (4) the companies were required to provide future financial statements to Law. The order also stated that Law was entitled to seek modification of the order to allow for the appointment of a receiver and the foreclosure of Zemp's interests in the companies. 55 The court held that the trial court s order was partially valid as to the limited partnerships because of the linkage of Oregon s limited partnership statute to the Oregon general partnership statute. 56 The court held that the court s order was valid as to the limited partnerships to the extent they were required to disclose financial information to Law, but that the trial court had 51 Daniel S. Kleinberger, The Plight of the Bare Naked Assignee, XLII Suffolk U. L. Rev. 587, 598 (2009). 52 Supra, note 7. 53 278 Or. App. at 853. 54 Id. 55 Id. 56 Arguably, the court was incorrect in its analysis. The Oregon limited partnership statute provides: On application to a court of competent jurisdiction by any judgment creditor of a partner, the court may charge the partnership interest of the partner with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the partnership interest. This chapter does not deprive any partner of the benefit of any exemption laws applicable to the partner's partnership interest. ORS 70.295. The Oregon limited partnership statute also states that in any case governing limited partnerships that is not provided for in this chapter, the provisions of ORS chapter 67 [the Oregon general partnership statute] govern. ORS 70.615. The Oregon limited partnership statute does provide for charging orders. Why is it appropriate to say, as the court in Law v. Zemp did, that the limited partnership statute is supplemented by the general partnership statute? 276 Or. App. at 861. 14
exceeded its authority in ordering the limited partnerships not to make any loans until Law s judgment was paid and in prohibiting the limited partnerships and its partners from transferring, modifying, or encumbering any partnership interest until Law s judgment was paid. 57 The court held that the trial court was not authorized to issue any of the four additional orders against the limited liability company. 58 Who Must be A Party to an Action Seeking a Charging Order? Before a recent decision of a Texas court, courts in other states appeared uniformly to hold that the LLC or partnership need not be a party to an action seeking a charging order against the interest of a member or partner, principally on the ground that a charging order does not require the entity to do anything other than cut a check to the creditor instead of the debtor member or partner. 59 However, in Spates v. Office of the Attorney General, 60 a Texas court of appeals held that a charging order could be issued in a proceeding in which the LLC was a party but its sole member, whose interest would be subject to the charging order, was not. Spates, although the opinion did not focus on this fact as controlling, involved the intervention by the Texas Attorney General to collect judgments for unpaid child support. The author believes that the better rule is that stated in Mahalo and the other cited cases holding that jurisdiction over the debtor member is sufficient. The contrary rule in Spates would require a creditor to be able to assert jurisdiction over the LLC, which would often be difficult or extremely expensive. This would be particularly true in the case of, for example, the Nevis LLC at issue in Barber. 61 Moreover, the holding of Spates is very broad, and could be read to mean that anytime a creditor with an unsatisfied judgment against a member of an LLC can find a suit in which the LLC is a party and can assert a basis for intervening, the creditor could seek a charging order against the member. The language of most LLC statutes charging order provisions 62 are substantially the same as that of 57 Id. at 863. 58 Id. 59 See, e.g., Mahalo Investments v. First Citizens Bank & Trust Company, Inc., 330 Ga. App. 737 (Ga. App. 2015) (citing as support Bank of America, N.A. v. Freed, 983 N.E.2d 509, 520-512 (Ill. App. 2012)). Two recent decisions did not address whether the LLC must be a party but affirmed the issuance of charging orders where only the debtor member and not the LLC was a party. Sand Creek Partners, Ltd. v. American Federal S&L Association, 2015 WL 316750 (D. Nev. 2015); Wells Fargo Bank, N.A. v. Barber, 2015 WL 470589 (M.D. Fla. 2015). 60 S.W.3d, 2016 WL 354417 (Tex. App. Jan. 28, 2016). 61 Discussed infra, notes 72-73 and accompanying text. 62 See, e.g., RULLCA 503(a): 15
the Georgia statute considered in Mahalo 63 and the Texas statute at issue in Spates. 64 Taken together, these cases, particularly the uncertainty created by Spates, suggest that states should consider revising their charging order statutes to clearly state what parties must be before the court before a charging order may be issued. Recognition of One State s Charging Order Provisions in Another State Whether a court in a state that has not limited its charging order statutes must recognize the limitations of the state of formation on a creditor s rights in an action brought in that other state against a member (including the sole member) of a Delaware, Kansas, Nevada, or Wyoming LLC is a question of the full faith and credit clause of the U.S. Constitution 65 and the state internal affairs doctrine: The internal affairs of a corporation will be governed by the corporate statutes and case law of the states in which the corporation is incorporated. 66 Many states have extended the internal affairs doctrine to LLCs and other entities, as well. 67 The question then is: what exactly are the internal affairs of a corporation, partnership, or LLC formed under a state with asset protection provisions? The courts and the commentators generally consider the internal affairs of an entity to be matters involving voting, fiduciary On application by a judgment creditor of a member or transferee, a court may enter a charging order against the transferable interest of the judgment debtor for the unsatisfied amount of the judgment. 63 Supra, note 59, discussing OCGA 14-11-504(a). 64 Supra, note 60, discussing TEX, BUS, ORG, CODE 101.112(a). 65 U.S. CONST., art. IV, 1. 66 CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 89-90 (1987); Edgar v. Mite Corp., 457 U.S. 624, 645 (1982); Shaffer v. Heitner, 433 U.S. 186, 215, n.44 (1977); Rogers v. Guaranty Trust Co. of New York, 288 U.S. 123, 130 (1933); VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108, 1116-18 (Del. 2005); McDermott, Inc. v. Lewis, 531 A.2d 206, 215 (Del. 1987). Of course, Delaware has significant encouragement to expand the internal affairs doctrine as far as possible to protect the national and international applicability of the Delaware General Corporation Law to Delaware corporations. See Timothy P. Glynn, Delaware s Vantage Point: the Empire Strikes Back in the Post-Post-Enron Era, 102 NW. U. L. REV. 91 (2008); note, Internal Affairs Doctrine: California versus Delaware in a Fight for the Right to Regulate Foreign Corporations, 48 B.C. L. REV. 1047 (2008); Norwood P. Beveridge, Jr., The Internal Affairs Doctrine: The Proper Law of a Corporation, 44 BUS. LAW. 692 (1988). 67 E.g., COLO. REV. STAT. 7-90-805(4) provides that As to any foreign entity transacting business or conducting activities in this state, the law of the jurisdiction under the law of which the foreign entity is formed shall govern the organization and internal affairs of the foreign entity and the liability of its owners and managers. 16