by Jay D. Adkisson
Reprinted from Developments, April 2005
Business entities are created by state legislatures primarily
to allow individuals to group together to invest capital
for new ventures. The primary statutory goal of most entities
is to shield the investors from the liabilities of the
business, so that their risk is limited by the amount of
the capital investment. Thus, if the business itself has
a creditor, the creditor’s relief is limited to the
assets of the business, and, except in extreme cases, the
creditor cannot pursue any assets other than those of the
business itself.
The liabilities of the business are known as “inside
liabilities,” and the claims of creditors against
the business are known as “inside creditors”.
As long as the entity is distinct from its owners, is adequately
capitalized, and is not used to perpetuate a fraud, then,
the entity should protect its investor-owners from inside
liabilities and inside creditors. The exception is the
general partnership. In a general partnership, general
partners are liable for the debts and liabilities of the
partnership. Similarly, general partners of Limited Partnerships
and related entities are also liable for the liabilities
of the partnership.
The flipside is where an investor-owner attempts to protect
partnership from personal creditors of the investor-owner.
The creditors of an investor-owner are known as “outside
creditors,” and the claims giving rise to those creditors
are likewise called “outside liabilities”.
From a statutory perspective, the creditors of an investor-owner
are treated much differently than the creditors of the
business itself. The hard truth is that most state legislatures
have no desire to protect a debtor’s interest in
a business entity from creditors. To the contrary, if an
investor-owner has debts, then he or she should pay those
debts from whatever non-exempt property is available, including
shares of stock and interests in partnerships and like
entities.
In a corporation, a creditor may simply attach the shares
of the debtor’s stock to gain all the rights that
the debtor had in the corporation, including rights to
sell the shares, voting rights, the right to view books
and records, and rights to bring derivative actions against
errant corporate officers and directors.
Note that if the corporation is an “S” corporation,
and the creditor is not an individual, then the creditor’s
attachment of the stock may cause the “S” election
to be terminated, which would possibly result in unwanted
tax consequences to the remaining shareholders.
Legislatures are not concerned with interference of corporate
business when a creditor has attached interest in stock
because shareholders are two full steps removed from business
operations. Shareholders elect the directors, directors
elect the officers, and officers run the business. Allowing
a creditor to attach the shares of a corporation only indirectly
affects the corporation in the election of directors.
Partnerships and pseudo-partnership entities, such as
the Limited Liability Company (LLC), are different from
corporations. In a partnership or LLC, the investor is
a partner and may directly affect the entity’s business
operations. A change in ownership may disrupt the operations
of the partnership and force non-debtor partners into an
involuntary partnership with the creditor.
Thus, state legislatures have not allowed creditors to
attach partnership interests and become the partners themselves.
Instead, legislatures have only allowed creditors a limited
form of relief against the debtor’s partnership interest
through a “Charging Order”.
Of Interests and Charging Orders
The charging order and its function can only be examined
in light of the character of the partnership interest itself.
This leads to the fundamental question of what a partnership
interest constitutes.
A partnership interest is unlike holding shares in a corporation.
With the latter, the shareholder has no duties and all
of his or her rights are bound into the share certificates
(whether physically issued or not). For instance, a shareholder
may lend his voting rights to others and these rights remain
part of the rights that are bound into the share certificates.
On the other hand, in exchange for the partner’s
investment, the partner receives a bundle of rights that
includes the rights to distributions and the rights that
are set out in the operating agreement. The partner may
or may not be required to perform certain duties in order
to receive the rights outlined in the partnership’s
operation agreement.
A charging order is held against the partner’s right
to distributions from the entity. The comments to the Uniform
Partnership Act and LLC Act describe the charging order
as “in the nature of a garnishment.” To define
a charging order as a “business garnishment” would
closely describe the charging order. However, one could
also characterize a charging order as being an “assignment
of income” or as an assignment of the partner’s
economic right to distribution from the partnership.
Charging Order Protected Entity (COPE) is the term used
to describe entities for which external creditors are usually
limited to the charging order remedy, meaning that the
creditors cannot simply attach the partner’s interest
as if they were shares in a corporation. The best known
COPE entities are the Limited Partnership (LP) and the
Limited Liability Company (LLC). However, COPES also include
Limited Liability Partnerships (LLP) and Limited Liability
Limited Partnerships (LLLP), as well as the new Series
LLC.
“Charging Order Protection” is somewhat of
a misnomer. A charging order is a remedy that is affirmatively
sought by a creditor. A better term may be “anti-invasion
protection” because the benefit sought from a charging
order protection is making invasion of the entity by a
creditor difficult.
Barbarians at the Gate:
Creditors’ Remedies
A creditor must usually follow this path to relief when
seeking to obtain assets from a COPE:
1. Obtain a judgment.
2. Charge the interest.
3. Foreclose the charging order.
4. Appoint a receiver.
5. Partition the entity.
Each step and its role in protecting the assets of the
LLC from the creditor is discussed in detail below.
First, the creditor must obtain a judgment, since the
charging order is only available to “judgment creditors”.
Thus, on the defense side, there is often time for additional
structuring or drafting to make sure that the structure
is rock solid. Sadly, many planners do not take the opportunity
to fix slight flaws in the entity structure or drafting
before the creditor obtains the charging order.
After obtaining a judgment, the creditor must obtain a
charging order. The charging order is against the debtor’s
economic rights to distribution from the entity. A limited
partner or member in an LLC does not own shares of stock
as in a corporation. Partners own a bundle of rights as
defined by the entity’s operating agreement, including
certain economic rights to distribution. However, partners
do not own a direct interest in the assets of the entity.
The creditor may also garnish or obtain a forcible assignment
of the debtor’s right to distribution from the partnership.
That is, the partnership must pay the creditor instead
of the debtor until the judgment is satisfied. However,
the right to payment does not make the creditor a partner
or member and does not give the creditor any voting rights.
If the entity is formed in the same state where the creditor
obtained the original judgment, obtaining a charging order
from the court is not difficult. However, if the entity
is formed in another state, the creditor may have to register
the judgment in the other state and ask the courts of that
state to issue the charging order. This is discussed more
fully in “Conflicts & Koh” below.
The creditor may also foreclose on the debtor’s
partnership interest. The foreclosure is on the interest
in the partnership, not on the entity itself or on the
entity’s assets. Foreclosure of a charging order
is one of the most misunderstood and misrepresented concepts
in asset protection. Contrary to the oft-repeated (including
at seminars and in poorly researched articles) but false
belief, the foreclosure of the interest is not a foreclosure
of the entity’s assets. The foreclosure is of the
charging order against the debtor’s economic right
to distributions.
The difference between a creditor holding a charging order
and a creditor foreclosing on the charging order is the
permanence of the creditor’s interest. A charging
order is a temporary remedy that has the effect of assigning
income to the creditor until the judgment is paid. After
the assignment of income (or garnishment, if you want to
look at it that way) terminates, the debtor regains the
right to distributions.
By contrast, foreclosure of the interest makes the assignment
(or garnishment) permanent, which means that the creditor
becomes the owner of the distributional interest. The creditor
may then attempt to sell the interest to an interested
buyer. If a limited partnership or LLC has few members
and is controlled by persons friendly to the interests
of the debtor, the creditor attempting to sell the foreclosed
interest may have a very tough time finding buyers.
In real life litigation, the most common result after
a foreclosure of the interest has occurred is that the
entity offers to redeem the creditor’s interest at
some value that is much less than the percentage interest
in distributions held by the creditor. However, redemption
is not a sure thing for either the creditor or the entity.
The disadvantage to a foreclosing creditor is that after
foreclosure, the creditor is responsible for the tax liabilities
generated to the partners or members by the entity (there
is substantial doubt as to whether this occurs at the charging
order stage). Thus, the creditor risks receiving K-1 distributions
of “phantom income.” That is, the creditor
has to pay a share of the entity’s taxes even though
the creditor does not receive actual income.
A disadvantage to the entity after is foreclosure of an
interest by a creditor is that the creditor may be entitled
to certain derivative rights from the entity, depending
on how well the operating agreement for the entity is drafted.
The derivative rights may include the rights to inspect
books and records, request distributions, and request the
appointment of a receiver.
The creditor may ask the court to appoint a receiver in
order to ensure that the entity makes distributions to
the creditor’s interest. Normally, the creditor is
able to obtain the appointment of a receiver, which is
possible when the operating agreement is not immaculately
drafted to hinder the possibility of giving the creditor
derivative rights to involuntary distributions from the
entity. Like most derivative rights issues, the possibility
of obtaining a receiver is more likely if the creditor
has foreclosed upon the majority interest in the entity.
However, appointment of a receiver is less likely if the
creditor holds only a minority interest.
Finally, the creditor may attempt to request the court
to partition the entity’s assets and place the creditor
in charge of the entity’s assets equal to the interest
the creditor holds. This is a long shot for the creditor,
but it is theoretically possible in extreme cases in where
the entity has not been structured correctly, and the operating
agreement has been poorly drafted.
State Restrictions of Remedies
In response to misperceptions about what the role of charging
orders, some states have attempted to limit creditors’ remedies
to a charging order by forbidding the foreclosure of the
interest. Although such laws are attractive on the surface,
under some circumstances, these limitations are less attractive
from an asset protection standpoint.
A creditor who holds a mere charging order is probably
not liable for the taxes of the entity. Even though this
belief is preached at asset protection seminars, there
is not any substantial basis for believing that a charging
creditor is liable for the taxes of the charged entity.
To the contrary, many tax planners have concluded that
a creditor holding a charging order is not liable for the
taxes of the entity.
On the other hand, there is little doubt that a creditor
who forecloses on a charging order is treated as an owner
of the charged entity for tax purposes. Foreclosure becomes
a potential trap for a creditor to be “K.O.’d
by the K-1”. The tax liability (which is not something
that creditors’ attorneys are typically even aware
of) can sometimes facilitate a quick and cheap redemption
of the foreclosed interest from the creditor. Or as we
litigators say, “They no longer want the cheese;
they just want out of the trap.”
From the asset protection perspective, foreclosure is
sometimes good, and the states that have eliminated the
foreclosure remedy in order to attract asset protection
work may have unwittingly taken a step backwards. However,
some would argue that the fact that the creditor is stopped
at the charging order stage may facilitate settlement by
the creditor even without the surprise leverage of the “thank
you for foreclosing, here’s your K-1”.
Conflicts & Koh
In which state should the creditor apply for a charging
order?
Consider the following hypothetical. Hubris LLC is formed
in Delaware, has its offices and principal place of business
in Kansas, is qualified to do business and owns real property
in Oregon. Hubris does not do business or hold assets in
Alabama. However, a member of Hubris LLC lives in Alabama,
where he is successfully sued. The Alabama creditor seeks
to charge the debtor’s interest in Hubris LLC to
satisfy the Alabama judgment. Where does the Alabama creditor
apply for the charging order?
This is a trick question, because nobody really knows
where the application for the charging order should be
filed. In particular, the drafters of the Revised Uniform
Limited Partnership Act (RULPA) and the Uniform Limited
Liability Company Act (ULLCA) have not addressed the issue.
Therefore, it is left to the courts to decide.
While an Alabama court can issue a charging order, Hubris
LLC has no minimum contacts in Alabama; thus, Alabama has
no personal jurisdiction over Hubris LLC. If Hubris LLC
ignores the Alabama court’s order, the court does
not have jurisdiction if Hubris is not within its borders.
In order to obtain a charging order, the Alabama creditor
should register the judgment in a state where Hubris LLC
has minimum contacts and obtain the charging order against
Hubris under that state’s laws. This issue was addressed
by a Washington appellate court in Koh
v. Inno Pacific Holdings Ltd, 114 Wash App 268,
54 P.3d (Wash App Div 1 2002), which halfheartedly concluded
a California creditor did not violate due process by bringing
an application for a charging order in the state in which
the LLC was located.
The Debtor in Bankruptcy
Chris and I have said many times in relation to many asset
protection strategies, “In bankruptcy, all bets are
off.” Where debtors hold interests in limited partnerships
and LLCs and are forced into bankruptcy, there is a possibility
that a court will allow a creditor to attach the assets
of the partnership or LLC itself.
Interests in limited partnerships and LLCs are held by
the members in a contractual nature, as defined, first
by applicable state law, and then by the partnership’s
operating agreement. For bankruptcy purposes, interests
can be defined two ways: executory interests and non-executory
interests.
Executory interests require the partner or member to execute
some affirmative act that benefits the entity in order
for the partner or member to receive distributions. One
might define executory interests as “active” interests.
Non-executory interests are do not require the partner
or member to do anything. Distributions are made without
any further act of the partner or member. Non-executory
interests are “passive” interests.
When a partner filed bankruptcy, whether his interests
are as executory or non-executory determines the parameters
of the bankruptcy trustee’s powers. If the interest
is non-executory, then the court-appointed Trustee is not
bound by limitations in the entity’s operating agreement.
That is, the Trustee may invade the assets of the entity
and sell the assets in order to satisfy judgments against
the debtor. Such was the precise result in a recent Arizona
bankruptcy case, In re Ehmann, 2005 WL 78921,
Bkrtcy.D.Ariz. (Jan 13, 2005).
By contrast, if the debtor’s interests are executory,
the Trustee is probably bound by the entity’s operating
agreement, including any limitations on creditors’ remedies.
Thus, it is critical that the operating agreement is immaculately
drafted to ensure that the interest is treated as executory,
so that the Trustee cannot argue for treatment of the interest
as non-executory.
From the debtor’s perspective, the key to keeping
creditors from the assets of the entity is intelligent
structuring and meticulous drafting, which is the very
essence of good asset protection planning.
Single Member LLCs
Recall that with a corporation, shareholders are twice
removed from the operations of the corporation because
the shareholders elect the directors, and the directors
elect the officers who actually run the corporation. Thus,
if the creditor attaches shares of a corporation, the creditor
will not directly influence operations until there has
been at least one meeting of directors at which new officers
can be elected.
In a limited partnership or LLC, however, the change of
ownership from the debtor to a creditor could directly
impact the operations of the entity and affect the remaining
non-debtor members. The primary purpose of the charging
order is thus to protect the non-debtor members from being
involuntarily forced into a partnership with a the debtor
member’s creditor.
However, there is only one member in a SMLLC, so there
are no non-debtor members to protect. It also defies common
sense that a creditor would not be able to get at the assets
of an entity where the debtor is the only owner.
Some planners argue that even though it may not make any
sense to have charging order protection where there is
only one member, the language of the statute is nonetheless
protective. Some states, such as Arizona, have modified
their LLC acts in such a manner that suggests protection
of the debtor’s indirect interest in the assets of
the entity, even if the creditor has charging order.
Planners who believe that SMLLCs are protected by charging
orders in the same manner as other LLCs and partnerships
argue that, unless it is apparent that the creditor’s
judgment may never be satisfied by distributions from the
SMLLC, the creditor should not be allowed to invade the
LLC.
After years of speculation and the lack of any solid case
law, the issue of whether SMLLCs are afforded the protections
of the charging order was finally addressed by a U.S. bankruptcy
court, In re Albright, No. 01-11367 (Colo. Bkrpt.
April 4, 2003). The judge in Albright held that
charging order protection does not exist for a SMLLC because
there are no non-debtor members to protect. The court granted
full economic and non-economic rights to the trustee, allowing
the bankruptcy trustee to manage the debtor’s LLC.
The trustee subsequently sold the LLC’s property
and distributed the net proceeds to the bankruptcy estate
for satisfaction of creditors’ claims.
Thus, until Albright is overturned or rejected
by other courts, the safe presumption will be that SMLLCs
probably do not provide charging order protection.
Based on Albright, sometimes I hear planners
blurt out, “Single Member LLCs provide no asset protection!” This
is wrong. The lack of charging order protection is a far
cry from concluding that SMLLCs are “worthless” as
asset protection vehicles. SMLLCs may still provide substantial
protection for owners against the liabilities of the entity
itself, which are so-called “internal liabilities”.
For example: SMLLC owns a strip mall and is successfully
sued by one of the tenants. If the SMLLC is adequately
capitalized, is not the alter ego of the sole member, and
is not used to perpetuate a fraud, the tenant may not assert
liability against the member.
There is no reason that a SMLLC should be treated much
differently from a sole shareholder corporation. Historically,
sole shareholder corporations have contained liability
within the entity and shielded the liability away from
its owners.
To summarize, even if SMLLCs do not offer the same charging
order protection as multiple-member LLCs, they can still
be very valuable business planning vehicles. Certainly,
it is preferable from a liability standpoint to own one’s
business in a SMLLC than to run it as a sole proprietorship.
But of course, where external liability is a concern and
it is feasible to add another member, that should be done
so that charging order protection arises.
SMLLCs and LAMBs
An interesting question regarding SMLLCs is the consequences
of the partial sale of a debtor’s interest in a single
member LLC’s to a third party (sometimes referred
to as a “LAMB” for “Late Arriving Member”).
Does the sale of the debtor’s interest to a LAMB
invoke charging order protection in an SMLLC, even if there
were no other members at the time the claim arose?
The answer depends on when that the court tests the single
member status for charging order purposes. My gut feeling
is that this should be at the time that the application
for the charging order is made because the purpose of the
charging order is to protect non-debtor members. If this
is true, then it means that you can maintain an LLC with
a single member, but later add a member and charging order
protection will arise. Although a sophisticated creditor
may argue that the post-claim transfer of the LLC interest
was a fraudulent transfer, I’m not convinced that
is a winning argument so long as the transfer is not done
at the last minute, was for value, and can be justified
on other straight-faced business grounds.
Reverse Veil Piercing
It is unclear whether creditors are permitted to assert
a “reverse veil piercing” theory in order to
circumvent charging order protection. In the case of a
SMLLC, the application of such a theory is practical. However,
the application of reverse veil piercing in an SMLLC may
contradict the clear text of the RULPA and ULLCA.
Otherwise, as with corporations, the more members you
have the less likely it is that a reverse veil piercing
theory will be successful.
Summary
Charging order protected entities are some of the strongest and
most acceptable asset protection tools available.
These entities afford a significant degree of protection
for the partners or members against the internal liabilities
of the entity, yet they also severely restrict the collection
rights of the creditors of a partner or member.
But as shown by Ehmann and other cases, merely
forming a limited partnership or LLC isn’t going
to protect assets. The key to the success of these entities
is intelligent structuring and meticulous drafting that
addresses the several potential avenues of creditor attack.
But such is the very nature of good – as opposed
to cookie-cutter – asset protection planning.
The problem is that many people have COPES, predominantly
in the widely-sold “Family Limited Partnership” form,
but these entities are often not structured correctly for
asset protection purposes (which may not mesh entirely
with estate planning purposes) and their operating agreements
are an open invitation to creditor attack.
Even if initially correctly structured, the operating
agreements of COPES must be updated to keep up with the
discovery of new landmines. Yet, in practice, these entities
tend to suffer from the same neglect that often brings
corporations to grief, which is that their books and records
are not updated and they fall into disrepair.
People wouldn’t even think about letting their car
go for a year without service, but somehow they think that
they can go for years and years without updating their
Family Limited Partnership and that it will work anyhow.
Especially as creditors become more organized and aggressive
in attacking such structures, this is very dangerous.
There are sundry other issues relating to the drafting
and operation of partnerships and LLC that are critical
for these entities to maintain their legal separateness
and to keep creditors and disgruntled members at bay. We
will explore those issues at depth in future issues of
Developments.
-- Jay
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