The economic crises sparked in 2008 have driven significant interest in the charging order. The 1990s saw the rise of the LLC as a preferred form for the organization of new business ventures across the country. In turn, the LLC, reflecting its roots in partnership law, incorporated the “charging order,” a mechanism by which the judgment-creditor of a member may make a claim on the distributions to be made by the LLC as a means of satisfying the judgment-debtor’s obligation. With the Great Recession, more and more creditors have dealt with judgment-debtors who were themselves members of LLCs. Hence, the newfound attention to these otherwise obscure statutes.
The three of us, at the 2012 LLC Institute sponsored by the Section of Business Law’s Committee on LLCs, Partnerships and Unincorporated Entities, were able to discuss a variety of issues of current currency involving LLCs, thoughts and comments here digested.
By way of background, although the statutory formulae are somewhat different between the various states, the charging order is a remedy provided to the judgment-creditor of a member or assignee of a member by which that creditor may attach the distributions (interim and liquidating) made to the member-assignee, thereby diverting that income stream to the satisfaction of the judgment. Essentially, the charging order is a lien attaching to any distributions that might be made to the member or assignee that is as well the judgment-debtor. The objective of the charging order is to secure the judgment-creditor’s receipt of those distributions while at the same time precluding that judgment-creditor from interfering with the activities of the LLC as a going concern. Precluding a claim by the judgment-creditor that it may somehow directly attach the assets of the LLC, the charging order buttresses the asset partition function of the LLC as a legal entity distinct from its members. Under most state formulae, the charging order is subject to redemption, and a lien upon the LLC interest created by the charging order is subject to foreclosure.
For a more comprehensive review of the charging order generally, see, e.g., Thomas E. Rutledge and Sarah S. Wilson, An Examination of the Charging Order Under Kentucky’s LLC and Partnership Acts (Part I), 99 Kentucky Law Journal Online 85 (2011); (Part II), 99 Kentucky Law Journal Online 107 (2011). Professor Bishop publishes a pair of resources regularly updated, that are particularly helpful with respect to remaining current with respect to developments in LLCs. The first is a tabular review of the charging order provisions that exist in the various LLC Acts, namely Fifty State Series: LLC Charging Order Statutes, available on SSRN.com. The second table, also available on SSRN, is titled Fifty State Series: LLC Charging Order Case Table, an invaluable resource in knowing the status of the law both in any individual state and across the country.
The Taxation of Distributions Diverted to the Judgment-Creditor
One of the more contentious issues with respect to charging orders, and a topic on which there has been published a great deal of misinformation, is taxation. It has been asserted by some that the judgment-creditor holding a charging order will bear the tax liability with respect to allocations and distributions made with respect to the judgment-debtor’s interest in the LLC, the net effect of which is to expose the judgment-creditor to the risk of phantom income should the LLC not make any distributions. Simply put, this is false.
Under Revenue Ruling 77-137, until such time as the judgment-creditor might foreclose on the charged LLC interest, thereby becoming an assignee thereof, it is the judgment-debtor who remains, for tax purposes, the member in the LLC. It is to the judgment-debtor who is the member in the LLC that the allocation of profits, losses, and other tax items on Form K-1 will be reported, and not the account of the judgment-creditor. This outcome is consistent as well with the principle that the judgment-debtor should satisfy the judgment with after-tax dollars; if the judgment-debtor were able to shift to the judgment-creditor the tax liability with respect to the funds ultimately distributed, the judgment-debtor could, effectively, satisfy the debt with pre-tax dollars. Whether the judgment-creditor will need to report as income the payments received pursuant to the charging order is a matter resolved elsewhere in the Code. For example, if the judgment involved the judgment-debtor’s personal injury of the judgment-creditor, under Code Section 104(2) the payments may not be taxable income.
Turning from tax law, a variety of decisions on charging orders have been released in the last year or so, and they illustrate the many ambiguities that exist. For example, the decision of the Federal District Court for Kansas rendered in Meyer v. Christie, 2011 WL 4857905 (Oct. 13, 2011), illuminates that court’s confusion regarding the status of the holder of an assignee interest in an LLC and the holder of a charging order. The court incorrectly conflated the two positions, an outcome especially pernicious in Kansas as that state has an atypical statute, it providing that the assignee of the sole member of an LLC has the right to participate in the LLC’s management and affairs.
The decision of a Montana bankruptcy court rendered in In re Jonas, No. 10-60248-11, 2012 WL 2994724 (July 3, 2012), reviewed the authority of a receiver appointed to enforce a charging order. Almost every statute allows the court issuing a charging order to appoint a receiver to receive the proceeds thereof. In the Jonas decision, it was unclear whether the charged judgment-debtors held 50 percent or 100 percent of the interest in the subject LLC, but it is clear that a receiver was appointed with respect thereto. However, the court went on to discuss the receiver taking control of the LLC and its assets, rather than simply receiving the distributions as made. In the context of a single member LLC, if in fact that is what was the situation, the court may have, at least subconsciously, applying the rule set forth in In re Albright. See also Thomas E. Rutledge and Thomas Earl Geu, The Albright Decision, Why an SMLLC is not an Appropriate Asset Protection Vehicle, 5 Bus. Ent. 16 (Sept./Oct. 2003). If, on the other hand, the LLC had another member, the charging order receiver taking control of the LLC itself was clearly inappropriate.
Turning to the decision of the Iowa Court of Appeals rendered in Wells Fargo Bank, N.A. v. Continuous Control Solutions, Inc., No. 2-431/11-1285 (Aug. 8, 2012), the court determined that the holder of a charging order does not, in that capacity, have the right to compel the LLC to disclose its books and records. In that an assignee of an interest in an LLC does not have document inspection rights, the holder of a charging order, being one step further removed from the LLC, will have no inspection rights. In a similar vein was the decision of the Nevada court rendered in Waddell v. H2O, Inc., 128 Nev. Adv. Op. No. 9 (March 1, 2012), to the effect that an entry of a charging order does not divest the judgment-creditor of the right to participate in the LLC’s management. Rather, in that the charging order does not transfer title to the charged interest, it is retained by the judgment-debtor and they may continue to exercise the rights of a member.
Leonard v. Leonard, 2012 WL 4558390 (N.J. J. super A.D. June 13, 2011), is a most curious decision in which the court directed that a “writ of execution” be issued in support of a charging order. Those who are regularly involved with charging orders found this decision most confusing in that it was not clear what was added to a charging order by a writ of execution. Having consulted with several practitioners in New Jersey, it became clear that, in light of the lack of familiarity with the charging order as compared with the effect of a writ of execution, the latter was entered as a “belt and suspenders” to the comparatively obscure charging order.
In a recent decision by the Federal District Court for the Central District of Illinois, it considered the rights of the receiver over limited partnerships controlled by, apparently, married taxpayers. Its reasoning, however, may lead to the conclusion that the charging order is ineffective in a single-member LLC in Illinois. United States v. Zabka, ___ F. Supp. 2d ___, 2012 WL 5246918 (C.D. Ill. Sept. 11, 2012).
Federal tax liens were assessed against Robert and Deborah Zabka for numerous years of their personal tax liability. Judgment having been entered in favor of the government, the matter before the court involved the appointment of a receiver to collect, manage, and ultimately sell the Zabka’s property in order to satisfy the federal tax liens. One argument made by the Zabkas was that the federal receiver must comply with the Illinois charging order statute under the Limited Partnership Act, namely 805 Ill. Comp. Stat. 215/703. This statute expressly provides that it is the “exclusive remedy” of a judgment-creditor.
In rejecting that argument, the court noted that the government’s lien attached to all of the Zabka’s property, which “property and rights to property included their 100 percent ownership interest in the Limited Partnerships.” 2012 WL 5246918, *5. The court went on to note that the statutory language addresses the rights of a judgment-creditor of “a” (i.e., a singular) partner or transferee. From there, the court wrote:
The plain language of that statute – which refers to a judgment-creditor of an individual partner – demonstrates that it was designed to protect other partners in a partnership when one, but perhaps not all of the partners, have become encumbered with a judgment-creditor. In that respect, the Court finds that the state statute is irrelevant to the circumstances of the instant case because the Government’s federal tax lien attached to the Zabka’s 100 percent ownership interest of the Limited Partnerships.
By this reasoning, if a judgment-debtor is the sole member of an LLC, the judgment-creditor is not restricted to a charging order. Whether, in that situation, the judgment-creditor is able to seize the entirely of the LLC transferable interest, thereby becoming an assignee of all the economic benefits of the venture, and seize as well the management rights in the company or something else, is left to be determined. What is clear, however, is that the dangerous step of eliminating the charging order in the single-member LLC, simply because it is a single-member LLC, appears to have been taken.
Bay Guardian and Choice of Law
Bay Guardian Company, Inc. v. New Times Media LLC is an important charging order decision in that the primary question involved in this litigation is whether it is the law of the jurisdiction in which a judgment is entered against a member of a LLC that will govern the scope and effect of the charging order versus a requirement that there be applied the law of the jurisdiction of the LLC’s organization. This choice of law question arises because there are, between the charging order provisions of the various states, important differences. For example, under the law of many states, it is provided that the judgment-creditor may foreclose on the charging order lien, thereby converting their lien interest into a title interest (assuming, of course, it is the judgment-creditor who purchases the lien upon the foreclosure sale). Other states expressly provide that there may not be a foreclosure on the charging order lien.
Memorably, at the LLC Institute, Mr. Adkisson suggested that the charging order bears the burden of illegitimacy (he actually utilized a somewhat more flowery term), and was able to share with the group some illuminating information. The charging order first arose under the British Partnership Act, there created as a mechanism to avoid the judgment-creditor invading the partnership and seizing certain of its assets in satisfaction of the judgment. As expertly reviewed in J. Gordon Gose, The Charging Order Under the Uniform Partnership Act, 28 Wash. L. Rev. & St. B. J. 1 (1953), the charging order was created to preclude the judgment-creditor invading the partnership and seizing all or a portion of its assets in order to satisfy the claim against only an individual partner. It is this concept that was then carried forward into American law and most notably the Uniform Partnership Act. But here, Jay suggests, it where the mistake was made. According to his research, at the time the charging order was incorporated into the English Partnership Act, the English law did not otherwise provide for a lien upon the distributional interest in the partnership. Hence, the charging order was created to fill that gap. When the charging order was incorporated into the American Uniform Partnership Act (and from that act into all of the subsequent unincorporated entity laws including those of LLCs), it was not recognized that American law already provided for a lien on the distributional interest. Consequently, there existed no lacuna in American law requiring that the charging order be created. Consequently, it would be possible to delete the charging order’s provisions from all of these various acts and rely upon generally available remedies law to address the rights of the judgment-creditor of a judgment-debtor who is either a member in an LLC or a partner in a partnership.
Turning from that point, the charging order is a remedy; for example, the Delaware LLC Act provides that “a charging order is the exclusive remedy by which a judgment-creditor. . . .” Del. Code Ann. tit. 6, § 18-703(d). Hence, the charging order is a question of the law of remedies and “the law of remedies is always local.” Applying this rule, the conflicts question is resolved, and it is appropriate for the court to apply the law of the jurisdiction in which it sits in determining what remedies, including the characteristics of any charging orders that may be entered, will apply irrespective of the law of the jurisdiction of organization. Assume a Delaware LLC with a member resident in Kentucky; Delaware does not allow for foreclosure on the charging order while Kentucky does. A judgment is entered in Kentucky against the member and a charging order is to be issued against the interest in the Delaware LLC. Is the Kentucky court justified in applying Kentucky law to the question of whether there may be foreclosure? Under the principle that all remedies law is local, the answer is “yes.”
Following from that path of analysis, efforts by various states to increase their rankings with respect to asset protection are somewhat misleading. While a state may gain an increased ranking by, for example, precluding the foreclosure on the charging order lien, that statutory limitation will be effective only in that individual state. If there is judgment against a member in another state, and that other state has more liberal laws, the asset protection objectives may be thwarted.
As charging orders exist in almost every state’s partnership, limited partnership and LLC acts, irrespective of distinctions between the various states, there likely is no policy basis for having different statutory formulae for the charging orders in a single state. Rather, in order to avoid judicial distinctions based upon what are likely unintended language distinctions, it would serve state drafting committees to provide a single formula that is used by each state. The exception to this might be additional language addressing single member LLCs used for asset protection purposes that are deemed abusive; of course, as the partnership or limited partnership require at least two owners, that language may be unique to the LLC Act.
The problem for practitioners is that numerous unresolved issues exist as to the application of charging orders. The courts are just beginning to scratch the conflicts-of-law issues, creditors are with mixed success are utilizing other theories of relief such as alter ego law to circumvent charging order protection, and the effectiveness of charging order protection in a bankruptcy proceeding is still less than certain. However, these challenges seem to be most successful in the single-member (or effectively single-member) context, and less successful in true multiple-member situations where the interests of the other, non-debtor members are substantial.
In other words, this area is still ripe for litigation, and planners for the time being should err on the side of the conservative use of partnerships and LLCs to the extent one is concerned about future creditor challenges to a member of such an entity. At the same time, there exists great opportunity to forestall these questions, at least to the degree they are dependent upon state law, by careful redrafting of the charging order provisions of the various acts.