LLC & ASSET PROTECTION

 

SUMMARY

• Asset Protection with LLC
• Draft Operating Agreement to maximize the utility of the Charging order.
• Keep the business running while charging order is pending and in-effect
• Can only pursue member interests with charging order
• If against individual, only has right of the member – not the entire LLC
• Draft as follows:

1. Assignments: can only assign economic interest – not entire interest

(a) If family LLC, then can say no assignability

1. Business purpose: LLC must have a proper purpose
2. Distributions: Must be made to the members on a pro-rata basis.
   1. The managing member has to make distributions have to be made either to all members or none.
   2. Managing members may not make any distributions if there is a pending charging order. 

 

CHARGING ORDERS

A Charging order, in English law, is an order obtained from a court or judge by a judgment creditor, by which the property of the judgment debtor in any stocks or funds or land stands charged with the payment of the amount for which judgment shall have been recovered, with interest and cost

 

§ 708.310 OF THE CALIFORNIA CODE OF CIVIL PROCEDURES

If a money judgment is rendered against a partner or member but not against the partnership or limited liability company, the judgment debtor’s interest in the partnership or limited liability company may be applied toward the satisfaction of the judgment by an order charging the judgment debtor’s interest pursuant to § 15673, 16504, 17302 of the California Corporations Code.

 

Summary: If a money judgment is rendered against a partner but not against the partnership, the judgment debtor’s interest in the partnership may be applied toward the satisfaction of the judgment by an order charging the judgment debtor’s interest pursuant to Section 15029 or 15673 of the Corporations Code

 

§ 708.320 SERVICE OF NOTICE OF MOTION FOR ORDER CHARGING INTEREST AS CREATING LIEN ON INTEREST – DURATION.

1. A lien on a judgment debtor’s interest in a partnership or limited liability company is created by service of a notice of motion for a charging order on the judgment debtor and on either of the following:

 

1. All partners or the partnership;
2. All members or the limited liability company.
3. If a charging order is issued, the lien created pursuant to subdivision (a) continues under the terms of the order. If issuance of the charging order is denied, the lien is extinguished.

 

§ 15673 CALIFORNIA CORPORATIONS CODE

On application to a court of competent jurisdiction by any judgment creditor of a partner, the court may charge the limited 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 limited partnership interest. This chapter does not deprive any partner of the benefit of any exemption laws applicable to the partner's limited partnership interest.

 

Summary: On application to a court of competent jurisdiction by any judgment creditor of a partner, the court may charge the limited 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 limited partnership interest

 

§ 15672 CALIFORNIA CORPORATIONS CODE

(a) A limited partnership interest is assignable in whole or in part. An assignment of a limited partnership interest does not dissolve a limited partnership or, other than as set forth in this chapter, entitle the assignee to become or to exercise any rights of a partner. An assignment entitles the assignee to receive, to the extent assigned, the distributions and the allocations of income, gain, loss, deduction, credit, or similar item, to which the assignor would be entitled. Except as otherwise provided in the assignment, an assignee of a limited partnership interest in a limited partnership with over 100 limited partners also shall be entitled to all of the rights granted to a limited partner pursuant to Section 15634. A limited partner remains a partner upon assignment of all or part of the limited partner's limited partnership interest, with the rights that the assignee does not acquire or possess, subject to the assignee becoming a limited partner pursuant to subdivision

(a) of Section 15674.

          (b) The pledge of, or granting of a security interest, lien, or

other encumbrance in or against any or all of the partnership

interest of a partner shall not cause the partner to cease to be a

partner or to grant to anyone else the power to exercise any rights

or powers of a partner.

            c) A partnership agreement may provide that a general partner may

not assign or encumber a partnership interest in a limited

partnership.

 

Summary: An assignment of a limited partnership interest does not dissolve a limited partnership or, other than as set forth in this chapter, entitle the assignee to become or to exercise any rights of a partner. An assignment entitles the assignee to receive, to the extent assigned, the distributions and the allocations of income, gain, loss, deduction, credit, or similar item, to which the assignor would be entitled.

 

§16504 CALIFORNIA CORPORATIONS CODE

(a) On application by a judgment creditor of a partner or of partner's transferee, a court having jurisdiction may charge the transferable interest of the judgment debtor to satisfy the judgment.  The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor in respect of the partnership and make all other orders, directions, accounts, and inquiries the judgment debtor might have made or that the circumstances of the case may require.

   (b) A charging order constitutes a lien on the judgment debtor's

transferable interest in the partnership. The court may order a

foreclosure of the interest subject to the charging order at any

time. The purchaser at the foreclosure sale has the rights of a

transferee.

   (c) At any time before foreclosure, an interest charged may be redeemed in any of the following manners:

               (1) By the judgment debtor.

               (2) With property other than partnership property, by one or more

               of the other partners.

               (3) With partnership property, by one or more of the other

               partners with the consent of all of the partners whose interests are

               not so charged.

   (d) This chapter does not deprive a partner of a right under

               exemption laws with respect to the partner's interest in the

               partnership.

   (e) This section provides the exclusive remedy by which a judgment

               creditor of a partner or partner's transferee may satisfy a judgment

               out of the judgment debtor's transferable interest in the

partnership.

 

§ 17302 CALIFORNIA CORPORATIONS CODE

(a) On application by a judgment creditor of a member or of a member's assignee, a court having jurisdiction may charge the assignable membership interest of the judgment debtor to satisfy the judgment. The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor in respect   the limited liability company and may make all other orders, directions, accounts, and inquiries that the judgment debtor might

have made or that the circumstances of the case may require.

   (b) A charging order constitutes a lien on the judgment debtor's assignable membership interest. The court may order a foreclosure on the membership interest subject to the charging order at any time. The purchaser at the foreclosure sale has the rights of an assignee.

 

   (c) At any time before foreclosure, a membership interest charged may be redeemed in any of the following manners:

            (1) By the judgment debtor.

            (2) With property other than property of the limited liability company by one or more of the other members.

            (3) With property of the limited liability company by one or more of the other members with the consent of all of the members whose membership interests are not so charged.

   (d) This section does not deprive any member or assignee of a membership interest of the benefit of any exemption laws applicable to the membership interest in the limited liability company.

   (e) This section provides the exclusive remedy by which a judgment creditor of a member or of a member's assignee may satisfy a judgment out of the judgment debtor's membership interest in the limited liability company.

 

Summary: On application by a judgment creditor of a member or of a member’s assignee, a court having jurisdiction may charge the assignable membership interest of the judgment debtor to satisfy the judgment.

 

§ 17301 CALIFORNIA CORPORATIONS CODE

(a) Except as provided in the articles of organization or the operating agreement:

   (1) A membership interest or an economic interest is assignable in whole or in part, provided, however, that no membership interest may be assigned without the consent of a majority in interest of the members not transferring their interests, as required pursuant to Section 17303.

   (2) An assignment of an economic interest does not of itself dissolve the limited liability company or, other than as set forth in the articles of organization or operating agreement, entitle the assignee to vote or participate in the management and affairs of the limited liability company or to become or exercise any rights of a member.

   (3) An assignment of an economic interest merely entitles the assignee to receive, to the extent assigned, the distributions and the allocations of income, gains, losses, deductions, credit, or similar items to which the assignor would be entitled.

   (4) Upon the assignment of all or part of an economic interest, the assignor shall provide the manager or member of the limited liability company responsible for maintaining its books and records with the name and address of the assignee, together with details of the interest assigned. Upon receipt of that notice, the limited liability company shall amend the list required by paragraph (1) of subdivision (a) of Section 17058 accordingly. Until the assignee of that interest becomes a member, the assignor continues to be a member and to have the power to exercise any rights and powers of a member, including the right to vote which, in the case of a member who has assigned his or her or its entire economic interest in the limited liability company, shall include the right to vote in proportion to the interest in current profits that the assigning member would have, had the assignment not been made.

   (b) Except to the extent assumed by agreement, until an assignee of an economic interest in a limited liability company becomes a member, the assignee shall have no liability to the limited liability Company under Chapter 5 (commencing with Section 17200) and Chapter 6 (commencing with Section 17250) solely as a result of the assignment. The assignor of a membership interest is not released from liability as a member solely as a result of the assignment.    (c) The pledge of, or granting of, a security interest, lien, or other encumbrance in or against any or all of the membership interest of a member shall not cause the member to cease to be a member or to grant to anyone else the power to exercise any rights or powers of a member.

            Summary:

(a)(1) A membership interest or an economic interest is assignable in whole or in part, provided, however, that no membership interest may be assigned without the consent of a majority in interest of the members not transferring their interests.

 

(a)(2) An assignment of an economic interest does not of itself dissolve the limited liability company or, other than as set forth in the articles of organization or operating agreement, entitle the assignee to vote or participate in the management and affairs of the limited liability company or to become or exercise any rights of a member.

 

(a)(3) An assignment of an economic interest merely entitles the assignee to receive, to the extent assigned, the distributions and the allocations of income, gains, losses, deductions, credit, or similar items to which the assignor would be entitled.

 

Note: If asset protection is the primarily or sole reason for setting up the limited partnership or the LLC, the partner/member may have nothing to lose by adding, in some form, the non-assignability language.

The author particularly favors granting a third-party manager approval rights over assignability and transferability of all interests, including economic rights. The downside of this practice would cause one to default to the standard charging order rules discussed above. The upside would deprive the creditor even from the right to receive distributions. This strategy will not work in Delaware, because the creditor is expressly granted the right to receive distributions.

 

CHARGING ORDER CASES IN CALIFORNIA

 

Charging Order Cases

There are not a great many cases on charging orders, primarily for two reasons. First, many creditors fail to find the charging order to be a useful remedy, and seek to settle with the debtor rather than hoping to get a distribution out of the entity. Second, even when creditors pursue the charging order remedy, the charging order is granted by a trial court and is rarely appealed, so there are few published opinions. Many of the reported cases deal with the creditor’s ability to foreclose; most cases authorize the creditor to foreclose but restrict the buyer of the interest to the economic component of the interest. There are also some interesting outliers, readily demonstrating the degree of judicial imagination involved in statutory interpretation.

The California Supreme Court has affirmed that the charging order has replaced levies of execution as the remedy for reaching partnership interests. The two most interesting charging order cases out of California are Crocker Nat. Bank v. Perroton, and Hellman v. Anderson.

In Crocker, the court concluded that a partnership interest may be foreclosed upon if the sale of the interest does not violate the partnership agreement and the other partners consent to the sale. In Hellman, the court confirmed that foreclosure of the charged interest is authorized by the charging order statute, but disagreed with Crocker that consent of non-debtor partners is required. The court concluded that consent from other partners is not required because pursuant to the foreclosure sale the buyer receives only the economic interest in the partnership, but not voting or management rights. Consequently, the buyer will never have ability to interfere with the business of the partnership and inconvenience the non-debtor partners. Going even further, the Hellman court remanded the case back to trial court for a determination whether the foreclosure of the economic interest (limited as that interest may be) would unduly interfere with the partnership business.

In the only reported Florida opinion, the court concluded that the simplicity of the language of the charging order statute - “the judgment creditor has only the rights of an assignee” - “necessarily” precluded foreclosure. Florida statutes were subsequently amended to specifically preclude foreclosure (see above).

A Minnesota court held that the “exclusivity” of the charging order must be read in conjunction with the Uniform Fraudulent Conveyances Act. In this case a limited partnership interest subject to a charging order was transferred in a fraudulent conveyance to the debtor’s wife and attorney. The creditor was allowed to pursue the limited partnership interest transferred through the fraudulent conveyance and retain its charging order.

In Deutsch v. Wolff, a Missouri court analyzed, in a charging order context, the receiver’s right to manage the partnership. The court drew a distinction between a creditor who becomes an assignee of the debtor-partner (no management rights), and a receiver appointed by the court. A receiver may be granted management rights “when manager of a partnership has willfully engaged in a series of illegal activities…” It seems that in this case the court found the ability to appoint the receiver through the Missouri charging order statute, but vested the receiver with management rights using equity arguments unrelated to the charging order (i.e., a receiver could have been appointed simply because the general partner was defrauding the limited partners). A similar conclusion, under similar circumstances, was reached by courts in Nevada, Kansas and Minnesota.

In Baker v. Dorfman, a New York district court assigned 75% of the single-member’s interest in an LLC (the assignment was limited to the profits of the LLC) to the judgment creditor (pursuant to the New York LLC charging order statutes) and appointed a receiver. The receiver was empowered by a magistrate not only to collect the profits, but also to participate in the management of the LLC and to work to increase its profitability. The LLC itself was also a debtor of the judgment creditor in its capacity as a successor in liability of the member-debtor.

The magistrate’s ability to do anything but collect profits was later affirmed (with minor modifications) by the Second Circuit. By granting the receiver the ability to manage the LLC, the court certainly went far beyond New York’s charging order statute (discussed above). Similar to Deutsch, Tupper, Arkansas City and Windom, there were allegations of fraud against the debtor, and appointment of the receiver may have been possible even absent a charging order. These cases seem to reaffirm that a debtor subject to a charging order cannot lose its management rights because of the charging order.

In a different New York decision, the court concluded that the charging order was not the sole remedy authorized by the charging order statute, and that levy of the charged interest was proper. The court did make it apparent that the levy did not confer on the creditor a greater interest than the one obtained through the charging order.

MAXIMIZING THE UTILITY OF THE CHARGIN ORDER

 

Maximizing the Utility of Charging Orders

Most partnership and operating agreements being drafted today provide that only the economic interest in the LLC may be assigned, but not the entire membership interest. This mirrors the uniform acts and the various state statutes.

A carefully drafted partnership or operating agreement can greatly enhance the charging order protection. As discussed above, the statutes allow partners and members to override the default statutory provision of assignability of interests. In most business dealings it would not be possible for practitioners to make LLC interests entirely non-assignable. Clients want to retain flexibility and ability to dispose of their LLC interests. However, in family settings, or for LLCs set up solely for liability protection purposes, it may be possible to either prevent assignability altogether or to limit it in such a manner so as to make the charging order remedy of little value to the creditor.

Because the charging order protection is predicated on the debtor’s continued ability to manage the entity and thus control distributions, the distribution clauses of partnership/LLC agreements become critical. If the agreement provides that all distributions must be made to the partners/members on a pro-rata basis, then distributions have to be made either to all partners/members or none. This means that if one partner/member is pursued by a creditor holding a charging order, protecting that partner/member would mean withholding distributions from all other partners/members of that LLC. Consequently, agreements should be drafted to deal with this potential problem.

One possible solution is to allow the general partner or the manager, in the partnership or operating agreement, to make distributions to all other members, and not the debtor-member. The author’s preferred solution, is to provide that the debtor vests in the distribution (i.e., cash and assets are distributable to the debtor) but instructing the general partner or the manager to withhold the distribution while the charging order is pending. This allows the entity to allocate taxable income to the creditor (following a foreclosure) without distributing cash to the creditor.

Pursuant to the uniform acts and most state statutes that allow foreclosure, prior to the foreclosure, the debtor may redeem its partnership/membership interest. The statute does not specify that the interest must be redeemed for fair market value. This leaves room for drafters to insert various favorable redemption provisions into the operating agreement, such as a poison pill.

A poison pill provision usually allows either the entity itself or the non-debtor partners/members to buy-out the debtor for a nominal amount of money. The poison pill has the effect of substituting the debtor’s interest in the entity with a nominal amount of cash, which limits the assets that a creditor can collect against. If the entity is established well in advance of any creditor challenges, when the partners/members do not know who will benefit from the poison pill and who will find it detrimental, it should be enforceable (although there are no cases on this point). Because the poison pill will kick in automatically, it should not be deemed a fraudulent transfer, although a challenge is likely. Poison pill provisions are usually limited to family-setting LLCs where the family members are on good terms with each other.