Charging Order Protections

Charging order protections are some of the most important but least understood business organization law features of LLCs under all U.S. LLC statutes. The fact that LLCs provide charging order protections and corporations do not is of significant importance in business entity formation practice. The law governing charging order protections is arguably one of the single most comlex area of LLC business organization law. Charging orders are also comlex and often misunderstood froma federal income tax viewpoint. 

What types of business and business owners can benefit from charging order protections?

Any business that has valuable business assets, including cash, intelectual property, or hard assets such as real property, vehicles and equipement, can derive major benefits from LLC charging order protections.

A few issues concerning charging orders:

  1. The protection of management rights means that even if a business does not have any valuable business assets that the business can still benefit from LLC charging order protections.
  2. Charging order protections apply only to debts arising outside the course of an LLC's business.
  3. Charging order protections do not apply when LLC members incur debts in connection with the LLC's business. In this situation, the creditors in question will  be creditors not only of the culpable members and the LLC will be at risk to these creditors to the extent that any judgments that the creditors may obtain exceed or are not covered by the members or the LLC's liability insurance
  4. Charging order protections will most likely not protect your single member LLC (see related cases)

(1) Overview

What is a charging order?

When creditors of members of multi-member LLCs ("member-debtors-in-default") obtain unsatisfied judgments for conduct member-debtor-in-default unrelated to the business of their LLCs, these creditors may obtain "charging orders" agianst the LLC. These orders will require these LLCs to pay these creditors any amounts otherwise payable as distributions by these LLCs to these member-debtor-in-default. With respect to the member-debtor-in-default, the other members, and the LLC these chargind orders are the creditors' only remedy. In particular, the creditors cannot obtain any of the members' other rights, including voting rights. Which means that the creditor cannot become a substituted member to the LLC and therefore cannot forc the sale of LLC assets in satisfaction of their judgments.

Do Single Member LLCs Provide Sufficient Charging Order Protection?

Under the LLC acts of most states, the relevant case law and the policies underlying charging order provisions hold or strongly suggest that charging order protections are available only to the members of multi-member LLCs. Wyoming, however, has amended the charging order provisions in its LLC act to provide the members of single member LLCs with charging order protections (see § 17-29-503 of the Wyoming LLC Act). However there is serious doubt as to whether other states would enforce these provisions of the Wyoming LLC Act.

Quick Facts:

  1. Charging order protections are significantly different from limited liability protections
  2. All 51 LLC acts provide for charging order protections. 
  3. Charging order protections are little known among lawyers (this is changing however).
  4. Corporations do not provide charging order protections. The only corporate act that contains provisions allowing for charging order protections is that of Nevada. The fact that LLC statutes do provide for charging order protections and that most corporate acts do not is, for many business owners, the single most important business organization law difference between these two types of business organization law statutes.
  5. The fact that multi-member LLCs do Provide charging order protections and that single (as well as multi-shareholder corporations) do not provide them constitutes a major business organization law factor in choosing multi-member LLCs over single- or multi-shareholder corporations for business start-ups. 

(2) History and Purpose of Charging Order Protections

LLC charging order protections originated in the 1880s in Enlgish general partnership law. There are three somewhat diverse policies underlying charging order protections:

  1. Protect Non-Debtor Members: Protection of non-debtor members of an LLC from losing the going-concern value of their LLC because of misconduct by debtor-members unrelated to the LLC's business.
  2. Pick-your-partner: The classic "partnership compatibility" policy sometimes called the "pick-your-partner" principl. This principle is that because of their joint and several partnership liability and for other reasons, the partners of general partnerships should be able to choose their own partners and not be forced to accept creditors of debtor-members as partners. As a matter of policy, the applicability of this principle to LLCs and other limited liability entities may be questioned, at least in cases which, as a practical matter, the pick-your-partner principle doesn't make sense.
  3. Asset Partitioning: It has been suggested that also underlying charging orders is a policy to make the assets of a business equally available to all of its unsecured creditors in accordance with the usual standards of "first-in-time," etc.

(3) Value of Charging Order Protections

Charging order protections can provide several different kinds of powerful business asset protections to multi-member LLCs and their members. Therefore if LLC formation clients need or can benefit from charging order protections, you should form their LLCs as a multi-member LLC and have at least two members. However, remember that the LLC must have a business purpose.

(4) LLC Interests and Debt Settlement

Due to the collection of unsatisfied judgments under charging orders being a slow process, the availability of charging order protections to member-debtors-in-default may effectively force creditors to negotiate settlements of their judgments on less then favorable terms. Nontheless, because members whose interests are subject to LLC charging orders must pay taxes on their shares of LLC income even though they cannot receive LLC distributions until the relevant credit judgments are paid in full, their liability for these taxes may cause some member-debtors-in-default to settle with judgment holders on terms that are unfavorable to these members.

(5) Statutory conversion from corporation to LLC

Due to the charging order protections that are provided by LLCs and not corporations means that many corporations should convert to LLCs to obtain charging order protections. Under the laws of many states there is a process called "statutory conversion" that makes these conversions relatively easy. If properly structured these statutory conversions are "F reorganizations" under the Internal Revenue Code (IRC § 361(a)(1)(f) and are tax-free.

(6) Charging orders under the Delaware LLC Act (DLLC)

 

The DLLC act is the preeminent United States LLC act, has strongy impacted many other state's LLC acts, and many charging order provisions in non-Delaware LLC acts generally resemble DLLC Act §18-703.

Overview as provided by § 18-703 of the DLLC Act: 

  • As provided by a judgment creditor of a member of member's assignee, a court having jurisdiction may charge the LLC interest of hte judgment debtor to satisfy the judgment. The the extent so charged, the judgment creditor has only the right to recieve any distributions to which the judgment debtor would otherwise have been entitled in respect of such limited liability company interest.
  • A charging order constitutes a lien on the judgment debtor's LLC interest
  • This chapter does not deprve a member of member's assignee of a right under exemption laws with respect to the judgment debtor's LLC interest.
  • The entry of a charging order is the exclusive remedy by which a judgment creditor of a member of a member's assignee may satsify a judgment out of the judgment debtor's LLC interest.
  • No creditor of a member or of a member's assignee shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to the property of the LLC
  • The Court of Chancery shall have jurisdiction to hear and determine any matter relating to any such charging order.

Charging orders as creditors' remedies against LLC member-debtors-in-default

Creditors' only Remedy: A judgment creditor that holds an unsatisfied judgment against a member of a Delaware LLC who is a member-debtor-in-default may obtain from a court of competent jurisdiction a "charging order" against a the LLC. This is the exclusive remedy of the judgment creditor as it is the only way that the judgment creditor may satisfy the judgment based on the member's LLC interest

The Effect:  The order requires that the LLC distribute to the creditor, to the extent of the judgment, any assets (including cash), which it would otherwise distribute to the member

LLC property:

The creditor has no remedy with respect to the LLC's property which is arguably because creditors can obtain an LLC's property only if they are able to vote to distribute this property to themselves in an LLC liquidation or otherwise.

Important: Distributions v. Compensation:

Definitions:

a) Compensation: By an LLC to its members means payments by the LLC to its members specifcally regarding compensation for their services.

b) Distributions: Transfers by the LLC to its members of cash and other assets in the members' capacity as members not as compensation for members' services to or for the LLC.

Types of Asset Protection Afforded by Charging Order Provisions under the DLLC Act:

  1. Protection of member-debtor-in-default from losing the member's rights as an LLC member, excluding the members rights to distributions from the LLC and is applicable regardless of the voting power of the member-debtor-in-default. Whether the member-debtor-in-default has minority voting power, equal voting power, or majority voting power. Charging order provisions protect from the creditor all of the member's rights as a member except his right to recieve distributions.
  2. Protection of other members from having to accept the creditor as a subistituted member for the defaulting member which is applicable regardless of the voting power of the defaulting member. Whether the defaulting member has a miniroty, equal, or majority voting power charging order protections protect the other members from having to accept the creditor as a substituted member for the defaulting member. What this does is preserve the "delectus personae" or "pick your partner" policy of partnership-like state-law business entities including LLCs. This protectection is not only important for business reasons but also for family and personal reasons.
  3.  Protection of the LLC from deadlock- only applicable if the defaulting member has equal voting power: if the defaulting member has equal voting power in the LLC, charging order protections protect the defaulting member, the other members, and the LLC from the risk of a deadlock in deciding matters regarding the operation of the LLC.
  4. Protection of the business of the LLC and its going-concern value in the hands of the defaulting member and the other members from any risk that the creditor will be able to exercise the voting power of the defaulting member to control the LLC and in particular the risk that the creditor will be able to use this power to force a sale of LLC assets in an attempt to satisfy the judgment. This is appicable if the defaulting member has a majority voting power. If the defaulting member has a majority voting power, charging order protections protect the defaulting member, the other members, and the LLC from risk that the creditor will be able to gain control of the LLC and from the risk that upon gaining control of the LLC that the creditor will be able to force a sale of LLC assets to satisfy the judgment.

Federal Income Tax Implications of Charging Order Protections for Creditors and Defaulting Members

Creditors who hold charging orders under DLLC Act § 18-703 have the rights of assignees with respect to distributions to the defaulting members but the are not the assignees. Under DLLC Act § 18-703, creditors that are holders of charging orders have, to the extent provided by the charging order, the rights of assignees of the LLC interest of the defaulting member to distributions tot he defaulting members. However creditors do not own these interests; they are not assigness of the LLC interest. Therefore for federal income tax purposes, they do not have the members' federal tax obligations, including, in  particular, any obligation to pay federal income taxes on income allocated to the members.

For federal income tax purposes, chargine order payments should not be thought of as "distributions" to creditors holding unsatisfied judgments against defaulting members, but rather, as transfer of LLC cash to these creditors in satisfaction of a judgment. In other words, creditors that obtain charging orders should not thereby be deemed to incur "phantom income," and payments to them from LLCs under charging orders should be deemed for federal income tax purposes to be distributions of cash by the LLCs to the relevant defaulting members followed by payments of cash by these defaulting members to their creditors in satisfaction of their judgment.

Notwithstanding any existing charging order, these defaulting members remain subject to federal income tax on allocations to them of LLC profits. Creditors who recieve payments under charging orders must treat these payments as repayment of debts. These creditors are taxable on these payments only to the extent the payments consist of interest on these debts.

State Tax Consequences of Charging Orders:

The state tax consequences of charging order protections may vary widely from state to state. That being said, never overlook the impact of state tax issues.

(7) Charging order protections v. limited liabilty

Charging order protections:  Charging order protections apply only when an LLC member incurs an unsatisfied judgment to a creditor in a claim unrelated to the business of the LLC. Charging orders do not protect the the general assets of the member-debtor-in-default but only that member's membership rights, excluding the members' rights to distributions. Charging order protections do not directly protect the assets of the LLC or the membership rights of the other members. They do however protect these rights and assets indirectly.

Limited Liability:

Limited liability protections apply to protect the personal assets of LLC members, including their LLC membership rights, from claims against the LLC. These claims can result from negligence by the LLC's employees. It is important to be aware that the LLC liability shield will not protect an LLC member from the consequences of the members personal misconduct relating to the business of the LLC- No liability shield affords this protection.

(8) Charging orders and bankruptcy law

Section 365(c)(1)(A) of the Bankruptcy Act as possible defense against trustee in bankruptcy. There are many unanswered questions concerning the impact of federal bankruptcy law and state insolvency law on the protections afforded by LLC statutory charging order provisions. However the existing case law under § 365 (c)(1)(A) of the Federal Bankruptcy Act suggests that with regard to debtors in default that are members of multi-member LLCs, partners of general partnerships, limited partners of limited partnerships, and beneficiaries of statutory business trusts (referred to here collectively as "debtors"):

  1. Trustees in bankruptcy will, in general, succeed to all of the rights of these debtors in these entities, including voting and other non-economic rights, in proceedings under Chapter 7 of the Federal Bankruptcy Act
  2. However to the extent that these debtors are directly and meaningfully involved in the management of these entities, their co-members may be able to prevent these trustees from succeeding to the management rights of the defaulting members under the executory agreement exception in Federal Bankruptcy Act § 365(c)(1)(A) (See In re Baldwin)

(9) Charging order protections and drafting of LLC operating agreements

Is there a need to include provisions in operating agreements regarding charging orders?

Charging orders do not affect LLC operations, they only have an economic effect on the defaulting member. Therefore there should be no need to address charging order issues in LLC operating agreements.

It is however possible to insert provisions to address charging order matters in the operating agreement of an LLC by minimizing the right to distributions and maximizing guaranteed payments, etc. Though because of charging order considerations the members of some LLCs may want to maximize the amount of LLC profits paid to working members on the basis of salary. guaranteed payments, or bonuses, and mazimize payments in the form of distributions.

Converting distributions to guaranteed payments, etc.,

 LLC members may want to provide for the possibility of charging orders against their members if the LLC becomes subject to a charging order because of a judgment against a defaulting member, the LLC will convert amounts that might otherwise be paid to the  member as distributions to salary of bonus. In this case the allocations to the member will be reallocated pro rata among the other members.

Dissociation of members:

In the case of a member whose misconduct results in charging orders agianst the LLC the othe members may want to provide in their operating agreements that if a member engages in conduct that results in a charging order against the LLC, the other members may dissociate the member. This provision may be useful because, among other considerations, members who are no longer able to receive distributions from their LLCs by reasons of charging orders may lose some or all of their motivation to provide competent services to or for their LLC. However, if the LLC of the other members have a right or duty to buy out the dissociated member, this buy-out may involve significant financial burdens for the LLC or the other members.