There are relatively few types of assets that are statutorily protected from claims of creditors. Membership interests in limited liability companies ("LLCs") and partnership interests are afforded a significant level of protection through the charging order mechanism.
The Importance of History
Before the advent of the charging order, a creditor pursuing a partner in a partnership was able to obtain from the court a writ of execution directly against the partnership's assets, which led to the seizure of such assets by the sheriff. This result was possible because the partnership itself was not treated as a juridical person, but simply as an aggregate of its partners.
The seizure of partnership assets meant that the sheriff could shut down the partnership's place of business. That caused the non-debtor partners to suffer financial losses, sometimes on par with the debtor partner, a process one court referred to as "clumsy."
To protect the non-debtor partners from the creditor of the debtor-partner, and to keep the creditor out of partnership affairs, it was necessary to keep the creditor from seizing partnership assets. This was also in line with the developing perception of partnerships as legal entities and not simple aggregates of partners. These objectives could be accomplished only by limiting the collection remedies that creditors previously enjoyed. Because any limitation on a creditor's remedies is a boon to the debtor, over the years charging orders have come to be perceived as asset protection tools.
The rationale behind the charging order limitation applied initially only to general partnerships, where every partner was involved in carrying on the business of the partnership; it did not apply to corporations because of their centralized management structure. However, over the years the charging order protection was extended to limited partners and LLC members.
Deconstructing the Uniform Acts
Most domestic and foreign partnership and limited liability company statutes provide for charging orders. Almost all domestic statutes are based on the uniform acts, such as the Revised Uniform Partnership Act of 1994 ("RUPA"), the Uniform Limited Partnership Act of 2001 ("ULPA") or the Uniform Limited Liability Company Act of 1996 ("ULLCA"), or the earlier versions of these acts.
The very first references to the charging order in the United States appeared in Section 28 of the Uniform Partnership Act of 1914 and Section 22 of the Uniform Limited Partnership Act of 1916. Both allowed creditors to petition the court for a charging order against the debtor's partnership interest. Both statutes, directly or indirectly, addressed the fact that the charging order was not the exclusive remedy of the creditor. Appointment of a receiver and foreclosure of the partnership interest were anticipated.
A 1976 amendment to the Uniform Limited Partnership Act clarified the charging order remedy. It provided that a judgment creditor has the rights of an assignee of the partnership interest.
Section 504 of both RUPA and ULLCA, and the ULLCA, at Section 504, introduced the following concepts: (i) a charging order is a lien on the judgment debtor's transferable interest; (ii) the purchaser at a foreclosure sale has the rights of a transferee; and (iii) the charging order is the exclusive means by which the creditor could pursue the partnership interest.
Both acts also provide that the charging order does not charge the entire partnership or membership interest of the debtor, but only the "transferable" (RUPA) or "distributional" (ULLCA) interest. However, the language providing that the creditor has the rights of an assignee was dropped.
Most recently, ULPA, in addition to the new language in the RUPA and the ULLCA, provides that (i) the judgment creditor has only the rights of a transferee, and (ii) the court may order a foreclosure only on the transferable interest.
All three most recent acts also provide that the charged interest may be redeemed prior to foreclosure.
The uniform acts make four important points: (1) the charging order is a lien on the judgment debtor's transferable/distributional interest; it is not a levy, (2) the creditor cannot exercise any management or voting rights because the creditor has only the rights of an assignee/transferee, (3) the foreclosure of the charged interest does not harm the debtor because the buyer at the foreclosure sale receives no greater right than was possessed by the original creditor, and (4) the creditor, expressly, has no remedy other than the charging order and foreclosure on the charging order.
Because the charging order creates a lien and not a levy, and because the creditor is not a transferee under ULPA, but has only the rights of a transferee, the creditor does not become the owner of the charged interest unless there is foreclosure. This has important tax ramifications, discussed below.
If the creditor is an assignee/transferee, or has the rights of an assignee/transferee, the uniform acts deprive the creditor of any voting, management or access to information rights. Let us use ULPA to see how that happens.
ULPA defines a "transferable interest" as a right to receive distributions. A "transferee" is defined as a person who receives a transferable interest. ULPA defines two bundles of rights that a partner may have in a partnership: economic rights and other rights. While economic rights are freely transferable, other rights (which include management and voting rights) are not transferable, unless made so in the partnership agreement.
ULPA further clarifies that a transferee has the right only to receive distributions, if and when made. The comments to the charging order section of ULPA provide:
This section balances the needs of a judgment creditor of a partner or transferee with the needs of the limited partnership and non-debtor partners and transferees. The section achieves that balance by allowing the judgment creditor to collect on the judgment through the transferable interest of the judgment debtor while prohibiting interference in the management and activities of the limited partnership.
Under this section, the judgment creditor of a partner or transferee is entitled to a charging order against the relevant transferable interest. While in effect, that order entitles the judgment creditor to whatever distributions would otherwise be due to the partner or transferee whose interest is subject to the order. The creditor has no say in the timing or amount of those distributions. The charging order does not entitle the creditor to accelerate any distributions or to otherwise interfere with the management and activities of the limited partnership.
Foreclosure of a charging order effects a permanent transfer of the charged transferable interest to the purchaser. The foreclosure does not, however, create any rights to participate in the management and conduct of the limited partnership's activities. The purchaser obtains nothing more than the status of a transferee.
ULLCA has similar provisions that restrict the creditor to a "distributional interest" (identical, except in name, to ULPA "transferable interest") that does not confer on the creditor any voting or management rights.
The creditor's inability to vote the charged interest or participate in the management of the entity is at the heart of the asset protection efficacy of the charging order. If the partnership or the LLC halts all distributions, the creditor has no ability to force the distributions.
Some practitioners fear the creditor's ability to foreclose. This fear appears to be entirely unfounded - the uniform acts clearly provide that only the charged interest may be foreclosed upon, and further provide that the purchaser at the foreclosure sale has only the rights of a transferee. To grant the purchaser of the foreclosed interest an interest greater than the right to receive distributions would mean granting to the purchaser voting and management rights associated with the debtor's interest in the entity. That would be contrary to the very reason why charging order statutes exist in the first place.
A creditor holding a charging order usually does not know whether any distributions will be forthcoming from the entity. This uncertainty is of little value to most creditors. But it may be possible to find a third party, possibly a collection firm, willing to buy the charged interest at a steep discount and then wait to get paid (which may be folly due to possible adverse tax consequences). Consequently, the ability to foreclose affords the creditor some limited value.
The creditor's ability to foreclose has no effect on the debtor. As long as no one can take away the debtor's management and voting rights, the debtor is not made worse off.
The exclusivity of the charging order (including the ability to foreclose on the charging order), which may be found in each recent uniform act, relates back to the origin of the charging order. The drafters of the uniform acts did not want to allow the creditor any possibility of gaining voting or management rights, and the exclusivity language should be read in that light.
A common point of confusion needs to be addressed with respect to exclusivity. Many cases dealing with charging orders focus on whether the charging order is the exclusive creditor remedy, or whether foreclosure is authorized (see discussion below). The uniform acts, until RUPA in 1994, never made the charging order the exclusive creditor remedy, although it was always understood that the creditor can never gain management rights. Beginning with RUPA, all uniforms acts have introduced the element of exclusivity, but it is not the charging order that is made the exclusive remedy. Instead, the acts make the respective sections of the acts dealing with charging orders the exclusive remedy, and these sections specifically allow foreclosure.
Some practitioners and commentators have suggested that the exclusivity language may mean that fraudulent transfer laws would not apply to transfers of assets to partnerships or limited liability companies. While a strict reading of the exclusivity language may, at first glance, suggest such an outcome, it would be incorrect. The charging order limitation protects the debtor's interest in the legal entity. If a creditor successfully establishes that a transfer of assets to a legal entity is a fraudulent transfer (which would be a separate legal action from the application for a charging order), the creditor no longer needs to pursue the debtor's interest in the entity. With a fraudulent transfer judgment, the creditor gains the ability to pursue the entity itself, in its capacity as the transferee of the assets. Accordingly, if the creditor has the ability to pursue the partnership or the LLC, the protection of the debtor's interest in the entity through the charging order becomes a moot point. Several courts have now opined on this subject as well, uniformly holding that the exclusivity language of the charging order statutes is not a bar to a fraudulent transfer challenge.
Charging Order Cases
There are few cases dealing with charging orders, 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 hope to get a distribution from the entity. Second, even when creditors pursue the charging order remedy, the charging order is granted by a trial court and is rarely appealed, resulting in 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 the foreclosure sale results in the buyer receiving only the economic interest in the partnership, 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 opinion of its kind, the Connecticut Supreme court determined that the uniform acts authorize not only foreclosure by sale, but also strict foreclosure (forfeiture of the partnership interest to the creditor, a concept now unique to Connecticut).
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.
Single-Member LLCs
Single-member LLCs deserve special attention in the charging order analysis. It may be argued that given the historical framework of charging orders, they should not protect single member LLC members, because there are no other "partners" to protect from the creditor.
Neither the uniform acts nor any of the state charging order statutes make any distinction between single-member and multi-member LLCs. Some courts have held that the charging order limitation would apply where all of the partners of a limited partnership were the debtors of a single creditor. The creditor had argued, to no avail, that because there were no "innocent" (non-debtor) partners to protect, the charging order protection should not apply.
One bankruptcy court held that the charging order protection does not apply to single-member LLCs. In Albright, the debtor was the sole member and manager of an LLC. The bankruptcy trustee asserted that it acquired the right to control the LLC and sell its assets, while the debtor sought to deny those rights, under the rationale discussed above.
The bankruptcy court concluded that based on Colorado LLC law, a membership interest in an LLC can be assigned, including management rights. The relevant statute provides that if all the other members do not approve of the assignment, then the assignee does not acquire management rights. If all the other members do approve, then the assignee may become a substituted member, acquiring all rights of a member).
Because in a single-member LLC there are no other members who can "not approve," an assignee will always become a substituted member. The statute was not revised following the introduction of single-member LLCs. The bankruptcy court concluded that if the LLC in Albright were a multi-member LLC, a different result would have been reached and the bankruptcy trustee would have been entitled only to the distributions of profits, but not management and control over the LLC.
The court's application of the Colorado assignability statutes is faulty. These statutes are implicated only when a member dies or assigns its interest, not in the context of bankruptcy.
The Albright case is often interpreted as a case on single-member LLC charging orders. However, the bankruptcy court devoted most of its analysis to the assignability of interests statutes, and only in passing noted that the debtor made a charging order argument. The court dismissed the debtor's charging order argument out of hand, noting that charging orders were intended to protect non-debtor "partners," and in single-member LLCs there is no one to protect.
The very limited analysis of charging orders engaged in by the Albright court is troubling. The court analyzes and follows Colorado statutes when dealing with the assignability of interests and determining how the charging order would work in a multi-member context. Inexplicably, the court completely ignored Colorado law with respect to applicability of the charging order. The Colorado charging order statute does not exempt single-member LLCs from the charging order limitation. The court completely ignores that and focuses on the historical framework of charging orders.
It is inappropriate to analyze legislative intent and historical origins of statutes when there is a clear statute on point. The Colorado charging order statute clearly limits the creditor to an economic interest in the LLC. When the Colorado legislature introduced the single-member LLC statute it is presumed to have known of the charging order statute. It chose not to make any changes to the latter. The Albright decision conveniently ignores these legal principles.
To date, with the exception of the Albright case, there are no cases analyzing the efficacy of charging orders in the single-member LLC context. Attorneys should caution their clients that if they are seeking to maximize their charging order protection, they should be forming multi-member LLCs or adding new members to existing LLCs. These new members would need to have some membership interest in the LLC, but is difficult to gage how large of an interest would be sufficient, and whether an economic interest would suffice, or are voting rights required as well. In Albright, the court concluded that if the analysis was carried out under the Colorado charging order statute, and there was another member, with a passive interest, of an "infinitesimal" nature, the bankruptcy trustee would not acquire any management or control rights.
In a community property state, if an LLC's only members are two spouses, holding their interests as community property, the LLC would probably not enjoy the protection of a multi-member LLC. If only one spouse were a debtor, then under the community property laws the creditor will be able to charge the LLC interests of both spouses. Thus, there would be no non-debtor members to protect with the charging order.
Reverse Piercing
Because of the charging order limitation, partnerships and LLCs afford a liability shield to its owners, by protecting (to some extent) the assets within these entities from the liabilities of the owners. Similar to the traditional liability shield commonly associated with limited liability entities, the protection of the charging order may be pierced by a creditor. In that eventually the charging order limitation becomes a moot point, because the entity is no longer considered to have a separate legal identity from its owners.
In Litchfield Asset Management Corp. v. Howell, after a judgment was entered against the debtor, she set up two LLCs and contributed cash to the two LLCs. The LLCs never operated a business, never made distributions or paid salaries, and the debtor used the assets of the LLC to pay her personal expenses and to make interest-free loans to family members. The court found that the debtor used her control over the LLCs to perpetrate a wrong, disregarded corporate formalities and exceeded her management authority (in making interest-free loans), and ordered reverse piercing of the LLCs.
Because there has always been a strong presumption against piercing the corporate veil (including reverse piercing), this threat to the charging order protection should be easily avoidable.
Practitioners should be wary about using partnerships and LLCs to protect personal property, such as investment accounts and residences. Most states allow the formation of partnerships and LLCs for any lawful purpose; others require a business purpose (profit or non-profit). In a state requiring a business purpose, a partnership or an LLC holding personal property may be subject to a reverse piercing claim. Entities holding personal assets should be formed in states like Delaware, that allow entities to be formed for any lawful purpose.
Tax Consequences
The tax consequences of the charging order, to the creditor and to the debtor, vary before and after foreclosure.
Until the charging order is foreclosed upon, it is a lien on the debtor's transferable interest similar to a garnishment. If the entity makes distributions to the creditor, then the tax consequences to the creditor are determined with reference to the underlying judgment.
The distributions made pursuant to a charging order are made in satisfaction of a judgment. Judgments are taxable based on the underlying cause of action, according to the "origin of the claim" test. For example, if the judgment relates to a personal injury or sickness, it may be entirely exempt from income under Section 104(a) of the Internal Revenue Code of 1986, as amended ("IRC"). Similarly, the judgment may be to enforce a loan extended by the creditor to the debtor, and the repayment of the loan would not be taxable. If the judgment does not relate to a personal injury or sickness, it will be taxable as either ordinary income or capital gain. Generally, recovery which compensates for harm to capital assets is a capital gain. All other income is ordinary.
While the creditor is being taxed on the distributions it receives, the debtor is also being taxed on the income of the entity. There are three ways to arrive at this conclusion. First, absent foreclosure, the debtor remains the owner of the economic interest in the entity. Whether the entity is taxed as a sole proprietorship, a partnership or a corporation, it is the owner of the economic interest who is properly taxable. Second, paying off the creditor reduces the outstanding liabilities of the debtor, which is an economic benefit to the creditor, and therefore taxable under the Haig-Simons definition of income. Third, the charging order (to the extent it works) simply forces the debtor to pay off its debts. Paying off debts is not always deductible (see below), and changing the mechanism of debt payment (debtor paying creditor directly after getting taxed on its share of distributions, versus intercepting distributions from the entity) should not alter that result by giving the debtor the equivalent of a deduction.
The debtor may be able to obtain a deduction for any distributions made by the entity to the creditor, if the judgment relates to the debtor's business, and paying it off would be deemed an "ordinary and necessary" business expense.
If there are no distributions being made to a creditor, then (absent foreclosure) the creditor is not taxable on the income of the entity.
Once a creditor forecloses on the partnership or membership interest, the charging order lien is converted into an actual economic interest in the entity, now owned by the creditor (or the buyer of the interest at a foreclosure sale). For federal tax purposes, the creditor acquires a property right in the economic interest (compared to the right to income), and is now treated as the owner of such interest.
The tax consequences to the creditor depend on two factors: (i) whether distributions are being made, and (ii) the federal income tax treatment of the entity.
If distributions are being made, then if the entity is taxed as a sole proprietorship (because it is disregarded for tax purposes) as a partnership, or subchapter S corporation, both the debtor's share of the income of the entity and the character of the income being generated by the entity will pass through to the creditor. If the entity is a subchapter C corporation, its distributions will be taxed to the debtor as dividends.
If distributions are not being made to the creditor, then if the entity is taxed as a sole proprietorship, partnership or S corporation, the creditor is still taxed on its share of the income of the entity, causing the creditor to receive "phantom" income. If the entity is a subchapter C corporation, the creditor will not be taxed on the income of the entity until it is distributed.
Maximizing the Utility of Charging Orders
Most partnership and operating agreements 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 limitation. 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 vary the partnership or operating agreement to allow the general partner or the manager to make distributions to all members other than 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, the debtor, prior to the foreclosure, 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 sum. The poison pill has the effect of substituting the debtor's interest in the entity with a nominal amount, which limits the assets that a creditor can obtain. If the entity is established well in advance of any creditor challenges, before the partners/members know who will benefit and who will suffer from the poison pill, it should be enforceable, but 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.
A Practical Take on Charging Orders
Charging orders allow debtors to retain control over partnerships and LLCs and determine the timing of distributions. There are some exceptions to that general rule, particularly when: (i) there is a fraudulent transfer, and (ii) in a bankruptcy. It may be argued that single-member LLCs should also be deemed an exception to this general rule, based on the Albright case and the historical origin of charging orders. This author believes the Albright case to be an outlier, and in direct conflict with the charging order statutes of all states that have adopted single-member LLC provisions. Historical origin is also of little significance in this area. There is no need to interpret statutes that are very clearly drafted to apply to all LLCs.
Purchasing a foreclosed partnership interest may be foolhardy when the debtor, or a person friendly to the debtor, remains in control of the entity and can hold up the creditor's share of distributions. This will lead to adverse tax consequences for the creditor.
As a practical matter, creditors rarely chose to pursue charging orders. A charging order is not a very effective debt collection tool. The creditor may find itself holding a charging order, without any ability to determine when the judgment will be paid off. Practitioners should remember that any uncertainty surrounding charging orders is uncertainty for both the debtor and the creditor. This uncertainty forces most creditors to settle the judgment with the debtor, on terms more acceptable to the debtor, rather than pursue the charging order remedy.
