LLCs And Charging Order Protection

LLCs And Charging Order Protection.

By Ryan Fowler, Consultant - Email Editor - Editor Bio

Date : 18-Jan-2007

Dear Subscriber:

Ryan Fowler, an Asset Protection practitioner in Salt Lake City, recently prepared this very interesting article on LLC’s and charging order protection. Yep, it’s a little on the technical side, but a worthwhile read. Finally, remember one of my mantras: Never ever count on charging order protection as the basis of your plan. It is good, helpful… sometimes it even saves the bacon; but, alone it is never enough in my mind. With that said, take it away Ryan.

Rob Lambert

Recent case law such as In re: In re: Ashley Albright [1] shows us single member LLCs may provide less than bulletproof charging order protection [2] . However, although rare, even multi-member LLCs or partnerships (also known as Charging Order Protected Entities, or COPEs) sometimes find their charging order protection compromised. Fortunately, a COPE can be reinforced against this threat, as we'll explore below.

Before discussing how to reinforce a COPE, we must examine the circumstances in which a COPE's charging order protection fails. Besides In re: Ashley Albright [3] , three other cases are relevant to this topic. The first two, Crocker National Bank v. Perroton [4] , and Hellman v. Anderson [5] , come from California district courts. In both cases, the court decides to ignore a limited partnership's charging order protection because, the court ruled, charging order protection was originally enacted as a means of protecting the non-debtor partners, and to insure that partnership business is not interrupted [6] , not so that a debtor partner can escape paying his debts. In both cases the partnership interest could be transferred to the creditor without causing an interruption in partnership business. As a result, the courts on both occasions decided that charging order protection did not apply, and the partnership interest was transferred to the creditor. Although in Crocker the court only allowed this transfer with the other partners' consent, in Hellman the court allowed the transfer without the consent of the other partners. Though these cases currently only apply in California, they set a precedent that may be imitated nationwide.

Another situation in which charging order protection may fail is found in a recent bankruptcy proceeding, In re: Ehmann [7] . The court ruled in Ehmann that the debtor's membership interest in Fiesta Investments, LLC was forfeit to the bankruptcy estate because the LLC's operating agreement was not an executory contract. Under bankruptcy law, an executory contract would include an agreement wherein the member and the LLC have reciprocal obligations. Such an executory contract would be subject to §§ 365(c) and (e) of the Bankruptcy Code (Title 11 U.S.C.), which would uphold the limitations of state or other applicable law. The court makes it clear however, that §§ 365 (c) and (e) do not apply to non-executory contracts when it states:

“The Court here concludes that because the operating agreement of a limited liability company imposes no obligations on its members, it is not an executory contract. Consequently when a member who is not the manager files a Chapter 7 case… the limitations of §§ 365(c) and (e) do not apply.”

If an operating agreement is non-executory, the LLC interest would instead be subject to Title 11 U.S.C. §§ 541(a) and (c)(1). As the court noted:

“Code § 541(c)(1) expressly provides that an interest of the debtor becomes property of the estate notwithstanding any agreement or applicable law that would otherwise restrict or condition transfer of such interest by the debtor. All of the limitations in the Operating Agreement, and all of the provisions of Arizona law on which Fiesta [Investments LLC] relies, constitute conditions and restrictions upon the member's transfer of his interest. Code § 541(c)(1) renders those restrictions inapplicable. This necessarily implies the Trustee has all of the rights and powers with respect to Fiesta that the Debtor held as of the commencement of the case.” [Emphasis is mine.]

Although there was plenty in Fiesta Investments, LLC's operating agreement that obligated the LLC and its manager to the debtor, there was nothing that obligated the debtor to perform any service or make any contribution to the LLC. Therefore, the operating agreement was non-executory, and the debtor's membership interest was forfeit, statutory charging order protection notwithstanding.

In light of the above cases, there is yet another situation wherein charging order protection may be circumvented. That is where all members of the LLC are debtors to the same creditor. In this situation, the underlying reasons for charging order protection would not apply to the fact pattern, and therefore a court could conceivably disregard charging order restrictions.

To summarize, we can see that the following factors may jeopardize the charging order component of an Asset Protection Plan:

1) The LLC is a single member LLC - this is especially dangerous.
2 )The LLC's operating agreement is non-executory in nature (however this is currently only a problem in bankruptcy.)
3 )The forfeiture of a debtor's membership interest to a creditor would not interrupt
partnership business.
4) All members of the LLC become a debtor of the same creditor.

It is obvious that if we wish to structure an LLC or LP [8] for maximum Asset Protection, we must effectively counter the above pitfalls. These pitfalls are sidestepped by “entangling” the relationships of various LLC members with the LLC and each other (in connection with their obligations and rights to benefit from LLC membership) so that if a particular member of the LLC was taken out of the picture, then the business of the LLC, and the interests of the other members, would be significantly impaired. We are fortunate to have case law that confirms the efficacy of this strategy, since the courts generally forbid a “reverse-piercing” [9] of an entity (even a non-charging order protected entity, such as a corporation) if innocent company owners or creditors of the company would be harmed. In one case, for example, we read the following:

“We recognize … that there are other equities to be considered in the reverse piercing situation -- namely, whether the rights of innocent shareholders or creditors are harmed by the pierce. [10] ”

Another case echoes this sentiment in greater detail:

“In addition, the reverse-pierce theory presents many problems. … third parties may be unfairly prejudiced if the corporation's assets can be attached directly. Although … our particular concern was with non-culpable third-party shareholders of the corporation being unfairly prejudiced, no greater culpability should attach to the third-party corporate creditors harmed by reverse-piercing in this case. See id. ("… the doctrine cannot be applied to prejudice the rights of an innocent third party.'") (quoting 1 William Meade Fletcher et al., Fletcher Cyclopedia of the Law of Private Corporations § 41.20, at 413 (1988 Supp.)) …; see also Hamilton v. Hamilton Properties Corp., 186 B.R. 991, 1000 (Bankr. D. Col. 1995) ("The reverse piercing theory is an aberration which, if invoked, would prejudice . . . the rightful creditors of the corporation whose assets are subsumed for the benefit of the creditors of the individual. What of the creditors of [the corporation] who relied on its separate corporate existence in doing business with it?"); Cargill, Inc. v. Hedge, 375 N.W.2d 477, 479 (Minn. 1985) (holding that in considering propriety of reverse pierce, "also important is whether others, such as a creditor or other shareholders, would be harmed by a pierce"). [11]

Obviously, if there is only one member in an LLC, there is no one else to become entangled with (especially if there are no LLC creditors), so the first thing we must do is make sure an LLC has multiple members. There is no real obstacle to doing this since a grantor trust can easily be added as a 2nd member, thus preserving an LLC's disregarded entity status if such is desired for tax reasons. [12]

The next thing we must do is ensure that the LLC operating agreement is executory. It goes without saying that there are many considerations that must be made when drafting an operating agreement, in order to ensure that the highest possible degree of Asset Protection is obtained. Such considerations are without the scope of this article, yet we'll explore a few ideas for making such an agreement executory. In re: Ehmann shows us that an LLC agreement is executory when the members have the following obligations:

1) Ongoing obligations to contribute cash to the entity;
2) Ongoing obligations to contribute non-managerial services to the entity;
3) Ongoing obligations to contribute equipment or other property to the entity; or
4) Ongoing obligations to manage the entity.

The easiest way to accomplish this is to require every LLC member to do one of the following:

1) A managing member should have a written agreement to act as a company manager as long as he holds a membership interest, as a condition of continued membership.
2) A non-managing member should agree to act in an advisory or consulting role to the company as long as he is a member, as a condition of continued membership. These services should be demonstrable in court. For example, he could submit an annual report to the company, giving his recommendations as to how the company could increase its profits and become more efficient. Such a report could then be submitted to a court to prove that ongoing executory obligations are being performed.

In addition to the foregoing, the company operating agreement should stipulate that members and managers, unless incapacitated, cannot transfer their obligations while they remain members, due to the fact that their intimate involvement with company affairs uniquely qualifies them to know how to best advise or manage the company.

Lastly, we must make sure that never, under any circumstance, could all members of the LLC personally become debtors of the same creditor. This could be done one of the following ways:

1) Make sure at least one of the LLC members is never exposed to liability. This may be accomplished by making one of the members a trust, LLC or other entity that only engages in “safe” activities, or;
2) Make sure that at least one member is not an insider or affiliate of any other member under the U.F.T.A.

Obviously, this type of structuring necessitates a high level of skill. However, when implemented correctly, Charging Order Protected Entities (set up before creditor threats arise) pose an extremely formidable Asset Protection barrier that would survive many situations a lesser plan would not.

Ryan Fowler

If you have questions or comments please contact us at:

______________________________________________________________________

[1] In re: Ashley Albright, Case No. 01-11367 (Bkrptc.D.Col. 04/04/2003).

[2] “Charging order protection” actually refers to a creditor's limited statutory remedy against an LLC's or partnership's member or partner (a.k.a. owner). This remedy only allows a creditor to receive distributions from the company that the debtor-owner would have otherwise received. It generally forbids the creditor from accessing company assets, voting as an owner of the company, or from managing the company. Because the creditor has no right to manage the company, he has no right to compel distributions, and thus often never receives any distributions, making the charging order an often near-worthless remedy.

[3] Ibid.

[4] Crocker National Bank v. Perroton , (208 Cal. App. 3d 1, 1989).

[5] Hellman v. Anderson , (233 Cal. App. 3d 840, 1991).

[6] Note that this observation was also made by the Colorado District Bankruptcy Court in the In re: Ashley Albright case..

[7] In re: Ehmann ( 2005 WL 78921 (Bankr. D. Ariz. 2005)).

[8] For the purposes of this newsletter, we will hereafter consider LLCs and LPs as one and the same, unless otherwise noted.

[9] “Reverse Piercing” is where the creditor of a company's owner is allowed to reach company assets for the owner's debt. This is the same situation in which charging order protection would prevent company assets and/or control from falling into the hands of an owner's creditor.

[10] LFC Marketing Group, Inc. v. Cebe W. Loomis , 116 Nev. 896; 8 P.3d 841 (Nev. S.C., 2000).

[11] Floyd v. I.R.S. , 151 F.3d 1295, 1300 (10th Cir. 1998).

[12] See IRS Rev. Rul. 2004-77, which demonstrates it is possible to structure a multi-member LLC that is disregarded from its owner for tax purposes

ABOUT THIS EDITOR:

Ryan Fowler, an Asset Protection practitioner in Salt Lake City, recently prepared this very interesting article on LLC’s and charging order protection.

Full Bio - Email Ryan Fowler

Email Article Print Article