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Charging Orders

By John Dietz - Email Editor

Date : 11-Dec-2007

Dear Subscriber:

As businesses evolve, so do the mechanisms that house and protect them. There was a time when C-Corps and S-Corps were all the rage. Back in the day, you simply went to your local attorney and asked which entity would be best for your business needs; choices were limited then.

Then came the promoters and along with them the need to evade, avoid or escape some sort of tax. I will not go on a rant, other than to say, in most instances, the reason to form a particular entity was for one purpose: tax savings. Today, we know there is a host of reasons to form one entity over another, and one should not be so quick to make hasty decisions.

We are now in the LLC (Limited Liability Company) business mode; it seems if you do not have one, you are probably not in the “in crowd” at your local club. The last few years have seen many changes to the ways we view LLCs. As more guidance has come down from the courts, we witness the changes in Limited Liability Companies' statutes.

As most of our long time readers have seen, Charging Orders do not hold up with a single member LLCs, and they offer no material Asset Protection. The remedy for the judge has been to look through the entity as though it was not there, thus the LLC provides very little protection. We are now seeing cases with multiple-member LLCs in which judges have looked through. The law is not static on this issue, but rather it evolves similar to the growth of businesses. This is why we do not recommend anyone rely solely on Charging Order for protection.

It is important then to review Charging Order Protection. You have chosen a certain entity (or are in the process) based on you and your advisors analysis of the law as it currently exists. Changes in the law can yield significantly different results than the results once anticipated. The current climate for LLCs seems to lean toward a more creditor friendly period.

There is much legislation on a state-by-state basis as to what is the fiduciary responsibility to a member or partner who is charged with debt by a creditor. When a creditor achieves a judgment against a member of an LLC they may apply for a Charging Order, and then later try to persuade the court to foreclose on the LLC or force involuntary dissolution of the LLC.

What is a Charging Order?

Charging Order is an order obtained from a court or judge by a judgment creditor, by which the property of the judgment debtor is held against the partner’s right to distribution from the entity. The Uniform Partnership Act and LLC Act describe the charging order as “in the nature of a garnishment” from a business. A Charging Order may be analogous to a garnishment because it is an assignment of the partner’s economic right to distribution from the partnership.

The rationale behind Charging Orders came from historical remedies to punish debtors. In the 1800s a simple remedy was to punish debtors by having a law enforcement agency of the church or the town simply close the company down, even if one partner was at fault and the others had no judgment. Eventually the non-debtor partners got wise and began to protect themselves with legal remedies from the liability of their partners and file in court for remedies against the violation of their rights. It may sound confusing or unreal, but this is a natural cycle in law.

To protect the non-debtor partners from the creditor of the debtor-partner it was necessary to keep the creditor from seizing partnership assets (which was also in line with the developing perception of partnerships as legal entities and not simple aggregates of partners) and to keep the creditor out of partnership affairs.

These complicated questions face the courts when remedying these types of judgment.

• What happens if a judgment is obtained against a partner, but not the partnership?
• What happens if the judgment closes the company down?
• What if there is another remedy besides the remedy to close the company?
• Is it fair against to punish the non-debtor partners who have no judgment against them?
• Should the courts permit involuntary dissolution of the company?

A judicial dissolution threat would either force a sale of the entity's assets or require the other members to purchase the interest from the foreclosure and purchasing creditor. Either would be highly disruptive to the successful continuation of the LLCs business and represent a serious impediment to the use of the LLC entity form. Moreover, the eventuality of judicial dissolution would represent a serious threat to “Asset Protection” goals of using an entity's separate existence to insulate personal assets from the reach of that member's creditors.

A CHARGING ORDER defines CREDITOR as a substituted Limited Partner for tax purposes an LLC.

The concern is that the rights transferred (the transferee rights) are only economic rights and not management rights and that the transferee has not rights to petition the court for dissolution of the LLC. However, creditors are currently lobbying Congress to revise the Uniform Limited Liability Company Act to abolish the flexible role of the “fiduciary” in Operating Agreements to abolish the ability to “eliminate fiduciary duties” within the LLC.

Those opposed to these changes site reasons of strain on the Full Faith and Credit Act, the differences between states on fiduciary responsibilities and contract obligations and the difference between each state’s individual drafting of LLC versus the Uniform Code Law.

In the future, it is likely that the courts will develop a “reasonable test” for Charging Orders. This will likely mean that if you want to negate your fiduciary responsibilities by contract, you would have to choose other Asset Protection options or combine your options because the courts would not permit the abatement of fiduciary responsibility. This approach is contrary to some states such as Delaware and Nevada, where fiduciary responsibility is easily abated or diminished by contract clauses in the Operating Agreement.

Remember that state law does not necessarily dominate law; public policy does. I leave you with the known fact, that one tool, technique or company does not “have it all” in Asset Protection. It is here where good practitioners look deeper. In deciding which tools and entities are best for you, your personal financial affairs and business affairs should be accessed and evaluated, especially when considering “pass through” entities.

We always advocate that it is worth your time, effort and money to do everything you can to educate yourself on Asset Protection. The foundation of your protection is in your knowledge and understanding of the subject; an educated client is an asset to a good practitioner.

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Until next time,

John

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