LLCs, Partnerships, & Other Charging Order Protected Entities in Boise, ID
If you own shares in a C corporation, your shares may be attached and sold by your creditors following a judgment or by a bankruptcy trustee in the course of settling your bankruptcy estate. In such cases, the creditor or trustee steps into your shoes and will have all of the rights you had as a shareholder including voting the shares (thereby influencing appointment of directors and operating issues), receiving dividends, the right to accountings and inspection of books and records, and the ability to bring shareholder derivative actions. In short, the creditor may (depending on the size and rights of the shareholding) obtain significant control over the company, and, because the shares are assigned to the creditor, he receives the shares in perpetuity. In closely held companies such a result can be highly destructive to the business and may ultimately result in its liquidation.
In contrast, charging order protection, which is only available to limited liability companies ("LLCs") and partnerships (including limited liability partnerships and limited partnerships), may substantially limit the creditor's collection rights, improve the debtor's position in negotiating a settlement, and preserve the business as a going concern.
What is a Charging Order?
A charging order is a state law specific remedy that allows a creditor to place a lien upon and become an assignee of the debtors interest in the entity, and potentially foreclose and sell the interest in the partnership or LLC. The difference between this remedy and the receipt of shares in a corporation is that, due to the particular nature of partnerships and LLCs and applicable law, the creditor only receives a right to profit distributions, when made by the partnership or LLC, and typically does not, unless the other members admit the creditor as a member or partner, have the right to vote the shares of the company, elect managers, influence operating or profit distribution decisions. This places the creditor in a position of having to wait, potentially a very long time, to receive distributions in satisfaction of a debt. In addition, if the creditor forecloses on the partner's or LLC's interest, the creditor will be liable for payment of taxes on potentially undistributed income. These disincentives combine to increase the debtor's ability to negotiate a more favorable settlement and possibly dissuade the creditor from pursuing the interest in the first place.
The charging order originally developed in relation to partnerships and has been codified in most states by their adoption of the Uniform Partnership Act, Unified Limited Partnership Act ("ULPA"), Revised Uniform Partnership Act ("RUPA"), and Revised Uniform Limited Partnership Act ("RULPA"). LLCs are a relatively new form of entity that share many of the features of a partnership. As a result, the courts have applied much of partnership law as it pertains to charging orders to LLCs. The courts view partnerships and LLCs as founded on personal relationships and trust between the partners. Given the personal nature of the association, courts will not compel the partnership to allow an outsider to interfere in the operation of the entity; however, they will allow creditors to receive profit distributions when made.
Depending on state law, charging orders may not be the exclusive remedy available to creditors. When they are not, creditors may be able to take control of the LLC or partnership and in worst cases liquidate it. To understand the implications, the Florida Supreme Court, in Olmstead v. FTC, held that, the absence of language expressly limiting creditors rights to a charging order in the Florida LLC Act, in contrast to the finding of such language in the Florida' RUPA and RULPA (as applicable to partnerships and limited partnerships), indicated an intent on the part of the legislature that creditors were not limited solely to distributions when and as made, but instead could take the entire ownership interest. The finding resulted in the creditor gaining full control over a single member LLC to the effect that it was liquidated and the owner lost not only his entire interest in the entity, but also lost his ability to make a living from the entity. In response to the concern that the Court's ruling could be applied to multi-member LLCs, the Florida legislature changed the LLC Act to provide that the charging order is the exclusive creditor remedy regarding multi-member LLCs; but not single member LLCs. Idaho in contrast amended its LLC' statute in 2008 to provide that charging order protection is the exclusive remedy to judgment creditors in respect of a judgment debtor's interest in an LLC. In contrast to Florida's statute, Idaho Code §30-6-503(7) does not make an exception for single member LLCs. Note, however, that a bankruptcy case decided before the Idaho Code was revised held that where "there are not other members in the LLC... the Debtor's bankruptcy filing effectively assigned her entire membership interest in the LLC to the bankruptcy estate, and the Trustee obtained all the right to control the management of the LLC...[and such control includes] decisions regarding liquidation of the entity's assets" Until an Idaho court addresses a case relating to the revised Idaho Code, there is a question as to whether charging order protection for a single member LLC in Idaho would necessarily prevent a bankruptcy trustee from gaining control of the LLC and causing its liquidation.
Charging order protected entities are a powerful asset protection tool that promotes continuation of closely held businesses without interference by outsiders. There are many nuances, limitations and opportunities to properly structuring these closely held business entities as well as drafting the operating and partnership agreements that govern their operation.
Attorneys at Mathieu, Ranum & Allaire recognize the value of charging order protected entities as a vehicle for preventing wholesale liquidation of business entities in satisfaction of creditor claims. We keep apprised of the issues and rapidly changing case law in this area and regularly advise clients on how to structure their businesses to protect their business and personal assets.