One of the principal reasons for forming a business entity is to protect the owners from personal liability for the debts of the corporation. At the same time, business owners may use the business, most often a limited liability company, as a way to protect their business interests from being at risk for personal liabilities.
Understanding how a charging order could ultimately be applied is particularly important for individuals in high-risk professions. This includes not just the professionals like doctors or engineers, but also anyone who routinely deals with intellectual property, including patents, copyrights, trademarks and trade secrets. In all of these areas, the insurance coverage is poor and the risk is high. For that reason, many individuals will seek to hold assets inside of other vehicles, including a limited liability company.
Limited Liability Companies Provide Asset Protection
The limited liability company has characteristics that make it difficult for outside parties to reach the interests of individual members, at least in most cases. This provides protection from both individual claims and can insulate businesses from claims that arise from activities of affiliated businesses – consider, for example, the series of real estate companies with common principal owners.
There is one pitfall, however, that those starting a new business should consider. The single-member limited liability company may be susceptible to being taken over by a creditor. Here is why.
Choose Your Partner Rules in LLC and Partnership Law
One of the core principles of the law of the closely held business is that no one should be forced to become partners with another against their will. Small businesses are given a great deal of leeway to assure that this does not happen in corporations. In the context of partnerships and limited liability companies, it is a part of the statutory scheme that no person may become an owner without the consent of all of the owners unless they have already agreed otherwise in the operating or partnership agreement.
Some partnerships and limited liability companies have agreements that permit the admission of new members on a vote less than all of the owners, but most do not.
This brings us to the charging order. Because no one can force the owners of a small business to accept them as owner, the judgment creditor of a partner or limited liability owner cannot foreclose on the partnership interest or limited liability company membership interest. What the creditors can do is get a charging order that requires that any money paid to the judgment debtor on account of their partnership or membership interest will be paid to them instead.
Charging Orders to Reach Assets of LLC Member or Partner
In the context of the LLC or partnership, the law divides the management rights from the financial interest. An owner can assign their financial interest – the right to receive distributions and profits – but can never assign their management interest. The judgment creditor, meanwhile, who is seeking to convert the asset into cash will want to force the company to dissolve and sell its assets, ultimately resulting in a payment to the members.
The single member member LLC may be subject to a different set of rules. First, there is no one to object. The concept of not being forced to partner with someone over your objection does not apply. Similarly, the holder of a charging order may have a statutory right to become a member. A few cases illustrate this point:
- In re Albright, 291 B.R. 538 (Bankr. Colo., 2003). Trustee of the bankruptcy estate of sole member of an LLC seeks to assume management rights and liquidate property owned by the LLC. Court holds that the trustee taking possession of debtor’s interest under § 541 of the Bankruptcy Code assumes all of the rights of the debtor and is now the sole member. The Court reasons that principle purpose of the charging order, to protect other members, is inapplicable with a single-member limited liability company.
- In re Ehmann, 334 B.R. 437 (Bankr. Ariz., 2005). Under the Bankruptcy Code, 11 U.S.C. § 541, all property of the debtor becomes property of the bankruptcy estate and, therefore, the trustee succeeds to all of the rights of the bankrupt member, notwithstanding any contract that limits the transfer of the debtor’s interest. Thus, the trustee could pursue involuntary dissolution and seek to challenge actions taken after the appointment of the trustee.
- United States v. Zabka, 900 F.Supp.2d 864 (C.D. Ill., 2012). The debtors are jointly liable for federal tax liens and the government moves to appoint a receiver. The application is granted and liquidation by the receiver is permitted. The limitation provided by a charging order was “designed to protect other partners in a partnership when one, but not all, of the partners had become encumbered with a judgment creditor.”
Asset protection attorneys will often suggest that a second person hold an interest in the limited liability company to prevent the type of merger of interests that may permit a judgment creditor to force the liquidation of a limited liability company. Some limited liability company statutes may also allow an operating agreement to provide for the required approvals of third parties – an approval that is not going to be obtained.
These are just some of the strategies that a lawyer may use to assist clients in preventing unnecessary exposure of their financial assets to judgment creditors. Please call us if you have questions.