If you own a small business, you face the prospect of losing ownership of your business in certain scenarios. A creditor can attach a judgment to any interest that an individual debtor may have in any business. In a corporation, a creditor may simply attach itself to the shares of the debtor’s stock to gain all the rights that the debtor had in the corporation, including rights to sell the shares, voting rights, the right to view books and records and rights to bring derivative actions. If the corporation is an “S” corporation and the creditor is not an individual, then the creditor’s attachment of the stock may cause the “S” election to be terminated, which would possibly result in unwanted tax consequences to the remaining shareholders. Obviously, allowing a creditor to obtain voting rights and other non-economic rights of the debtor is not in the best interests of the other owners. In single shareholder or small, closely held corporations, judgment creditors present major concerns. If you operate a corporation and are the sole shareholder or you are the majority shareholder, control of your business is essentially lost if a creditor attaches a judgment against your interest in the corporation!

 

Charging Order Protection Offers Partners A Shield

A limited partner or member in an LLC does not own shares of stock as in a corporation. Partners own a bundle of rights as defined by the entity’s operating agreement, including certain economic rights to distributions. But, partners do not own a direct interest in the assets of the entity. In a general or limited partnership or in an LLC, the debtor is a partner with the other owners (LLC’s are partnerships). A change in ownership due to an attachment of the partner’s interest by a creditor may disrupt operation of the partnership. This would essentially force non-debtor partners into an involuntary partnership with the creditor. State law does not allow the existence of this type of involuntary partnership to occur. Instead, a creditor is limited to obtaining a “charging order” against the partner’s interest in the business.

A charging order is the temporary right of a creditor to step into the partners shoes and only receive his or her right to distributions from the partnership until the judgment is satisfied. It is basically a garnishment by the creditor or an assignment of the partner’s economic right to distributions from the partnership. A charging order is held against the partner’s right to distributions from the entity. However, this right to payment does not make the creditor a partner or member and does not give the creditor any voting rights. Of course, any debtor-members are not typically gracious enough to vote for such distributions, so the creditors are usually stuck without any real recourse.

The creditor may also foreclose on the debtor’s partnership interest. The foreclosure is on the debtor’s interest in the partnership, not on the entity itself or its assets. This is an important distinction to understand. The foreclosure is of the charging order against the debtor’s economic right to distributions. After the foreclosure, the assignment of the right to distributions to the creditor becomes permanent. This means that the creditor becomes the owner of the distributional interest and the creditor may then attempt to sell the interest.

The creditor may also be entitled to certain derivative rights, such as the rights to inspect books and records and request distributions. This is possible when the operating agreement is not drafted to restrict the possibility of giving the creditor derivative rights to involuntary distributions from the entity. In extreme cases (where the entity is improperly structured or the operating agreement has been poorly drafted), the creditor may attempt to request the court to partition the entity’s assets and place the creditor in charge of the entity’s assets equal to the interest the creditor holds.

One disadvantage to creditors after foreclosure is that the creditor is responsible for the tax liabilities generated to the partners or members by the entity (there is substantial doubt as to whether this occurs without foreclosure of the charging order). Thus, the creditor risks becoming responsible to pay a share of the entity’s taxes even though the creditor does not receive actual profit distributions!. This may deter many creditors from foreclosing upon a debtor’s partnership interest.

You must form a “charging order protected entity” (COPE) to restrict creditors to only obtaining a charging order. Limited Partnerships (LP’s), LLC’s, Limited Liability Partnerships (LLP’s) and Limited Liability Limited Partnerships (LLLP’s) are all considered to be COPE’s. If you elect to form any of these entities, any future outside creditor will be limited to the charging order remedy (but see my warning about using single-member LLC’s below). The bottom line is that charging order protection should be a consideration in deciding which entity you use to organize your business.

 

Do Single-Member LLC’s Provide Charging Order Protection?

The primary purpose of the charging order is to protect the non-debtor members from being involuntarily forced into a partnership with the debtor member’s creditor. However, there is only one member in a single member LLC, so there are no non-debtor members to protect. There has been a lot of disagreement over whether the single member LLC enjoys charging order protection. Some lawyers and legal scholars argue that charging order protection does not exist for single member LLC’s. They believe it defies common logic as there are no partners to protect. Many other lawyers argue that the express language of the LLC statutes are protective of the single member from outside liabilities.

After years of theoretical debate among attorneys, this issue was finally addressed by a U.S. bankruptcy court, In re Albright, 291 B.R. 538, 540 (D. Colo. 2003). The Court in this case held that charging order protection does not exist for a single member LLC because there are no non-debtor members to protect. The court granted full economic and non-economic rights to the trustee, allowing the bankruptcy trustee to manage the debtor’s LLC. The trustee subsequently sold the LLC’s property and distributed the net proceeds to the bankruptcy estate for satisfaction of creditor claims.

In fact, in a recent case, the Supreme Court of the State of Florida decided that charging orders are not the exclusive remedy available to creditors of an LLC, especially a single member LLC (Olmstead vs. Federal Trade Commission, 2010). The court based its decision partly on the fact the Florida LLC statute was silent on whether the charging order was the exclusive remedy available to creditors of members of an LLC in general. So, this decision seems to apply equally to multi-member LLC’s. Nevertheless, the foundation of the court’s decision was the uncontested right of the sole member in a single member LLC to transfer the owner’s full interest in the LLC.

Conclusion: 1) Single member LLC’s probably will not provide charging order protection; and 2) In light of the Olmstead vs. FTC decision, some states may be safer to organize a multi-member LLC if their LLC statutes provide that the charging order is the exclusive remedy available to outside creditors. Keep in mind, this does not mean single member LLC’s do not provide substantial liability protection for owners against the liabilities of the entity itself (“internal liabilities”). Even though single member LLC’s probably don’t provide the same charging order protection as multi-member LLC’s, this is still a better option than conducting business as a sole proprietor.