South Carolina’s LLC Act authorizes courts, on request of a judgment creditor, to issue charging orders and to foreclose an LLC member’s interest. Last month South Carolina’s Supreme Court considered for the first time the standards for foreclosure and the relationship between foreclosure and charging orders. The court held that the primary factor in determining whether to order foreclosure of an LLC member’s interest is whether the charging order is likely to result in payment of the debt in a reasonable amount of time. Kriti Ripley, LLC v. Emerald Invs., LLC, No. 27277, 2013 WL 3200596 (S.C. June 26, 2013).
Background. In 2003 Kriti Ripley, LLC and Emerald Investments, LLC formed Ashley River Properties II, LLC. The plan was to develop condominiums and a marina on a piece of property in Charleston, South Carolina. Emerald contributed the property and its permits to Ashley River for its 70% member interest, and Kriti contributed $1.25 million for its 30%. Id. at *1.
Unfortunately, Emerald immediately diverted and misappropriated the funds contributed by Kriti to Ashley River. When Kriti learned of Emerald’s wrongdoing it initiated arbitration pursuant to Ashley River’s operating agreement. That began a long and complex series of legal proceedings between Kriti and Emerald, consisting of two separate arbitrations and five different lawsuits. Id. at *2-3.
Kriti eventually obtained an award of $706,000 against Emerald in arbitration in New York, confirmed the arbitration award in a New York court, and registered the New York judgment in South Carolina. Kriti then filed suit in South Carolina and in 2008 obtained a charging order on Emerald’s interest in Ashley River, in the amount of Kriti’s judgment against Emerald.
By 2011, Kriti’s charging order had yielded no funds towards satisfaction of its judgment, and Kriti filed a motion to foreclose on Emerald’s interest in Ashley River. The trial court viewed foreclosure as a drastic remedy, found that the charging order was sufficient protection for Kriti’s interests, and denied Kriti’s motion to foreclose on Emerald’s interest in Ashley River. Id. at *4-6.
Court’s Analysis. The Supreme Court first examined South Carolina’s statute on LLC charging orders and foreclosures:
(a) On application by a judgment creditor of a member of a limited liability company or of a member’s transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment. The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor and make all other orders, directions, accounts, and inquiries the judgment debtor might have made or which the circumstances may require to give effect to the charging order.
(b) A charging order constitutes a lien on the judgment debtor’s distributional interest. The court may order a foreclosure of a lien on a distributional interest subject to the charging order at any time. A purchaser at the foreclosure sale has the rights of a transferee.
S.C. Code Ann. § 33-44-504(b). The court noted that foreclosures are actions in equity, and therefore the decision to grant or deny foreclosure under Section 504 is equitable. Kriti Ripley, LLC, 2013 WL 3200596, at *7.
In denying Kriti’s motion for foreclosure of the charging order, the trial court had viewed other provisions of the LLC Act as providing alternative remedies, including dissolution and the forced purchase of a member’s interest. The Supreme Court rejected that as a factor in the decision whether to order foreclosure, pointing out that Kriti sought foreclosure as a judgment creditor, not as a member, and that Section 504 provides that charging orders and foreclosure are the exclusive remedies of a judgment creditor. Id.
The Supreme Court also rejected the trial court’s characterization of foreclosure as a drastic remedy. “It is a remedy commonly used around the country when a charging order on a debtor’s interest in an entity alone will not result in payment of a judgment. . . . Moreover, the statute provides no indication that a foreclosure is ‘drastic’ or only to be used in extreme circumstances.” Id. at *8.
The trial court had also considered foreclosure to be a form of forfeiture and therefore disfavored. The Supreme Court differed, describing forfeiture not as a penalty but rather as a remedy for collection of a debt. The member’s interest is not divested without compensation, because the value of the foreclosed interest is applied against the member’s debt. Id.
Having swept the trial court’s considerations from the board, the Supreme Court pointed out that as an equitable matter, the forfeiture decision requires consideration of all the circumstances in the individual case. The court referenced opinions from Georgia and New Jersey, and concluded that the primary and usually determinative factor is whether the judgment creditor will be paid in a reasonable time through distributions via the charging order. Id.
The court’s review of the evidence showed that Kriti had received no payments on its judgment since the grant of its charging order in 2008, that Ashley River could not pay its debts, and that it was unlikely that any distributions would be made in the foreseeable future.
The court also found that Emerald had acted inequitably: “Emerald and Longman have attempted to game the system in order to avoid any consequences for their wrongful acts while at the same time trying to make a profit at Kriti and Ashley River II’s expense. On the other hand … Kriti has repeatedly been found to have acted appropriately.” Id. at *9.
The Supreme Court accordingly reversed the trial court and remanded for the entry of a foreclosure order on Emerald’s interest in Ashley River, without further delay. Id. at *10.
Comment. All state LLC statutes authorize courts to issue charging orders on LLC member interests, to satisfy judgments against the member. But only a minority of the state statutes go further and expressly allow foreclosure of the debtor’s LLC interest, as South Carolina’s Section 504 does.
Some of the statutes that don’t mention foreclosure say that a charging order is the creditor’s exclusive remedy. Others are silent on whether a charging order is the creditor’s only remedy, implying that it is not exclusive.
Delaware, for example, says: “The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or of a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest.” Del. Code Ann. tit. 6, § 18-703(d). Washington’s LLC Act, on the other hand, is silent on exclusivity. Wash. Rev. Code § 25.15.255.
The Kriti case does not address what happens after a judgment creditor forecloses on a debtor’s member interest. Assuming that a judgment creditor successfully forecloses, what then?
The creditor that acquires the debtor’s LLC interest at a foreclosure sale would become a transferee of the debtor’s member interest, but unless the LLC agreement or the other members allow it, the creditor would not be admitted as a member and would not have a member’s right to vote or participate in management. See, e.g., S.C. Code Ann. §§ 33-44-502, -503.
In Kriti this presumably would not be a problem, because Kriti is the only other member and could approve its own admission with regard to the LLC interest acquired from Emerald.
LLCs have become the entity of choice for most new businesses, and as a result charging orders are being sought more and more frequently. A novel charging-order question came up recently when the Ohio Court of Appeals was faced with an objection to a charging order against a physician’s member interest in a medical LLC. FirstMerit Bank, N.A. v. Xyran, Ltd., No. 98740, 2013 WL 1183340 (Ohio Ct. App. Mar. 21, 2013).
Background. In May 2010 FirstMerit Bank obtained a judgment against neurosurgeon Bhupinder Sawhny on his guaranty of a promissory note. The bank garnished Sawhny’s wages, and Sawhny later left his employer and opened his own business, The Center for Neurosurgery, L.L.C.
FirstMerit then filed a motion with the trial court for a charging order against Sawhny’s member interest in The Center. The court granted the motion without a hearing.
Charging Orders. Ohio’s LLC Act gives a judgment creditor of an LLC member the right to obtain a charging order against the member’s LLC interest, for payment of the unsatisfied amount of the judgment. Ohio Rev. Code § 1705.19. A charging order gives the judgment creditor only the rights of an assignee, meaning that any distributions by the LLC that would otherwise go to the member must instead be paid to the creditor. The creditor is not admitted as a member, has no right to participate in management of the LLC, and cannot force the LLC to make any distributions. In 2012 Ohio amended its LLC Act to clarify that a charging order is a judgment creditor’s exclusive remedy to satisfy a judgment against the membership interest of an LLC member, which I wrote about, here. Most state LLC acts authorize charging orders.
Charging order issues keep coming up. In the past two years I have written about (a) whether an Illinois LLC whose member interest is being charged must be a party to the suit, here, (b) whether a judgment creditor’s charging order entitles it to quarterly financials from an Iowa LLC, here, (c) whether the holder of a charging order against a single-member Kansas LLC can assert rights to manage the LLC, here, and (d) whether the holder of a charging order against a Florida single-member LLC can foreclose on the member’s interest and take over complete ownership of the LLC, here.
Court of Appeals. Sawhny appealed the grant of the charging order. He contended that the charging order assigned his ownership interest in The Center to FirstMerit in violation of Ohio’s statute barring the unauthorized practice of medicine, Ohio Rev. Code § 4731.41. He also argued that The Center’s operating agreement did not permit him to assign his member interest to anyone who is not a licensed physician in Ohio.
The court’s analysis ran as follows: Under Section 1705.19 a judgment creditor receives only “the rights of an assignee of the membership interest as set forth in section 1705.18.” “Membership interest” is defined in Section 1705.01 as “a member’s share of the profits and losses of a limited liability company and the right to receive distributions from that company.” Under Section 1705.18 an assignee is not entitled to become a member or to exercise any rights of a member, unless authorized by the LLC’s operating agreement, and therefore FirstMerit had no right to manage the Center. The court concluded that the charging order merely allowed FirstMerit to garnish Sawhny’s financial interest in The Center, and therefore did not allow the unauthorized practice of medicine or violate The Center’s operating agreement. FirstMerit Bank, 2013 WL 1183340 at *1.
Sawhny also argued that the trial court violated his constitutional rights to due process by failing to hold a hearing on FirstMerit’s motion for a charging order. Id. But, said the Court of Appeals, Sawhny’s brief failed to set forth a legitimate basis for opposing the charging order, because the only objections raised were those relating to the unauthorized practice of medicine and the prohibition in the LLC’s operating agreement. Id. at *2. Both of those issues had been resolved by the court in the first part of its opinion, and there was no reason for an evidentiary hearing. Id.
Sawhny’s ownership of his member interest in The Center had already been established at a debtor’s examination. In Ohio an examination of a judgment debtor takes place pursuant to a court order requiring the debtor to appear and answer concerning his property, in front of the judge or a referee appointed by the judge. Ohio Rev. Code § 2333.09.
The court affirmed the trial court’s grant of the charging order.
Comment. The court’s ruling on the unauthorized practice of medicine issue seems right, given the lien-like nature of a charging order and the limitations on the charging order. Statutes barring the unauthorized practice of medicine are intended to prevent non-physicians from controlling how physicians practice. The holder of a charging order is not admitted as a member and does not have the right to vote or participate in management, so FirstMerit’s charging order could not control how Sawhny practiced medicine.
Illinois Court Issues Charging Orders Against LLC Member Interests When LLC Is Not a Party to the Suit
The Illinois Appellate Court was recently faced with an appeal of a trial court’s charging orders against 72 LLCs and limited partnerships (LPs), where none of the entities were made parties to the lawsuit. The Appellate Court upheld the charging orders on the grounds that the LLCs and LPs were not necessary parties because their interests were not sufficiently affected by the charging orders. Bank of America, N.A. v. Freed, 1-11-0749 et al., 2012 WL 6725894 (Ill. App. Ct. Dec. 28, 2012).
Bank of America sued the guarantors of a $205 million loan on their guaranty. Before addressing the charging orders, the court dealt with a significant contract law issue.
Nonrecourse Guaranty Carveout. The guarantors’ liability was limited to $50 million, but with a carveout that removed the limit if the guarantors contested, delayed or otherwise hindered any action taken by the lender in connection with the appointment of a receiver or foreclosure of the mortgage. The guarantors contested the Bank’s foreclosure action, and the Bank accordingly claimed that the guaranty was no longer limited and covered the full $205 million. In their appeal, the guarantors contended that the carveout provision was vague, ambiguous, overly broad, and an unenforceable penalty.
The enforceability of carveout provisions in nonrecourse or limited recourse contracts was an issue of first impression in Illinois. Id. at *9. The defendants contended that there was no connection between the additional amounts they owed as a result of the full liability provisions and any actual damages suffered by the Bank, and that accordingly the sole purpose of the carveout was to secure performance of the contract. Id. at *8.
The court concluded otherwise, reasoning as follows. First, the carveout operated principally to define the terms and conditions of personal liability, and not to fix the probable damages. Id. at *9. Second, the carveout provided for only actual damages – the lender could recover only the damages actually sustained, i.e., the amount remaining on the loan at the time of the breach. And third, the carveout did not preclude the guarantors “from contesting the appointment of a receiver or filing defenses to the foreclosure action, but by taking those actions they forfeited their exemption from liability for full repayment of the loan.” Id. at *12. The trial court’s judgment against the guarantors was affirmed.
Charging Orders. After entering judgment against the defendants in the amount of $207 million, the trial court entered charging orders against the defendants’ interests in 72 LLCs and LPs. None of the LLCs and LPs were made parties to the lawsuit. The defendants argued that the charging orders were invalid because the LLCs and LPs were necessary parties, and the court did not have jurisdiction over them. (These 72 LLCs and LPs were apparently formed under Illinois law, although the court never clarified that.)
The charging orders were entered under the authority of Section 30-20(a) of the Illinois LLC Act and Section 703(a) of the Illinois Uniform Limited Partnership Act. Both sections refer to charging orders being entered by a court having jurisdiction, and the defendants contended that the court therefore had to have jurisdiction over the LLCs and LPs. Id. at *12.
The language of the two Acts is not clear about whether the court is to have jurisdiction over the judgment debtor, the LLC, or both. For example, the LLC Act says “[o]n application by a judgment creditor of a member of a limited liability company or of a member’s transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment.” 805 Ill. Comp. Stat. 180/30-20(a) (emphasis added).
The court determined that the statute referred to jurisdiction over the judgment debtor, not necessarily the LLC, and that a charging order on a debtor’s interest in an LLC or LP does not affect the rights of the LLC or LP to the extent necessary to require that it be made a party. Bank of America, 2012 WL 6725894 at *12. For an LLC, for example, the holder of the charging order has only the right to receive distributions to which the member would otherwise be entitled. Even if the charging order is foreclosed, the holder has only the rights of a transferee. In either case the holder of the charging order will not be entitled to vote or otherwise participate in the LLC’s management or affairs. “Hence, the LLC has no interest to be protected and need not be made a party.” Id. The result is similar for an LP. The court therefore concluded that “the trial court did not err in entering charging orders against the 72 LLCs and limited partnerships even though they were not named as parties.” Id. at *13.
Comment. The LLC in a charging order scenario is not a party to the dispute between its member and the member’s creditor. The LLC is merely a potential distributor of assets to the member. (Like corporate dividends, LLC distributions are made to the members generally, per the terms of the LLC’s operating agreement.)
Given the LLC’s lack of skin in the game, and given the inability of the holder of the charging order to interfere with the management of the LLC, the court in Bank of America reached what appears to be a sensible conclusion: the LLC does not have an interest to be protected by requiring its joinder to the suit between the creditor and the member.
So what happens next? How does the Bank ensure that it will receive any distributions from the LLCs or LPs that would otherwise go to the defendants? Presumably the Bank will give formal notice of the charging order to each of the 72 LLCs and LPs. Any LLC or LP that ignores the charging order and makes a distribution to one of the defendants would appear to be liable to the Bank for the amount of the wrongful distribution, just as it would be if it erroneously sent one member’s distribution to another member.
Several judgment creditors obtained charging orders against their debtors’ interests in three LLCs, along with an order requiring the LLCs to provide quarterly cash flow statements. The LLCs objected to disclosure of their quarterly cash flows, and on appeal the Iowa Court of Appeals found that there was no statutory authority for the required disclosure and reversed the disclosure orders. Wells Fargo Bank, Nat’l Assoc. v. Continuous Control Solutions, Inc., No. 11-1285, 2012 WL 3195759 (Iowa Ct. App. Aug. 8, 2012).
Background. Iowa’s courts are authorized, on application by a judgment creditor of an LLC member or assignee, to enter a charging order against the judgment debtor’s economic interest in the LLC. Iowa Code § 489.503. A charging order requires the LLC to pay to the judgment creditor any distributions that would otherwise be paid to the judgment debtor. Id.
In Wells Fargo Bank the judgment creditors petitioned the trial court for charging orders, and also asked for an order requiring the three LLCs to provide quarterly cash flow statements “to verify no distributions have been made to the judgment debtors or any other entity or person with an ownership interest in these limited liability companies.” Wells Fargo Bank, 2012 WL 3195759, at *2. The judgment creditors may have been channeling Ronald Reagan and his mantra, “trust, but verify.” Or perhaps half of it.
The trial court relied on Iowa Code Section 489.503(2)(b), and included the disclosure requirement in its charging order. Id. Section 489.503(2) states:
2. To the extent necessary to effectuate the collection of distributions pursuant to a charging order in effect under subsection 1, the court may do all of the following:
a. Appoint a receiver of the distributions subject to the charging order, with the power to make all inquiries the judgment debtor might have made.
b. Make all other orders necessary to give effect to the charging order.
The Court of Appeals. The judgment creditors relied on Section 489.503(2)(b), which authorizes the court to make all other orders “necessary to give effect to the charging order.” The Court of Appeals began its analysis by noting that that section does not specifically authorize the disclosure orders that were requested. The court gave only a nod to Section 489.503(2)(a), which refers to the “power to make all inquiries the judgment debtor might have made,” presumably because the judgment creditors’ argument did not rely on it.
The court reviewed the comments in NCCUSL’s Revised Uniform Limited Liability Company Act (RULLCA) § 503, which Section 489.503 is modeled on, and found no support for including rights to information in an order “necessary to give effect to the charging order.” The court concluded that Section 489.503(2)(b) only authorizes orders that affect economic rights, not governance rights such as rights to information. Id. at *3.
The court’s conclusion was supported by Section 489.502(1)(c)(2), which provides that a transferee of an LLC member’s interest is not entitled to access to records or other information concerning the LLC’s activities (except upon the LLC’s dissolution). A charging order is a lien on the judgment debtor’s economic interest, and since the holder of a member’s economic interest is not entitled to access to the LLC’s records, the holder of a lien on the member’s economic interest should similarly be denied access to the LLC’s records or other information. Id.
The court vacated the trial court’s disclosure orders, stating: “To effectuate a charging order, Iowa Code section 489.503 authorizes a court to order an L.L.C. to disclose financial information to a court-appointed receiver only. We conclude there is no statutory authority for the disclosure orders the district court issued in this case.” Id.
Comment. The court’s conclusion seems correct, given the “pick your partner” principle inherent in LLC law. An assignee of an LLC interest has no rights to information from the LLC, so why should the holder of a charging order, which puts the judgment creditor in a position similar to that of an assignee, have more rights to information than the assignee?
The court’s opinion leaves open, however, what the result would have been if the judgment creditors had asked for appointment of a receiver for the distributions, and the receiver had then asked for the financials under the authority of Section 489.503(2)(b): “with the power to make all inquiries the judgment debtor might have made.” The Court of Appeals acknowledged that the judgment debtor retains its management power and rights to information, even after the entry of a charging order against its interest. Wells Fargo Bank, 2012 WL 3195759, at *2. The NCCUSL comments to RULLCA section 503 don’t answer that question.
Ohio has amended the charging order provisions of its Limited Liability Company Act to clarify that a charging order is the exclusive remedy of a judgment creditor against an LLC member. Governor Kasich signed Substitute House Bill 48 on February 2, 2012, and the bill becomes law on May 4, 2012.
The Ohio statute gives a judgment creditor of an LLC member the right to obtain a charging order against the member’s LLC interest. A charging order means that any LLC distributions that would otherwise go to the member must instead be paid to the judgment creditor. The creditor is treated like an assignee until the debt is satisfied, has no management rights, and cannot force the LLC to make any distributions. Most states have a charging order provision in their LLC Acts.
Ohio’s current statute is unclear whether a judgment creditor of an LLC member can also use other creditors’ remedies, such as foreclosing on the member’s interest. This lack of clarity is not uncommon. A number of states use language in their Acts such as “the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment.” E.g., Wash. Rev. Code § 25.15.255; N.Y. Ltd. Liab. Co. Law § 607. This sort of language clearly authorizes the charging-order remedy, but does not address the potential applicability of other remedies.
Ohio’s amendment makes clear that a judgment creditor’s charging order remedy is its exclusive remedy against the member-judgment debtor. The new language is italicized and bolded:
1705.19 [Effective 5/4/2012] Rights of judgment creditor
(A) If any judgment creditor of a member of a limited liability company applies to a court of common pleas to charge the membership interest of the member with payment of the unsatisfied amount of the judgment with interest, the court may so charge the membership interest. To the extent the membership interest is so charged, the judgment creditor has only the rights of an assignee of the membership interest as set forth in section 1705.18 of the Revised Code. Nothing in this chapter deprives a member of the member’s statutory exemption.
(B) An order charging the membership interest of a member of a limited liability company is the sole and exclusive remedy that a judgment creditor may seek to satisfy a judgment against the membership interest of a member or a member’s assignee.
(C) No creditor of a member of a limited liability company or a member’s assignee shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.
(D) A limited liability company or one or more members of a limited liability company who are not subject to a charging order entered in favor of a judgment creditor may at any time pay to the judgment creditor the full amount then still due under the judgment and by that payment succeed to the rights of that judgment creditor.
The amendment also clarifies that judgment creditors of an LLC member have no right to reach the assets of the LLC itself, although that should already have been clear from the entity nature of an Ohio LLC. See Ohio Rev. Code § 1705.03.
Presumably the amendment will be interpreted to apply to single-member LLCs, although some state court decisions have reflected a negative view of the asset-protection feature of single-member LLCs. E.g., Meyer v. Christie, No. 07-2230-CM, 2011 WL 4857905 (D. Kan. 2011); Olmstead v. FTC, 44 So. 3d 76 (Fla. 2010). I have discussed those cases, here (Meyer) and here (Olmstead). The amendment’s language appears to be applicable to all Ohio LLCs, however, regardless of the number of members.
Substitute House Bill 48 also makes several other changes to Ohio’s LLC Act. The most significant are that it (a) clarifies which default provisions of the LLC Act may be overridden by the operating agreement, and (b) adds fiduciary duties of loyalty and care for LLC members, apparently even if the LLC is manager-managed.
The ABA’s Revised Prototype Limited Liability Company Act has been published in the November 2011 Business Lawyer, copies of which were received at my firm last week. The Revised Prototype incorporates a number of welcome changes, and will likely become an even more widely used resource by states considering amendments to their LLC Acts.
Many state LLC Acts were first adopted in the early 1990s. In adopting and amending their LLC Acts, state legislatures have been able to look for guidance to several sources:
- The Uniform Limited Liability Company Act (“ULLCA”) promulgated by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”) in 1994;
- The Prototype Limited Liability Company Act (the “Prototype”) published in 1992 by the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities; and
Both the ULLCA and the Prototype were influential as the states drafted their LLC Acts, but neither fully occupied the field. As a result there is a lot of variation in LLC laws from state to state. According to NCCUSL, the revised ULLCA has been adopted by only the District of Columbia, Idaho, Iowa, Nebraska, Utah, and Wyoming. The Prototype also was used as the basis for several states’ LLC Acts, and has been used as a reference by other states in amending their Acts.
The Revised Prototype is a major revision and modernization of the Prototype. Changes include terminology, organization, and major points of law. The following is a partial list of the major changes.
Terminology. The name of the formation document has been changed from “articles of organization” to “certificate of formation,” and the principal contract that defines an LLC’s structure and the members’ rights has been renamed from “operating agreement” to “limited liability company agreement.” The latter change reflects the more common terminology, although it is cumbersome. E.g., Washington (RCW § 25.15.005), Delaware (DLLCA § 18-101).
Nonwaivable Provisions. Most state LLC statutes provide numerous default provisions that may be modified by an LLC agreement. Often each default rule will be preceded by language such as “except as otherwise provided in a limited liability company agreement.” Usually, however, some provisions of the statute will be nonmodifiable or nonwaivable by an LLC agreement, in which case the “except as otherwise provided …” language is not used to limit the statutory rule. This was the approach used in the 1992 Prototype.
The Revised Prototype instead simply states that the LLC agreement governs the LLC and its members, and that when the LLC agreement is silent the Act will govern, except that certain statutory provisions listed in Section 110 may not be modified by the LLC agreement. This approach eliminates the need to repeat variants of “except as otherwise provided [in an LLC agreement]” throughout the statute, as all of the default rules in the statute are subject to modification in an LLC agreement unless modification is barred by Section 110.
Manager-Managed vs. Member-Managed; Authority. Many state LLC Acts assume that management of the LLC will be vested either in the members or in one or more managers. Typically the statute will also describe the actual and apparent authority of the members or managers. Oregon and Washington both follow this approach, as did the Prototype.
The Revised Prototype instead takes a more flexible approach by eliminating the need to pigeon-hole the LLC as member-managed or manager-managed. The default rule is that the activities of the LLC are under the direction and oversight of its members. Revised Prototype, § 406. That can be changed by the LLC agreement, which may establish managers, officers, or other decision-makers and define their authority.
The Revised Prototype does not define any actual or apparent authority for members or managers. Instead, the actual and apparent authority of the members or of any officers, managers, or other agents, will be established by the LLC agreement, the decisions of the members, any filed statement of authority, or the common law of agency. Revised Prototype, Article 3.
Power. Most if not all state LLC Acts explicitly state that an LLC formed under the Act has adequate power. The statutes typically refer to LLCs having the powers that are “necessary or convenient” for their activities, or to comparable language. E.g. Delaware (DLLCA § 18-106(b), Washington (RCW § 25.15.030(2)), Oregon (ORS 63.077). Entity power is a fundamental attribute. For example, if an entity lacks power to form a contract and purports to do so, the contract will not be enforceable.
The importance of this issue is shown by legal opinion-letter practice. Lawyers for parties in major transactions are often required as a condition of the transaction to provide a legal opinion to the other party covering, among other things, the power of the lawyer’s client to enter into and carry out the transaction. The TriBar Opinion Committee’s 2006 Report on LLC closing opinions states that a lawyer’s opinion that an LLC has the power to enter into and perform its obligations under an agreement means that the LLC “has that power under … the statute under which it was formed.” TriBar Opinion Committee, Third-Party Closing Opinions: Limited Liability Companies, 61 Bus. Law. 679, 687 (2006) (emphasis added).
The Prototype intentionally did not include any language dealing with the LLC’s power to carry out its activities, apparently relying on the contractual aspect of LLCs. See Prototype, § 106, Commentary. The Revised Prototype, however, has included a statement that an LLC will have the powers “necessary or convenient to the conduct, promotion, or attainment of the business, purposes, or activities” of the LLC. Revised Prototype, § 105(b).
The Revised Prototype explicitly recognizes the entity nature of LLCs, defining an LLC as “an entity formed or existing under this Act.” Revised Prototype, § 102(13) (emphasis added). The Prototype, in contrast, defines an LLC as “an organization formed under this Act.” Prototype, § 102(F) (emphasis added).
It seems odd that the summary of major changes in the introduction to the Revised Prototype makes no mention of the addition of a powers clause, which I think most practicing lawyers would consider major, and the comment to Section 105 of the Revised Prototype makes no mention of the change.
Fiduciary Duties. The Revised Prototype does not provide for fiduciary duties and allows broad latitude to the LLC agreement to expand, restrict, or eliminate fiduciary duties. The implied contractual covenant of good faith and fair dealing may not be eliminated. Revised Prototype, § 110. Note that the absence of a default specification of fiduciary duties does not mean that the applicable state’s common law would necessarily hold that managers of LLCs have no fiduciary obligations. See Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012), which I wrote about, here.
Charging Orders. The Prototype provided that a court may issue a charging order, which gives an LLC member’s judgment creditor the right to receive any distributions the member would otherwise receive. The Prototype left unclear whether a charging order was a judgment creditor’s exclusive remedy. I wrote about the exclusivity of charging orders last year, here.
The Revised Prototype makes clear that a judgment creditor’s charging order is its exclusive remedy against an LLC member’s interest in the LLC. This change brings desirable clarity, but many would argue that there is a policy issue left unaddressed by the Revised Prototype, i.e. whether the charging order should be exclusive even in the case of a single-member LLC.
The new provision provides additional detail about the exercise of the charging order, and also makes clear that a charging order may be obtained against an assignee’s LLC interest.
Derivative Suits. The Prototype did not provide a default rule for derivative suits, although nothing in the Prototype prevented an LLC agreement from authorizing derivative suits. The Revised Prototype authorizes derivative suits for members as a default rule, although not for assignees (unlike Delaware, which allows members and assignees to bring a derivative suit, DLLCA § 18-1001).
Series LLCs. Series LLC provisions were added to the Revised Prototype. A series LLC is an LLC that is split into separate series, each having its own members and managers, owning its own assets separate from the assets of the LLC or any other series, and incurring obligations enforceable only against its own assets. At least eight states have authorized series LLCs (see my blog post, here).
Evergreen. The Revised Prototype has been published by the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities. The Committee deserves praise for this comprehensive revision and the thoughtful comments.
The Committee stated in the overview to the Revised Prototype that it will be revised on an ongoing basis, to anticipate and respond to legal and business changes affecting LLCs. This will be especially useful if the Committee can make such revisions publicly available on the Internet (once released), with clear delineation of the changes from one version to another and with adequate comments explaining the changes.
Comments. The Committee has encouraged interested parties to submit suggestions and comments on the Revised Prototype. The Committee can be reached through the ABA’s website, here.
Judgment creditors of LLC members usually have the right under state law to obtain a charging order against a member’s LLC interest. A charging order mandates that any distributions by the LLC that would otherwise be made to the member be paid instead to the creditor. The charging order provides no benefit, though, if no distributions are made to the LLC’s members. And if the judgment debtor is the only member of the LLC, it’s unlikely that he or she will cause the LLC to make distributions, since those would have to go to the creditor.
The U.S. District Court in Kansas recently had to determine the scope of a charging order against a single-member LLC in Meyer v. Christie, No. 07-2230-CM, 2011 U.S. Dist. LEXIS 118590 (D. Kan. Oct. 13, 2011). Although the Kansas LLC Act says a charging order against an LLC member’s interest is the creditor’s exclusive remedy, the court surprisingly found that, in the case of a single-member LLC, the creditor could assert management rights and take control of the LLC.
The relevant facts are straightforward. The plaintiffs obtained a final judgment of about $7 million against the defendants, who had interests in several Kansas LLCs. The plaintiffs asked the judge to issue a charging order against the defendants’ interests in the LLCs, under the authority of Kansas’s LLC Act:
Rights of judgment creditor. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest. This act does not deprive any member of the benefit of any exemption laws applicable to the member’s limited liability company interest. The rights provided by this section to the judgment creditor shall be the sole and exclusive remedy of a judgment creditor with respect to the member’s limited liability company interest.
Kan. Stat. Ann. § 17-76,113 (emphasis added).
A charging order is a limited remedy – the creditor has only the rights of an assignee, i.e., the economic right to receive distributions, and no rights to participate in management. The Kansas statute also provides that the charging order is the exclusive remedy, so the creditor cannot attach or foreclose on the member’s interest and thereby take control. (The charging order provisions of some state LLC Acts are silent on whether the charging order is a creditor’s exclusive remedy. See my discussion of Florida’s Olmstead v. FTC case on charging orders, here.)
The court acknowledged the Kansas LLC Act’s clear statement that the charging order is the only remedy by which a member’s judgment creditor can reach the member’s LLC interest, and discussed the partnership law origins of the LLC charging order. In the case of partnerships, a creditor’s charging order against a partner will not entitle the creditor to participate in the management of the partnership. Meyer, 2011 U.S. Dist. LEXIS 118590, at *10.
But, said the court, the result is different in the case of an LLC with only one member. That’s because of a specific provision in the Kansas LLC Act:
If the assignor of a limited liability company interest is the only member of the limited liability company at the time of the assignment, the assignee shall have the right to participate in the management of the business and affairs of the limited liability company as a member.
Kan. Stat. Ann. § 17-76,112(f). That paragraph is not in the Act’s section on charging orders, but is part of a long section dealing with assignments of LLC interests.
Without discussion, the court simply assumed that the holder of a charging order not only has the rights of an assignee but actually is an assignee. The court then held that under Section § 17-76,112(f), “the assignee/creditor shall have the right to participate in the management of the business and affairs of the LLC as a member.” Meyer, 2011 U.S. Dist. LEXIS 118590, at *11. With those rights, the holder of a charging order against an LLC’s sole member can take over the LLC, make distributions to itself, and liquidate the LLC if it so chooses.
The problem with the court’s holding is that the creditor’s rights under a charging order are limited to satisfaction of the debt. Once the judgment debtor’s obligation is satisfied, the charging order is extinguished. An assignment, in contrast, is a permanent transfer of the property rights assigned. The charging order statute accordingly recognizes that the rights of the creditor are limited: “To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest.” Kan. Stat. Ann. § 17-76,113 (emphasis added). The Meyer court ignored the inherent limitations of charging orders. Its confusion between the limited economic rights granted under a charging order and the full transfer of rights granted under a true assignment led it to the wrong result.
Some states have added provisions to their LLC Acts to clarify this point and avoid a Meyer result. Thomas Rutledge recently blogged about the Meyer case, here, and pointed out that Kentucky has amended its LLC Act to provide that “[a] charging order does not of itself constitute an assignment of the [LLC] interest.” Ky. Rev. Stat. § 275.260(3).
Michigan similarly provides in its LLC Act that a charging order is not an assignment of the member’s interest, and that the holder of a charging order does not become a member of the LLC. Mich. Comp. Laws § 450.4507.
One recent publication that is a useful reference for investigating state LLC charging order laws is Carter G. Bishop, Fifty State Series: LLC Charging Order Statutes , Suffolk University Law School Research Paper No. 10-03 (Oct. 6, 2011) .
Bill Callison’s article, Charging Order Exclusivity: A Pragmatic Approach to Olmstead v. Federal Trade Commission, recently came out on SSRN and should be available soon in Volume 66 of The Business Lawyer. Callison’s article reviews the Olmstead court’s analysis of charging orders for single-member LLCs and suggests how the court should analyze charging orders for multi-member LLCs.
Background. In Olmstead the FTC won a judgment against Olmstead, and then obtained an order allowing it to execute on Olmstead’s member interest in his single-member Florida LLC, including his right to vote and control the LLC. Olmstead v. FTC, 44 So. 3d 76 (Fla. 2010). By executing on all of Olmstead’s member rights, the FTC could cause the LLC to make distributions, liquidate the LLC, or take other actions.
Florida’s LLC Act gives a judgment creditor of an LLC member the right to obtain a charging order against the member’s LLC interest. Olmstead contended that the charging order remedy was exclusive and provided the only way for a judgment creditor to reach the member-debtor’s interest in the LLC.
A charging order requires that any LLC distributions payable to the member be paid instead to the creditor. Fla. Stat. § 608.433(4). A charging order does not require the LLC to make any specific distributions, so if the FTC were limited to having a charging order, it might not receive distributions or any other value from Olmstead’s rights in the LLC for a very long time. Very, very long.
Olmstead Decision. The Florida Supreme Court pointed out that the LLC Act’s charging order provision was nonexclusive on its face, and ruled that the FTC could execute on Olmstead’s full member interest. “[W]e hold that a court may order a judgment debtor to surrender all right, title, and interest in the debtor’s single-member LLC to satisfy an outstanding judgment.” Olmstead, 44 So. 3d at 83.
The Olmstead decision has received a lot of attention. It reduces the asset-protection usefulness of single-member LLCs, and it is from the highest court of a populous state with large centers of commerce. And many states have LLC acts with charging order provisions that, like Florida’s, lack exclusivity language. E.g., Wash. Rev. Code § 25-15-255; N.Y. Ltd. Liab. Co. Law § 607 (McKinney 2007).
As Callison points out, Olmstead leaves several questions unanswered. Is the court’s holding limited to single-member LLCs, i.e., would the result have been the same if Olmstead’s LLC had other members? How is “single member” interpreted? For example, should an LLC with two spouses as the only members be treated as a single member LLC? If the Olmstead result applies to multiple-member LLCs, to what extent can the members’ operating agreement limit the rules that would otherwise apply to a judgment creditor’s rights?
The Olmstead court saw the charging order as a special remedy, responsive to the basic principle of Section 608.433(1): “Unless otherwise provided in the articles of organization or operating agreement, an assignee of a limited liability company interest may become a member only if all members other than the member assigning the interest consent.” This is the “pick-your-partner” principle, which is integral to partnership and limited partnership law and is a part of most partnership and limited partnership statutes. But because in a single-member LLC no other member’s consent is necessary to admit an assignee as a member, the court saw no need for the charging order to be the only remedy available to the judgment creditor.
The court also examined Florida’s general and limited partnership statutes. Both expressly provide that the charging order on a partnership interest is the judgment creditor’s exclusive remedy. Fla. Stat. §§ 620.8504, § 620.1703. As a matter of statutory interpretation, the presence of exclusivity in the partnership charging order statutes and the lack of such a provision in the LLC Act supported the conclusion that the LLC charging order was not intended by the legislature to be exclusive. Olmstead, 44 So. 3d at 82.
Extrapolation. How should the Florida court rule when a charging order case involves a multi-member LLC? Callison notes that the default rules of Florida’s LLC Act include pick-your-partner principles, and concludes that there should be a rebuttable presumption that charging orders are exclusive. Callison, supra, at 12. He proposes that in single-member LLCs, and in multiple-member LLCs whose operating agreement allows complete transferability of interests, the presumption would be overcome and the charging order would not be the exclusive creditor’s remedy. Id. at 12-13.
Callison also proposes a similar rebuttable presumption for incorporation into LLC statutes, using statutory language such as:
Charging orders are the exclusive remedy by which a member’s judgment creditors can reach the member’s interests in the company; provided, however, that if the judgment creditor can demonstrate that all or any part of the member’s interest in the company can be assigned by the member to a third party without the other members’ consent, then the charging order shall not be an exclusive remedy with respect to such freely assignable interest.
Id. at 20. This is an interesting approach – an attempt to pragmatically balance the policies of implementing “pick your partner” principles against the goal of providing judgment creditors with reasonable remedies.