Iowa Court Denies Request by Holders of LLC Charging Orders for Quarterly Financials
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.
Kansas Authorizes Series LLCs
Kansas recently became the latest state to authorize series limited liability companies. Governor Sam Brownback signed Substitute House Bill 2207 on March 29, 2012, amending the Kansas Limited Liability Company Act to authorize series LLCs. Sub. H.R. 2207. The bill will become law on July 1, 2012, and Kansas will then join the eight other states that have authorized series LLCs.
Series LLCs. A series LLC can partition its assets and members into one or more separate series, each of which can have designated members and managers, and can own its own assets separately from the assets of the LLC or any other series. The liabilities of each series will be enforceable only against the assets of that series, and each series can enter into contracts, sue, and be sued in its own name.
Multiple series within one LLC can be used to avoid some of the inefficiencies and costs involved with using multiple LLCs. For example, separate parcels of real estate could each be owned by a separate series, but all within one LLC. Or, the divisions of a business could be held within one LLC, but with each division in a separate series.
Other States. Delaware was the first state to authorize series LLCs, in 1996. Del. Code Ann. tit. 6, § 18-215. Since then Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah have enacted statutes similar to Delaware’s, although there are some differences. I previously wrote about series LLCs when Texas passed its series LLC law in 2009, here, and when the Internal Revenue Service proposed regulations for series LLCs, here.
Kansas Requirements. The Kansas statute is similar in many respects to the Delaware Act. Both authorize an LLC’s operating agreement to establish one or more designated series, and both provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
- the records of the series account for its assets separately from the assets of any other series or the LLC generally,
- the operating agreement states the liability limitations, and
- the certificate of formation, and in the case of a Kansas LLC, the articles of organization, give notice of the limitations on liability.
Series LLCs are relatively new. There are few reported opinions dealing with series LLCs, and the IRS’s proposed regulations have not yet been finalized. There are therefore many unresolved legal questions about series LLC issues such as taxation, bankruptcy, liability limitations, and piercing the veil, particularly when doing business in states outside the state of formation. Caution is advised when implementing a series LLC, given the uncertainty and lack of predictability inherent in their use.
Nebraska and Wyoming Enact the Revised Uniform LLC Act
The National Conference of Commissioners on Uniform State Laws (NCCUSL) was formed in 1892 to promote uniformity in state laws by providing states with proposed legislation. NCCUSL’s record has been mixed, but it has had notable successes in the area of commercial and business law. Examples include the Uniform Commercial Code (in cooperation with the American Law Institute), the Uniform Partnership Act, and the Uniform Trade Secrets Act.
LLC law has not been one of NCCUSL’s shining successes. NCCUSL released its first Uniform LLC Act (ULLCA) in 1995, after almost all the states had already adopted LLC statutes. ULLCA has since been adopted by only eight states.
In 2006 NCCUSL released a revised version, the Revised Uniform Limited Liability Company Act (RULLCA). In 2008 RULLCA was enacted by Idaho and Iowa.
Earlier this year Nebraska and Wyoming enacted RULLCA, doubling the number of RULLCA states from two to four. Nebraska’s new law was signed by the governor on April 1, 2010. It becomes effective January 1, 2011 and has a two-year transition period. The new Wyoming Act was signed by the governor on March 8, 2010 and became effective July 1, 2010, with a four-year transition period.
There is significant variation among the current state LLC laws, other than those of the eight states that enacted ULLCA, and the four states that have now adopted RULLCA. Many were originally modified versions of the states’ limited partnership laws, while some were copied in part from other states’ laws, from ULLCA, and from the ABA’s 1992 Prototype Limited Liability Company Act.
RULLCA has been criticized. Larry E. Ribstein, An Analysis of the Revised Uniform Limited Liability Company Act, 3 Va. L. & Bus. Rev. 35 (2008). Professor Ribstein has referred to it as “the incredibly misguided Revised Uniform Limited Liability Company Act,” here. His view is that RULLCA “threaten[s] to impose substantial risks and costs on limited liability companies … that there is little reason for states to adopt the Act, and that practitioners should be wary about advising clients to form under it.” Id.
The major criticisms of RULLCA include the following issues. Ribstein, supra, at 78-79.
- Unworkable provisions on shelf registration, i.e., creating an LLC with no initial members
- No provisions for series LLCs
- An overly broad definition of the elements of the operating agreement
- Unclear rules on the agency power of members and managers
- Broader fiduciary duties than the traditional duties of loyalty and care, with uncertain boundaries, and intricate restrictions on operating agreement waivers of fiduciary duties
RULLCA is a valuable resource for states looking to review and revise their LLC statutes, but its prognosis for becoming widely adopted looks bleak.
Given the relatively recent appearance of LLCs on the legal stage, a variety of state approaches may not be such a bad thing. Over time, case law will play out against the statutory backdrops, LLC statutes will be revised based on business needs and the results of litigation, and lawyers and business people can in effect vote with their feet by forming LLCs using whatever states’ laws best fit their needs.
Texas Joins the Series LLC Crowd
Texas has joined the seven other states that have authorized series LLCs. The Texas bill authorizing series LLCs was signed by Governor Perry in May and will become effective on September 1, 2009. S.B. 1442. The states that currently authorize series LLCs are Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee and Utah.
Most state LLC acts allow an LLC to provide for classes of members with different member rights per class. But a series LLC can go further by establishing multiple series of assets, members and managers. The debts and obligations of a series will be enforceable only against the series’ assets, and will not be enforceable against the other series in the LLC or against the LLC generally, and vice versa. The members associated with a series can be given separate rights and duties with regard to the assets of the series.
The separation of assets and partitioning of liabilities between series, all within one LLC, can avoid many of the inefficiencies and costs associated with multiple related entities. For example, a series LLC could be used to hold multiple parcels of real estate, each in a separate series and all within the one LLC. Or, separate divisions of a business could be held by one LLC, but with each division in a separate series.
The Texas statute is similar in many respects to the Delaware act. Both authorize an LLC’s operating agreement to establish one or more designated series. Both acts provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
(a) the records of the series account for its assets separately from the assets of any other series or the LLC generally,
(b) the operating agreement states the liability limitations, and
(c) the certificate of formation gives notice of the limitations on liability.
Each series may in its own name sue and be sued, contract, and hold title to its assets, including real estate and personal property.
Series LLCs can be useful, but there are legal uncertainties involved in their use. Series LLCs are relatively new – Delaware was the first state to authorize series LLCs, in 1996, and there is almost no case law on them. Major areas of uncertainty involve taxation, bankruptcy, and doing business in multiple states.
There are many open tax questions with regard to series LLCs. Although the Internal Revenue Service issued a Private Letter Ruling in 2008 and clarified that each series’ federal tax characterization is determined independently, other state and federal tax questions remain.
It is unclear whether an LLC series will be treated as a debtor in federal bankruptcy court, or whether the bankruptcy court will ignore the series and only consider the entire LLC. The result may depend on whether the relevant state law will treat the series as a separate entity with its own liability shield.
Including Texas there are now eight states whose LLC acts authorize series LLC, but that leaves 42 other states with no series provisions in their acts. It is not at all clear what the courts of a non-series state would do when faced with a claim by a local creditor against an out-of-state series LLC formed under the laws of, say, Delaware. Will the non-series state honor the series structure and respect the internal liability shield? Would a non-series state even allow a series of an LLC formed under the laws of another state to register to transact business in the non-series state?.jpg)
The law of series LLCs is an infant, still a little unsteady on its feet. But at one time LLCs were new and LLC law was the infant. There were many articles back then pointing out the uncertainties and risks of using LLCs when they were first adopted by Wyoming in 1977 and later by other states. Many conservative lawyers recommended against using LLCs in the early years of their authorization by the various states, but eventually all the states authorized LLCs. Today LLC law is more mature and LLCs are the most popular entity form for new businesses. History predicts that the question for series LLCs is not whether they will become routinely used, but when.
