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.
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) .