by Jay Adkisson & Chris Riser as supported by www.assetprotectionbook.com
jay wrote:Charging Order Protected Entity (COPE)
Efficacy of Charging Order Protection
by Jay D. Adkisson
Reprinted from Developments, April 2005
Business entities are created by state legislatures primarily to allow individuals to group together to invest capital for new ventures. The primary statutory goal of most entities is to shield the investors from the liabilities of the business, so that their risk is limited by the amount of the capital investment. Thus, if the business itself has a creditor, the creditor’s relief is limited to the assets of the business, and, except in extreme cases, the creditor cannot pursue any assets other than those of the business itself.
The liabilities of the business are known as “inside liabilities,” and the claims of creditors against the business are known as “inside creditors”. As long as the entity is distinct from its owners, is adequately capitalized, and is not used to perpetuate a fraud, then, the entity should protect its investor-owners from inside liabilities and inside creditors. The exception is the general partnership. In a general partnership, general partners are liable for the debts and liabilities of the partnership. Similarly, general partners of Limited Partnerships and related entities are also liable for the liabilities of the partnership.
The flipside is where an investor-owner attempts to protect partnership from personal creditors of the investor-owner. The creditors of an investor-owner are known as “outside creditors,” and the claims giving rise to those creditors are likewise called “outside liabilities”.
From a statutory perspective, the creditors of an investor-owner are treated much differently than the creditors of the business itself. The hard truth is that most state legislatures have no desire to protect a debtor’s interest in a business entity from creditors. To the contrary, if an investor-owner has debts, then he or she should pay those debts from whatever non-exempt property is available, including shares of stock and interests in partnerships and like entities.
In a corporation, a creditor may simply attach 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 against errant corporate officers and directors.
Note that 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.
Legislatures are not concerned with interference of corporate business when a creditor has attached interest in stock because shareholders are two full steps removed from business operations. Shareholders elect the directors, directors elect the officers, and officers run the business. Allowing a creditor to attach the shares of a corporation only indirectly affects the corporation in the election of directors.
Partnerships and pseudo-partnership entities, such as the Limited Liability Company (LLC), are different from corporations. In a partnership or LLC, the investor is a partner and may directly affect the entity’s business operations. A change in ownership may disrupt the operations of the partnership and force non-debtor partners into an involuntary partnership with the creditor.
Thus, state legislatures have not allowed creditors to attach partnership interests and become the partners themselves. Instead, legislatures have only allowed creditors a limited form of relief against the debtor’s partnership interest through a “Charging Order”.
Of Interests and Charging Orders
The charging order and its function can only be examined in light of the character of the partnership interest itself. This leads to the fundamental question of what a partnership interest constitutes.
A partnership interest is unlike holding shares in a corporation. With the latter, the shareholder has no duties and all of his or her rights are bound into the share certificates (whether physically issued or not). For instance, a shareholder may lend his voting rights to others and these rights remain part of the rights that are bound into the share certificates.
On the other hand, in exchange for the partner’s investment, the partner receives a bundle of rights that includes the rights to distributions and the rights that are set out in the operating agreement. The partner may or may not be required to perform certain duties in order to receive the rights outlined in the partnership’s operation agreement.
A charging order is held against the partner’s right to distributions from the entity. The comments to the Uniform Partnership Act and LLC Act describe the charging order as “in the nature of a garnishment.” To define a charging order as a “business garnishment” would closely describe the charging order. However, one could also characterize a charging order as being an “assignment of income” or as an assignment of the partner’s economic right to distribution from the partnership.
The best description of a charging order is that it is the legal vehicle by which a lien is placed on the debtor member's distributive rights, i.e., the rights of the debtor to receive profit distributions from the entity. The effect of the charging order is to create a lien.
Charging Order Protected Entity (COPE) is the term used to describe entities for which external creditors are usually limited to the charging order remedy, meaning that the creditors cannot simply attach the partner’s interest as if they were shares in a corporation. The best known COPE entities are the Limited Partnership (LP) and the Limited Liability Company (LLC). However, COPES also include Limited Liability Partnerships (LLP) and Limited Liability Limited Partnerships (LLLP), as well as the new Series LLC.
“Charging Order Protection” is somewhat of a misnomer. A charging order is a remedy that is affirmatively sought by a creditor. A better term may be “anti-invasion protection” because the benefit sought from a charging order protection is making invasion of the entity by a creditor difficult.
Barbarians at the Gate:
A creditor must usually follow this path to relief when seeking to obtain assets from a COPE:
1. Obtain a judgment.
2. Charge the interest.
3. Foreclose the charging order.
4. Appoint a receiver.
5. Partition the entity.
Each step and its role in protecting the assets of the LLC from the creditor is discussed in detail below.
First, the creditor must obtain a judgment, since the charging order is only available to “judgment creditors”. Thus, on the defense side, there is often time for additional structuring or drafting to make sure that the structure is rock solid. Sadly, many planners do not take the opportunity to fix slight flaws in the entity structure or drafting before the creditor obtains the charging order.
After obtaining a judgment, the creditor must obtain a charging order. The charging order is against the debtor’s economic rights to distribution from the entity. 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 distribution. However, partners do not own a direct interest in the assets of the entity.
The creditor may also garnish or obtain a forcible assignment of the debtor’s right to distribution from the partnership. That is, the partnership must pay the creditor instead of the debtor until the judgment is satisfied. However, the right to payment does not make the creditor a partner or member and does not give the creditor any voting rights.
If the entity is formed in the same state where the creditor obtained the original judgment, obtaining a charging order from the court is not difficult. However, if the entity is formed in another state, the creditor may have to register the judgment in the other state and ask the courts of that state to issue the charging order. This is discussed more fully in “Conflicts & Koh” below.
The creditor may also foreclose on the debtor’s partnership interest. The foreclosure is on the interest in the partnership, not on the entity itself or on the entity’s assets. Foreclosure of a charging order is one of the most misunderstood and misrepresented concepts in asset protection. Contrary to the oft-repeated (including at seminars and in poorly researched articles) but false belief, the foreclosure of the interest is not a foreclosure of the entity’s assets. The foreclosure is of the charging order against the debtor’s economic right to distributions.
The difference between a creditor holding a charging order and a creditor foreclosing on the charging order is the permanence of the creditor’s interest. A charging order is a temporary remedy that has the effect of assigning income to the creditor until the judgment is paid. After the assignment of income (or garnishment, if you want to look at it that way) terminates, the debtor regains the right to distributions.
By contrast, foreclosure of the interest makes the assignment (or garnishment) permanent, which means that the creditor becomes the owner of the distributional interest. The creditor may then attempt to sell the interest to an interested buyer. If a limited partnership or LLC has few members and is controlled by persons friendly to the interests of the debtor, the creditor attempting to sell the foreclosed interest may have a very tough time finding buyers.
In real life litigation, the most common result after a foreclosure of the interest has occurred is that the entity offers to redeem the creditor’s interest at some value that is much less than the percentage interest in distributions held by the creditor. However, redemption is not a sure thing for either the creditor or the entity.
The disadvantage to a foreclosing creditor is that after foreclosure, 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 at the charging order stage). Thus, the creditor risks receiving K-1 distributions of “phantom income.” That is, the creditor has to pay a share of the entity’s taxes even though the creditor does not receive actual income.
A disadvantage to the entity after is foreclosure of an interest by a creditor is that the creditor may be entitled to certain derivative rights from the entity, depending on how well the operating agreement for the entity is drafted. The derivative rights may include the rights to inspect books and records, request distributions, and request the appointment of a receiver.
The creditor may ask the court to appoint a receiver in order to ensure that the entity makes distributions to the creditor’s interest. Normally, the creditor is able to obtain the appointment of a receiver, which is possible when the operating agreement is not immaculately drafted to hinder the possibility of giving the creditor derivative rights to involuntary distributions from the entity. Like most derivative rights issues, the possibility of obtaining a receiver is more likely if the creditor has foreclosed upon the majority interest in the entity. However, appointment of a receiver is less likely if the creditor holds only a minority interest.
Finally, 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. This is a long shot for the creditor, but it is theoretically possible in extreme cases in where the entity has not been structured correctly, and the operating agreement has been poorly drafted.
State Restrictions of Remedies
In response to misperceptions about what the role of charging orders, some states have attempted to limit creditors’ remedies to a charging order by forbidding the foreclosure of the interest. Although such laws are attractive on the surface, under some circumstances, these limitations are less attractive from an asset protection standpoint.
A creditor who holds a mere charging order is probably not liable for the taxes of the entity. Even though this belief is preached at asset protection seminars, there is not any substantial basis for believing that a charging creditor is liable for the taxes of the charged entity. To the contrary, many tax planners have concluded that a creditor holding a charging order is not liable for the taxes of the entity.
On the other hand, there is little doubt that a creditor who forecloses on a charging order is treated as an owner of the charged entity for tax purposes. Foreclosure becomes a potential trap for a creditor to be “K.O.’d by the K-1”. The tax liability (which is not something that creditors’ attorneys are typically even aware of) can sometimes facilitate a quick and cheap redemption of the foreclosed interest from the creditor. Or as we litigators say, “They no longer want the cheese; they just want out of the trap.”
From the asset protection perspective, foreclosure is sometimes good, and the states that have eliminated the foreclosure remedy in order to attract asset protection work may have unwittingly taken a step backwards. However, some would argue that the fact that the creditor is stopped at the charging order stage may facilitate settlement by the creditor even without the surprise leverage of the “thank you for foreclosing, here’s your K-1”.
Conflicts & Koh
In which state should the creditor apply for a charging order?
Consider the following hypothetical. Hubris LLC is formed in Delaware, has its offices and principal place of business in Kansas, is qualified to do business and owns real property in Oregon. Hubris does not do business or hold assets in Alabama. However, a member of Hubris LLC lives in Alabama, where he is successfully sued. The Alabama creditor seeks to charge the debtor’s interest in Hubris LLC to satisfy the Alabama judgment. Where does the Alabama creditor apply for the charging order?
This is a trick question, because nobody really knows where the application for the charging order should be filed. In particular, the drafters of the Revised Uniform Limited Partnership Act (RULPA) and the Uniform Limited Liability Company Act (ULLCA) have not addressed the issue. Therefore, it is left to the courts to decide.
While an Alabama court can issue a charging order, Hubris LLC has no minimum contacts in Alabama; thus, Alabama has no personal jurisdiction over Hubris LLC. If Hubris LLC ignores the Alabama court’s order, the court does not have jurisdiction if Hubris is not within its borders.
In order to obtain a charging order, the Alabama creditor should register the judgment in a state where Hubris LLC has minimum contacts and obtain the charging order against Hubris under that state’s laws. This issue was addressed by a Washington appellate court in Koh v. Inno Pacific Holdings Ltd, 114 Wash App 268, 54 P.3d (Wash App Div 1 2002), which halfheartedly concluded a California creditor did not violate due process by bringing an application for a charging order in the state in which the LLC was located.
The Debtor in Bankruptcy
Chris and I have said many times in relation to many asset protection strategies, “In bankruptcy, all bets are off.” Where debtors hold interests in limited partnerships and LLCs and are forced into bankruptcy, there is a possibility that a court will allow a creditor to attach the assets of the partnership or LLC itself.
Interests in limited partnerships and LLCs are held by the members in a contractual nature, as defined, first by applicable state law, and then by the partnership’s operating agreement. For bankruptcy purposes, interests can be defined two ways: executory interests and non-executory interests.
Executory interests require the partner or member to execute some affirmative act that benefits the entity in order for the partner or member to receive distributions. One might define executory interests as “active” interests.
Non-executory interests are do not require the partner or member to do anything. Distributions are made without any further act of the partner or member. Non-executory interests are “passive” interests.
When a partner filed bankruptcy, whether his interests are as executory or non-executory determines the parameters of the bankruptcy trustee’s powers. If the interest is non-executory, then the court-appointed Trustee is not bound by limitations in the entity’s operating agreement. That is, the Trustee may invade the assets of the entity and sell the assets in order to satisfy judgments against the debtor. Such was the precise result in a recent Arizona bankruptcy case, In re Ehmann, 2005 WL 78921, Bkrtcy.D.Ariz. (Jan 13, 2005).
By contrast, if the debtor’s interests are executory, the Trustee is probably bound by the entity’s operating agreement, including any limitations on creditors’ remedies. Thus, it is critical that the operating agreement is immaculately drafted to ensure that the interest is treated as executory, so that the Trustee cannot argue for treatment of the interest as non-executory.
From the debtor’s perspective, the key to keeping creditors from the assets of the entity is intelligent structuring and meticulous drafting, which is the very essence of good asset protection planning.
Single Member LLCs
Recall that with a corporation, shareholders are twice removed from the operations of the corporation because the shareholders elect the directors, and the directors elect the officers who actually run the corporation. Thus, if the creditor attaches shares of a corporation, the creditor will not directly influence operations until there has been at least one meeting of directors at which new officers can be elected.
In a limited partnership or LLC, however, the change of ownership from the debtor to a creditor could directly impact the operations of the entity and affect the remaining non-debtor members. The primary purpose of the charging order is thus to protect the non-debtor members from being involuntarily forced into a partnership with a the debtor member’s creditor.
However, there is only one member in a SMLLC, so there are no non-debtor members to protect. It also defies common sense that a creditor would not be able to get at the assets of an entity where the debtor is the only owner.
Some planners argue that even though it may not make any sense to have charging order protection where there is only one member, the language of the statute is nonetheless protective. Some states, such as Arizona, have modified their LLC acts in such a manner that suggests protection of the debtor’s indirect interest in the assets of the entity, even if the creditor has charging order.
Planners who believe that SMLLCs are protected by charging orders in the same manner as other LLCs and partnerships argue that, unless it is apparent that the creditor’s judgment may never be satisfied by distributions from the SMLLC, the creditor should not be allowed to invade the LLC.
After years of speculation and the lack of any solid case law, the issue of whether SMLLCs are afforded the protections of the charging order was finally addressed by a U.S. bankruptcy court, In re Albright, No. 01-11367 (Colo. Bkrpt. April 4, 2003). The judge in Albright held that charging order protection does not exist for a SMLLC 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 creditors’ claims.
Thus, until Albright is overturned or rejected by other courts, the safe presumption will be that SMLLCs probably do not provide charging order protection.
Based on Albright, sometimes I hear planners blurt out, “Single Member LLCs provide no asset protection!” This is wrong. The lack of charging order protection is a far cry from concluding that SMLLCs are “worthless” as asset protection vehicles. SMLLCs may still provide substantial protection for owners against the liabilities of the entity itself, which are so-called “internal liabilities”.
For example: SMLLC owns a strip mall and is successfully sued by one of the tenants. If the SMLLC is adequately capitalized, is not the alter ego of the sole member, and is not used to perpetuate a fraud, the tenant may not assert liability against the member.
There is no reason that a SMLLC should be treated much differently from a sole shareholder corporation. Historically, sole shareholder corporations have contained liability within the entity and shielded the liability away from its owners.
To summarize, even if SMLLCs do not offer the same charging order protection as multiple-member LLCs, they can still be very valuable business planning vehicles. Certainly, it is preferable from a liability standpoint to own one’s business in a SMLLC than to run it as a sole proprietorship. But of course, where external liability is a concern and it is feasible to add another member, that should be done so that charging order protection arises.
SMLLCs and LAMBs
An interesting question regarding SMLLCs is the consequences of the partial sale of a debtor’s interest in a single member LLC’s to a third party (sometimes referred to as a “LAMB” for “Late Arriving Member”). Does the sale of the debtor’s interest to a LAMB invoke charging order protection in an SMLLC, even if there were no other members at the time the claim arose?
The answer depends on when that the court tests the single member status for charging order purposes. My gut feeling is that this should be at the time that the application for the charging order is made because the purpose of the charging order is to protect non-debtor members. If this is true, then it means that you can maintain an LLC with a single member, but later add a member and charging order protection will arise. Although a sophisticated creditor may argue that the post-claim transfer of the LLC interest was a fraudulent transfer, I’m not convinced that is a winning argument so long as the transfer is not done at the last minute, was for value, and can be justified on other straight-faced business grounds.
Reverse Veil Piercing
It is unclear whether creditors are permitted to assert a “reverse veil piercing” theory in order to circumvent charging order protection. In the case of a SMLLC, the application of such a theory is practical. However, the application of reverse veil piercing in an SMLLC may contradict the clear text of the RULPA and ULLCA.
Otherwise, as with corporations, the more members you have the less likely it is that a reverse veil piercing theory will be successful.
Charging order protected entities are some of the strongest and most acceptable asset protection tools available. These entities afford a significant degree of protection for the partners or members against the internal liabilities of the entity, yet they also severely restrict the collection rights of the creditors of a partner or member.
But as shown by Ehmann and other cases, merely forming a limited partnership or LLC isn’t going to protect assets. The key to the success of these entities is intelligent structuring and meticulous drafting that addresses the several potential avenues of creditor attack. But such is the very nature of good – as opposed to cookie-cutter – asset protection planning.
The problem is that many people have COPES, predominantly in the widely-sold “Family Limited Partnership” form, but these entities are often not structured correctly for asset protection purposes (which may not mesh entirely with estate planning purposes) and their operating agreements are an open invitation to creditor attack.
Even if initially correctly structured, the operating agreements of COPES must be updated to keep up with the discovery of new landmines. Yet, in practice, these entities tend to suffer from the same neglect that often brings corporations to grief, which is that their books and records are not updated and they fall into disrepair.
People wouldn’t even think about letting their car go for a year without service, but somehow they think that they can go for years and years without updating their Family Limited Partnership and that it will work anyhow. Especially as creditors become more organized and aggressive in attacking such structures, this is very dangerous.
There are sundry other issues relating to the drafting and operation of partnerships and LLC that are critical for these entities to maintain their legal separateness and to keep creditors and disgruntled members at bay. We will explore those issues at depth in future issues of Developments.
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