Adkisson's

Charging Orders

The Creditors' Primary Remedy Against A Debtor's

Interest In A Limited Liability Company Or Partnership

Caution state law variances!

 

The Charging Order Practice Guide: Understanding Judgment Creditor Rights Against LLC Members, by Jay D. Adkisson (2018), published by the LLCs, Partnerships and Unincorporated Entities Committee of the Business Law Section of the American Bar Association, click here for more

 

Available for purchase at https://goo.gl/faZzY6

SECTION 502. TRANSFER OF TRANSFERABLE INTEREST.

- and -

SECTION 102(23-25). TRANSFER-RELATED DEFINITIONS

 

For the full text of the Uniform Limited Liability Company Act click here

 

{ The boldface emphasis found in the Reporter's Comments were not found in the original, but was added by me because I found those particular passages to be of special importance. Note that the Reporter might disagree. }

 

SECTION 102(23-25). TRANSFER-RELATED DEFINITIONS

(23) “Transfer” includes:

(A) an assignment;

(B) a conveyance;

(C) a sale;

(D) a lease;

(E) an encumbrance, including a mortgage or security interest;

(F) a gift; and

(G) a transfer by operation of law.

 

Reporter's Comment

 

“Transfer” [(23)]—The term “transfer” is broadly defined to include all types of conveyances of interests in property. The reference to “transfer by operation of law” is significant in connection with Section 502 (Transfer of Transferable Interest). That section severely restricts a transferee’s rights (absent the consent of the members), and this definition makes those restrictions applicable, for example, to transfers ordered by a family court as part of a divorce proceeding and transfers resulting from the death of a member. The restrictions also apply to transfers in the context of a member’s bankruptcy, except to the extent that bankruptcy law supersedes this act.

 

JayNote: "Transfer" is a term that is to be expansively interpreted, and the methods of transfer listed in ¶¶ (A) through (G) are meant to illustrate the various forms of transfer that would meet the definition and are not exclusive.

 

(24) “Transferable interest” means the right, as initially owned by a person in the person’s capacity as a member, to receive distributions from a limited liability company, whether or not the person remains a member or continues to own any part of the right. The term applies to any fraction of the interest, by whomever owned.

 

Reporter's Comment

 

“Transferable interest” [(24)]—Absent a contrary provision in the operating agreement or the consent of the members, a “transferable interest” is the only interest in an LLC which can be transferred to a non-member. See the comment to Section 502.

 

This paragraph defines “transferable interest” as an interest “initially owned by a person in the person’s capacity as a member,” because this act does not contemplate an LLC directly creating interests that comprise only economic rights. See Sections 401 (addressing how a person becomes a member), 502 (addressing how a person becomes a transferee).

 

JayNote: The term "transferable interest" is one of the most important definitions found in the ULLCA, as well as in the UPA and ULPA. The term "transferable interest" is effectively synonymous with the common-usage terms "right to distribution" or "distributional rights", or (sometimes, and very loosely and somewhat inaccurately) "economic rights".

 

Of critical importance is that "transferable interest" is limited to a member's rights to distributions, and nothing else. The term "transferable interest" does not, repeat not, include those things that are not distributions as defined in the Act. Thus, salary, wages, management fees, etc., are not considered to be "distributions", although there may be "implied distributions" where distributions have been called one of those things but they are actually just distributions disguised not to look like distributions.

 

The takeaway is that charging orders only apply to a "transferable interest", which is by way of saying that charging orders only apply to distributions; that this may limit the practical effectiveness of a charging order is a substantial understatement.

 

(25) “Transferee” means a person to which all or part of a transferable interest has been transferred, whether or not the transferor is a member. The term includes a person that owns a transferable interest under Section 603(a)(3).

 

Reporter's Comment

 

“Transferee” [(25)]—This definition should be read in light of Section 603(a)(3), which subject to limited exceptions provides that “any transferable interest owned by the person in the person’s capacity as a member immediately before dissociation as a member is owned by the person solely as a transferee.”

 

JayNote: A "transferee" is anybody who is in the chain-of-ownership of a transferable interest.

 

Example. Tom is a member of Alpha LLC and has a right to distributions. Tom sells his right to distributions to Harry, who then sells his right to distributions to Mary. Mary gets into financial trouble, and David obtains a charging order against Mary's interest and later forecloses on the interest, acquiring it at the judicial sale. All of Tom, Harry, Mary, and David are "transferees" under this definition.

 

SECTION 502. TRANSFER OF TRANSFERABLE INTEREST.

 

Reporter' Comment

 

One of the most fundamental characteristics of LLC law is its fidelity to the “pick your partner” principle. See, e.g., Bynum v. Frisby, 73 Nev. 145, 149-50, 311 P.2d 972, 975 (1957) (stating that (i) “the assignment of a partnership interest from one partner to a stranger does not bring that stranger into fiduciary relationship with the remaining partners” and (ii) absent consent by the remaining partners “[t]he stranger remains a stranger” with no rights to management or even information).

 

This section is the core of the act’s provisions reflecting and protecting that principle. A member’s rights in a limited liability company are bifurcated into economic rights (the transferable interest) and governance rights (including management rights, consent rights, rights to information, rights to seek judicial intervention). Unless the operating agreement otherwise provides, a member acting without the consent of all other members lacks both the power and the right to: (i) bestow membership on a non-member, Section 401(d); or (ii) transfer to a non-member anything other than some or all of the member’s transferable interest, Section 502(a)(3). The rights of a mere transferee are quite limited – i.e., to receive distributions, Section 502(b), and, if the LLC dissolves and winds up, to receive specified information pertaining to the LLC from the date of dissolution. Section 502(c).

 

This section applies regardless of whether the transferor is a member, a transferee of a member, a transferee of a transferee, etc. See Section 102(24) (defining “transferable interest” in terms of a right “initially owned by a person in the person’s capacity as a member” regardless of “whether or not the person remains a member or continues to own any part of the right”).

 

This section does not directly consider whether a member may transfer governance rights to another member without obtaining consent from all the other members. As noted above, Section 501, cmt., the question is moot under this act’s default rule for allocating governance rights.

 

However, the question can be pivotal when the operating agreement displaces the default rule on governance rights but does not determine whether transfer restrictions (whether contractual, statutory, or both) apply to transfers of governance rights from one member to another. Case law is scant but suggests that this act does not protect members from control shifts that result from transfers among members (as distinguished from transfers to non-members who seek thereby to become members). Blythe v. Bell, No. 11 CVS 933. 2012 WL 7807800, at ¶ 6 (N.C. Dist. Dec. 10, 2012) (holding in a case of “first impression in North Carolina” that “in the absence of articles of incorporation or an operating agreement to the contrary . . . the assignment of control (i.e., governance) interests between members is effective without unanimous member consent;” Achaian, Inc. v. Leemon Family L.L.C., 25 A.3d 800, 810 (Del. Ch. 2011) (Strine, Ch.) (holding that the terms of the LLC agreement did not preclude one member of a three-member LLC from transferring the member’s entire interest (including governance rights) to a second member without first having the consent of the third member; stating that the third member’s “argument relies on a very thinly sliced version of [the “pick-your-partner principle, the strained version being] . . . that once one chooses his initial co-members, one continues to hold a veto over how much additional voting power they may acquire;” explaining that “[t]he problem for [the third member] is that nothing in the LLC Agreement supports [that member’s] reading of it that would require an already admitted Member, like [the acquirer – i.e., the second member], to be become once, twice (or even three times) a Member each and every time that Member acquires an additional block of Interests”).

 

Other law may affect the applicability of this section. See 11 U.S.C. § 541(c)(1) (providing that, initially at least, all property of a debtor becomes part of the bankruptcy estate regardless of restrictions on transfer); UCC §§ 9-406, 9-408 (overriding specified restrictions on assignment in specified circumstances, regardless of whether state law or a contract imposes the restrictions).

 

In any event, this section does not apply to the transfer of ownership interests in a member that is an entity.

 

EXAMPLE: ABC, LLC has three members: Ralph (an individual), Alice, Inc. (“Alice”), and Norton, LLC (“Norton”). Section 502 applies to any attempt by Ralph, Alice, or Norton to transfer their respective membership interest in ABC. Section 502 is inapplicable, however, to a change in control of Alice or Norton or even a complete change in their respective membership.

 

(a) Subject to Section 503(f), a transfer, in whole or in part, of a transferable interest:

 

Reporter's Comment to Subsection (a) - The definition of “transfer,” Section 102(23), and this subsection’s reference to “in whole or in part” combine to mean that this section encompasses not only unconditional, permanent, and complete transfers but also temporary, contingent, and partial ones. Thus, for example, a charging order under Section 503 effects a transfer of part of the judgment debtor’s transferable interest, as does the pledge of a transferable interest as collateral for a loan and the gift of a life-interest in a member’s rights to distribution.

 

(1) is permissible;

 

JayNote: The phrase "is permissible" denotes that a transferable interest can be transferred, unless it can't. As the Reporter's Comment to Subsection (a) notes, there may be limitations on the transfer of an interest, such as if the interest is subject to a charging order or has been pledged as collateral (and thus is subject to a security interest) or otherwise pledge. Additional limitations on transfer may be found, for example, in the LLC's Operating Agreement or similar documents.

 

(2) does not by itself cause a person’s dissociation as a member or a dissolution and winding up of the limited liability company’s activities and affairs; and

 

Reporter's Comment to Subsection (a)(2) - The phrase “by itself” contemplates Section 602(5)(B), which creates a risk of dissociation via expulsion when a member transfers all of the member’s transferable interest.

 

JayNote: Recall that the transferable interest (or right to distributions a/k/a economic rights) is just one of a bundle or rights held by an LLC member. Subsection (a)(2) states that if only the economic rights are transferred, the transferring member remains a member of the LLC unless something else happens to cause the transferring member to be divested of those other rights. For instance, a particular state LLC statute or the LLC's Operating Agreement might provide to the effect that "there can be no non-economic member", i.e., a member's loss of the transferable interest will result in the member's dissociation from the LLC.

 

(3) subject to Section 504, does not entitle the transferee to:

 

Reporter's Comment to Subsection (a)(3) - Mere transferees have no right to participate in management or otherwise intrude as the members carry on the affairs of the limited liability company and their activities as members.

 

Because Section 102(22)(G) defines “transfer” to include “a transfer by operation of law,” this section affects the power of other law to effect transfers of a member’s ownership interest. For example, a divorce court lacks the power to award a member’s spouse anything beyond the member’s transferable interest. Nor does the member have the power to enter into a property settlement purporting to effect any greater transfer.

 

For the divorce court, the best solution is to value the member’s complete ownership interest (i.e., the transferable interest as enhanced by the management and information rights and the standing to sue) and: (i) if possible, award the member’s spouse marital property of equal value; or (ii) if not possible, award the member’s spouse a money judgment and a charging order to enforce the judgment.

 

Granting the non-member any part of member’s transferable interest is almost always imprudent; marital discord will almost inevitably carry over into the business relationship. Granting the member’s ex-spouse the entire transferable interest is rarely a viable alternative. If the member is an active participant in the limited liability company, the approach is impossible. The member’s transferable interest will typically constitute much or all of the member’s remuneration for the partner’s activity. Even if the member is essentially passive, granting the transferable interest to the ex-spouse puts him or her at great risk as a “bare naked assignee.” See the comment to Section 107(b).

 

When a member dies, subject to the operating agreement other law may effect a transfer of the member’s transferable interest to the member’s estate or personal representative. However, for the reasons just stated, other law lacks the power to transfer anything more than a transferable interest. (Section (504) does provide extra information rights for the purposes of settling the estate of the deceased member.)

 

(A) participate in the management or conduct of the company’s activities and affairs; or

 

JayNote: Commensurate with the "pick your partner" doctrine that underlies partnership and LLC law in general, and charging order exclusivity in particular, Subsection (3)(a) prohibits the creditor from exercising any management or voting rights, etc., in the LLC. In other words, Subsection (3)(a) prohibits what would amount to a involuntary partnership between the non-debtor members and a creditor.

 

(B) except as otherwise provided in subsection (c), have access to records or other information concerning the company’s activities and affairs.

 

Reporter's Comment to Subsection (a)(3)(B) - See Section 410(g) (providing that that section’s information rights do not apply to transferees).

 

JayNote: For the same reasons that support Subsection (3)(a), a transferee of the transferable interest may not assert any informational rights against the LLC. Note, however, that the transferee may be able to assert other law to obtain these rights; for example, a transferee may be able to assert rights under Title 26 of the U.S. Code to obtain an IRS Form K-1 from the LLC so that the transferee can make its own tax filings as required by that law.

 

To give another example, if a receiver or bankruptcy trustee has been appointed for a debtor/member, the receiver or bankruptcy trustee can "step into the shoes" of the debtor/member and obtain whatever information to which the debtor/member was entitled. While some Operating Agreements attempt to terminate a member's informational rights upon insolvency or bankruptcy, these clauses would likely be ineffective as a so-called "ipso facto" clause.

 

Also note that Subsection (3)(b) does not say that the transferee cannot obtain this information from other sources. Most commonly, this issue comes up where a creditor holds a judgment against a debtor/member of the LLC. In such a case, the debtor/member may retain informational rights from the LLC, and the creditor can subpoena or examine the debtor and obtain this information from the debtor.

 

(b) A transferee has the right to receive, in accordance with the transfer, distributions to which the transferor would otherwise be entitled.

 

Reporter's Comment to Subsection (b) - Amounts due under this subsection are of course subject to offset for any amount owed to the limited liability company by the member or person dissociated as a member on whose account the distribution is made. Section 404(d). As to whether an LLC may properly offset for claims against a transferor that was never a member is matter for other law, specifically the law of contracts dealing with assignments.

 

JayNote: Subsection (b) is the provision that describes what the transferee does receive, which is only and exclusively distributions.

 

(c) In a dissolution and winding up of a limited liability company, a transferee is entitled to an account of the company’s transactions only from the date of dissolution.

 

Reporter's Comment to Subsection (c) - This very limited grant of information rights encompasses only transactions occurring at or after the date of the LLC’s dissolution. The transferee has only the right to information as to the allocation of net assets among the LLC’s creditors, members, and transferees - and only from the date of dissolution.

 

This subsection does not prevent a transferee from contracting with a member-transferor to require the member-transferor to disclose further information to the transferee. Whether such an agreement would breach the operating agreement, the implied contractual obligation of good faith and fair dealing, Section 409(d), or a fiduciary duty depends on the circumstances.

 

If a dissolved LLC rescinds its dissolution, Section 703, this subsection no longer applies.

 

JayNote: When the LLC is wound up, the transferee gains the ongoing right to accountings to make sure that the transferee is paid his share of the distributions made pursuant to the dissolution, i.e., the transferee's share of the net assets at dissolution.

 

(d) A transferable interest may be evidenced by a certificate of the interest issued by a limited liability company in a record, and, subject to this section, the interest represented by the certificate may be transferred by a transfer of the certificate.

 

Reporter's Comment to Subsection (d) - The use of certificates can raise issues relating to Articles 8 and 9 of the Uniform Commercial Code.

 

JayNote: Subsection (d) provides that a transferable interest may be certificated and, if the LLC's governing documents allow, a transfer of the certificate may effect the transfer of the transferable interest.

 

Example. Alpha LLC goes public, and sells 100,000 membership units which are represented by certificates. David buys 50 membership units at the IPO, and later sells them to Tom, who himself later sells them to Peter. The transfers of the membership units are accomplished by the physical transfer of the certificates between the custodian securities broker-dealer for the benefit of all of David, Tom, and Peter.

 

(e) A limited liability company need not give effect to a transferee’s rights under this section until the company knows or has notice of the transfer.

 

JayNote: Subsection (e) is an "ignorance is bliss" provision and works to protect the LLC and the non-debtor members by providing that they owe no duties to the transferee unless and until the LLC is put on notice of the transfer or acquires knowledge of that transfer by other means.

 

It is this provision that mandates that upon issuance of a charging order, the creditor should immediately send a "notice of charging order" (with the charging order attached) to the LLC. The better practice is to have this notice personally served on the LLC or its registered agent so that there is no later dispute as to when the LLC received the notice.

 

(f) A transfer of a transferable interest in violation of a restriction on transfer contained in the operating agreement is ineffective if the intended transferee has knowledge or notice of the restriction at the time of transfer.

 

Reporter's Comment to Subsection (f) - This provision originated as UPA (1997) § 503(e), was then consistent with U.C.C section 9-318(3), and is now consistent with U.C.C section 9-406(a) (stating that “an account debtor . . . may discharge its obligation by paying the assignor until, but not after, the account debtor receives a notification, authenticated by the assignor or the assignee, that the amount due or to become due has been assigned and that payment is to be made to the assignee”).

 

The term “notice” includes “reason to know,” Section 103(b)(1), and ordinarily a potential transferee has reason to inquire about transfer restrictions that might be contained in the operating agreement.

 

JayNote: Simply, if the transferee knows that the transfer will violate the LLC's operating agreement, the attempted transfer will be ineffective. Many LLCs have operating agreements that provide that a transfer is not effective until approved by the other members, and this provision will prevent a transferee from taking the interest if the transferee has knowledge of the restriction.

 

(g) Except as otherwise provided in Section 602(5)(B), if a member transfers a transferable interest, the transferor retains the rights of a member other than the transferable interest transferred and retains all the duties and obligations of a member.

 

Reporter's Comment to Subsection (g) - Under this subsection, a member remains a member (with all attendant rights and obligations) even after permanently transferring the entirety of the transferable interest, unless: (i) the other members opt for expulsion under Section 602(5)(B); or (ii) as otherwise provided in the operating agreement.

 

JayNote: Arguably a redundant provision, subsection (g) makes clear that only the member's right to distributions are transferred, and the member retains all other rights (voting and informational rights, etc.) in the LLC

 

(h) If a member transfers a transferable interest to a person that becomes a member with respect to the transferred interest, the transferee is liable for the member’s obligations under Sections 403 and 406 known to the transferee when the transferee becomes a member.

 

JayNote: An LLC's Operating Agreement for a transferee to be admitted as a full member of the LLC; in that case, the new transferee member will become liable for the LLC's obligations to the same extent that the former member was liable, such as for cash calls.

 

For the full text of the Uniform Limited Liability Company Act click here

 

 

C O M M O N      P A G E      F O O T E R

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2019.02.18 ... Florida Order Awarding LLC Interest To Creditor Reversed In Pansky

 

More Articles On Charging Orders click here

 

THE CHARGING ORDER PRACTICE GUIDE BY JAY ADKISSON

 

The Charging Order Practice Guide: Understanding Judgment Creditor Rights Against LLC Members, by Jay D. Adkisson (2018), published by the LLCs, Partnerships and Unincorporated Entities Committee of the Business Law Section of the American Bar Association, click here for more

 

Available for purchase at https://goo.gl/faZzY6

LAW REVIEW ARTICLES BY JAY ADKISSON

 

For more on the historical background of Charging Orders and contemporary issues involving the same, see Jay Adkisson's article, Charging Orders: The Peculiar Mechanism, 61 South Dakota Law Review 440 (2016). Available at SSRN: https://ssrn.com/abstract=2928487

WEBSITE CONTENTS

 

Appeal - Issues relating to the appeal of a charging order

 

Bankruptcy - Treatment of the debtor/member's interest in bankruptcy

 

Compliance - Issues for the LLC and non-debtor members in complying with a charging order

 

Conflicts-Of-Law - Determining which state's laws apply to a charging order dispute

 

Creditor Rights Restrictions - Limitations on creditors' management and informational rights

 

Economic Rights - Limitation of charging order and foreclosure to debtor's economic rights

 

Exclusivity - The charging order as the sole remedy available to creditors and exceptions

 

Exemptions - Available state and federal protections that may apply to charging orders

 

Foreclosure - Liquidation by judicial sale of the debtor's right to distributions

 

Information Rights - Creditors' ability to access information about the LLC

 

Intra-Member Disputes - Where one member obtains a charging order against another

 

Jurisdiction - Issues relating to the court's authority over out-of-state debtors and LLCs

 

Lien - The lien effect of a charging order and priority issues

 

Procedure - The procedure for obtaining a charging order and ancillary provisions

 

Receiver - The role of the receiver in charging order proceedings

 

Single-Member LLCs - Enforcing the judgment against an LLC with a sole member

 

Taxes - Tax issues relating to charging orders for all involved parties

 

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Additional Court Opinions About Charging Orders - Unsorted

 

OTHER INFORMATIONAL WEBSITES BY JAY ADKISSON

 

  • About Jay Adkisson - More about Jay D. Adkisson, background, books, articles, speaking appearances - https://jayadkisson.com/

 

  • Captive Insurance Companies - Licensed insurance companies formed by the parent organization to handle the insurance and risk management needs of the business - https://captiveinsurancecompanies.com/

 

 

  • Collecting On A Judgment - An explanation of common creditor remedies, strategies and tactics to enforce a judgment, including a discussion of common debtor asset protection strategies - https://collectingonajudgment.com/

 

  • Voidable Transactions - Discussion of the Uniform Voidable Transactions Act (a/k/a 2014 Revision of the Uniform Fraudulent Transfers Act) and fraudulent transfer law in general - https://voidabletransactions.com/

 

  • Private Retirement Plans - An exploration of a unique creditor exemption allowed under California law which can be very beneficial but is often misused - https://privateretirementplans.com/

 

  • Protected Series LLCs - An examination of the single most complex statutory legal structure yet created, with particular reference to the Uniform Protected Series Act of 2017 - https://protectedseriesact.com/

 

  • California Enforcement of Judgments Law - Considers the topic of judgment enforcement in California, including the California Enforcement of Judgments Law and other laws related to California creditor-debtor issues - https://calejl.com/

 

 

Contact Jay Adkisson:

 

Phone: 702-953-9617     Fax: 877-698-0678     jay [at] jayad.com

 

Unless a dire emergency, please send me an e-mail first in lieu of calling to set up a telephone appointment for a date and time certain.

 

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© 2018 Jay D. Adkisson. All Rights Reserved. No claim to government works or the works of the Uniform Law Commission. The information contained in this website is for general educational purposes only, does not constitute any legal advice or opinion, and should not be relied upon in relation to particular cases. Use this information at your own peril; it is no substitute for the legal advice or opinion of an attorney licensed to practice law in the appropriate jurisdiction.  This site is https://chargingorder.com Contact: jay [at] jayad.com or by phone to 702-953-9617 or by fax to 877-698-0678.

 

Additional related sites: Voidable Transactions