Charging Orders: Questions Mount Over Asset Protection for LLC Members

A recent case in Alabama is bringing to light a difficult choice of law issue affecting the use of LLCs throughout the United States.  The critical question raised is:  Which state’s law determines the remedies a creditor has against a member’s interest in an out-of-state LLC?

The assumption most lawyers make is that the law of the jurisdiction in which the LLC was formed should govern the scope of creditor remedies.  Unfortunately, recent case law – including the decision handed down by the Alabama court – suggests that this assumption is wrong.  While there is no clear uniformity of opinion on the matter just yet, the selection of a jurisdiction in which to form an LLC poses substantial risks in certain states, and lawyers need to be aware of these risks, particularly if relying on an LLC for asset protection planning benefits.

Framing the Issue

To properly frame the debate, let’s assume a fact pattern that resembles a popular practice among many lawyers:

Facts:

Will and Kate, residents of California, have decided that, with the birth of their second child, now is the time to engage an estate planning lawyer.  They soon thereafter meet with Charles, a California estate planning attorney with experience in asset protection planning.  Will is a successful businessman being groomed to assume the role of CEO of a large company.  Most of the young couple’s now-substantial wealth comes from Will’s side of the family, but Kate is an emerging celebrity and earns a good income.

Among many of the recommendations made by Charles is to form a family limited liability company under the laws of the State of Delaware.  One of the key benefits of Delaware LLC law, according to Charles, is that 6 Delaware Code § 18-703 limits a creditor of an LLC member to a charging order against the member’s interest in the LLC as the sole and exclusive remedy.  While a charging order is not a panacea, Charles assures Will and Kate that they need not fear a creditor foreclosing on their LLC and taking their hard-earned wealth.  

In reliance on Charles’ advice, Will and Kate form Windsor Family Delaware Limited Liability Company and capitalize the entity with a substantial portion of their net worth.  At Charles’ suggestion, Will and Kate retain sufficient assets in their own names so as to remain solvent.

Five years later, Kate incurs a judgment in a class action lawsuit when a line of “green” household cleaning products that she sponsors turns out to contain harmful chemicals.  The judgment creditor lodges a claim in California state court seeking foreclosure on Kate’s membership interest.  

Kate’s litigation counsel, Andrew, runs into court and contends that foreclosure is not a permissible remedy, citing the Delaware statute which provides that the charging order is the exclusive remedy of the creditor.  The judgment creditor counters, however, that Delaware law does not apply in the California courts to restrain a creditor’s rights against Kate’s membership interest.  

Andrew argues that, even if Delaware law does not apply, California Corporations Code § 17705.03 at least applies to confine the creditor to a charging order as the exclusive remedy, with the foreclosure remedy available under § 17705.03 subject to substantial conditions precedent and confining the creditor to transferee status.  The judgment creditor, undeterred by Andrew’s argument, directs the court’s attention to California Corporations Code § 17701.02(k), which defines the term “limited liability company” as a domestic entity formed under the California Revised Uniform Limited Liability Company Act.  Because the family LLC was formed in Delaware, not California, the judgment creditor claims that § 17705.03 is inapplicable and, as such, there are no restrictions whatsoever on the scope of remedies available to the judgment creditor. 

Question:  Which law applies to govern the judgment creditor’s remedy against Kate’s membership interest in the family LLC?  Is it:

1. The law of the state in which the LLC is organized (in this case, Delaware, which provides creditors a charging order only)?
2. The law of the forum jurisdiction (in this case, California, which permits creditors a charging order with possibility of foreclosure)?
3. None of the above (in which case the California court can fashion any remedy it wants at law, or perhaps none at all)?

Existing Rulings

Since LLC legislation was first enacted in Wyoming in the late 1970s, there have been very few rulings on this choice of law issue.  Surprisingly, the handful of rulings that have been issued indicate that all three possible outcomes to our question can be supported.  The variation among courts seems to turn in part on what a court believes the outcome would be if a given statute were not to apply.  For example, assume you are in a state that recognizes the charging order as the exclusive remedy of a creditor:  If the remedy is regarded as inapplicable to a foreign LLC, does that mean the creditor is free from any constraint imposed by a charging order, or does that mean the creditor has no remedy whatsoever?

Outcome #2:  The Law of the Forum Jurisdiction Governs 

The most recent case to apply the law of the forum jurisdiction is Vision Mktg. Res., Inc. v. MacMillin Group, LLC, No. 10-2252-KHV-TJJ (D. Kan. May 8, 2015).  The case involved a creditor in Kansas who obtained a default judgment against an individual residing in Georgia along with his Georgia limited liability company.  The creditor then sought to obtain a charging order against the debtor-member’s interest in the Georgia LLC.  The debtor objected, arguing that, while the courts in Kansas had jurisdiction over him personally, the Kansas courts did not have jurisdiction over the Georgia LLC.  The court concluded that it could issue a charging order given the intangible nature of the LLC membership interest and the jurisdiction of the court over the individual member of the LLC.

The court in Vision Marketing was then asked to consider whether the charging order remedy was even available, given that the Kansas LLC Act only applies to “limited liability companies,” which is defined under the act to exclude foreign LLCs.  The Kansas court agreed that the charging order statute in Kansas should apply even as to a foreign LLC:

(Citations omitted.)

As can be seen, the Vision Marketing court clearly believed that, if the Kansas statute were not to apply, the creditor would be without a collection remedy against the debtor-member’s LLC interest.

Outcome #3:  No Law Applies

Perhaps the most notorious case on this subject in recent history is Fannie Mae v. Heather Apartments, Case No. A13-0562 (Minn. App. 2013), in which a judgment debtor invested in a Belize LLC hedge fund that was beyond the reach of his creditors.  When the trial court cited the debtor for contempt, the debtor argued that – under Minnesota LLC law – the creditor was limited to a charging order as the exclusive remedy in respect of the debtor’s Belize LLC membership interest.  Both the trial court and appeals court disagreed, with the Minnesota appeals court concluding that Minnesota LLC law was inapplicable to a non-Minnesota LLC.  Further, the appeals court determined that there was no limitation on the scope of remedies the court might award the creditor as against a debtor-member’s LLC interest, including incarceration of the debtor-member for contempt of court.

Of course, this was a hollow victory given that the creditor still had no remedy against the Belize LLC itself.  We also understand that the creditor in Heather Apartments was never able to collect on its judgment in the Minnesota courts.  It is noteworthy, however, that the Minnesota courts regarded the inapplicability of its charging order statute for domestic LLCs as giving the creditor a greater scope of potential remedies, whereas the Vision Marketing court operated on the exact opposite assumption (believing that inapplicability of the domestic LLC charging order statute as against a foreign LLC would deprive the creditor of any remedy).

To make matters even more confusing, a similar result – based on exact opposite reasoning – was reached in Arrayos, LLC v. Ellis, Misc. Action 15-0027-WS-M, 2016 WL 1642676 (S.D. Ala. April 25, 2016).  In Arayos, a creditor obtained a judgment against an individual member of three separate Alabama LLCs, one Wyoming LLC, and a Nevada LLC.  The judgment creditor sought to obtain a charging order against all five LLC membership interests through the Alabama court.  Citing Alabama’s LLC law on charging orders, the court found no issue with granting the requested charging orders against the three Alabama LLC membership interests.  However, the district court refused to wander outside the physical boundaries of the state, declining to issue charging orders against membership interests in the two out-of-state LLCs:

The same conclusion does not hold true for Lodge Entertainment, LLC and Jonesboro Investments, LLC. As an initial matter, plaintiff has made no showing that [the judgment debtor] is a member of either of these entities. More importantly, as noted supra, plaintiff’s filings reflect that Lodge Entertainment is a Wyoming limited liability company, and that Jonesboro Investments is a Nevada limited liability company. Plaintiff has presented no argument explaining why it contends a provision of the Alabama Business and Nonprofit Entities Code would empower this Court to issue a charging order as to a judgment debtor’s membership interest in Wyoming and Nevada limited liability companies, as part and parcel of the judgment creditor’s efforts to enforce a judgment entered by a federal court in Maine.  On its face, Alabama Code § 10A-5-6.05(a) does not appear to authorize issuance of charging orders relating to foreign limited liability companies.

Thus, the court declined to grant the charging order against a non-Alabama LLC while assuming that it would deprive the creditor of a remedy under Alabama law.

New Times v. Bay Guardian:  Outcome Uncertain in California

There is one California case on point, but which leaves the hypothetical question unanswered: New Times Media, LLC v. Bay Guardian Company, Inc., C.A. No. 10-72-GMS-LPS, 2010 WL 2573957 (D. Del. June 28, 2010).  In 2008, a California court entered a judgment  in favor of Bay Guardian and against New Times for conspiring to artificially lower the prices for alternative newspaper advertising in the San Francisco area. In an effort to collect on its California judgment, Bay Guardian obtained a charging order against a series of New Times’ subsidiary operating LLCs organized in Delaware.  Relying on California’s version of the LLC charging order statute, Bay Guardian argued that it had the right to foreclose on New Times property. New Times disagreed, contending that Delaware law applied exclusively to its Delaware LLC subsidiaries, and the Delaware charging order statute does not provide for foreclosure.

In 2010, New Times sued Bay Guardian in the Delaware Court of Chancery.  New Times requested a declaratory judgment that, if Bay Guardian sought to enforce the charging order in the California courts, then Delaware law would apply to preclude foreclosure. Bay Guardian subsequently removed the case to the Delaware federal court. The federal cout declined to intervene, observing in a footnote that the California court had not technically resolved whether California or Delaware law should govern:

Contrary to Bay Guardian’s contention (Tr. at 17), the California Superior Court does not appear to have decided whether or not to apply to Delaware law, in the event that Bay Guardian does file a foreclosure motion. Rather, the Superior Court seems to have held — as both parties argued, see Cal. Tr. at 3-4, 18-19; see also Tr. at 5 (New Times observing that Bay Guardian, to obtain the relief it has suggested it might seek, would “need[] to go back into the California court … and file further motions and proceedings in order to exercise those rights”); Tr. at 2] (Bay Guardian representing: “I’d have to file a motion to foreclose, we’d have proceedings, and they’d have all sorts of time and all sorts of argument … before a California court would order that.”) — that further proceedings will be necessary before any foreclosure occurs. See Cal. Tr. at 21 (“[T]here are further steps that must be followed prior to a foreclosure sale of the charged entities.”). Part of what will remain to be resolved in the further California proceedings would be the issue of whether Delaware or California law applies.

While New Times is often cited as authority for the proposition that local law governs the charging order (Outcome #2 in our hypothetical), New Times does not in fact reach that conclusion, and the California courts have simply not ruled on this point.

Analysis

LLC Membership Interests as Intangibles… And More

Our analysis begins with the general premise that LLC membership interests are intangible.  They are also typically uncertificated.  As a consequence, the law of the forum jurisdiction typically applies if the court has personal jurisdiction over the LLC member.  Hotel 71 Mezz Lender, LLC v. Falor, 926 N.E.2d 1202, 1204 (N.Y. 2010).  This follows the general premise, established by the U.S. Supreme Court over 100 years ago, that “the obligation of the debtor to pay his debt clings to and accompanies him wherever he goes.” Harris v. Balk, 198 U.S. 215, 222 (1905).

Notwithstanding the general premise that jurisdiction over an intangible turns on personal jurisdiction, the Restatement (Second) of Conflicts of Laws § 65 (1971) imposes an additional element – that the exercise of jurisdiction be “reasonable”:

A state has power to exercise judicial jurisdiction to affect interests in an intangible thing which is not embodied in a document if the relationship of the state to the thing and to the parties involved makes the exercise of such jurisdiction reasonable.

Nevertheless, the reasonableness requirement seems merely to require a closer connection to the intangible, such that in rem jurisdiction alone may be insufficient and in personam jurisdiction over the interest holder may be required.  See Simpson v. Loehmann, 21 N.Y.2d 305 (1967).

While the Restatement (Second) of the Conflicts of Laws does not address LLCs (because they did not exist in 1971, when the Restatement was last published), Section 297 of the Restatement instructs us on how to deal with foreign corporations, whether organized in another state or another country.  Specifically, the Restatement tells us that, “Incorporation by one state will be recognized by other states.”  This reflects the principle that, under principles of comity, jurisdictions should accord recognition to the legal structure of business entities organized in other jurisdictions.  The Restatement does not suggest that a Delaware corporation can engage in business in California without first qualifying under that state’s laws, but it does make clear that California should recognize a Delaware LLC under principles of comity.  As comment a to Section 297 notes:

 A distinction must here be drawn between recognition of a foreign incorporation and permitting a foreign corporation to do various kinds of acts. The corporate status will be recognized everywhere, but, as stated in Topic 4 (§§ 311-312) of this Chapter, it is customary for a state to place limitations upon the privilege of a foreign corporation to do business, or to conduct other activities, within its territory. The more important effects of the recognition of a corporate status are stated in Comments b-d.

Comment b expands on the ability of a foreign corporation to sue or be sued in the forum jurisdiction.  Comment c, however, is more relevant, declaring that “a state will usually recognize the immunity of the shareholders of a foreign corporation from being sued as individuals on matters arising out of the acts or omissions of the corporation and from having their individual property made responsible for obligations of the corporation.”  Reinforcing this point, comment d provides that, “The local law of the state of incorporation will be applied to determine a corporation’s purposes and whether a given act is ultra vires.”

Thus, the Restatement supports the argument that the law of the forum jurisdiction should apply to govern an intangible – such as an LLC membership interest – where the forum has in personam jurisdiction.  Yet, the Restatement would seem to command the forum jurisdiction to respect the LLC and its relationship with its member vis-a-vis the outside world under the local law of the LLC’s jurisdiction of formation.  So while the creditor in our hypothetical might succeed in obtaining a charging order under California law against Kate’s interest in a Delaware LLC, the Restatement would suggest that the California remedy of foreclosure should not apply, to the extent inconsistent with Delaware law, whether as a “reasonable” exercise of jurisdiction or under broader principles of comity.

What is the Creditor Remedy if Not a Charging Order?

Another way of analyzing this issue is as follows, taking the Heather Apartments ruling in Minnesota as an example.  If the Minnesota courts decide that a Belize LLC is not a “limited liability company” for purposes of Minnesota law, then what is the property interest to which the creditor seeks attachment under Minnesota law?  Is it an LLC membership interest or something else?  What is the relationship between that person identified as the “member” and that entity identified as a non-Minnesota business enterprise?

Perhaps the better question is, “If no charging order remedy applies, then what is the scope of possible remedies in the lex forum?”  This is where the more experienced courts considering these issues have found that real collections often require a receivership and supporting court orders, which can only be issued by a court with jurisdiction over the LLC and its assets.

Consider the Florida case of Edelsten v. Mawardi, 37 So. 3d 459 (Fla. 4th DCA 2014), in which a Florida LLC and its wholly-owned subsidiary Ohio LLC defaulted on a commercial loan.  The trial court, at the request of the creditor, appointed a receiver in Florida to take charge of the Ohio LLC.  On appeal, the Fourth District Court of Appeals reversed the trial court order, acknowledging that court-appointed receivers only have in rem jurisdiction over assets located within the state, which would exclude the Ohio LLC and its properties.  Also, the appeals court took note of Ohio law requiring that a receiver for an Ohio LLC be one located in the State of Ohio.  The Edelsten court cited in support of its position the holding in Paciocco v. Young, Stern & Tannenbaum, P.A., 481 So. 2d 39, 39 (Fla. 3d DCA 1985), wherein the Third District Court of Appeals held that Florida courts do not have in rem jurisdiction over notes secured by mortgages on real property located in another state.

The LLC Membership Interest as an Aggregation of Property Rights

As intangible property, a creditor should arguably have recourse under the law of the forum jurisdiction to attach an interest in an LLC membership interest if the forum has in personam jurisdiction over the LLC member.  Yet, an LLC membership interest reflects a bundle of diverse property rights that are sanctioned and meted out under the local law of the jurisdiction in which the LLC is organized, just like the secured notes in Pociocco.  Accordingly, while the law of the forum jurisdiction may be relevant to confirm that a creditor has an interest in the debtor-member’s LLC membership interest, the Restatement and case law indicate that the local law of the state of LLC organization is best able to tell us what that creditor’s interest consists of in relation to the LLC and its assets.  Under this approach, a court might be able to award remedies under the law of the forum jurisdiction (including charging orders and foreclosure on a member’s interest in the LLC), but the LLC remains unconstrained by those decisions to the extent inconsistent with the local law of the LLC’s jurisdiction of organization.

Constitutional Issues:  Equal Protection

The Full Faith and Credit Clause, Article IV, Section 1 of the U.S. Constitution is the primary authority by which a creditor can obtain a judgment in one state and collect on it in another state.  The Full Faith and Credit Clause embodies the principle of comity, albeit it is limited to judgments.  As one scholar explains:

The practical effect whereof to date has been, in the main, to leave the extrastate protection of rights, except such as have ripened into a definite judicial judgment, exactly where the Constitution found it, that is to say, on a basis of comity, and so at the mercy of the adverse local policy of the forum state.

Edward S. Corwin, “The ‘Full Faith and Credit’ Clause,” 81 U. Pa. L. Rev. 371, 374 (1933).  Thus, the Full Faith and Credit Clause does not obligate the State of California to recognize the internal laws of the State of Delaware, albeit it must recognize the effect of a judgment emanating from Delaware.  Likewise, a Delaware court is obliged to recognize a judgment issued by a California court.

Another provision of the Constitution, however, which has not been factored into state law decisions on LLC members and charging orders is the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution.  In 1985, the U.S. Supreme Court reaffirmed the long-held view that corporations are entitled to equal protection under the Constitution.  See Metro. Life Ins. Co. v. Ward, 470 U.S. 869, 881 n.9 (1985); see also S. Ry. Co. v. Greene, 216 U.S. 400, 412 (1910) (“That a corporation is a person, within the meaning of the Fourteenth Amendment, is no longer open to discussion.”)  This has enabled corporations to assert themselves in court to protect the property interests of their shareholders.  See Herbert Hovenkamp, “The Classical Corporation in American Legal Thought,” 76 Geo. L.J. 1593, 1649 (1988) (the corporate personhood doctrine of Santa Clara County v. Southern Pacific Railroad Co., 118U.S.394 (1886), represents an efficient way for the corporation to assert the property rights of its shareholders).

Denying the protection of a Minnesota charging order statute while refusing to honor a similar charging order statute conferred under Belize LLC law, such as was done in Heather Apartments, denies the LLC and its member equal protection under the laws of Minnesota.  Likewise, a creditor may argue that the denial of a charging order in Alabama against LLCs formed in Nevada and Wyoming, where such a remedy is afforded under the laws of both those states, denies the creditor equal protection under Alabama law.  Analyzed this way, the decisions in Heather Apartments and Arrayos – the Outcome #3 in our hypothetical – may be constitutionally infirm.

This leaves Vision Marketing:  Does the Kansas law pass constitutional muster where the Kansas courts choose to apply their charging order remedy against the membership interest of an out-of-state LLC?  Arguably, yes, as both the creditor and the debtor would not likely experience a different outcome were the LLC organized under Kansas law.  However, Vision Marketing should not held up as a lodestar for other courts.  By failing to follow the Restatement and apply principles of comity, the Kansas court has committed a disservice to interstate commerce.  The Kansas court was right to recognize the creditor’s claim under Kansas law, but should have deferred to the laws of Georgia governing what in rem property rights of the member could be attached by the creditor in the Kansas court.  Likely, we would have reached the same result but with better reasoning.

Conclusion

Revisiting our hypothetical set of facts posed at the beginning of this article, we asked whether Delaware or California law would apply in the California courts to determine the rights of a creditor in laying claim to Kate’s membership interest in a Delaware LLC.  The Restatement suggests that Outcome #2 (California law) should be applied by the California courts to determine the availability of a charging order, but not to tinker with the underlying LLC – or its relationship with the member and the outside world – under principles of comity… A quasi-Outcome #1 (Delaware law) answer.

Of the trio of cases cited above, the ruling most consistent with this approach is the Kansas holding in Vision Marketing, and yet there are aspects of the Kansas ruling that are inconsistent with principles of comity.  Unfortunately, the rulings in Alabama and Minnesota inject great uncertainty in this area, suggesting that Outcome #3 (no state’s law) is a plausible outcome.  Not only does this deprive evolving LLC charging order case law of any meaningful analysis under conflicts of laws principles, Outcome #3 raises a genuine question whether the LLC and its members enjoy equal protection under the Fourteenth Amendment to the U.S. Constitution.  Moreover, it leads to a hollow conclusion if the forum jurisdiction is unable to enforce its judgments through the exercise of jurisdiction over the LLC and its underlying assets.  For these reasons, we expect Outcome #2-type decisions such as Vision Marketing to withstand the test of time, whereas Outcome #3-type holdings such as Heather Apartments and Arroyos should eventually be overruled by more thoughtful jurisprudence.