JUDGMENT ENFORCEMENT AGAINST INTERESTS IN PARTNERSHIPS AND LLCs. by Jeffrey L. Smoot

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1 Jeffrey L. Smoot Oles Morrison Rinker & Baker LLP 701 Pike Street, Suite 1700 Seattle, WA (206) JUDGMENT ENFORCEMENT AGAINST INTERESTS IN PARTNERSHIPS AND LLCs by Jeffrey L. Smoot Author s Note: This article has evolved through various iterations of legal seminar materials over the past several years. The version published here was most recently updated for the Judgment Enforcement in Washington seminar on July 23, 2013 sponsored by Lorman Education Services. Copyright 2014 by Jeffrey L. Smoot. Published for informational purposes only, and may not be reproduced in whole or in part without the author s express written consent. A certain legal maxim declares A right is only as great as its remedy. In other words, a right is only meaningful to the extent there is adequate recourse or compensation to restore or repair the given right in the event of its breach or deprivation. Indeed, where a remedy is severely limited and practically inadequate, the underlying right to which that remedy attaches is either lacking in value or subordinate to a greater right. It follows then, that a party seeking to restore a right lacking in remedial recourse will not dedicate much time or resources to the endeavor because the ultimate recompense, if any at all, is not likely to justify the cost of securing it Enter the charging order 1 1 The Charging Order and Estate Planning: An Overview of Charging Order Protected Entities and Their Role in Wealth Preservation, Jeffrey Burr, Article% pdf.pdf. 1

2 Enforcing judgments against an individual partner s or member s interest in a partnership or LLC can be challenging. Enforcing a judgment against a debtor s interest in a corporation requires simply executing upon and selling the debtor s stock. However, unless there has been fraud, conspiracy, or other misconduct among the partners or members intended to hinder, delay or defraud a creditor of the individual partner or member, a creditor s exclusive remedy in enforcing a judgment against a debtor s interest in a partnership or LLC is to obtain a charging order pursuant to RCW or RCW These statutes provide the exclusive remedy by which a judgment creditor can satisfy a judgment out of a partner s or LLC member s transferable interest in the partnership or LLC. RCW (5). Charging orders were included in the Uniform Partnership Act in 1914, supplanting the prior undesirable (from a partner s perspective) process which allowed creditors to satisfy judgments from the partner s interest in partnership assets, a process which invariably caused the compulsory dissolution and winding up of the partnership. 2 The UPA resolved the problem by placing partnership assets out of reach to judgment creditors of individual partners. A charging order is simply an order creating a lien upon and directing the partnership or LLC to account for and pay to the judgment creditor all of the debtor s transferable interest in the partnership or LLC. A transferable interest is defined in the uniform acts as a right to receive distributions. An interest in an LLC or a limited/general partnership commonly consists of two bundles of rights: 1. An economic (also called assignable, transferable, or distributional) interest i.e., the right to receive distributions of cash and property and the corresponding allocations of income, gain, loss, and deduction; and 2. Management and voting rights. All available creditor remedies (e.g., charging order and foreclosure) are directed solely at the economic interest; management and voting rights are, in most cases, untouchable by creditors. A charging order requires the partnership or LLC to distribute the partner or member s share of the profits or assets to the judgment creditor in satisfaction of the judgment. It does not, however, grant management rights to the judgment creditor unless those rights are transferable pursuant to the terms of the partnership or LLC agreement or with the consent of all other partners or members. Nor does it provide the creditor with means to accelerate distributions to the debtor member or prevent dissipation of LLC assets via loans and other devices designed to funnel LLC assets out the back door while the 2 J. Gordon Gose, The Charging Order Under the Uniform Partnership Act, 28 WASH. L. REV. & ST. B.J. 1 (1953). 2

3 judgment creditor waits. It only requires that the debtor-member s share of distributions when distributed be distributed to the creditor. Put another way: Charging orders typically compel creditors to helplessly wait as assignees until the LLC makes distributions to its members. A charging order lien remains in effect until the judgment is paid, or expires. Because a distribution may not be made to the debtor member for years, creditors and their attorneys should be sure to renew judgments prior to their expiration, otherwise the lien becomes unenforceable. 1. Charging Order Against Partnership Interest. Under RCW , on application by a judgment creditor, a partner s transferable interest in a partnership may be subjected to a charging order. The partner s transferable interest is his economic interest; management rights are not transferable unless all other partners approve or the partnership agreement otherwise provides. When issuing a charging order, the court can appoint a receiver or make all other orders, directions, accounts, and inquiries the judgment debtor might have made or which the circumstances of the case may require. RCW (1). This gives the court fairly broad power to protect the judgment creditor s rights, by allowing a receiver or making any other appropriate order to shine light on the partnership s financial transactions, which can aid the otherwise frustrated creditor in assuring or at least uncovering conspiratorial conduct within the partnership intended to hinder, delay or defraud the creditor, which can open the door to a fraudulent transfer or civil conspiracy claim against the other partners who aid and abet the debtor in preventing the partnership from distributing otherwise available funds to the creditor or structuring payments from the partnership to the debtor member as loans or other purported non-distribution payments. A charging order constitutes a lien on the judgment debtor s transferrable interest in the partnership. RCW (2). The court may order a foreclosure of the interest subject to the charging order at any time. RCW (2). Such a foreclosure would foreclose only the interest subject to the charging order, i.e., the economic interest. Again, RCW provides the exclusive remedy by which a judgment creditor of a partner or partner s transferee may satisfy a judgment out of the judgment debtor s transferrable interest in the partnership. RCW (5). 2. Enforcement of Judgments Against LLC Memberships Interests. Washington s partnership statutes are analogous to the LLC statutes and provide some guidance regarding the court s powers and the reach of a charging order. See Koh v. Inno-Pacific Holdings, Ltd., 114 Wn. App. 114 Wn. App. 268, , 54 P.3d 1270 (2002) (appropriate to look at cases interpreting partnership acts when interpreting right to charging order under LLC act). 3

4 A member s ownership interest in an LLC is considered personal property. RCW (1); Koh, 114 Wn. App. at 270 n.1. Once a creditor determines that a debtor holds an interest in a partnership or LLC, the creditor can ask the court to charge that interest with the payment of the judgment. See RCW , RCW Under RCW , a member s LLC interest may be charged with payment of the unsatisfied amount of a judgment, with interest. Use of the word may places issuance of a charging order within the court s discretion. To the extent charged, the judgment creditor has only the rights of an assignee of the limited liability company interest. RCW ; Koh, 114 Wn. App. at 271. An assignee has no right to participate in management of the LLC. Under RCW (1), the assignee of a member s LLC interest shall have no right to participate in the management of the business and affairs of the LLC except upon approval of all of the members of the LLC other than the member assigning his interest, or as provided in the LLC agreement. It would be important for a judgment creditor to obtain a copy of the LLC agreement to determine what it provides regarding rights of assignees, if anything. RCW (3)(a) suggests that all of a member s LLC interest may be sold by foreclosure or execution sale. However, this does not appear to mean that foreclosure or execution would provide a way around the charging order procedure or allow proceeding against a member s management rights. Rather, this section appears to say that although a pledge or granting of a security interest against all of the member s LLC interest is not deemed to be an assignment, a foreclosure or execution sale with respect to all of a member s LLC interest shall be deemed to be an assignment of the member s limited liability company interest to the transferee pursuant to such foreclosure or execution sale or exercise of similar rights. An assignment, as provided in RCW (1), confers no right to participate in management of the LLC unless all other members approve or as provided in the LLC agreement. Thus, a foreclosure or execution sale even of all of a member s LLC interests would confer no right to participate in management of the LLC unless all other members approved or the LLC agreement so provided. Many states provide that the charging order is the exclusive remedy and do not authorize foreclosure; Washington does authorize foreclosure. RCW (2). In Washington and other states allowing foreclosure of the charging order lien, LLC members may be forced to purchase the debtor member s interest at a judicial sale to avoid dissociation of the member and dissolution of the LLC. This effectively forces an untimely distribution from a partnership or LLC and a forfeiture of the debtor s share of earnings and thwarts the typical response of an LLC to a charging order: to cease making distributions to the debtor member. Unless the LLC agreement specifically allows distributions to some but not all members, withholding distributions from a judgment creditor who has foreclosed and is thus acting as an assignee of the debtor member s economic interest means the other LLC members do not receive their share of the LLC profits, either. 4

5 Upon assignment of the member s LLC interest, the member ceases to be a member and no longer has the right to exercise any rights or powers of a member, unless otherwise provided in the LLC agreement. RCW (2)(b). In the case of a single-member LLC, this would effectively freeze the LLC as there would be no one authorized to manage it unless the LLC agreement provided otherwise, creating a need to appoint a receiver. An assignee of a member s LLC interest can become a member if all other members (except the assigning member) approve, or if allowed by the LLC agreement. RCW (1). However, an assignee who becomes a member becomes liable for all of the assigning member s obligations including any obligation to make contributions. Until the assignee becomes a member, however, the assignee has no liability for the member s obligations unless otherwise provided in the LLC agreement. RCW (5). Only an assignable interest in the entity may be charged by the creditor, and the lien attaches to only the assignable interest. The assignability of an interest is governed by the agreement of the members. Consequently, to thwart creditors, potential operating agreements commonly either (1) make membership interest (or just economic interest) non-assignable, or (2) make the assignment subject to the prior approval of the manager or a majority of the members. The entity agreement may also contain a poison pill provision, setting a predetermined redemption price for a member s interest that is triggered by a collection action against any member, to prevent a foreclosure sale of the interest. But the distribution clause in the agreement may empower the manager to determine the timing and the amount of a distribution, but require pari passu distribution, requiring distribution to all members/partners in accordance with their percentage interests or to none, which would benefit a creditor and possibly justify a clawback of improper distributions made to some but not all members after service of the charging order. Based on all of the contingencies relating to what is provided in the LLC agreement, it is important to obtain a copy of the LLC agreement. B. Creditor Liability for Phantom Income As mentioned previously, Washington s charging order statute allows foreclosure of a partner s or member s assignable interest. A creditor that forecloses on a judgment debtor s partnership or LLC interest takes on a potential risk: income tax liability of the debtor partner, including liability for phantom income. This is the K.O. d by the K-1 theory urged by many asset-protection practitioners; it provides that a creditor with a charging order against the debtor member s transferrable interest becomes liable for income tax on so-called phantom income : income that is recognized for tax purposes but for which no cash is actually distributed. Supporters of this theory rely on Revenue Ruling , IRS General Counsel Memorandum (1977), and Evans v. Commissioner, 447 F.2d 547 (7th Cir. 1971). 5

6 In Rev. Rul , a limited partnership interest holder, as authorized in the partnership agreement, assigned his right to share in profits and losses and receive all distributions to which he was entitled, and agreed to exercise any residual powers (including voting rights) in favor of the assignee. The IRS concluded that because the assignee had acquired substantially all of the dominion and control over the limited partnership interest, the assignee would be treated as a substitute limited partner for federal income tax purposes. Before the ruling was issued, the IRS sought a concurring opinion from Chief Counsel. Chief Counsel agreed with the decision, relying heavily on Evans, a Tax Court decision involving a sale of a partnership interest to a corporation without the other partner s consent. A distinguishing fact in Evans is that the assignor was an officer of the assignee corporation. According to GCM 36960, if the assignee was a stranger, the assignor should continue to be taxed on partnership income if he held residual powers that were greater than the assignee s, but because the assignee was a corporation controlled by the assignor partner, the assignee would be taxed. This conformed with Rev. Rul , where the assignor transferred not only his transferrable interest but also agreed to exercise all residual powers on the assignee s behalf, resulting in all dominion and control having been effectively transferred. Effectively, for an assignee creditor to become liable for phantom income tax, the IRS will have to recognize the creditor as a substituted partner with dominion and control over the entire partnership interest. A charging order does not confer dominion and control over the entire partnership interest, but is only a lien on the debtor partner s economic interest (unless the operating agreement provides otherwise or all other members consent to the charging creditor taking assignment of the debtor member s management rights). Thus, Rev. Rul does not seem to apply to a judgment creditor with only a charging order lien but not a controlling interest in the partnership. However, it is not as clear how the IRS would treat a creditor that judicially foreclosed its charging order lien, or where the operating agreement or other members authorized the charging creditor to take assignment of all of the debtor-member s rights. If any of these contingencies results in a transfer of a controlling interest in the partnership such as against a single-member LLC as discussed below then it would be more likely that the IRS would recognize the creditor as a substituted partner with dominion and control, and thus more likely that the creditor could be liable to pay taxes even on phantom income. C. Single-Member LLCs. There is a fair question, supported by a growing number of published opinions, as to whether the member s management rights in an LLC or even the LLC form itself needs to be respected in the case of a single-member LLC. There appear to be no Washington cases discussing the rights and protections of members and creditors with respect to a single-member LLC. However, in several bankruptcy court decisions from other jurisdictions, courts have treated single-member LLCs differently than they would have been treated if the LLCs had multiple members. 6

7 In the case of In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003), a Colorado bankruptcy court ruled that the assets of a single-member LLC could be used to pay creditors of the debtor member who filed bankruptcy. Colorado s LLC statute was similar to Washington s statute, granting the creditor the right to charge the debtor member s economic interests but treating the charging order as an assignment and requiring consent of all other members to confer any management rights on the charging creditor. Colo. Rev. Stat The charging order, under Colorado law, exists to protect other members of an LLC from having to involuntarily share management with someone they did not choose or to have to accept a creditor as a co-manager. However, [a] charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order protection serves no purpose in a single member limited liability company, because there are no other parties interests affected. Albright, 291 B.R. at 541. Accordingly, the bankruptcy court allowed the Trustee, standing in the shoes of the debtor as a hypothetical judgment creditor and, thus, the sole member of the LLC, to cause the LLC to sell its property and distribute net proceeds to his bankruptcy estate, or distribute the LLC s property to himself and liquidate the property himself. The court further noted: [T]he Limited Liability Company Act requires the unanimous consent of other members in order to allow a transferee to participate in the management of the LLC. Because there are no other members in the LLC, no written unanimous approval of the transfer was necessary The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties interests affected. Albright, 291 B.R. at 540, 541. See also In re Modanlo, 412 B.R. 715 (D. Md. 2006) (citing Albright favorably for the proposition that because there were no other members to protect, the purpose of preventing a creditor from becoming a substituted member of the LLC does not apply when the LLC is a single-member LLC). [U]sing the principles of statutory construction and adopting the reasoning of the bankruptcy court in Albright the sections] of the Delaware LLC Act [regarding assignment of LLC interests and rights of assignees to become members] do not apply to single member LLCs. Modanlo, 412 B.R. at 730. Once cannot simply substitute in someone else who is a stranger without affecting those (personal) relationships among [multi-member LLC] members. That reasoning, however, is substantially undermined, if not meaningless, in the context of single member limited liability companies. By definition, there can be no remaining members of a single member LLC whose personal relationships (among members) could be 7

8 compromised by being forced to accept substitute performance from a stranger Modanlo, 412 B.R. at 727. See also In re A-Z Electronics, LLC, 350 B.R. 886 (Bankr. D. Idaho 2006), where an Idaho bankruptcy court dismissed a chapter 11 petition signed by the single member of the LLC because he did not have authority to act on behalf of the LLC based on his own chapter 7 bankruptcy. The court stated that in a multi-member LLC, when a single member files bankruptcy, the bankruptcy estate is entitled only to receive the debtor members share of profits or other compensation and the return of contributions to which the debtor member would be entitled. However, when the debtor is the only member of the LLC, the bankruptcy trustee steps into the shoes of the debtor and can exercise management powers over the LLC to the same extent the single member could do. This analysis comports with RCW (2)(b), which divests an LLC member of his membership rights and powers, unless otherwise provided in the LLC agreement; thus, when the sole member of an LLC files bankruptcy, the trustee stands in the debtor s shoes and assumes all economic and management rights on behalf of the debtor s estate. In a more-recent Florida Supreme Court decision, Olmstead v. Federal Trade Commission, 44 So.3d 76 (2010), the exclusivity of the charging order was denied to a single-member LLC and the levy of the LLC interests was allowed. The Florida Supreme Court reasoned that: 1. Under the Florida statute, the assignee becomes a member unless the non-debtor members fail to consent (and in a single-member LLC there are no other members who can file to consent); and 2. The comparable Florida limited partnership act does not make the charging order remedy the exclusive remedy. Based on this growing line of cases, two arguments could be made by a judgment creditor seeking to collect assets held by a debtor s single-member LLC: (1) A receiver should be appointed by the court to manage the single-member LLC after entry of a charging order. By statute, the single member of the LLC would be divested of his management rights. A receiver would arguably be entitled to manage the LLC and sell its property and distribute the proceeds to the judgment creditor after payment of all partnership debts, or manage the LLC property and distribute the profits to the judgment creditor until the judgment was fully satisfied; or (2) The provisions of the Washington LLC act regarding assignment of membership interests, charging orders, and limitations on assignees becoming managers of the LLC do not apply to single-member LLCs because there are no other members to protect, and therefore the court could allow the judgment creditor to execute on and sell the entire 8

9 LLC interest including the entire bundle of LLC rights (management and right to receive profits). These arguments could be carried a step further where all of the members of an LLC were debtors of the creditor. In such a situation, the underlying reasons for protection from the charging order would not apply, and a court could conceivably disregard the usual charging order restrictions and allow a creditor or trustee to assume management of the LLC for the benefit of the creditor or estate. Charging order protection has also failed in a bankruptcy context where the debtor s membership interest was declared forfeited to the estate because the LLC s operating agreement was not an executory contract. See In re Ehmann, 2005 WL (Bankr. D. Ariz. 2005). Under bankruptcy law, an executor contract would include an agreement where the member and the LLC have reciprocal obligations and, thus, be subject to sections 365(c) and (e) of the Bankruptcy Code. The Ehmann court ruled that, because the operating agreement was not executory, the LLC interest was subject to sections 541(a) and (c)(1), which provide that an interest of the debtor becomes property of the estate notwithstanding any agreement or applicable law that would otherwise restrict or condition transfer of such interest by the debtor. Section 541(c)(1), the court held, rendered inapplicable the restrictions against the debtor member s transfer of his interest contained in the operating agreement, and that therefore the trustee had all of the rights and powers in the LLC that the debtor held as of the commencement of the case. Note that Wyoming has, effective July 1, 2010, become the first state to give protection to single-member LLCs organized under Wyoming law. Wyo. Stat provides that the charging order is the exclusive remedy by which a person seeking to enforce a judgment against a debtor, including any judgment debtor who may be the sole member, disassociated member, or transferee, may, in the capacity of the judgment creditor, satisfy the judgment from the judgment debtor s transferable interest or from the assets of the limited liability company. (Emphasis added). -o0o- This article is for informational purposes only, and should not be relied upon as legal advice. No attorneyclient relationship is created or intended by publication of this article. If you desire legal advice or representation regarding the issues discussed in this article, please contact the author. 9