What are the rights of a creditor to LLC interests to satisfy their claim? That question was at issue in a recent opinion from the Alabama Supreme Court.[1] In that case, the creditor received a “charging order” (discussed below) requiring that distributions from the LLC made to the debtor be instead transferred to the clerk of court to be payable to the creditor. The dispute at issue involved payment of personal expenses by the LLC, distributions to other members, the terms of the LLC’s operating agreement, and various related items.
Charging Orders
A hallmark of LLCs is that LLC members are afforded the right to select the other members of the LLC, i.e. the persons with whom they desire to do business. As a result, depending on state law, transfers are typically limited to current members or those permitted under the terms of the LLC’s operating agreement.[2] In its comments to § 502 of the Uniform Limited Liability Company Act, the Uniform Law Commission stated that “one of the most fundamental characteristics of LLC law is its fidelity to ‘pick your partner’ principal.”[3] Allowing creditors of a member to seize the debtor’s LLC interests would be out of line with this principal. In that circumstance, the non-debtor members would be forced to be partners with a stranger with whom they did not choose to do business.
It is for this reason that creditors of LLC members are generally limited in how they enforce their rights against the debtor’s LLC interests.[4] Alabama statutes were applicable to the parties in SE Property Holdings, LLC. The primarily relevant statute[5], cited in its entirety, provides as follows:
(a) On application to a court of competent jurisdiction by any judgment creditor of a member or transferee, the court may charge the transferable interest of the judgment debtor with payment of the unsatisfied amount of the judgment with interest. To the extent so charged and after the limited liability company has been served with the charging order, the judgment creditor has only the right to receive any distribution or distributions to which the judgment debtor would otherwise be entitled in respect of the transferable interest.
(b) A limited liability company, after being served with a charging order and its terms, shall be entitled to pay or deposit any distribution or distributions to which the judgment debtor would otherwise be entitled in respect of the charged transferable interest into the hands of the clerk of the court so issuing the charging order, and the payment or deposit shall discharge the limited liability company and the judgment debtor from liability for the amount so paid or deposited and any interest that might accrue thereon. Upon receipt of the payment or deposit, the clerk of the court shall notify the judgment creditor of the receipt of the payment or deposit. The judgment creditor shall, after any payment or deposit into the court, petition the court for payment of so much of the amount paid or deposited as is held by the court as may be necessary to pay the judgment creditor’s judgment. To the extent the court has excess amounts paid or deposited on hand after the payment to the judgment creditor, the excess amounts paid or deposited shall be distributed to the judgment debtor and the charging order shall be extinguished. The court, may in its discretion, order the clerk to deposit, pending the judgment creditor’s petition, any money paid or deposited with the clerk, in an interest bearing account at a bank authorized to receive deposits of public funds.
(c) A charging order constitutes a lien on the judgment debtor’s transferable interest.
(d) Subject to subsection (c):
(1) a judgment debtor that is a member retains the rights of a member and remains subject to all duties and obligations of a member; and
(2) a judgment debtor that is a transferee retains the rights of a transferee and remains subject to all duties and obligations of a transferee.
(e) This chapter does not deprive any member or transferee of the benefit of any exemption laws applicable to the member’s or transferee’s transferable interest.
(f) This section provides the exclusive remedy by which a judgment creditor of a member or transferee may satisfy a judgment out of the judgment debtor’s transferable interest and the judgment creditor shall have no right to foreclose, under this chapter or any other law, upon the charging order, the charging order lien, or the judgment debtor’s transferable interest. A judgment creditor of a member or transferee shall have no right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of a limited liability company. Court orders for actions or requests for accounts and inquiries that the judgment debtor might have made, are not available to the judgment creditor attempting to satisfy the judgment out of the judgment debtor’s transferable interest and may not be ordered by a court.
While this statute is not perfectly uniform with the statutes of all states, its content is fairly typical for a charging order statute. There are a number of materials available which discuss state-to-state charging order remedy statutes.[6]
Facts
After obtaining a judgment of approximately $9 million against David Harrell in 2010, SE Property Holdings, LLC (“SEPH”) received a charging order against Harrell’s interests in Southern Land Brokers, LLC (“SLB”). Under the terms of the charging order, SLB was to “report and distribute” to SEPH any amounts that become due or distributable to Harrell. Having not been paid by the year 2020, SEPH sought to hold Harrell, in his capacity as manager of SLB, in contempt.
Relevant to SEPH’s motion to hold Harrell in contempt were certain facts relating to the LLC:
- SLB was owned 50/50 between Harrell and his wife, Carolyn.
- SLB’s operating agreement required that all distributions be made pro rata among SLB’s members and appointed Harrell as manager responsible for making those distributions.
- During the years at issue, SLB made distributions to Harrell’s wife. Also, SLB paid credit card bills which contained charges SEPH alleged to have been for Harrell’s personal expense.
- For years at issue, SLB issued IRS Form K-1s to Harrell showing that he received distributions.
As a result of these facts, SEPH argued that Harrell should be held in contempt for failing to comply with the terms of the court-imposed charging order. Specifically, SEPH argued that Harrell violated the terms of the LLC operating agreement by failing to make pro rata distributions and, instead, making distributions solely for the benefit of his wife, Carolyn. SEPH also argued that payment of the credit card bills for Harrell’s personal expenses (and for certain amounts credited to “cash”) were deemed distributions to Harrell which were not paid for the benefit of SEPH pursuant to the terms of the charging order.
Although somewhat difficult for me to follow, Harrell seemed to argue that since he received no actual cash, that he had not taken any distributions from SLB. Further, he had not transferred any “transferrable interest”[7] upon which SEPH had been granted a lien.
Outcome
The trial court, without any objection received from Harrell or SLB and without any hearing, dismissed SEPH’s motion to hold Harrell in contempt. SEPH appealed this denial. It is upon this appeal that the Alabama Supreme Court’s opinion in this case is rendered. Ultimately, the court reversed the trial court and remanded the matter for further proceedings consistent with its result.
In reversing the trial court, the Supreme Court discussed Alabama’s charging order statute as well as the operating agreement of SLB. The court noted that a “distribution” from an LLC is defined as “a transfer of money or other property from a limited liability company, or series thereof, to another person on account of a transferrable interest.”[8] A “distribution” does not include “amounts constituting reasonable compensation for present or past services or reasonable payments made in the ordinary course of the limited liability company’s activities and affairs under a bona fide retirement plan or other benefits program.” As such, Harrell received distributions as none of the payments made on his behalf qualified for the exception. Also, as manager of SLB, Harrell made cash distributions to his wife without making pro rata distributions to himself as required by SLB’s operating agreement. In confirming this conclusion, the court cited to the Form K-1s which showed distributions made to Harrell and his wife.
As noted above, although Harrell raised certain arguments against this outcome, the court stated that “Harrell did not provide any additional information in support of that assertion. He also did not attach any documentation or evidence to his objection showing that to be the case, and there is nothing in the record before us, other than his conclusory denial, supporting his assertion. There is nothing before us demonstrating that he did not intentionally avoid otherwise required disbursements.”[9] It is unclear whether Harrell had any such evidence that he could have presented. However, his failure to do so left the court with no other conclusion than distributions were made in violation of the charging order.
Although the Alabama Supreme Court rendered such finding, under applicable Alabama law, someone may not be held in contempt without an evidentiary hearing. As such, the Supreme Court remanded the case back to the trial court to hold an evidentiary hearing to determine the amount of distributions which Harrell received and to determine whether he should be found in contempt.
Conclusion
It is clear that many people believe a charging order to be the silver bullet to avoid creditors.[10] That simply is not true. Charging orders are very protective of the rights of non-debtor members of an LLC. However, the debtor cannot avoid their creditors merely by limiting creditors’ remedies to a charging order. This is discussed in the comments to the Uniform Limited Liability Company Act in its comments to subsection (f) to § 503 (the charging order statute) where the comments state that:
The charging order remedy—and, more particularly, the exclusiveness of the remedy—protect the “pick your partner” principle. That principle is inapposite when a limited liability company has only one member. The exclusivity of the charging order remedy was never intended to protect a judgment debtor, but rather only to protect the interests of the judgment debtor’s co-owners. Put another way, the charging order remedy was never intended as an “asset protection” device for judgment debtors.
By ignoring the rights of creditors in making distributions in violation of the LLC’s operating agreement and making deemed distributions in the form payments for his own benefit (credit card payments), Harrell violated the required terms of the operating agreement. To be clear, LLC member debtors may make ordinary course of business payments in operating the LLC and may pay themselves compensation (subject to potential garnishment by the creditor), but they may not simply disregard the creditor’s rights under the charging order or violate the LLC operating agreement to avoid paying the creditor. When that happens, the creditor may avail themselves of any number of remedies. These remedies may even include a right to proceed directly against the LLC as having become a creditor of the LLC entitled to distributions.[11]
Charging orders can be very protective of the rights of LLC members. As stated above, at the heart of an LLC is the ability to deal only with those of your choosing. To that end, charging orders protect the rights of non-debtor LLC members, which often may be family members of the debtor. However, after a charging order is obtained, debtors should be careful not to find themselves in Mr. Harrell’s position. Charging orders sound great in theory, but when the debtor and the debtor’s family having been living out of the LLC, it becomes very hard to avoid attempts to access LLC resources in a way that would not violate the charging order.
Some thoughts to avoid this result, beyond merely complying with the terms of the charging order, may include having the debtor resign as manager of the LLC to avoid direct contempt as well as potential increased access to LLC information by the creditor, granting authority to retain cash in the LLC rather than mandating distributions, allowing special allocations and non pro rata distributions in the operating agreement, including in the operating agreement a right to redeem interests subject to a charging order on preferential terms (but not pushed to the extent a court would likely disregard), etc.
It appears these “poison pills” were likely not included in the planning for SLB. Then, when Harrell, acting as manager, made distributions solely to his wife and deemed distributions to himself outside of any exception to the definition of “distribution,” he placed himself and the LLC squarely in the crosshairs of his creditor. Careful planning may not have completely avoided this result, but certainly could have helped Mr. Harrell and SLB.
[1] Ex Parte SE Property Holdings, LLC, 2021 WL 5145446.
[2] See, e.g., § 502 Uniform Limited Liability Company Act (2006), as amended in 2013.
[3] Id.
[4] Note that there may be limitations to charging order protection applicable to single-member LLC’s where other members’ interests which otherwise should be protected would not exist. See Olmstead v. F.T.C., 44 So.3d 76, 83 (Fla. 2010) and In re Albright, 291 B.R. 538, 540 (Bankr. D. Colo. 2003). Some states have addressed this issue by statute. For example, see Fla. Stat. § 605.0503 and Nev. Rev. Stat. § 86.401.
[5] AL Code § 10A-5A-5.03.
[6] See, e.g., Bishop, Carter, G., “Fifty State Series: LLC Charging order Statutes,” Suffolk University Law School Research Paper No. 10-3, Oct. 6, 2011, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1542244.
[7] Under AL law, a “transferrable interest” is “a member’s right to receive distributions from a limited liability company or a series thereof.” AL Code § 10A-5A-1.02(t).
[8] AL Code § 10A-5A-1.02(h).
[9] Ex Parte SE Property Holdings, LLC, 2021 WL 5145446, *4.
[10] Note that this also sometimes includes reference to the creditor being KO”s by the K-1 by taxing the creditor on the LLC’s income without distributions being made. Notwithstanding those who make this claim, this appears not to be the correct tax result. See Geeraerts, Michael, “Who Gets K.O.’d by the K-1?,” The CPA Journal, January 2017, https://www.cpajournal.com/2017/01/22/who-gets-k-o-d-by-the-k-1/#:~:text=To%20further%20promote%20the%20creditor,and%20be%20responsible%20for%20the and Jay Adkisson, “Charging Orders and K.O.’d by the K-1…Not,” July 31, 2011, https://www.forbes.com/sites/jayadkisson/2011/07/31/charging-orders-and-k-o-d-by-the-k-1-not/?sh=4abe65b5210e.
[11] See § 404(d) Uniform Limited Liability Company Act (2006), as amended in 2013, stating that “If a member or transferee becomes entitled to receive a distribution, the member or transferee has the status of, and is entitled to all remedies available to, a creditor of the limited liability company with respect to the distribution.” See also EarthGrains Baking Cos. V. Sycamore Family Bakery, Inc., 2018 WL 5776545 (D. Utah Nov. 2, 2018) and 2019 WL 6001940 (D. Utah Nov 14, 2019).
