Clients often ask where they should form a new legal entity to obtain the best creditor protection. Blogs, marketing materials, and similar items often tout one or another jurisdiction as the best place to form legal entities. It certainly is the case that state laws differ. One of those areas is in “charging order” protections for LLC members.[1]
The problem with selecting one jurisdiction over another due to these protections being more favorable is that the law of the state of formation typically only applies to the “internal affairs” of the entity.[2] While the Full Faith and Credit Clause to the U.S. Constitution generally prohibits one state from disregarding a judgment properly rendered in another state, it “does not mean that States must adopt the practices of other States regarding the time, manner, and mechanism for enforcing judgments.”[3] Similar issues were raised in a recent New York state court case involving enforcement of a judgment against out-of-state LLC’s.[4]
Discussion
In the Wright case, a New York state court entered charging orders against two LLC’s of a New York state corporate debtor. The LLC’s were formed in Virginia and South Carolina. The LLC’s moved to vacate the charging orders. A primary argument was that the two LLC’s were not properly served with process on the hearing to issue the charging order. As such, the court should vacate the order.
This argument may have held weight had the order addressed other issues. However, here, the order was to charge the LLC interests of a New York debtor in favor of a creditor. The court held that under the laws of all applicable states, LLC interests are intangible personal property. Therefore, LLC interests are located where the member is located. In this case, that was New York. Since a charging order does not purport to touch upon any property of the LLC, there is no reason to involve the LLC in the proceedings:
[A] charging order against Cavan’s membership interest in either LLC does not frustrate the property right of either company, thus the court is not asserting in rem jurisdiction over the property outside New York. Whether the court has personal jurisdiction over the LLC has no bearing on the issue in dispute here. Since the debtor Cavan is a New York State corporation and is subject to the personal jurisdiction of the court, the court has jurisdiction over its personal property in consequence.
Based on this reasoning, there is no need to involve the two LLC’s or otherwise turn to the laws of the states of formation to determine what remedies apply. Rather, since an LLC interest is the personal property of an in-state debtor, the local court can enforce remedies based on local law and without involvement of the LLC’s involved.
As can be seen here, a court was able to use local state law to fashion remedies without reference to the charging order statutes of the states of formation and without service upon the out-of-state LLC’s. While this case did not cite to the “internal affairs doctrine,” there is at least some analogous application. The Wright case involved a third-party creditor’s rights in enforcing a judgment against an LLC member rather than rights and obligations among the LLC’s members themselves.
Although the number of cases where the “internal affairs doctrine” has been relevant are too numerous to discuss here, a few somewhat recent cases include:
- In Jenkins,[5] in discussing what state law to apply in determining whether a corporation was a taxpayer’s alter ego, the Tax Court cited the internal affairs doctrine in determining that the law of the taxpayer’s residence applied rather than the law of jurisdictions where the relevant entities were formed.
- In EarthGrains,[6] the U.S. District Court refused to apply Nevada charging order laws, even though Nevada was the state of the LLC’s formation. Rather, the court noted that “all of the LLC’s activities, dealings, and properties are located in Utah, and Leland Sycamore is a resident of Utah. Therefore, the court concludes that the Charging Order was properly issued under Utah law…”
- A Texas Bankruptcy Court[7] has held that alleged fraudulent transfer claims are tort claims not bound by the internal affairs doctrine even related to an LLC’s distributions to its members. Further, since fraudulent transfer claims are creditors’ claims rather than claims among the LLC’s members or between the member and the LLC, the internal affairs doctrine does not apply.
For a case where the internal affairs doctrine is discussed related to requiring reliance on the laws of the state of formation, see the Juul Labs case[8] from Delaware. In that case, the dispute related to the rights over corporate records. There, although there were procedural issues also sustaining the outcome, the Delaware court refused to apply California law to a shareholder’s dispute related to a right to corporate records. Rather, for the Delaware corporation, the court applied Delaware law.
Unrelated to a legal entity, but rather a trust, a somewhat recent opinion from the Supreme Court of South Dakota addressed an issue involving applicable state law related to creditors’ rights.[9] In that case, a California court issued a judgment for child support. Under California law, spendthrift protections available for trusts beneficiaries do not apply to child support claims making the assets of the trust accessible to creditors seeking to recover unpaid child support. However, the relevant trust was moved to South Dakota and administered by a South Dakota trustee. In discussing whether California or South Dakota law applied, and therefore whether the child support exception for child support claims applicable in California but not South Dakota applied, the court noted that “the time, manner, and mechanisms” of enforcing judgments are the providence of the state where the judgment is being enforced rather than where the judgment was entered. It is true that the Full Faith and Credit Clause to the U.S. Constitution required South Dakota to respect the California judgment. However, it was found not to require South Dakota to apply California law in the enforcement of that judgment. Here, since the judgment would be enforced in South Dakota, the laws of South Dakota applied. While postured differently than the cases involving corporations or LLC’s, this case also illustrates that the state where judgments are being enforced will be the relevant state’s laws that apply.
Conclusion
The state where legal entities are formed may be important for a variety of reasons. Those reasons include issues involving “internal affairs” such as fiduciary duties, rights/obligations of the owners, and similar considerations. In addition, there may be tax distinctions, particularly with regards to franchise taxes. However, the state of formation typically will not control the rights of third parties to the legal entities such as an owner’s creditors. Such third parties will be able to use the laws of the jurisdiction where they are enforcing their remedies, often the state of residency of the relevant owner.
With this rule, caution is to be advised when selecting state of formation. There may be times when the formation state’s charging order or similar creditors’ rights laws will be important, but much less often than promoters of using certain jurisdictions seem to urge. Especially given the added complexity involving multi-state entities (i.e. formed in one state but operating in another), it often will simply be best to form in the state where the entity operates. This will not always be the case, particularly for states operating in multiple states. However, creditors’ rights will generally not be the primary consideration. Entity owners would be well advised to consider a number of variables, rather than merely an asset protection pitch, in choosing where to form their entities.
[1] Generally, under a charging order, creditors of an LLC member may “charge” the interest by obtaining a right to any distributions made to the debtor-member but may not seize the member’s interests, exercise management rights, compel the sale of LLC property, etc. In many state statutes, a “charging order” is an exclusive remedy even for single member LLC’s. I have written about charging order issues previously. See Gray Edmondson, “Charging Orders – SE Property Holdings, LLC,” Jan. 25, 2022, https://esapllc.com/charging-orders-se-property-holdings-llc-2022/, and “A Tale of Two Charging Orders,” March 23, 2022, https://esapllc.com/a-tale-of-two-charging-orders/.
[2] The “internal affairs” of a legal entity include “matters particular to the relationships among or between the corporation and its current officers, directors, and shareholders.” Edgar v. MITE Corp., 457 U.S. 624, 645 (1982) (citing Restatement (Second) Conflict of Laws § 302). “Different conflicts principals apply, however, where the rights of third parties external to the corporation are at issue.” First Nat’l City Bank v. Banco Para El Comercio Exterior de Cuba, 462 U.S. 611 (1983).
[3] See, e.g., Matter of Cleopatra Cameron Gift Trust, Dated May 26, 1998, 931 N.W.2d 244 (2019 S.D. 35), citing Baker by Thomas v. Gen. Motors Corp., 522 U.S. 222, 235, 118 S. Ct. 657, 665, 139 L. Ed. 2d 580 (1998); and Restatement (Second) of Conflict of Laws § 99 (1971) (“The local law of the forum determines the methods by which a judgment of another state is enforced.”).
[4] Wright v. Shenandoah Investors, LLC, 2023 NY Slip Op. 31392 (U), https://casetext.com/case/wright-v-shenandoah-invrs.
[5] Jenkins, T.C. Memo 2021-54.
[6] Earthgrains Baking Companies, Inc. v. Sycamore Family Bakery, Inc., 2015 WL 5009376. For a discussion of other aspects of this case, see Edmondson, Gray, “A Tale of Two Charging Orders,” March 23, 2022, https://esapllc.com/a-tale-of-two-charging-orders/.
[7] In re The Heritage Organization, 413 B.R. 438 (Bankr. N.D. Tex. 2009).
[8] Juul Labs, Inc. v. Grove, 238 A.3d 904 (Del. Ch. 2020). For a discussion of the case related to application of the internal affairs doctrine, see Andrew J. Meyer, “Strengthening the Internal Affairs Doctrine: Juul Labs, Inc. v. Grove, 238 A.3d 904 (Del. Ch. 2020),” 86 Mo. L. Rev. 1359 (2021).
[9] Matter of Cleopatra Cameron Gift Trust, Dated May 26, 1998, 931 N.W.2d 244 (2019 S.D. 35). See supra Note 3 and Edmondson, Gray, “Can You Avoid Creditors by Moving Assets (Or Yourself) to Another State?,” Oct. 23, 2019, https://esapllc.com/can-you-avoid-creditors-by-moving-assets-to-another-state/.
