Why the Charging Order Exclusive Remedy Must be Saved

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Why the Charging Order Exclusive Remedy Must be Saved

by Richard Keyt, an Arizona business law attorney who has formed 3,600+ Arizona LLCs

On October 4, 2012, I attended a meeting of the RULLCA committee of the Arizona State Bar Association at which the members present at the meeting voted 11 – 4 to eliminate the provision of Arizona LLC law that provides that the sole remedy of a creditor of a member who gets a judgment against the member is to serve a charging order on the LLC.  This provision is, in my opinion as an Arizona attorney who has practiced business law since 1980 and has formed 3,600+ Arizona LLCs since 2001, the single most important provision of Arizona’s limited liability company Act.

I constantly tell people that you should only form an LLC in a state that has good LLC law.  A state has good LLC law only if the state’s LLC law provides that the charging order is the sole remedy of a creditor of a member who gets a judgment against the member.  Arizona, Nevada and Wyoming are examples of good LLC states.  California and the other six states that have adopted RULLCA are examples of bad LLC law states.  I know a California asset protection attorney who told me that because California has bad LLC law he does not form California LLCs for his clients, but instead forms LLCs in Arizona or Nevada.

California adopted its revised version of RULLCA on September 21, 2012 (effective January 1, 2014).  Most of us know that California has an anti-business legislature so I’m not surprised its legislature passed its version of RULLCA and that Governor Jerry Brown signed the law.  California’s adoption of RULLCA is another sign to me that Arizona should not go that route.  See an article written by a California business lawyer called “California’s New LLC Act – Call Me Laocoon, But I Foresee A Mess!” in which he states:

“Out with old, in with the new, what could be wrong with that?  It turns out plenty. . . . If a constitutional infirmity were not sufficient cause for concern, the RULLCA suffers from some more practical, but no less significant deficiencies.”

If the RULLCA committee has its way and is successful in convincing the Arizona legislature to pass a bill that repeals current LLC law and replace it with RULLCA Arizona will move from a good LLC law state to a bad LLC law state.

Arizona’s Charging Order Exclusive Remedy Statute

Arizona Revised Statutes Section 29-655 states:

A. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the member’s interest in the limited liability company with payment of the unsatisfied amount of the judgment plus interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the member’s interest.

B. This chapter does not deprive any member of the benefit of any exemption laws applicable to his interest in the limited liability company.

C. This section provides the exclusive remedy by which a judgment creditor of a member may satisfy a judgment out of the judgment debtor’s interest in the limited liability company.

Emphasis added.  Note that subsection C provides that the charging order authorized in subsection A is the creditor’s EXCLUSIVE remedy.  This means that the creditor cannot foreclose on the member’s interest in the LLC and sell it to the highest bidder.  Section 29-655 is the reason that Arizona has good LLC law.  In a RULLCA state, a creditor of a member can foreclose on the member’s economic interest in the LLC and sell it to the highest bidder.

Section 29-655 is the single most important reason why most of the time it is malpractice for an Arizona attorney to recommend or allow his or her client to form an Arizona corporation instead of an Arizona LLC.  Arizona corporate law does not contain a provision similar to Section 29-655.  A creditor of a shareholder of an Arizona corporation can foreclose on the shareholder’s stock of the corporation and sell it to the highest bidder.

The presence or absence of the charging order as the sole remedy of a creditor of the member of an LLC is best illustrated by the following examples.

Example 1 Current Arizona LLC Law:  Homer Simpson owns 50% of the membership interests in World Wide Widgets AZ, LLC, an Arizona limited liability company.  WWWA sells widgets.  Homer works full time in the business and is the primary reason the business is successful.  Ned Flanders owns the other 50% of WWWA, but he is not involved in the business.  Ned contributed $100,000 of seed capital to the LLC that employs eight people.  WWWA is valued at $1,000,000.  Homer and Marge divorced and their property settlement requires Homer to pay Marge $50,000.  Homer cannot raise the money because he has cash flow problems and defaults on the payment.  Marge sues and gets a judgment against Homer for $62,000 (principal of $50,000 plus attorneys fees and accrued interest).  Marge’s sole remedy with respect to Homer’s interest in WWWA is to get a court order that orders WWWA to pay to Marge instead of Homer any distributions that would otherwise be payable to Homer.  Result:  Homer does not lose his ownership of the LLC or the economic value associated with it.

Example 2 Current Arizona Corporate Law:  Same facts as in Example 1, but instead of an Arizona LLC WWWA is an Arizona corporation.  After getting the judgment against Homer for $62,000 Marge forecloses on Homer’s stock and sells it at a public auction to the highest bidder who bid $5,000.  Result:  Homer’s inability to pay the $62,000 when due caused him to lose his entire interest in WWWA, an economic loss to Homer of $500,000 and after the foreclosure he still owes Marge $57,000.  In addition Homer continues to be a “member” of the LLC who can vote, but he will never receive any future distributions of profits from the LLC.  Homer quits working for the LLC, which causes it to fail and all employees lose their jobs and Ned loses his investment in the company plus his share of its value.

Example 3 RULLCA with Foreclosure:  Same facts as Example 1 except Arizona adopted RULLCA, a law that eliminates the charging order sole remedy law and replaces it with a law that allows the creditor of a member of an Arizona LLC to foreclose and sell the economic interest in the LLC to the highest bidder.  Result:  Homer’s inability to pay the $62,000 when due caused him to lose his economic interest in WWWA, an economic loss to Homer of $500,000 and after the foreclosure he still owes Marge $57,000.  In addition Homer continues to be a “member” of the LLC who can vote, but he will never receive any future distributions of profits from the LLC.  Homer quits working for the LLC, which causes it to fail and all employees lose their jobs and Ned loses his investment in the company plus his share of its value.

RULLCA Committee Votes to Replace Current Arizona Law with RULLCA & Give Arizona LLC Members Example 3

A majority of the lawyers on the RULLCA subcommittee who represent people who form Arizona LLCs and become members of the LLCs voted 11 – 4 on October 4, 2012, to replace Section 29-655 with RULLCA Section 503 as revised by them in their wisdom.

The introduction to RULLCA states this whopper about charging orders in the second sentence:

“The charging order mechanism: (i) dates back to the 1914 Uniform Partnership Act and the English Partnership Act of 1890; and (ii) is an essential part of the “pick your partner” approach that is fundamental to the law of unincorporated businesses. The new Act continues the charging order mechanism, but modernizes the statutory language so that the language (and its protections against outside interference in an LLC’s activities) can be readily understood.

When you read RULLCA Section 503 below, compare it with Arizona Revised Statutes Section 29-655 and ask yourself which section: (i) can be “readily understood” (ii) favors the creditor of a member of an LLC over the member, and (iii) will lead to more litigation and money in the pockets of litigation lawyers?

RULLCA Section 503 Charging Order

The following is the text of RULLCA Section 503:

SECTION 503. CHARGING ORDER.

(a) On application by a judgment creditor of a member or transferee, a court may enter a charging order against the transferable interest of the judgment debtor for the unsatisfied amount of the judgment. A charging order constitutes a lien on a judgment debtor’s transferable interest and requires the limited liability company to pay over to the person to which the charging order was issued any distribution that would otherwise be paid to the judgment debtor.

(b) To the extent necessary to effectuate the collection of distributions pursuant to a charging order in effect under subsection (a), the court may:

(1) appoint a receiver of the distributions subject to the charging order, with the power to make all inquiries the judgment debtor might have made; and

(2) make all other orders necessary to give effect to the charging order.

(c) Upon a showing that distributions under a charging order will not pay the judgment debt within a reasonable time, the court may foreclose the lien and order the sale of the transferable interest. The purchaser at the foreclosure sale obtains only the transferable interest, does not thereby become a member, and is subject to Section 502.

(d) At any time before foreclosure under subsection (c), the member or transferee whose transferable interest is subject to a charging order under subsection (a) may extinguish the charging order by satisfying the judgment and filing a certified copy of the satisfaction with the court that issued the charging order.

(e) At any time before foreclosure under subsection (c), a limited liability company or one or more members whose transferable interests are not subject to the charging order may pay to the judgment creditor the full amount due under the judgment and thereby succeed to the rights of the judgment creditor, including the charging order.

(f) This

[act] does not deprive any member or transferee of the benefit of any exemption laws applicable to the member’s or transferee’s transferable interest.

(g) This section provides the exclusive remedy by which a person seeking to enforce a judgment against a member or transferee may, in the capacity of judgment creditor, satisfy the judgment from the judgment debtor’s transferable interest.

Conclusion

As an Arizona attorney who represents people who form Arizona LLCs, I cannot support changing Arizona’s LLC law to eliminate the asset protection feature of Arizona LLC law that prevents members from losing forever their economic interest in their Arizona LLC.  I am on the side of the members of the LLCs I form, not on the side of their creditors.  The loss of the charging order protection provided by ARS Section 29-655 would be unfair and a devastating blow to the members of 500,000+ existing Arizona LLCs who formed LLCs in Arizona in reliance on Arizona’s current LLC law and it would cause knowledgeable people to form their future LLCs in a state other than Arizona that has good LLC law.

Arizona estate planning attorney Les Raatz agrees with me.  See his comments about the importance of the charging order sole remedy, which concludes with the following statement:

A weakening of protection to those who have organized and operated Arizona LLCs relying upon existing rules is unfair and can do nothing if not create distrust in the use of Arizona as a place with reliable laws under which to build an estate plan, or for that matter, build a business or venture.”

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By |October 28th, 2012|Charging Order Exclusive Remedy, RULLCA Cons|1 Comment

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One Comment

  1. sdewald November 13, 2012 at 9:56 pm

    I agree that RULLCA should not be adopted in Arizona without customizing it and correcting what Arizona practitioners believe to be unwise provisions. That’s why a group of lawyers has been studying it carefully for many months, and so far have proposed many revisions to RULLCA for eventual adoption in Arizona. (This same thing happened when the Uniform Revised Limited Partnership Act was promulgated.)
    As for charging orders, it is not obvious that circumstances could never justify a remedy beyond a charging order. There are many states with statutes that provide that charging orders are NOT the exclusive remedy for a creditor of an LLC member, some of which specifically exclusive single-member LLCs. Here is a current survey:
    http://ssrn.com/abstract=1542244
    The group of lawyers Rick refers to are considering allowing foreclosure in instances of fraud, and are motivated in part by cases like this one (facts show fraud, court expressed that its hand were tied by the statute):
    http://wellsfargovkinas.blogspot.com/
    If you are concerned about this, please join in the working committee.
    Just as it is not constructive to vilify as protectors of fraud those who would defend the status quo, it is not constructive to vilify those who would make changes that would allow courts to give appropriate remedies for fraud.

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