The Charging Order - A Halt to Collection
William G. Fig
Why is it necessary to obtain a personal guaranty when dealing with an "S" corporation or a limited liability company ("LLC")? A personal guaranty is critical because it allows you to obtain a judgment against the individual guarantor of the LLC's debt, which, in turn, allows you to reach the individual's assets to satisfy the debt. However, for the reasons set forth below, it is also important to pursue a judgment against the business entity, especially when that entity is an LLC.
A judgment allows a creditor to have the sheriff seize and sell the judgment creditor's assets and personal property that are not subject to the bankruptcy exceptions. In the case of a corporation, the sheriff, via a writ of execution, may seize and sell the judgment debtor's shares of stock in a corporation. This is true even with closely-held or family "owned" "S" corporations. The reasoning for allowing such action is that, in theory, the ownership of the stock is not directly tied to the control or management of the corporation.
However, in terms of enforcing a judgment against an individual judgment debtor, an LLC is treated more like a partnership. An LLC does not have ownership certificates; instead, each member has a membership interest in the entity, which is typically identified in the LLC's operating agreement. Unlike a corporation, it is assumed that each member has an active role in controlling or managing the business of the LLC.
Thus, in most circumstances, if the LLC has more than one member, the court will not allow a judgment creditor to seize and sell a judgment debtor's membership interest in an LLC. In other words, the court will not force the non-debtor members of the LLC to be "partners" with a party not of their choosing. As a result, the creditor's remedy against a multi-member LLC is limited to obtaining a charging order from the court. A creditor's remedy in regard to a single member LLC may not be as limited. This is because some courts have treated such an entity as a sole proprietorship, thereby allowing a creditor access to the LLC's assets when enforcing a judgment against the sole member of the LLC.
A charging order is a temporary remedy. It is similar to a writ of garnishment in that it assigns any profits or distributions owed to the debtor member to the creditor until the creditor's judgment is satisfied. The effectiveness of this remedy is somewhat limited and obviously depends on whether the LLC is profitable or generates any distributions to the members.
The creditor may foreclose on a charging order, which makes the creditor the owner of the debtor member's economic right to receive distributions (i.e.
the distributional interest). It does not affect any of the LLC's assets, nor does it make the creditor a member of the LLC. While foreclosing the charging order may provide leverage in negotiating a payoff from the other LLC members, a creditor must carefully consider this tact. Caution is warranted because, as the owner of a member's distributional interest, the creditor may end up paying taxes on the LLC's phantom income. When the goal is to collect monies owed, this would be a bitter pill for a creditor to swallow.
As a result, if possible, it is beneficial to obtain a judgment against an LLC and
the debtor member. A judgment against the LLC allows the creditor to directly pursue the LLC's assets. Enforcing a judgment against a judgment debtor's LLC membership interest will likely present some challenges, especially if the interest is held in a multi-member LLC. Conversely, to protect the LLC's assets, a sole member LLC would be wise to consider adding one or more minority members.
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