When most people set up limited liability companies (“LLCs”), they do so to protect their personal assets from the creditors of their business. This type of creditor protection is sometimes referred to as inside creditor protection. Although this protection is very important, it is not the only creditor protection an LLC can provide. An LLC can also provide protection of the LLC’s assets from an owner’s personal creditors, which is often referred to as outside creditor protection.
Policy Behind the Charging Order
Imagine if three people decide to create a partnership and go into business. Each of these three individuals contributes funds to the newly formed company and the company starts purchasing assets to begin the business. Some of these assets may include computers, inventory, machinery, licenses, etc… The company needs all of these assets to operate. After a couple of years struggling and hard work to make the company profitable, one of the partners causes a car wreck and seriously injures a driver in another vehicle. Although the injured driver lives, he will be paralyzed for the remainder of his life. Because of the injuries, there will be medical bills, pain, and suffering, and continuous care required. The injured person sues the owner of the business, winning a judgment in the amount of $3 million. The business owner’s car insurance only covers the first $2 million, so the business owner is left with a $1 million debt. Most of the owner’s savings are in his business, so the creditor’s attorney attempts to go after the business assets.
In the above situation, would it be fair to the other two partners of the company, who had nothing to do with the accident, if the business was significantly disrupted or destroyed because the third partner acted negligently? The courts have sought to balance the other partners’ rights with the rights of the creditor. They have done this through a mechanism called a “charging order.”
So what is a Charging Order?
A charging order is very similar to the garnishment of an employee’s wages. It is an order made by a court to a company requiring the company to pay all distributions from the company that would otherwise go to the debtor-owner of the company to the owner’s judgment creditor. Often, a court will provide a charging order as a remedy and not allow the creditor to reach inside the partnership and take the assets. The downside of a charging order to a creditor is that the company may delay distributions for years without paying anything out the creditor. Additionally, there is some argument that because the creditor will ultimately receive the distributions, he or she could be responsible for the annual tax liability. Simply put, just because there is a charging order doesn’t mean distribution will be made by the company.
State LLC Statutes
Most, if not all, state LLC statutes provide some form of charging order protection against personal creditors of a member of the LLC from reaching the assets owned by the LLC. With the exception of Nevada, such protection does not apply to corporations (only LLCs and partnerships).
Utah’s LLC statute is generally not considered to be a strong asset protection statute. Under Utah law, a judgment creditor can bypass a charging order, and sale the member’s interest in the LLC to obtain the proceeds if the creditor can show that “distributions under a charging order will not pay the judgment debt within a reasonable time.” Other states have statutes that are significantly more debtor-friendly. In fact, in some jurisdictions, a charging order is the exclusive creditor remedy even if the LLC is owned by one member, which goes against the historical reasons for the charging order laws. Some of these states are Alaska, Nevada, Wyoming, and Delaware. For example, Delaware’s statute reads as follows:
“The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or of a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest.”
Because some states have stronger LLC creditor protection laws than others, business owners in states with statutes similar to Utah, often organize LLCs in more debtor-friendly jurisdictions. The question then becomes: which state laws will a court apply in a dispute? The following case is important to the discussion.
American Institutional Partners LLC v. Fairstar Resources Ltd (“Fairstar”)
InFairstar, Fairstar Resources LTD and Goldlaw PTY, LTD (“Creditors”) obtained a charging order in a Utah state court against American Institutional Partners, LLC, AIP Resort Development, LLC, and Peninsula Advisors LLC (“Debtors”), all of which were LLCs formed as Delaware LLCs under Delaware law. However, the Debtor’s principal place of business was in Utah, management was located in Utah, and was registered to do business in Utah. The Utah court applied Utah law to the LLCs allowing the Creditors to foreclose on the Delaware LLC interests. Although the significant effort was made to invalidate the foreclosures in the Delaware Courts, the ultimate outcome was that the foreclosures were held to be valid and the application of Utah law permitted.
A Little Uncertainty
The Fairstar decision provides a strong indication of how the Utah courts will likely rule with respect to LLCs formed in other states. However, the facts of Fairstar still left some uncertainty regarding what circumstances would lead to an application of Utah law with LLCs formed in other states.
The Debtors’ principal place of business in the Fairstar case was located in Utah, and it was registered to operate a business in Utah. What if the Delaware LLC was not an operating company, but a holding company with Utah owners and no Utah operations? Or what would happen if the Delaware LLC held property and operated in Delaware and Utah? What would happen if one of the owners was from Delaware? Would any of these facts change the outcome? The answers to these questions are not entirely clear.
This uncertainty still provides some incentive for owners to form LLCs in debtor-friendly jurisdictions like Delaware, Nevada, and Wyoming under some sets of circumstances. Although a judge will likely rule that Utah law applies, the creditor still has to fight the case and has some risk of losing the case. Additionally, a debtor may have more settlement leverage under these conditions than he or she might otherwise have if the LLC is formed in Utah.
The Downside of Other Jurisdictions
One downside to creating LLCs in other jurisdictions is worth mentioning: increased cost. In Utah, the LLC filing fee is currently $70 with an annual fee of $15. Additionally, one of the owners of the LLC can act as the registered agent. Conversely, if someone forms an LLC in Wyoming, for example, the registration fee is $100 plus an annual fee of up to $50 depending on the assets in the state. Furthermore, a registered agent needs to be located in Wyoming to receive service of process in the event of a lawsuit. Registered agent fees generally range from $50 to $300 per year.