There are relatively few types of assets that are statutorily protected from claims of creditors. Membership interests in limited liability companies (“LLCs”) and partnership interests are afforded a significant level of protection through the charging order mechanism. LegalZoom LLC service review
The Importance of History
Before the advent of the charging order, a creditor pursuing a partner in a partnership was able to obtain from the court a writ of execution directly against the partnership’s assets, which led to the seizure of such assets by the sheriff. This result was possible because the partnership itself was not treated as a juridical person, but simply as an aggregate of its partners.
The seizure of partnership assets meant that the sheriff could shut down the partnership’s place of business. That caused the non-debtor partners to suffer financial losses, sometimes on par with the debtor partner, a process one court referred to as “clumsy.”
To protect the non-debtor partners from the creditor of the debtor-partner, and to keep the creditor out of partnership affairs, it was necessary to keep the creditor from seizing partnership assets. This was also in line with the developing perception of partnerships as legal entities and not simple aggregates of partners. These objectives could be accomplished only by limiting the collection remedies that creditors previously enjoyed. Because any limitation on a creditor’s remedies is a boon to the debtor, over the years charging orders have come to be perceived as asset protection tools.
The rationale behind the charging order limitation applied initially only to general partnerships, where every partner was involved in carrying on the business of the partnership; it did not apply to corporations because of their centralized management structure. However, over the years the charging order protection was extended to limited partners and LLC members.
Deconstructing the Uniform Acts
Most domestic and foreign partnership and limited liability company statutes provide for charging orders. Almost all domestic statutes are based on the uniform acts, such as the Revised Uniform Partnership Act of 1994 (“RUPA”), the Uniform Limited Partnership Act of 2001 (“ULPA”) or the Uniform Limited Liability Company Act of 1996 (“ULLCA”), or the earlier versions of these acts.
The very first references to the charging order in the United States appeared in Section 28 of the Uniform Partnership Act of 1914 and Section 22 of the Uniform Limited Partnership Act of 1916. Both allowed creditors to petition the court for a charging order against the debtor’s partnership interest. Both statutes, directly or indirectly, addressed the fact that the charging order was not the exclusive remedy of the creditor. Appointment of a receiver and foreclosure of the partnership interest were anticipated.
A 1976 amendment to the Uniform Limited Partnership Act clarified the charging order remedy. It provided that a judgment creditor has the rights of an assignee of the partnership interest.
Section 504 of both RUPA and ULLCA, and the ULLCA, at Section 504, introduced the following concepts: (i) a charging order is a lien on the judgment debtor’s transferable interest; (ii) the purchaser at a foreclosure sale has the rights of a transferee; and (iii) the charging order is the exclusive means by which the creditor could pursue the partnership interest.
Both acts also provide that the charging order does not charge the entire partnership or membership interest of the debtor, but only the “transferable” (RUPA) or “distributional” (ULLCA) interest. However, the language providing that the creditor has the rights of an assignee was dropped.
Most recently, ULPA, in addition to the new language in the RUPA and the ULLCA, provides that (i) the judgment creditor has only the rights of a transferee, and (ii) the court may order a foreclosure only on the transferable interest.
All three most recent acts also provide that the charged interest may be redeemed prior to foreclosure.
The uniform acts make four important points: (1) the charging order is a lien on the judgment debtor’s transferable/distributional interest; it is not a levy, (2) the creditor cannot exercise any management or voting rights because the creditor has only the rights of an assignee/transferee, (3) the foreclosure of the charged interest does not harm the debtor because the buyer at the foreclosure sale receives no greater right than was possessed by the original creditor, and (4) the creditor, expressly, has no remedy other than the charging order and foreclosure on the charging order.
Because the charging order creates a lien and not a levy, and because the creditor is not a transferee under ULPA, but has only the rights of a transferee, the creditor does not become the owner of the charged interest unless there is foreclosure. This has important tax ramifications, discussed below.
If the creditor is an assignee/transferee, or has the rights of an assignee/transferee, the uniform acts deprive the creditor of any voting, management or access to information rights. Let us use ULPA to see how that happens.
ULPA defines a “transferable interest” as a right to receive distributions. A “transferee” is defined as a person who receives a transferable interest. ULPA defines two bundles of rights that a partner may have in a partnership: economic rights and other rights. While economic rights are freely transferable, other rights (which include management and voting rights) are not transferable, unless made so in the partnership agreement.
ULPA further clarifies that a transferee has the right only to receive distributions, if and when made. The comments to the charging order section of ULPA provide: