Charging Order Protection and Reverse Piercing


WHAT IS CHARGING ORDER PROTECTION?

A ‘Charging Order’ is actually a limited creditor remedy. But the remedy is so limited, it is viewed as being protective from an asset protection standpoint. Thus, all entities that benefit from the charging order are called “Charging Order Protected Entities” or COPEs.

Generally, a creditor of partner or member of a GP, LLC, LLP, LP, or LLLP (all of which are COPEs) may not seize ownership, become a member/partner, attach company assets, manage the company, or force assets out of the company.

They can only get a charging order, which is the right to receive a distribution instead of the owner-debtor, IF and WHEN the distribution is made. Usually a distribution is not made if it would only go to a creditor, meaning the creditor usually ends up with nothing.

Most creditors do not even attempt to get a charging order, since they believe it won’t get them anywhere. By way of example, I worked with an attorney whose firm handled 20,000 asset protection cases over a 45 year period. He set up well over 10,000 LLCs. Many of his clients had creditor problems. Only 3 or 4 ever got a charging order against them.

Most creditors do not even attempt to get a charging order, since they believe it won’t get them anywhere. By way of example, I worked with an attorney whose firm handled 20,000 asset protection cases over a 45 year period. He set up well over 10,000 LLCs. Many of his clients had creditor problems. Only 3 or 4 ever got a charging order against them.

Sometimes the other members/partners will buy the debtor-member’s interest out before a charging order attaches.

Or, the debtor or other members/partners buy off the creditor for pennies on the dollar. The creditor may be amenable to this since otherwise they wouldn’t get a dime.

Or, you don’t distribute anything to the creditor, but you structure the LLC so the creditor has to pay LLC taxes for undistributed profits. (See IRS Rev. Rul. 77-137). A charging order does NOT mean this will automatically happen. The operating agreement must be drafted so as to give a creditor sufficient “dominion and control” over the member’s interest, but not too much control! Or, just gift them the debtor’s member interest and then hit the creditor with a tax bill.

CHARGING ORDER PROTECTION – WHEN IT CAN FAIL

    A creditor may circumvent charging order protection if:

  • The debtor is the only owner of the entity (single member LLC), or owners are all debtors to the same creditor.
  • The state’s statute does not list the charging order as the “exclusive creditor remedy” against owners of an entity. This was an issue in the recent Florida case Olmstead v. FTC (2010). Note that a very few states list the charging order as the exclusive creditor remedy for partnerships, but not for LLCs (Florida!) In which case a LP or LLP may be preferable to an LLC.
  • The entity is used improperly, which allows it to be reverse-pierced.

What is Reverse piercing?

REVERSE PIERCING A COPE. This is tougher to do than normal piercing. Reverse piercing is where creditors of a business owner try to reach assets of the company. Because this would generally harm other owners, and may also harm legitimate creditors of the business itself, it is often not allowed, and is the main reason for statutory charging order protection in the first place. But, on occasion, it is allowed if no one that is not party to the suit or debt would be harmed.

“We recognize … that there are other equities to be considered in the reverse piercing situation – namely, whether the rights of innocent shareholders or creditors are harmed by the pierce.” LFC Marketing Group, Inc. v. Cebe W. Loomis, 116 Nev. 896; 8 P.3d 841 (Nev. S.C., 2000).

Another case echoes this sentiment in greater detail:

“In addition, the reverse-pierce theory presents many problems. …third parties may be unfairly prejudiced if the corporation’s assets can be attached directly. Although … our particular concern was with non-culpable third-party shareholders of the corporation being unfairly prejudiced, no greater culpability should attach to the third party corporate creditors harmed by reverse-piercing in this case.

See id. (“… the doctrine cannot be applied to prejudice the rights of an innocent third party.’”) (quoting 1 William Meade Fletcher et al., Fletcher Cyclopedia of the Law of Private Corporations § 41.20, at 413 (1988 Supp.)) …; see also Hamilton v. Hamilton Properties Corp., 186 B.R. 991, 1000 (Bankr. D. Col. 1995) (“The reverse piercing theory is an aberration which, if invoked, would prejudice . . .

…the rightful creditors of the corporation whose assets are subsumed for the benefit of the creditors of the individual. What of the creditors of [the corporation] who relied on its separate corporate existence in doing business with it?”); Cargill, Inc. v. Hedge, 375 N.W.2d 477, 479 (Minn. 1985) (holding that in considering propriety of reverse pierce, “also important is whether others, such as a creditor or other shareholders, would be harmed by a pierce”). Floyd v. I.R.S., 151 F.3d 1295, 1300 (10th Cir. 1998).

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