Entity Choice of Law Issues

RECOMMENDED READING: (Asset Protection in Financially Unsafe Times, by Dr. Arnold Goldstein and W. Ryan Fowler, chapters 8 and 18.)

A hotly debated question is: if you live in one state, can you form an entity in another state and take advantage of its more debtor-friendly laws, such as a stronger charging order statute?

The answer: MAYBE.

FACTORS THAT INFLUENCE CHOICE-OF-LAW ISSUES

  • Where the tort occurred “lex loci delicti”
  • Where the case is being tried
  • Where assets are located
  • Where an entity was formed
  • Case law in the court’s jurisdiction concerning the matter
  • The personality of the judge, what he had for lunch that day, and his mood at the time… really!

Many people insist that the jurisdiction where an entity is formed must be the jurisdiction whose laws are used because of a statute in most business acts that goes something like this:

  • “17450. Subject to the provisions of Section 17453: (a) The laws of the state or foreign country under which a foreign limited liability company is organized shall govern its organization and internal affairs and the liability and authority of its managers and members.” (Ca. Corp. Cd., § 17450 (a).

Here is how one court interpreted this statute:

“Defendants argue that Arizona law applies because the Beverly-Killea Limited Liability Company Act, Cal. Corp.Code § 17000, et seq., provides for the application of the law of the state of organization (here, Arizona) to issues of liability between an LLC and its management and officers as well as to issues concerning the organization of the LLC. Cal.Corp.Code § 17450(a) (“The laws of the state ... under which a foreign limited liability company is organized shall govern its organization and internal affairs and the liability and authority of its managers and members.”). The court finds, however, that § 17450(a) simply codifies the internal affairs doctrine, as applied to LLCs. [FN1] In other words, § 17450(a) does not apply to disputes that include people or entities that are not part of the LLC.”

The court then used CALIFORNIA corporate law to pierce an Arizona corporation!

However, other courts have ruled in an opposite manner. For example, see Sweeney, Cohn, Stahl & Vaccaro v. Kane, No. 2002-04052 (N.Y. App.Div. 03/08/2004).

In this case, a New York court considered which law should be used to pierce a Florida corporation. They decided to use Florida law. The court reasoned that the Florida corporation should be governed by the laws of the state where the corporation was formed, even though the plaintiffs, defendants, and cause of action were all located in New York.

MORAL OF THE STORY

If your state doesn’t have the most protective laws, consider using another state with more protective laws. BUT, realize this strategy MAY or MAY NOT be beneficial to you. A judge may use the foreign jurisdictions laws, or he may apply the laws of his jurisdiction.

The BEST thing to do is to structure your entity so that it will be protected no matter which state law is used. The best way to do this is to structure your entity so that management may never be replaced by a single person (or by persons who both may be debtors to the same creditor). Same thing goes with ownership, and you should make it so owners are never debtors to the same creditor.

Also, the governing document should be an executory contract where all owners have certain obligations to the company, and no withdrawal of capital is allowed, among other things.

REVERSE PIERCING

‘Reverse Piercing’ is when a creditor tries to get assets in a business for the debt of one of its owners. We discuss this in the lesson on charging order protection. “Normal” piercing is when a creditor tries to get an entity owner’s personal assets for a debt or judgment against the business.

Posted in ENTITIES (Trusts, FLP's, LLC's and Corporations).