Limited Liability Company Charging Orders Part I: Implications of Recent Maryland Amendments and Policy Ramifications

By Meredith Cipriano and Ariana DeJan-Lenoir

With input from Laura Gagne and Stuart Smith[1]

Under the auspices of John Orrick, Jr., Carmen Fonda and Marshall Paul[2]

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In 2011 and 2012 the Business Law Section of the Maryland Bar Association drafted legislation which was passed in the Maryland General Assembly to amend the Maryland Limited Liability Company Act (LLC Act).[3]  As twenty years had passed since the original adoption of the LLC Act and the last substantive amendments to the LLC Act occurred in 1997, the Business Law Section’s Committee on Unincorporated Business Associations identified areas of the LLC Act that warranted revisions and further clarity.

Charging Orders and Foreclosure Rights

One of the specific sections of the LLC Act addressed by the Committee was Section 4A-607,[4] dealing with the rights of a creditor of an individual who also happens to be a member of an LLC.  Section 4 A-607, as it currently stands, states that the creditor may obtain a “charging order” to attach the LLC member’s economic interest to satisfy a personal debt owed to that creditor.   The Section also specifies a right to foreclose on the charging order, that is, to sell to the creditor the debtor’s LLC member’s rights.  The right to foreclose, however, may be barred by the LLC operating agreement.

Charging Orders Origins and Policy

Charging order protections originated under twentieth century English partnership law and were adopted as part of the Uniform Partnership Act developed in 1914.[5]   As a matter of policy, charging orders serve to balance competing interests: the interests of the judgment creditor to collect on a judgment and the interest of the non-debtor partners to choose with whom they will co-manage the business.  On the one hand, charging orders act to protect a non-debtor member of an LLC from an outside party exercising governance rights over the LLC due to another member’s personal debts unrelated to the LLC’s business.  On the other hand, charging orders provide a remedy to creditors of a member of an LLC to access the member’s distributions from the LLC in order to satisfy the outstanding debt.

Prior to the 2011 and 2012 amendments, Section 4A-607 was ambiguous as to what part of a member’s interest could be attached through a charging order and made no mention of a creditor’s foreclosure rights.  The section itself had not been amended since its original adoption in 1992.  In the meantime, substantive amendments to the parallel charging order provisions of Maryland’s Revised Uniform Partnership Act[6] as well as recent case law in other jurisdictions[7]called into question whether the charging order under Section 4A-607 provided the exclusive remedy to a creditor seeking to attach an LLC member’s membership interest.

Charging Orders under Maryland LLC Law

Prior to the 2011 and 2012 amendments to the Maryland LLC Act, section 4A-607(c) stated “a charging order constitutes a lien on the interest of the debtor in the limited liability company.”  Section 4A-607(c)(1) now provides that:

A charging order constitutes a lien on the economic interest of the debtor in the limited liability company and requires the limited liability company to pay over to the creditor only any distributions that would otherwise be payable to the debtor whose economic interest is charged. [8]

The essential purpose of the charging order is to provide a judicial remedy to a creditor of a member with respect to the member’s interest in the LLC without disturbing the management structure of the LLC.  The LLC Act was amended to clarify the original intent of the legislation[9]— that the interest subject to the charging order is only the economic interest of the LLC member.[10]  As a result, a charging order entitles the creditor – to any distributions payable to the debtor-member.  The noneconomic interest of the debtor-LLC member as outlined in section 4A-101(o) (i.e., voting rights, rights to inspect books and records, ability to act as an agent of the LLC, etc.) is unaffected and is retained by the debtor.  Even though a charging order exists, the debtor remains a member of the LLC and is therefore able to exercise the management and other rights afforded to members by the LLC Act or the LLC’s operating agreement.  This restriction on the judgment creditor’s interest in the LLC underscores the freedom of contract inherent in Maryland LLC and partnership law.[11]

Foreclosing on Charging Orders

The recent amendments to the Maryland LLC Act also afford creditors a right to foreclose on a charging order.  Prior to 2011, the right of a creditor to foreclose on a member’s economic interest was ambiguous, as foreclosure of the interest was not explicitly allowed.  Without a right to foreclose on the economic interest, a creditor could be put in the position of holding its charging order lien indefinitely, and could be thwarted in its recovery if the managers of the LLC determined not to make distributions to the members. The right to foreclose gives the creditor the additional option of selling the economic interest in the LLC to a third party, albeit this right may be illusory as the market for assignee interests of nonpublic LLCs is generally pretty thin. In response to this problem, the Act was amended to explicitly allow the creditor to foreclose on the debtor-member’s economic interest in the LLC.  Section 4A-607(c)(3)(i) now provides:

Unless otherwise agreed, on a showing that the distributions under a charging order will not pay the amount owed to the creditor within a reasonable time, the court may order foreclosure of the economic interest subject to the charging order and order the sale of the economic interest of the debtor.

It is important to note, however, though the default rule for LLCs formed under Maryland statute is that a member’s personal creditor has the right to foreclose on a charging order, this provision of the statute is prefaced with the words “unless otherwise agreed.” [12]  Thus, Maryland law permits members of an LLC to prohibit the foreclosure of a member’s economic interest by explicitly disallowing this right in an LLC’s operating agreement.  Therefore, in practice, the members of a Maryland LLC can prevent foreclosure by a member’s personal creditor by carefully drafting the LLC’s operating agreement to disallow foreclosure on a member’s interest.

Thus, by default, if the operating agreement is silent on foreclosure, a judgment creditor may seek to foreclose on an LLC member’s economic interest in the LLC.  However, even when a foreclosure remedy is available, it is only permissible if the distributions made to the creditor will not be sufficient to satisfy the debt owed within a reasonable time period.[13]  Ultimately, the court of competent jurisdiction will determine whether foreclosure will be allowed.[14]  Upon foreclosure on a charging order, the purchaser at the foreclosure sale becomes an assignee of the economic interest in the LLC.

Note that a purchaser of the economic interest at the foreclosure sale is still only able to access the economic rights of the member’s interest, not the non-economic rights.  So while such a purchaser might sell or transfer the economic interest to a third party , the purchaser cannot force the LLC to make any distributions to it, to dissolve the LLC, or to cause the LLC to sell its assets in order to increase its cash flow.  A further concern is that, as the assignee of an economic interest, the purchaser at the foreclosure sale, will become a partner for federal and state income tax purposes and therefore receive allocations of income and loss as a result of its ownership of such interest to the same extent as other members of the LLC.[15]  However, this right of foreclosure may have different consequences for multi-member LLCs and single-member LLCs.

Exclusivity of Charging Order Remedies

Charging orders are a mechanism designed to prevent creditors of an LLC member from invading the assets of a business also owned by non-debtor partners or members.  The revisions to the Act also added Section 4A-607(f) that charging orders and foreclosure rights constitute the “exclusive remedies” by which a creditor can satisfy the debt of a debtor-member through the debtor-member’s interest LLC.

In Conclusion

By itself, the Maryland LLC Act charging order remedy provides a clear arrangement for personal creditors to access distributions that the member-debtor is entitled to receive from the business of the LLC—without infringing on the operations and management of the LLC.  As the recent Section 4A-607 amendments affirm, a fundamental policy of the LLC Act is to give maximum effect to the principles of freedom of contract.[16]  Moreover, if the members forming the LLC do not wish to allow the personal creditors of members the right to foreclose on a charging order, the Section’s amendments preserve members’ rights to preclude that possibility by indicating so in the operating agreement.