As an attorney located in Summerville, South Carolina, I am often asked to explain a charging order. Law Dictionaries have included a “charging order” definition since 1904. The advent of Limited Liability Companies (LLCs) has increased the need to understand charging orders. Keep in mind that the law governing LLCs is still evolving. In this article, I will explain charging orders, foreclosing on a charging order, and the effect of bankruptcy on a charging order in South Carolina.
What is a Charging Order in South Carolina?
A charging order is the collection remedy that a creditor uses against a judgment debtor’s interest in a partnership, limited partnership or limited liability company. A monetary judgment is needed against the debtor prior to seeking a charging order. Inform your attorney in advance of seeking the monetary judgment of the debtor’s known interests in partnerships, limited partnerships and/or limited liability companies. Your attorney may be able to explore the availability of certain actions to prevent disposition or transfer of these interests during the litigation for a money judgment.
A charging order can be a very helpful collection tool, however, it does not equate to a judgment against the partnership, limited partnership or limited liability company. It also does not give the creditor a seat at the owner’s table, the right to participate in management or vote. Rather, the charging order statute only gives the creditor the right to receive any distributions that are to be made to the judgment debtor and a lien on the judgment debtor’s transferable interest.
Information about the partnership, limited partnership or limited liability company is invaluable in connection with a charging order. Examples of information that can aid your attorney before pursuing or after entry of a charging order are:
- knowledge of the relationship between the debtor and the LLC/partnership – a family partnership or a single member limited liability company?
- knowledge of the frequency and amount of customary distributions from the LLC/partnership to the debtor.
- content of agreements that pertain to the entity, such as operating agreements for a limited liability company.
Remember that when the time comes where the creditor is seeking the charging order, it is unlikely that the debtor will be cooperating with the creditor any longer. To help the charging order process, obtaining as much information as possible prior to this time can be crucial. Therefore, when originating a loan where a borrower or guarantor owns these types of interests, the bank should gather as much information as possible about the interest, including operative documents, such as operating agreements. Additionally, during workouts, the bank should request updated information and operative documents in connection with the partnership, limited partnership or limited liability company interests.
It is important for LLC owners to draft and implement an operating agreement that takes into account the impact of a member filing bankruptcy or having a court judgment entered against him or her. For example, the LLC members may wish to include a provision in their operating agreement allowing for the expulsion of any member who files for bankruptcy; or allowing them to purchase the interest of any member who becomes subject to a charging order. A comprehensive operating agreement is particularly important for multi-member LLCs, since disputes may develop among the members.
Once obtained, a charging order is valid for a period of twenty years. During this period, the Charging Order can effectively serve as a continuing garnishment on distributions from the entity.
How is a Charging Order Foreclosed in South Carolina?
According to the South Carolina Supreme Court:
(b) A charging order constitutes a lien on the judgment debtor’s distributional interest. The court may order a foreclosure of a lien on a distributional interest subject to the charging order at any time. A purchaser at the foreclosure sale has the rights of a transferee.
(c) At any time before foreclosure, a distributional interest in a limited liability company which is charged may be redeemed:
(1) by the judgment debtor;
(2) with property other than the company’s property, by one or more of the other members; or
(3) with the company’s property, but only if permitted by the operating agreement.
(d) This chapter does not affect a member’s right under exemption laws with respect to the member’s distributional interest in a limited liability company.
(e) This section provides the exclusive remedy by which a judgment creditor of a member or a transferee may satisfy a judgment out of the judgment debtor’s distributional interest in a limited liability company.
The South Carolina Supreme Court decision affirmed the supremacy of creditors’ foreclosure rights and sounds a cautionary note for LLCs. The state’s high court said that LLCs cannot use an operating agreement to force a creditor to sell a distributional interest it obtained via judicial foreclosure.
The ruling came in Levy v. Carolinian, LLC, a case involving an LLC that owns an oceanfront hotel. One of the members, who owned about a quarter of the LLC, found himself with a judgment for $2.5 million. Creditors obtained a charging order against their debtor’s distributional interest in the LLC. The creditors then foreclosed on its charging lien and purchased the member’s distributional interest at public auction.
One of the advantages of an LLC is that operating agreements can restrict the sale or transfer of a member’s interest, often with a provision that requires the approval of other members, or that sets buyout terms. In this case, the LLC’s operating agreement forbade the transfer of a member’s interest – even involuntarily – without the consent of members representing at least 67 percent of the voting shares.
How are Single-Member LLCs Foreclosed in South Carolina?
Foreclosing on a single-member LLC in South Carolina is likely to be different from foreclosing on an interest in a multiple-member LLC.
The Uniform Limited Liability Company Act states:
(f)-The charging order remedy-and, more particularly, the exclusiveness of the remedy-protect the “pick your partner” principle. That principle is inapposite when a limited liability company has only one member. The exclusivity of the charging order remedy was never intended to protect a judgment debtor, but rather only to protect the interests of the judgment debtor’s co-owners.”
Put another way, the charging order remedy was never intended as an “asset protection” device for judgment debtors. Accordingly, when a charging order against an LLC’s sole member is foreclosed, the member’s entire ownership interest is sold and the buyer replaces the judgment debtor as the LLC’s sole member.”
How Does Bankruptcy Affect a Charging Order in South Carolina?
Assume a judgment creditor purchases a debtor’s LLC interest at a foreclosure sale. The creditor under this scenario becomes a “transferee” or “assignee.” The creditor is not admitted as a “member” of the LLC and has no say in the management of the LLC. This typical result may be different in the event of a bankruptcy.
It is possible for a bankruptcy trustee to become a “member” of the LLC with “voting rights.” If a bankruptcy trustee has management rights, the trustee might be able to force a dissolution of the LLC. The resolution of this issue typically depends on whether an operating agreement is an “executory contract.” Though the case law is split on the matter, courts finding that an operating agreement was not an executory contract typically have allowed the bankruptcy trustee to succeed to all of the rights of the debtor as a “member” of the LLC. In the case of single-member LLCs, the bankruptcy trustee will become a “member” whether or not the operating agreement is an executory contract.
As you can see, there are a lot of moving parts to Charging Orders, and it is wise not to go it alone. Should you have any questions regarding Charging Orders or probate matters, contact the Watts Law Firm.