Charging Orders: How to Protect an LLC from a Creditor

The importance of asset protection in our society cannot be overstated.

While the civil court system is a necessary part of a civilized society, suing over relatively trivial matters has become a way of life in America. And our uniquely litigious state of California is ground zero for this.

The long arm of the law can reach out and wrap its fingers around just about any citizen, but certain professions face especial risk, including doctors, lawyers, and real estate agents. If you are in one of these professions, you are likely aware of the risks you face.

Now, if you lose a lawsuit, there are a number of ways by which the courts can enforce payment of the judgment. If the judgment ranges into the millions, they may never be able to get the full amount, but they will find ways to strip you of almost everything you own. California is also one of the most creditor-friendly and debtor-unfriendly states, with low exemptions for bankruptcy, so if you live here, your fight to keep anything at all will be hard.

You probably already know that creditors can garnish your wages and place liens on your property and levies on your bank account in order to recover their debts. But what if you own a business?

Well, this makes things a little more complicated, because now the law is not just dealing with you, but with a completely separate entity (a legal “person”). While the procedure varies greatly depending on the type of business you own, when it comes to LLCs the typical remedy is a charging order.

How LLCs Work

Before getting into charging orders, we should explain a bit about LLCs, and how they differ from corporations.

If you own an LLC, you may already know some of this, but if you don’t, that’s okay! We’ve found that a lot of people, even those who own corporations and LLCs, aren’t always clear on the difference. The practical knowledge that it takes to run a business is often more important than knowing all the theoretical legal stuff.
LLCs are Limited Liability Companies. They are similar to corporations, but differ in several ways, permitting their owners (known as “members”) certain tax benefits and a more flexible leadership structure.

Like corporations, LLCs offer limited liability to their owners. This means that the owners of the LLC or corporation are not personally responsible for the debts of the business. Even if the business goes bankrupt, your personal property will not be touched, unless you have guaranteed it as collateral or mingled corporate and personal funds.

The veil of limited liability works the other way, too: just as individuals are not responsible for business debts, the business is also not responsible for the debts of its individual owners, nor is one owner responsible for the debts of another.

So, this being the case, how does a creditor who has obtained a judgment against you (the individual) collect assets that you may have tied up in your business?

If you own a corporation, this will be relatively simple. Your ownership of the business will be easily quantified by the amount of stock you own in the business, and in order to collect debts, a creditor must simply take control of your shares of stock. This will give them direct ownership of the business (or at least of the portion that you owned).

But LLCs are different. There’s no stock, and ownership is somewhat less easily quantifiable, in keeping with the more flexible business structure of LLCs. It’s not as easy to appropriate a member’s share of the business.

In order to go after your business assets in an LLC, a creditor will need to obtain a charging order.

What Is a Charging Order?

 

A charging order is, quite literally, an order which places a lien on your membership interest in the LLC. It is a request to the manager of the LLC to pay the creditor all of the profits and income that would have otherwise gone to you.

This may sound scary, but there are a couple of major limits on charging orders:

  • A charging order does not allow a creditor to actually take over your membership in the LLC, nor does it permit them any say in the management of the business. This would, after all, be unfair to the other members of the LLC, who never agreed to work with a new business partner, particularly one who sued their old one.
  • A charging order does not, in and of itself, force the LLC to make any payments to the creditor. This, too, would be unfair to the other LLC members who are not responsible for the debts of an individual member.

Essentially, all you have to do is tell the manager of the LLC to not give you any payments, and the creditor who obtained the charging order will not be able to recover anything.

Does this mean the charging order is useless? Well, not quite.

 

Laying Siege to Your Assets

A charging order can hurt you in one obvious way: it can prevent you from taking any money out of the LLC, thereby depriving you of a potentially important source of income.

If a creditor obtains a charging order, and you refuse to withdraw any income from the LLC, then the two of you will find yourself at an impasse. And with no way to solve this, it will lead to a waiting game.

You can think of it as being similar to a medieval siege. An attacking army will wait outside a castle, while the army defending the castle waits on the inside. The attackers will not go away until the defenders open the gates of the castle, and the defenders will not open the gates until the attackers go away.

This state of affairs, in theory, can continue indefinitely. In practice, though, one army will eventually run out of resources and the siege will end. And since the defenders typically have less access to resources than the attackers, they are often the first to fold.

This is precisely the position in which you will find yourself if a debtor obtains a charging order against you. They will lay siege to your interest in the LLC, and you will refuse to withdraw any money until they go away. So the two of you will begin a standoff which can last indefinitely.

Most of the time, however, the creditor will have more ability to hold the siege than you will. Your LLC will, in many cases, be your primary source of income, while your creditor may have many others. This is particularly true if they are a large debt collection entity with effectively unlimited resources, which will have the ability to wait you out forever.

Therefore, while charging orders may not be immediately effective (absent a foreclosure), in the long run they can be extremely powerful. This makes them a valuable bargaining chip for your creditor.

 

Foreclosure

Not only does your creditor likely have greater resources, but they also potentially have the power to break the siege early.

In the state of California, a creditor has the ability to foreclose on a debtor’s membership interest in the LLC if they do not make any payments within a reasonable period of time. Foreclosure allows the creditor to permanently take control of the debtor’s right to receive funds from an LLC.

Foreclosure is legally difficult to accomplish, and not the most likely of outcomes, but there is legal precedent for it. In the 1991 case Hellman v. Anderson, an appellate court ruled that a judgment debtor’s interest in a partnership may be foreclosed and sold even without the consent of the other partners, “provided the foreclosure does not unduly interfere with the partnership business.”

While this case dealt with a partnership rather than an LLC, the principle is the same.

Although all states permit charging orders, not all of them permit the option of foreclosure, as California does. However, California is actually better than some states which allow creditors to go even further in their pursuit of debts, all the way up to the forced dissolution of an LLC.

How to Protect Against Charging Orders

what is a charging order

Avoid Single-Member LLCs

Charging order exist because creditors cannot recover debts directly from an LLC without being unfair to the other members of the LLC.

But what about an LLC with only one owner? In this situation, the entire justification for a charging order becomes irrelevant, and the creditor should be able to take all of the assets within the LLC without needing a charging order… at least in theory.

This is a somewhat murky legal issue and case law is not entirely settled. However, it’s fairly clear that a single-member LLC does not have the same level of protection as a multiple-member LLC.

Therefore, one of the best actions you can take if you want to strengthen your position against potential creditors is to add one or more members to your LLC.

It isn’t enough to simply add another name to your LLC, though. In order for your LLC to receive real protection from creditors, these other members must be actual members with real decision-making power and financial interest in the company, not members in name only. Courts aren’t stupid and they can usually see through this sort of ploy.

Now, we understand why you might not want to share ownership of your LLC. But if protecting against charging orders is a high priority, then this is something to seriously consider.

Move Your LLC Outside of California

Just because you are a resident of California does not mean that you have to set up an LLC in our state.

Indeed, you can set up an LLC in a number of other jurisdictions, many of which have stronger protection against charging order than California does.

The first option is to move your LLC out of state.

Which state should you choose? Well, there are a few strong states, including Wyoming, Alaska, and Delaware, but if you live in California, it will probably be most convenient of you to do business in our next-door neighbor of Nevada.

Now, Nevada’s name comes up fairly often when we discuss about asset protection. The state is something of a haven for people looking to protect their assets, with some of the most debtor-friendly laws in the country, and its laws concerning charging orders are no exception.

In particular, Nevada has two major advantages over California:

  • A creditor is not allowed to foreclose against a debtor’s interest in an LLC. If they obtain a judgment, a charging order is the most they will be able to get, with no means of directly enforcing it if the debtor does not pay in a timely manner.
  • Nevada law specifically gives single-member LLCs the same protection as multi-member LLCs. This means that if you move your LLC to Nevada, you do not have to choose between risking your assets and adding another member.

The other option is to move your LLC out of the United States entirely.

There are several jurisdictions worldwide which have structured their laws so as to provide excellent protection against charging orders. In our opinion, the strongest of these jurisdictions is Nevis, a tiny island in the Caribbean with 12,000 residents.

Nevis LLCs have all of the benefits of a Nevada LLC, and several more to boot. For one thing, a charging order in Nevis expires after three years and cannot be renewed, making it easier to wait out the creditor. There are also a number of procedural hurdles in Nevis which make it very difficult to file a lawsuit in the first place.

Some people are reluctant to move their money offshore, but Nevis is a safe jurisdiction with strong legal institutions, and offshoring is perfectly legal so long as you pay all necessary taxes. We’ve written in greater detail about the various benefits in this Nevis LLC article.

Clients looking to offshore often ask a couple of questions:

Which jurisdiction should I choose? A Nevis LLC is safer than a Nevada LLC but it is more complicated to set up, and the costs of doing business in a foreign country are higher. It depends on the size of your LLC and the risk you face: if you have a very large LLC and face an extremely high risk of a lawsuit, then you should probably go to Nevis. If your LLC is smaller and your risk less severe, then you can often comfortably settle for Nevada.

Does moving my LLC offer absolute protection? No – and that’s why it’s important to do it carefully. Creating an LLC in Nevada, or Nevis for that matter, will not always protect one completely against California laws. When creating an out-of-state or offshore LLC, therefore, it is particularly important to enlist the help of an experienced asset protection attorney who knows what they are doing and can help you maximize the safety of your LLC while complying with all relevant laws.

Leave a Reply

Your email address will not be published. Required fields are marked *

X