Much is made in asset protection circles about charging orders and the circumstances in which they may occur. What is a charging order? It is a judge’s order enabling a creditor to intercept and receive any distributions, payments, or proceeds from a specific entity to the judgment debtor. The judgment creditor becomes, in effect, a court-ordered lienholder and assignee of any such funds. It is important to distinguish the applicability and effect of a charging order from the outright attachment or seizure of a judgment debtor’s interest in the entity. It is similarly important to identify which entities may be subject to a charging order. In Texas, these are limited liability companies and partnerships (general and limited).
Unlike an LLC membership interest or partnership interest which is only subject to a charging order, corporate stock may be seized and sold at public auction. Stock in a corporation is non-exempt personal property (Tex. Bus. Orgs. Code §21.801) that can be subject to levy, Tex. R. Civ. P. 641, Tex. Bus. & Com. Code §8.112; garnishment, Tex. R. Civ. P. 669; or turnover, Tex. Civ. Prac. & Rem. Code §31.002.
Law Applicable to Limited Liability Companies
The law relating to charging orders on LLC membership interests is found at Business Organizations Code Section 101.112:
(a) On application by a judgment creditor a member of a limited liability company or of any other owner of a membership interest in a limited liability company, a court having jurisdiction may charge the membership interest of the judgment debtor to satisfy the judgment.
(b) If a court charges a membership interest with payment of a judgment as provided by Subsection (a), the judgment creditor has only the right to receive any distribution to which the judgment debtor would otherwise be entitled in respect of the membership interest.
(c) A charging order constitutes a lien on the judgment debtor’s membership interest. The charging order may not be foreclosed on under this code or any other law.
(d) The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or of any other owner of a membership interest may satisfy a judgment out of the judgment debtor’s membership interest.
(e) This section may not be construed to deprive a member of a limited liability company or any other owner of a membership interest in a limited liability company of the benefit of any exemption laws applicable to the membership interest of the member or owner.
(f) A creditor of a member or of any other owner of a membership interest does not have the right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.
The charging order is an exclusive remedy of its type. The judgment creditor gets paid if and when distributions from the LLC occur. The charging order is therefore not tantamount to taking over the membership interest of a debtor or seizing control of the company. Moreover, the creditor may not attach the debtor’s membership interest; force its sale or transfer; or (absent a judgment piercing the veil) reach any assets of the LLC itself. In re Prodigy Servs., No. 14-14-00248-CV (Tex.App.—Houston [14th Dist.] 2014, orig. proceeding).
What if the LLC pays a member a salary for services? Is this a “distribution” subject to a charging order? Probably not. Such a salary would not be subject to garnishment since it is exempt under Property Code Section 42.001(b)(1) which provides that “current wages for personal services, except for the enforcement of court-ordered child support payments” is exempt “from garnishment, attachment, execution, and other seizure.” This includes severance pay.
The exclusive nature of a charging order does not limit a creditor’s remedies once a distribution has been carried out. Distributed funds or assets become non-exempt personal property once they are received by the debtor and may therefore be reached by attachment, garnishment, or turnover. Stanley v. Reef Secs., Inc., 314 S.W.3d 659 (Tex. App.—Dallas 2010, no pet.).
The rationale behind the exclusivity of the charging order remedy is to avoid undue disruption to the operation of the entity’s business; after all, the creditor involved has a judgment against a member, not the entity itself, so the entity should not (at least in theory) be adversely affected. This principle has been eroded somewhat by Heckert v. Heckert, No. 02-16-00213-CV, 2017 WL 5184840 (Tex. App.—Fort Worth Nov. 9, 2017, no pet. h.). The Heckert case involved persons who were formerly married and the entity involved merely owned stock and did not operate a business, so the ruling allowing turnover should be viewed within these narrow circumstances.
Are charging-order rules different for single-member LLCs?
No. A charging order remains the exclusive remedy for a judgment creditor (in the absence of actual fraud, which is always the standard caveat in Texas contract, business, and real estate law). The reason clients ask their attorney if a multi-member LLC is better for asset protection than a single-member LLC is because some states allow the holder of a judgment against an individual that owns 100% of an LLC to actually seize the judgment debtor’s LLC interest, which is not the case in Texas.
Law Applicable to Partnerships
The law relating to charging orders on partnership interests mirrors the law applicable to LLCs and is found in Business Organizations Code Section 152.308:
(a) On application by a judgment creditor of a partner or of any other owner of a partnership interest, a court having jurisdiction may charge the partnership interest of the judgment debtor to satisfy the judgment.
(b) To the extent that the partnership interest is charged in the manner provided by Subsection (a), the judgment creditor has only the right to receive any distribution to which the judgment debtor would otherwise be entitled in respect of the partnership interest.
(c) A charging order constitutes a lien on the judgment debtor’s partnership interest. The charging order lien may not be foreclosed on under this code or any other law.
(d) The entry of a charging order is the exclusive remedy by which a judgment creditor of a partner or of any other owner of a partnership interest may satisfy a judgment out of the judgment debtor’s partnership interest.
(e) This section does not deprive a partner or other owner of a partnership interest of a right under exemption laws with respect to the judgment debtor’s partnership interest.
(f) A creditor of a partner or of any other owner of a partnership interest does not have the right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the partnership.
It is important to note that a “judgment against a partnership is not by itself a judgment against a partner, so a creditor must obtain a judgment against the partner individually. A creditor may attempt to do so in the suit against the partnership or in a separate suit. It may not, however, seek satisfaction of the judgment against a partner until a judgment is rendered against the partnership.” American Star Energy & Minerals Corp. v. Stowers, 457 S.W.3d 427, 429-30 (Tex. 2015).
Asset Protection before Suit is Filed
Sound asset protection practice requires that planning and strategy take place well in advance. Once a lawsuit is threatened or filed, it is more challenging to find legitimate ways of reorganizing or redistributing one’s assets so as to reduce vulnerability to post-judgment collection efforts. One method of pre-suit planning is to form an LLC with two classes of membership: Class A and Class B. The company agreement should define Class B as any membership interest that has been substantially influenced or made subject to a collection device or court order, including a charging order. The conversion of Class A to Class B occurs automatically if that occurs. The effect? Class B members have no power to vote or serve as managers. Under such circumstances, it is difficult to see how a Class B member could force the liquidation of assets in order to benefit its own interests. Accordingly, Class B membership is of limited value unless the LLC is dissolved. In any case, such measures are generally useful only when taken as part of the set-up of one’s asset protection structure, well in advance of threatened or actual litigation.
Asset Protection after Suit is Filed: Fraudulent Transfers
Property Code Section 42.004 seeks to restrain fraudulent transfers, including the pay-down of exempt assets, if undertaken “with the intent to defraud, delay, or hinder” a creditor. This reaches back two years for liquidated claims, one year for unliquidated or contingent claims. However, proving intent may be a difficult task if the judgment debtor goes about his or her business in an orderly, incremental fashion that can plausibly be described as normal, or at least justifiable on grounds independent of litigation concerns. Tex. Prop. Code §42.004(c).
As noted above, charging orders are generally an exclusive remedy, but there are exceptions. In a case where the defendant formed two entities—an LLC and a limited partnership—after a divorce suit had been filed against him and for the obvious sole purpose of holding non-exempt assets and avoiding judgment execution, the Fort Worth court of appeals ruled that a turnover order was appropriate. The wife was thus awarded the husband’s interest in both entities, defeating his attempt to employ charging order rules as a defensive measure. Heckert v. Heckert, No. 02-16-00213-CV, 2017 WL 5184840 (Tex.App.—Fort Worth 2017, no pet.).
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.
Copyright © 2020 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.