One of the best asset protection features of LLCs is “charging order protection”. This is a concept borrowed from partnership law that comes from olden times.
To give you an idea of how charging orders work, consider the following example:
1. You have lots of assets. One of your assets is a 50% ownership interest in an LLC which owns and operates a rental property.
2. You are sued in an incident unrelated to the rental property. You lose and a $1M judgment is entered against you.
3. The other party in the incident is now your creditor, and you are a debtor. The creditor starts seizing your assets to cover the $1M.
4. The other party tries to seize your 50% interest in the rental property LLC.
In most states, under the law of “charging orders”, the creditor cannot take your LLC interest. The only thing the creditor is entitled to is a “charging order” against your interest. A charging order is simply a lien which tells the LLC that if it decides to distribute any money to you,to give that money to the creditor instead. The creditor cannot force the LLC to actually distribute any money, nor participate in any way in management of the LLC, nor even usually get information on the LLC’s activities.
This charging order concept is very beneficial to you as a debtor in the example. The key is that the creditor cannot force the LLC to make any distributions. The creditor may sit with its charging order for years, never receiving anything unless the LLC chooses to make a distribution. This usually gives you leverage to negotiate a settlement with the creditor where you pay less than the amount owed, and in return the charging order is removed and the judgment considered satisfied.
Traditionally, the chink in the armor of LLC charging order protection has been single member LLCs. The law of charging orders was originally created to protect the other members of the LLC from having to deal with a stranger entering the company. Its original intent wasn’t to protect the debtor himself. Therefore, in a single member LLC, courts have been eager to ignore charging order protection and give a creditor sole and complete ownership of an LLC. See, e.g., In re Ashley Albright, 291 B.R. 538 (D. Colo. Bkrpt. 2003).
In New Jersey, when the issue is finally taken up by a New Jersey court, many believe the court will follow the example of other states and will refuse to apply charging order protection to a single member LLC. In states like Delaware and Nevada, however, charging order protection is explicit by statute. Does this mean that NJ businesses should form a Nevada or Delaware LLC?
Along Comes Fairstar
In American Institutional Partners LLC v. Fairstar Resources Ltd., 2011 WL 1230074; 2011 Google Scholar 3785030167496996465 (D.De. 2011), a federal court in Delaware was asked to get involved in a charging order entered against several LLCs which were formed under Delaware law. The whole matter began when Fairstar filed suit in a Utah court. Fairstar won the case, and in collecting on its judgment asked the court to sell the debtors’ interest in the LLCs in a foreclosure action, as is permitted under Utah law. The debtors objected, claiming that because the LLCs were formed in Delaware, Delaware (rather than Utah) law applied to all remedies against the LLC interests. Under Delaware law (like Nevada), foreclosure sales are not permitted and a charging order is the sole remedy against an LLC interest. The Utah court ruled that since the LLC interests were under Utah jurisdiction, the Utah court had the power to apply Utah law and order the foreclosure sale despite the LLCs being “Delaware LLCs”.
The debtors then filed an action in federal court in Delaware to attempt to invalidate the foreclosure sale ordered by the Utah court. They were unsuccessful. The court recounted that the debtors had raised their objection that Delaware law should apply in the Utah proceeding, and that the objection was denied by the Utah court. The Delaware court found that it was bound to respect the Utah judgment, and under the doctrine of res judicata, it could not re-hear an issue which had already been definitely ruled upon by a valid final judgment (in this case, the judgment from the Utah court stating that Utah, not Delaware, law applied).
And then Barber
Further reinforcing the rationale of Fairstar is Wells Fargo Bank v. Barber, 2015 WL 470589 (M.D.Fla., Feb. 4, 2015). In Barber, a bank tied to foreclose on an LLC membership interest owned by a Florida resident, Sabrina Barber. The LLC was formed in Nevis, a small Caribbean island whose LLC statute does not allow foreclosure, much like the Delaware and Nevada statutes. Florida, on the other hand, does allow foreclosure. The court held that in such a conflict of laws situation, the law of the residence of the debtor applies. This meant that Florida law applied, regardless of where the LLC was formed. The creditor was allowed to foreclose.
Fairstar and Barber give the main reason why I don’t recommend forming LLCs in Nevada, Wyoming, Delaware, or any other “special” state unless you happen to live in or do business in one of those states. A New Jersey court is likely going to apply New Jersey law to any collections action regardless of where the LLC is formed, so it usually makes sense to form your LLC in your home state. [One exception to this general rule would be LLCs which are operating active businesses with complex relations between the members; I generally recommend forming such entities in Delaware.]
Any decisions regarding LLC formation should be made with advice from an experienced attorney. If you have any questions about in which state you should form an LLC, feel free to contact me.