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The Future of Creditors and Charging Orders

Posted on June 12th, 2010 by David L. Antognoli

It didn’t take long to surmise that the distinguished panel of Appellate Court justices had no previous exposure to a charging order, an important weapon in a creditor’s collection arsenal. Indeed, at the outset of the oral argument, one judge asked counsel directly and candidly, “What is a charging order anyway?” The question – posed by a seasoned jurist with a long background in commercial law—highlights the arcane nature of charging orders. But charging orders are not likely to remain obscure; the growth of the limited liability company (“LLC”) as a business entity of choice, coupled with current distressed economic conditions, will force creditors to resort to the remedy of a charging order with increasing frequency.

A charging order is a collection remedy with two unique features: (1) it applies only to a limited category of assets (i.e., LLC and partnership interests); and (2) it is the exclusive means to enforce a judgment against a debtor’s interest in an LLC or partnership. The remedy is designed to minimize disruption of an LLC’s business operations when a creditor of an individual member seeks to enforce a judgment against his LLC interest. A charging order gives the creditor the right to receive any distribution from the LLC that the debtor-member would otherwise be entitled to receive. However, the credit does not obtain the debtor-member’s voting rights or any other right to participate in management of the company.

A variety of practical issues detract from the efficacy of a charging order. Unless the LLC authorizes a distribution, the creditor receives nothing. And the creditor has no voice in the LLC’s decision whether to authorize a distribution. Although the court may order a foreclosure sale of interest subject to the charging order, bidders will be few and far between. Even after the creditor acquires the interest at foreclosure, he remains unable to participate in the LLC’s management and, therefore, may be at the mercy of management. Nonetheless, the charging order is the only method available to collect a judgment from a debtor-member’s LLC interest.

The LLC is rapidly becoming the business entity of choice among real estate developers and investors. Illinois first recognized this form of business entity in the mid-1980s. It gradually increased in popularity during the 1990s. Now our real estate clients now overwhelmingly favor the LLC over any other form of business entity. LLCs not only offer asset protection but also tremendous flexibility and avoid “double” income taxation associated with conventional business corporations.

A number of high-flying investors and developers who rode the real estate boom have crashed. Their creditors are struggling to find assets to satisfy tremendous liabilities. Since many of these debtors own membership interests in LLCs, their creditors must resort to the charging order remedy. As the demand for this remedy increases, it will emerge from obscurity. As resort to the charging order expands, a variety of unanswered legal issues will also emerge.

Some of these unanswered issues surfaced in the case described above, which involved multiple creditors competing for the same LLC interests. Creditor A used conventional collection methods and obtained a citation lien against the debtor’s LLC interest but never obtained a charging order. Creditor B obtained a charging order, but only after Creditor C had obtained a pre-judgment attachment. When Creditor C reduced its claim to judgment, it obtained a charging order, but its charging order came later than Creditor B’s. The trial court struggled with the tangled issue of priority for months, doubtless as a result of the striking lack of precedent in Illinois case law. Ultimately, the trial court ruled in favor of Creditor B. The Appellate Court has the case under advisement.

To discuss this or any legal issue related to Commercial Law or Real Estate Law, please contact the author, David Antognoli.