The charging order: a debtor-friendly LLC law

LLC gurus have often pushed novice investors to organize their LLCs in Nevada or Wyoming or some other faraway state. The charging order is usually the reason why the LLC laws of these states are considered “investor friendly.” Luckily, most states have now adopted these laws and most LLC states enjoy these types of benefits, including Ohio.

Let’s consider a brief scenario. You own an LLC that holds several rental properties worth over a million dollars. It’s your only substantial asset besides some money in the bank and other personal property. One day, when you’re backing out of your driveway, you accidentally run over and seriously injure a neurosurgeon who is walking to work. He’s out of work for two months, and after he recovers, he sues you personally. The court finds you personally liable to the doctor for $1 million in lost wages, pain and suffering, etc.

The neurosurgeon’s lawyer realizes that your cash in the bank is not going to cover the judgment, so he tries to collect on the assets in your LLC. In many states, the doctor can ask the court to foreclose on your ownership shares of the LLC, thus permanently depriving you of ownership of that LLC and all its property. He can also ask for the court to force a sale of the LLC’s assets and a distribution of all the cash proceeds to the doctor.

"Charging order" state statutes only allow our doctor-creditor to do one thing to get his money back–he may only ask the court for a “charging order.” Literally, a creditor asks for a court order to charge the debtor’s membership interest, which means that the creditor gets whatever distributions the debtor would ordinarily be entitled to by the operating agreement. That is the only remedy available to that creditor. The creditor then becomes an "assignee" of the membership interest, with no rights to vote or control the LLC.

The beauty of this protection is that one can write an LLC operating agreement in such a way that the LLC is never obligated to distribute any money, and thus that creditor will never get any money. What results is a sort of a standoff between creditor and debtor. While it may be true that the creditor can be more patient than the debtor, this also buys time for the debtor to make alternative arrangements to pay the debt without having a creditor force a firesale of all the LLC’s assets at deep discounts.