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Charging Order Procedural Issues Confronted in Textron Financial

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Textron Financial Corporation sued New Mexico resident Michael S. Gallegos in the U.S. District Court for Rhode Island for a loan made on a hotel deal gone bad. Textron was awarded a nearly $22 million verdict, but apparently was only able to collect a little more than $10,000.

Textron then assigned the judgments to SPE LO Holdings, and that company did some snooping around for Gallegos' assets, eventually obtaining documents from the California Secretary of State's office which indicated that Gallegos was at least the manager (it was unclear whether he was also a member) of two California entities: Pacific Pearls Hotel LLC and Pacific Pearl Management LLC.

SPE then filed a Motion for Charging Order in the U.S. District Court for the Central District of California against any interest that Gallegos had in the two LLCs. For those who don't know what a Charging Order is, the Court gave a nice, short summary as follows:

When there's a money judgment against an LLC member personally, but not against the LLC, the member's interest may be reached by a charging order. [] A charging order is a lien on the member's distributional interest. [] It only allows the judgment creditor to receive distributions to which the member would otherwise be entitled; it doesn't entitle the creditor to participate in the LLC's management or exercise the rights of a member. [] It thereby protects other members of an LLC from being forced to involuntarily share governance responsibilities with someone they did not choose, or from being forced to accept a creditor of another member as a co-manager. [Internal citations and quotations omitted]

Here, SPE did not hire a process server to deliver a copy of the Motion to the two LLCs, but instead simply dropped a copy of the Motion in the mail.

For his part, Gallegos (but not the companies) opposed the Motion for Charging Order, and asserting basically three arguments:

(1) The California Secretary of State documents were not admissible;

(2) Personal service by a process server of the Motion for Charging Order was not made on the LLCs and therefore they were not a party to the Motion; and

(3) There is no proof that Gallegos was a member of the LLCs such that he had an interest that could be charged.

Or, as the Court put it:

He doesn't contend that the Secretary of State records are inaccurate. Nor does he deny that he's a member of the LLCs. He just argues that SPE LO hasn't proved it.

Gallegos lost on his first argument, that the California Secretary of State documents were not admissible, largely because no witness from the Secretary of State's office authenticated them (i.e., they were "hearsay"). The Court rejected this argument, since as public records the Court could take judicial notice of the documents, and did.

Gallegos also lost on his second argument as well, which is that the notice of the Motion given to the two LLCs by mail was insufficient. The Court noted that personal service by a process server is not required, but notice by mail of the Motion was adequate to satisfy the requirements of California law. It was also wholly unnecessary to make the LLCs a party to the Motion for Charging Order.

This brings us to Gallegos last argument, which is that there was no proof that he was a member of the two LLCs.

On this point, the Court noted that prior California state court opinions require that a creditor present "substantial evidence" that the debtor has an interest in the LLC (or partnership) to be charged. But since the California Secretary of State documents only showed that Gallegos was a "manager" without also clearly showing that he was a "member", SPE failed on its burden of proof, and therefore its Motion would be denied.

However, "[t]o avoid the possibility that Gallegos has avoided entry of a charging order by playing coy", the Court would allow SPE to conduct discovery on the issue and re-submit the Motion if it found that Gallegos also had a membership interest in the two LLCs in addition to being a manager.

ANALYSIS

As to the last point, I think the Court made a reasonable decision based on the case law. However, I also think that this decision -- and the opinions which support it -- are wrong. Let me explain why.

In the post-judgment enforcement world, liens are commonly available to freeze a debtor's assets so that the debtor cannot dispose of those assets prior to collection (or, if the debtor does dispose of the asset, the transferee takes subject to the lien). Thus, post-judgment liens are almost always "blanket liens" -- liens which cover all the debtor's assets whether identified or not -- since the creditor usually doesn't know, at least initially, what assets the debtor has.

Thus, an Abstract of Title creates a lien on all the debtor's real property in the county, whether the debtor owns any property the county or not -- it is not necessary for the creditor to list the properties subject to the abstract.

Similarly, in California the filing of a Form JL-1 (short for "judgment lien") with the California Secretary of State's office has the effect of creating a lien on all the debtor's personal assets in California, whether the debtor has any personal assets in California or not (and other states have similar forms which have the same effect).

The service on the debtor of an Order to Appear for Examination (called an "OEX") likewise creates a lien on all the debtor's personal assets wherever located, and this lien is at least binding on the debtor whether the debtor has any personal assets or not.

JDA

There is no good reason why the lien created by a Charging Order should not work the same way, i.e., it should operate to put a lien on the debtor's interest in a partnership or LLC, whether that particular has been identified as being owned by the debtor or not.

Another way to look at this is that if the Charging Order is issued against an interest though (but not proven) to be owned by the debtor, but the debtor doesn't actually have such an interest, then the lien would not attach and it is a "no harm, no foul" result. A partnership or LLC that receives a Charging Order could safely ignore it if the debtor did not hold an interest in the entity -- just like any other post-judgment lien where a party holds no property of the debtor.

Indeed, there would seem to be nothing wrong with a Court entering a generic Charging Order which said something like "All interests of the debtor in any partnership or LLC are hereby charged with payment of the judgment," and if that Charging Order picks up such an interest then great, but if not then against it is a "no harm, no foul" result.

Of course, the partnership or LLC has its own significant concerns, which is making distributions to the right party (i.e., the debtor/member or the creditor) without fear of being held in contempt. Thus, the way the law works now, a lien created by a Charging Order is not said to be perfected until service of the Charging Order is made upon the entity.

What you don't want to happen is for some creditor to simply bomb-out a gazillion copies of a Charging Order to every LLC and partnership out there, hoping that a net the size of an ocean will catch at least a minnow. We don't have to have every LLC and partnership in a given jurisdiction be burden with checking their books to see if debtors have an interest in their companies, when there is utterly no reason to believe that they might, other than the insufficient believe of every creditor that a debtor must have assets somewhere.

Thus, as a practical matter, there has to be some standard of proof for a creditor seeking a Charging Order that a particular LLC or partnership does, in fact, have some connection to the debtor.

But I disagree that "substantial evidence" is the correct standard; probably "reasonable suspicion" is a much better standard for this purpose. Using a "reasonable suspicion" standard would allow a creditor to target specific LLCs and partnerships in which the debtor might have an interest, without allow the debtor to dodge the Charging Order because the ownership was not proven from the start.

Applied to this case, that Gallegos was the manager of the two LLCs would lend itself to the reasonable suspicion that he was also a member, and thus would have allowed the Charging Order to be entered against any interests that he had in those two LLCs (and if he did not have an interest, then, again, it is a "no harm, no foul" situation).

Keep in mind that only the debtor knows what interests he holds, debtors frequently lie about their holdings, and it is extremely difficult because of privacy and other laws to determine the identity of members of an LLC or partnership. Allowing Charging Orders based on reasonable suspicion as opposed to substantial evidence would ultimately save both the creditor and target LLCs and partnership from the costs of formally propounding or responding to discovery regarding a debtor's possible interests in the latter.

This leads me to my next point, which relates to the correct party to a Motion for Charging Order and what defenses can be appropriately asserted by whom.

I've never been convinced that a debtor should have much more to say about a Motion for Charging Order, other than:

(1) To contest the validity of the judgment, which will a total non-issue in 99.9% of such motions; and

(2) To claim an applicable exemption under state law (for instance, to claim a "wildcard exemption" for $10,000 or some amount which exists under some state's laws, or to claim that the distributions are really compensation subject to the 25% federal limitation on wage garnishment).

These are legitimate challenges that debtors should assert if they are entitled to them. But debtors will inevitably come in and complain about everything under the sun to try to bamboozle the Court, even though most of their arguments are really those of the affected LLC or partnership. This wastes the time of the creditor and the courts, and while the courts are usually good at seeing through this nonsense, it would be better if they started putting their foot down to end such challenges.

Yes, it is the debtor who loses a revenue stream, but the debtor should have thought about that before he engaged in the conduct that gave rise to the judgment in the first place -- the civil version of if you don't want to do the time, don't do the crime. It is the LLC or partnership, however, which faces the practical challenges of complying with the Charging Order.

Note that the LLC or partnership does not have an iron in the fight; it has utterly no good reason to care who receives the distributions made to the debtor's interests. The only concern of the LLC or partnership is that it receive timely notice of the Charging Order so that the entity can direct distributions to the right place.

As a considerable number of courts have now held, it is not necessary that the LLC or partnership be made a party to the case in which a Charging Order is issued. Instead, it is only necessary for the LLC or partnership to be put on notice of the Motion, as in some states (such as California where this case arose), the mere filing of the Motion and service on the LLC or partnership (or its members) creates a temporary lien on the debtor's economic interest, i.e., right to distributions. The subsequent granting of the Motion, and notice to the LLC or partnership that the Charging Order has been entered, makes that lien permanent until the judgment is satisfied.

Because the LLC or partnership only needs have notice of the Charging Order and its terms, delivery upon the LLC or partnership by mail is as good as any, and there is no technical requirement that a process server need be involved. However, I have always gone to the extra expense of having a process server deliver the Charging Order so that it is accomplished the same day, and to make it easier to get a contempt charge should the LLC or partnership fail to comply (as they sometimes do when controlled by the debtor).

It is worth noting here that a Charging Order is also binding upon the debtor as well as the LLC or partnership. Thus, if an LLC or partnership that is subject to a Charging Order makes a distribution to the debtor, then the debtor can be held in contempt of the Charging Order for failing to turn the proceeds over to the creditor. This can be important in situations where the debtor has a membership interest in a foreign LLC or partnership that is not subject to the contempt powers of a U.S. court, since the creditor can still effectively block distributions to the debtor by making the debtor turn over any such distributions to the creditor, or go sit in jail until he has done so.

Note that most Charging Orders usually have elaborate provisions to prevent a debtor from getting money out through the backdoor, by way of loans or management fees. Creditors may also chase distributions on what amounts to an "imputed income" theory, which keeps a debtor from having the LLC or partnership make an oversized distribution to his non-debtor spouse -- this would also be a fraudulent transfer.

Finally, it is my own opinion that the procedure for the issuance of Charging Orders is deeply flawed. Most post-judgment orders do not require Court intervention, but instead the court clerk issues the Order and then the defendant or other affected person (such as an employer receiving a garnishment summons) has a short period of time to lodge objection upon receiving the Order.

There really is no compelling reason why this should not be the procedure for Charging Orders too. In the vast majority of cases, having a Motion for Charging Order unnecessarily increases the cost for the creditor, wastes the creditor's time, and squanders the limited resources of the Court. Most of the time, the LLC or partnership doesn't care, so the hearing on the Motion is limited to the debtor showing up and whining about how unfair it all is that he has to pay on his judgment.

Nobody needs that grief. Somebody please simplify the Charging Order procedure.

CITE AS

Textron Financial Corp. v. Gallegos, C.D.Cal. Case No. 15cv1678 (Oct. 7, 2015). Full Opinion at https://chargingorder.com/opinion-2015-california-textron-financial-charging-order.html

This article at http://onforb.es/1RiZgPa and http://goo.gl/tBQHPL

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