• Adoption of the Uniform Limited Liability Company Act: Transferable Interests and Charging Orders
  • April 26, 2017 | Author: Frederick C. Leech
  • Law Firm: Leech Tishman - Pittsburgh Office
  • This Practice Alert is the second in a series of Practice Alerts. In the first Alert, the New Act was labeled as Pennsylvania’s “second generation” limited liability statute. The first Alert described the principal differences in statutory approach between the New Act and the Pennsylvania’s prior limited liability company law (the “Old Act”)[2]. The first Alert also addressed specifically the impact of the New Act on the duties of members - the fiduciary duty of loyalty, the duty of care and the duty of members to deal with each other in good faith and fair dealing.

    The First Alert underscored the New Act’s retention of the principle of “freedom of contract,” permitting members wide latitude to alter default rules through the company’s operating agreement. The principle of “freedom of contract” particularly holds true in regard to inter se rules - rules confined to the members and not involving creditors or other third parties. The right of members, however, to alter default rules - even inter se rules - is not without limits. The First Alert addressed these limits in the discussion of the duties of members to each other. [3]

    The practical point underscored in these Alerts is that members must pay attention to the New Act, in collaboration with their legal counsel, and in the current time frame. Specifically, it is important for members to
    • Become grounded in the default rules under the New Act, and to gain an appreciation of the impact that the default rules would have - if left unaltered - on the company and the relations among members; and
    • Review their existing operating agreement and put in place amendments to reform or eliminate (if possible) inapposite default rules so that the operating agreement remains aligned with the business and legal expectations of the members.
    Transferable Interests

    The extensive use of default rules under the New Act is a good step forward. This statutory approach provides members with a useful discussion framework, enabling them to reform their operating agreement to better serve their enterprise needs. The New Act also represents a good step forward because it provides clarity in key areas of limited liability company operations. Two such areas include - “transferable interests,” and legal actions between members. This Alert addresses the subject of transferable interests and the next Alert will address legal actions.

    The Old Act contemplated the distinction between economic rights and governance rights in relation to a company. The New Act addresses this distinction squarely with the statutory concept of the “transferable interest.”[4]

    A “transferable interest” is defined in the New Act as -

    The right, as initially owned by a person in the person’s capacity as a member, to receive distributions from a limited liability company, whether or not the person remains a member or continues to own any part of the right. The term applies to any fraction of the interest, by whomever owned.[5]

    In essence, the transferable interest of a company is the right to receive distributions. The New Act provides that this right is severable from other rights of membership. This attribute and other important attributes of the transferable interest are made clear in Section 8852 of the New Act (Transfer of Transferable Interest).[6]

    Under the New Act, the arrangements set forth below follow from the default rule characteristics of the transferable interest. Importantly, virtually all of these default rule results can be modified by the operating agreement.
    • Although a member can transfer his or her transferable interest, the member cannot transfer his or her governance rights to a non-member.[7]
    • A member who transfers his or her transferable interest retains the other rights and duties of company membership; and, in addition, as a corollary feature, the transfer of a transferable interest does not by itself cause the dissociation of the transferor as a member.[8]
    • Transferees of transferable interests have no right to participate in management or otherwise “intrude” (in the words of the Committee Comments) as the members carry on the affairs of the company and their activities as members.
    • The definition of “transfer” includes “a transfer by operation of law.” Therefore, the New Act affects the power of other law to effect transfers of a member’s ownership interest. For example, a divorce court lacks the power to award a member’s spouse anything beyond the member’s transferable interest.[9]
    • The transferor and the transferee can establish an economic arrangement between themselves, whereby a portion of company distributions go to the transferee and the remainder of the distributions stay with the transferor.
    Charging Order

    The New Act expressly addresses the concept of a charging order and the interrelationship between a transferable interest and a charging order.[10] The important elements under the New Act concerning a charging order are as follows:
    • The charging order rules use the term “judgment debtor,” and that encompasses both members and transferees.
    • During the time that a charging order is in effect, the order entitles the judgment creditor to whatever distributions would otherwise be due to the member or transferee whose interest is subject to the order. The judgment creditor, however, has no say in the timing or amount of those distributions. More specifically, the charging order does not entitle the judgment creditor to accelerate any distributions or to otherwise interfere with the management and activities of the company.
    • The lien of a charging order pertains only to a “distribution,” which is defined in the New Act to exclude “amounts constituting reasonable compensation for present or past service or payments made in the ordinary course of business under a bona fide retirement plan or other bona fide benefits program.”
    • The New Act provides a statutory means for the company or its members to eliminate the charging order (and thus the potential “mischief” which the judgment creditor may impose on the company). The drawback of this statutory mechanism is that the underlying judgment must be satisfied in full (vs. a negotiated settlement at less than par). The benefit of the feature, however, is that the charging order can be eliminated without the judgment creditor’s consent.
    • A court may order the foreclosure of the lien of the charging order and order the sale of the transferable interest. A purchaser at a foreclosure sale obtains only the very limited rights of a transferee. Moreover, in certain ways, the purchaser at a foreclosure sale has less power than the holder of a charging order. This is because, after a foreclosure sale, the court is no longer involved in the matter.
    • The New Act provides that a court can appoint a receiver. The receiver contemplated by the charging order rules, however, is not a receiver for the company, but rather a receiver for the distributions subject to the charging order. The principal advantage provided by this receiver provision is an expanded right to information. The right to information is limited, however, to “the extent necessary to effectuate the collections of distributions pursuant to a charging order.”
    • While the charging order is a remedy in favor of a judgment creditor, the provisions concerning charging orders in the New Act operate as well as a remedy limitation. The charging order is the sole method by which a judgment creditor of a member or transferee can extract any value from the member’s or transferee’s ownership interest in the company.
    • The charging order provisions are for the benefit of creditors. Therefore, under the general rule of the New Act - that default rules of the members inter se can be amended by the operating agreement but that default rules impacting third parties cannot be amended by the operating agreement - members do not have the power under the New Act to alter their operating agreement in a manner that would prejudice judgment creditors.
    Conclusion

    Extensive default rules in the New Act - including provisions concerning transferable interests - should assist members to consider appropriate reforms to their operating agreements. The New Act, however, demands attention. If members do not make appropriate amendments to their operating agreements in a timely manner, they could find themselves bound by default rules under the New Act which are at odds with their best interests.

    [1] The Pennsylvania limited liability company law has been revamped as new Chapter 88 of Title 15 of the Pennsylvania Consolidated Statutes. The enabling Pennsylvania legislation was Act 2016-170 (H.B. 1398), which was approved on November 21, 2016, and became effective on February 21, 2017. The New Act governs all Pennsylvania limited liability companies from and after April 1, 2017.

    [2] The Old Act was former Chapter 89 of Title 15 of the Pennsylvania Consolidated Statutes; P.L. 703, No. 106, as amended. The New Act contains a considerably larger number of “default” or “gap filling” rules as compared with the Old Act. The New Act is also largely self-contained and makes less use of incorporation of default rules from other Pennsylvania statutory schemes (e.g., corporation law, general partnership law and limited partnership law). Notably, however, the New Act refers and defers to other bodies of law in a numbers of instances, including agency law, bankruptcy law and the Uniform Commercial Code.

    [3] The Pennsylvania Committee Comments to Section 8815 provide useful guidance on this point:

    One of the most complex questions in the law of unincorporated business organizations is the extent to which an agreement among the organization’s owners can affect the fiduciary and other duties of those who manage the organization (e.g., members in a member-managed LLC; managers in a manager- managed LLC). As explained in detail in the comment to [Section 8815(d)(3)], Chapter 88 rejects the notion that a contract can completely transform an inherently fiduciary relationship into a merely arm’s length association. Within that limitation, however, this section provides substantial power to the operating agreement to reshape, limit, and eliminate fiduciary and other managerial duties.

    [4] The Committee Comments to Section 8852 sets this out this distinction clearly -

    This section is the core of this chapter’s provisions reflecting and protecting that principle [“One of the most fundamental characteristics of limited liability company law is its fidelity to the “pick your partner” principle”.]. A member’s rights in a limited liability company are bifurcated into economic rights (the transferable interest) and governance rights (including management rights, consent rights, rights to information, and rights to seek judicial intervention). Unless the operating agreement otherwise provides, a member acting without the consent of all other members lacks both the power and the right to: (i) bestow membership on a non-member; or (ii) transfer to a non-member anything other than some or all of the member’s transferable interest. The rights of a mere transferee are quite limited - i.e., to receive distributions as provided in subsection (b), and, if the company dissolves and winds up, to receive specified information pertaining to the company from the date of dissolution as provided in subsection (c).

    [5] The New Act, Section 8812(a).

    [6](a) General rule. - Subject to Section 8853(f) (relating to charging order), a transfer, in whole or in part, of a transferable interest:

    (1) is permissible;

    (2) does not by itself cause the dissociation of the transferor as a member or a dissolution and winding up of the limited liability company’s activities and affairs; and

    (3) subject to Section 8854 (relating to power of personal representative of deceased 21340 member), does not entitle the transferee to:

    (i) participate in the management or conduct of the company’s activities and affairs; or

    (ii) except as provided in subsection (c), have access to records or other information concerning the company’s activities and affairs.

    (b) Right to distributions. - A transferee has the right to receive, in accordance with the transfer, distributions to which the transferor would otherwise be entitled.

    (c) Right to account on dissolution. - In a dissolution and winding up of a limited liability company, a transferee is entitled to an account of the company’s transactions only from the date of dissolution.

    (d) Certificate of interest. - A transferable interest may be evidenced by a certificate of the interest issued by the limited liability company in record form and, subject to this section, the interest represented by the certificate may be transferred by a transfer of the certificate.

    (e) Recognition of transferee’s rights. - A limited liability company need not give effect to a transferee’s rights under this section until the company knows or has notice of the transfer.

    (f) Transfer restrictions. - A transfer of a transferable interest in violation of a restriction on transfer contained in the operating agreement is ineffective if the intended transferee has knowledge or notice of the restriction at the time of transfer.

    (g) Rights retained by transferor. - Except as provided in Section 8861(5)(ii) (relating to events causing dissociation), if a member transfers a transferable interest, the transferor retains the rights of a member other than the transferable interest transferred and retains all the duties and obligations of a member.

    [7] Note that the Committee Comments address the default rule results of a member’s transfer of his or her governance rights to another member -

    As to whether a member may transfer governance rights to a fellow member, the question is moot absent a provision in the operating agreement changing the default rule, 15 Pa.C.S. § 8847(b)(2), allocating governance rights. In the default mode, a member’s transfer of governance rights to another member: (i) does not increase the transferee’s governance rights; (ii) eliminates the transferor’s governance rights; and (iii) thereby changes the denominator but not the numerator in calculating governance rights.

    EXAMPLE: LCN Company, LLC is a member-managed limited liability company with three members, Laura, Charles, and Nora. [Assume for purposes of this Example that] [T]he operating agreement does not displace this chapter’s default rule on the allocation of governance rights among members. Thus, each member has 1/3 of those rights. Laura transfers her entire ownership interest to Charles. The transfer does not increase Charles’s governance rights but does eliminate Laura’s. After the transfer, Laura has no governance rights (regardless of whether Charles and Nora agree to expel Laura under 15 Pa.C.S. § 21321 8861(5)(ii)). As a result, Charles and Nora each have 1/2 of the governance rights.

    [8] “Dissociation” is the concept embodied in Subchapter F of the New Act (Sections 8861 through 8863) whereby a person’s rights as a member terminate. The default rules on dissociation provide that the transfer of all of a member’s transferable interest (other than for collateral security purposes or in connection with a charging order held by a judgment creditor of the member) results in the dissociation of the member. The default rules on dissociation also provide that a dissociated member who holds a transferable interest will continue to hold those rights in the status of a transferee (i.e., no governance or related rights).

    [9] The New Act provides certain additional rights to personal representatives of deceased members. In addition to the economic right to distributions, for the purposes of settling the estate of a deceased member, the member’s personal representative has the right to obtain information from the company prescribed in Section 8850 of the New Act.

    [10] (a) General rule. - On application by a judgment creditor of a member or transferee, a court may enter a charging order against the transferable interest of the judgment debtor for the unsatisfied amount of the judgment. Except as provided in subsection (f), a charging order constitutes a lien on a judgment debtor’s transferable interest and requires the limited liability company to pay over to the person to which the charging order was issued any distribution that otherwise would be paid to the judgment debtor.

    (b) Available relief. - To the extent necessary to effectuate the collection of distributions pursuant to a charging order in effect under subsection (a), the court may:

    (1) appoint a receiver of the distributions subject to the charging order, with the power to make all inquiries the judgment debtor might have made; and

    (2) make all other orders necessary to give effect to the charging order.

    (c) Foreclosure. - Upon a showing that distributions under a charging order will not pay the judgment debt within a reasonable time, the court may foreclose the lien and order the sale of the transferable interest. Except as provided in subsection (f), the purchaser at the foreclosure sale only obtains the transferable interest, does not thereby become a member, and is subject to section 8852 (relating to transfer of transferable interest).

    (d) Satisfaction of judgment. - At any time before foreclosure under subsection (c), the member or transferee whose transferable interest is subject to a charging order under subsection (a) may extinguish the charging order by satisfying the judgment and filing a certified copy of the satisfaction with the court that issued the charging order.

    (e) Purchase of rights. - At any time before foreclosure under subsection (c), a limited liability company or one or more members whose transferable interests are not subject to the charging order may pay to the judgment creditor the full amount due under the judgment and thereby succeed to the rights of the judgment creditor, including the charging order.

    (f) Foreclosure against sole member. - If a court orders foreclosure of a charging order lien against the sole member of a limited liability company:

    (1) the court shall confirm the sale;

    (2) the purchaser at the sale obtains the member’s entire interest, not only the member’s transferable interest;

    (3) the purchaser thereby becomes a member; and

    (4) the person whose interest was subject to the foreclosed charging order is dissociated as a member.

    (g) Exemption laws preserved. - This chapter shall not deprive any member or transferee of the benefit of any exemption laws applicable to the transferable interest of the member or transferee.

    (h) Exclusive remedy. - This section provides the exclusive remedy by which a person seeking to enforce a judgment against a member or transferee may, in the capacity of judgment creditor, satisfy the judgment from the judgment debtor’s transferable interest.