A charging order is supposed to be an exclusive remedy. This means that of all the remedies that are provided to creditors in a particular jurisdiction, the charging order should be used to the exclusion of these other remedies. The limitation of remedies is known as charging order exclusivity. Unfortunately, perhaps a majority of asset protection planners fundamentally misunderstand charging order exclusivity and wrongly equate it with an exclusivity of outcome, which in their belief is that the only possible result is that a creditor is stuck with a charging order. That the creditor being stuck with a charging order is belied by other theories through which a creditor may recover against a debtor/member’s interest in an LLC or partnership, such as through reverse veil piercing (a type of alter ego liability), voidable transaction liability, and suchlike. This article is about the appointment of a receiver as a means for a creditor to circumvent charging order exclusivity, as demonstrated in the opinion in Mexico Foods Holdings, LLC v. Nafal, 2023 WL 6284705 (Tex.App. Dallas, Sept. 27, 2023).
Husband and Wife sued each other for a divorce in Texas. At the outset of the case, Husband and his two brothers owned interests in Mexico Foods Holdings, LLC (“MFH”), which apparently was quite valuable. After the divorce court had entered a temporary order in the case which enjoined the parties from alienating any assets, MFH exercised its rights under a membership interest purchase option to buy out Husband for a little more than $33 million, with 10% being paid with cash down and the rest by a promissory note. Smelling a skunk in this transaction, Wife sued MFH and Husband’s two brothers for fraudulent transfer and also sought the appointment of a receiver to take charge of Husband’s MFH interest pending resolution of the divorce. Although opposed by MHH and Husband’s two brothers, the court granted Wife’s request for a receiver over Husband’s MFH interest. MFH then appealed the granting of the receiver.
The Texas Court of Appeals noted that the Texas Uniform Fraudulent Transfer Act (“UFTA
FTA
“) provides for the appointment of a receiver to take possession of a fraudulently-transferred asset. Because the lower court had found that it was likely that Wife would be found to have an interest in Husband’s interest in MFH, it was appropriate for the lower court to appoint a receiver to take possession of the interest until all the litigation dust settled. MFH argued that the receiver was unnecessary because Wife had not shown that less invasive remedies were not available, but the Court of Appeals simply held to the effect that having a receiver taking possession of the MFH’s interests were the safest way of securing them. Although MFH had deposited the 10% cash downpayment with the court clerk, the Court of Appeals noted that this did not adequately protect Wife in the event that she fully prevailed for the full $33+ million value of the interests.
The only other issue remaining was that of the Texas LLC Act, which restricts a judgment creditor to a charging order and has its own receivership provisions that are very limited. The Texas Court of Appeals ultimately did not consider this issue, finding first that MFH had not properly preserved it for appeal.
Thus, by the end of the opinion, the Texas Court of Appeals affirmed the appointment of a receiver to take possession of Husband’s MFH interests pending the resolution of the divorce proceeding and Wife’s UFTA case.
ANALYSIS
Even if the Texas Court of Appeals had confronted the issue of whether charging order exclusivity would have trumped the UFTA receivership provision, it is highly likely that the court would have ruled against MFH. There are several reasons for this, primarily that charging order exclusivity only applies to a “judgment creditor” (and not to any pre-judgment situation as here) and further that the fraudulent transfer laws have long been held to be an exception to charging order exclusivity. Nothing in the Texas LLC Acts operates to prevent a trial court from doing things to, basically, freeze the status quo until the litigation is resolved, and that’s what happened here.
Nonetheless, for both pre-judgment and judgment creditor cases, receiverships applied to LLC and partnership interests is a very difficult area of the law. On one side, LLC and partnership law operates on the concept of Pick Your Partner, which means that the non-debtor members of an LLC or partnership should be forced into what is essentially an involuntary partnership with the debtor/partner’s creditors. This is why a creditor cannot never be more than an involuntary assignee under LLC and partnership law, which basically gives a creditor the right to receive distributions and pretty much nothing else.
On the other side is the office of a receiver, which is something that is quite unique within the law insofar as a receiver is simultaneously all three of (1) an officer of the court, (2) a trustee similar to a bankruptcy trustee for the benefit of creditors, and (3) the agent for the debtor given involuntary powers of attorney. This last facet of a receivership is of most relevance in this situation.
When a receiver acts as the agent of the debtor, the receiver is essentially “stepping into the shoes” of the debtor, and acts for the debtor for all purposes. In other words, the receiver legally becomes the alter ego of the debtor. Thus, when a receiver is appointed for a debtor who has an LLC or partnership interest, the debtor is still the owner of the interest, but the receiver is the one who knows controls the interest. This throws charging order law on its head, since that law is designed for the situation of a creditor either taking a lien against the interest (the charging order lien) or ultimately foreclosing on the charging order in which case the purchaser at the judicial sale becomes the involuntary assignee. When a receiver acts on behalf of the debtor, the ownership of the interest has not changed, but control of that interest has certainly changed. While we have not had an opinion on the subject, at least that I can presently recall, it will be interesting when a receiver is appointed for the debtor and then attempts to vote the debtor’s interest or otherwise exercise voting rights in the LLC or partnership. Note that a receiver would have to receive prior permission from the court to do this, and such action would be contested by the non-debtor partners, so whether a court would even allow that is unknown.
The uniform LLC and partnership acts (the so-called Harmonized Acts constituting the UPA, ULLPA and ULLCA, and their revisions) have their own receivership provision that restricts the receiver to taking in distributions and little else. As discussed, however, other bodies of law, such as fraudulent transfer law under the UFTA/UVTA also provide for receivers, and then of course there is the general receivership statutes that are usually available to creditors. Thus, a creditor will be smart to have a receiver appointed under one of these other bodies of law, and thus avoid the restrictions of a receiver appointed under the Harmonized Acts.
The point of all this being that asset protection planners cannot count on charging order exclusivity to apply in all situations, since it can be circumvented by the appointment of a receiver under some non-LLC or non-partnership body of law.
Exactly as occurred in this case.
Read the full article here
