Choice of Entity: Creditor Voting Rights (from June 2010)
Because Ohio business organization is a large part of our practice, we’re often confronted with questions regarding which entity (normally LLC vs Corporation) is best for a particular client’s new venture. One blog post won’t answer that question in total, but, in terms of asset protection, there is one significant difference between an LLC and a corporation that’s often overlooked: voting rights.
I always prefer to explain things in terms of examples, so here goes: Suppose you are at fault in an auto accident unrelated to the work you do for your closely held business. Suppose further that the extent of the damages you owe to the injured party or their family exceed the limits of your insurance policy. Now you’ve got a problem. You are personally responsible to the injured party due to your negligent driving and the insurance company only covered a portion of that liability.
In this situation, it’s certainly true that your personal residence could potentially be under attack, it’s probably also true, particularly if you’ve used equity in the residence to finance business debt, that the house is subject to a significant mortgage to everyone’s favorite secured creditor, the bank. (As a complete aside, Ohio’s homestead exemption from judgment creditors is only $20,200.00 per Ohio Revised Code Section 2329.66). Given the bank’s position, the judgment creditor (our injured party) may not aggressively pursue the house because they’d have to finance the cost of a foreclosure action only to pay the bank off first and take what’s left. The creditor would rather scoop up investment accounts, savings accounts, and any other income producing asset. This is where the closely held business comes in.
If you weren’t working on behalf of the entity at the time of the accident, then the assets of the entity would not be directly subject to the judgment creditor’s claims, i.e., the injured party wouldn’t be suing the business for something you did outside the scope of your duties as a business owner. That means that our creditor won’t be directly taking business bank accounts, equipment, machinery, etc. However, you still individually own your interest in the closely held business – stock in the case of a corporation and membership interest in the case of an LLC. Thus, while the assets of the business aren’t directly in jeopardy, the certificates representing those assets are.
You may now be thinking: “Hey, this is great, the creditor has a claim against my ownership interest in the business, but, because I control the vote as to whether to distribute cash each month, I can just accumulate money within the business or invest in business property and only make cash distributions to myself the day before I write checks for all my personal bills. My creditor is out of luck and will eventually give up and go away.” Not quite.
If you’re the shareholder of a corporation, your personal judgment creditor may very well take a judgment against you and use it to attach and take control of your stock in the corporation, just like it would attach and take control (and ultimately sell) any marketable securities that you may have in an investment account. After the attachment, the creditor can vote your shares just like you could have voted them before the attachment. In other words, if you owned a controlling portion of your corporation’s shares, your creditor could vote to do things like (1) fire you and replace with new management; (2) reduce your salary to make room for more earnings; (3) distribute dividends instead of invest in the business; (4) sell assets that aren’t critical to your generation of income; and (5) any other item of business the new controlling shareholder may want to take. To make matters worse, if your business was being taxed as an S-Corp, the creditor’s position as a shareholder may ruin the subchapter S election for your other co-owners (in today’s world, judgments are sometimes sold to entities that handle collection efforts, an entity that may or may not be a qualified S shareholder). In short, with respect to a corporation, your personal judgment creditor may very well have a significant and real impact upon the future of your business, even though the accident was completely unrelated.
Contrast the corporation example with that of a limited liability company. In Ohio, a personal judgment creditor of a member (think shareholder) of an LLC is not afforded the opportunity to attach the membership units (think stock) of the member and vote or otherwise manage the LLC. Ohio Revised Code Section 1705.19 gives a judgment creditor of a member of an Ohio limited liability company the ability to obtain a charging order against the member’s interest in the LLC. However, that charging order only gives the creditor the rights of an assignee of the membership interest. Absent language in the operating agreement to the contrary, Ohio Revised Code Section 1705.18 expressly does NOT, despite a charging order, give the assignee of a membership interest (our judgment creditor) the ability to “exercise any rights of a member.”
Thus, in the LLC setting, even if all of your interest is assigned to the creditor, the remaining members won’t have to worry about a creditor taking over management or simply voting to dissolve the company. Further, you wouldn’t have to worry about a creditor unilaterally terminating your employment with the company. In short, while the creditor is entitled to your share of company distributions by virtue of the charging order (not wages – think dividends), the creditor cannot vote to compel the company to distribute funds or forgo investment opportunities.
That being said, with the charging order in place, particularly if the creditor forecloses on the charging order, the creditor will always be lying in wait with its hand out to take a distribution if the company wanted to make one. No owner is going to be thrilled with that result, especially if an owner needed to take cash out of the company for other personal expenditures. Thus, as a practical matter, the charging order limitation in the LLC setting really gives you bargaining strength with your creditor. If the creditor knows it will have to wait a significant period of time, maybe forever, to get a distribution, it may settle the judgment for cents on the dollar in order to get cash now rather than later, or never. Perhaps a cease-fire and accompanying payment plan could be negotiated. Alternatively, perhaps your company could finance the settlement with the judgment creditor and you could issue a note back to the company. In the meantime, you’ve been able to negotiate down a significant portion of uninsured liability, save your business and create an opportunity to take distributions out of the company and enjoy your successes without having a creditor hanging over your head – a terrible situation became a little more manageable.
As one final caveat, if your LLC had elected S-Corp tax treatment, you’d likely have the same potential S election problem mentioned above for corporations. If you’d elected partnership treatment, the company’s overall tax position wouldn’t endure any catastrophic changes.
– Mark Coriell
Categorized in: Business Transactions