LLC “Lien Priority” Battle: Charging Order vs. UCC Financing Statement
A charging order is a device used by a judgment creditor to collect on a judgment against an LLC member. The charging order imposes a lien on the judgment debtor’s economic (or “transferable”) interest in the LLC — the order essentially diverts the judgment debtor’s LLC distributions to the judgment creditor until the debt is satisfied. If the debt remains unsatisfied (e.g., due to no or insufficient distributions), the creditor can eventually “foreclose” on the charging order and obtain permanent ownership of the member’s economic interest.
A UCC financing statement is a different tool commonly used by a general creditor to secure debt owed by an LLC or LLC’s member. In a typical arrangement, the LLC member will pledge his/her interest in the LLC as security for the debt, and that pledge will be documented on a UCC financing statement, which is filed with the Secretary of State. Like a charging order, a UCC financing statement operates as a lien on the LLC member’s right to distributions.
A case recently published by California’s Second Appellate District — Rice v. Downs — addressed the competing “priority” of creditor liens against a debtor’s LLC interest, where one creditor had a post-judgment charging order and the other creditor had a UCC financing statement. The court also explained that even payments not called “distributions” might, in effect, be distributions subject to the reach of a charging order.
The charging order lien
Gary Downs sued and obtained judgment against William Rice for “hundreds of thousands of dollars” in a case arising from disputes within a company developing affordable housing.
Post-judgment, the trial court granted Downs’ motion for a charging order directing various LLCs in which Rice was a member to pay any distributions to which Rice was entitled directly to Downs until the judgment was satisfied.
The LLC’s “payment” (distribution?) to a third party
Downs eventually learned that one of Rice’s LLCs (Triton Community Development LLC) had paid $450,000 to Glasser Weil — a law firm representing Rice in his litigation against Downs.
Downs filed a motion in the trial court to enforce his charging order, arguing that Triton’s $450,000 payment to Glasser Weil violated the order. Downs contended that the payment was really a distribution subject to the charging order, and that Rice should either pay that sum to Downs or Glasser Weil should disgorge the funds to Downs.
The UCC financing statement lien
Glasser Weil opposed Downs’ motion, making two arguments:
First, it asserted that months before the $450,000 payment, Triton agreed to become a co-obligor on Rice’s debt to the law firm. Thus, Glasser Weil argued, the payment was not a distribution that would be subject to the charging order, but instead an independent payment on Triton’s debt.
Second, it asserted that it had a “perfected security interest” in the form of a UCC financing statement that was filed with the Secretary of State on the same date that Triton agreed to become a co-obligor on Rice’s debt to the firm — months before, and therefore “senior to” Downs’ charging order lien.
Trial court: equity trumps the UCC lien
The trial court granted Downs’ motion to enforce the charging order, relying on its “equitable exercise of jurisdiction.”
The court held it would be unfair to allow the money to pass hands as it did — “for the Glasser firm to tell Mr. Rice, ‘Pound sand. I got the money now. We perfected our lien. You have to figure out something else.”
Court of Appeal: reversed; the payment was a “distribution” subject to the charging order, but the UCC lien had first priority
The Court of Appeal reversed the trial court’s order.
The LLC’s payment was a “distribution” subject to the charging order …
Addressing Glasser Weil’s two arguments, the court rejected the first, holding that Triton’s $450,000 payment was, in effect, “a distribution subject to the charging order.”
The court held that Glasser Weil’s “narrow reading” of the charging order’s scope “disregards the reality that many LLCs, like Triton, are completely controlled by a single person who may distribute funds at his or her discretion. … Under Glasser Weil’s interpretation, such entities easily could evade charging orders by eschewing formal distributions and instead taking funds out of the LLC as the need arose.”
The court added: “Even if Triton made the payment pursuant to its own contractual obligation to Glasser Weil, the fact remains that the payment was for Rice’s legal expenses. … The payment therefore constituted a ‘distribution’ as much as had Rice received the money himself.”
As an additional, independent ground supporting its reasoning, the court also noted that the evidence supported a finding that “Triton was Rice’s alter ego,” and therefore the court could “look past the corporate formalities and deem the transaction as Rice distributing money to himself from Triton to pay his legal bills. … Triton and Rice were effectively one and the same.”
… but the UCC financing statement lien had priority over the charging order.
The court was more receptive to Glasser Weil’s second argument based on the priority of its UCC financing statement lien. The court held that the UCC financing statement lien had priority over Downs’ charging order lien, and “there was no equitable basis for the trial court to override that priority.”
In resolving the lien priority issue, the court followed the “first in time” rule — the starting point for “lien priority” analysis in a wide variety of California cases. Under that rule, “Other things being equal, different liens upon the same property have priority according to the time of their creation.”
Glasser Weil perfected its lien by filing its UCC financing statement in July 2019. Downey obtained his charging order lien several months later in October 2019. The court concluded: “Glasser Weil’s earlier perfected security interest therefore has priority.”
Lesson
Under Rice v. Downs, the priority of competing liens on an LLC interest (here, a charging order vs. a UCC financing statement) will be determined by the “first in time” rule. Also, charging orders cannot be evaded simply by re-characterizing what is functionally a distribution as some other type of payment.