In October of 2010, SE Property Holdings LLC (SEPH) obtained a judgment in Alabama state court for a little more than $9 million against David Harrell on his loan guarantee for a real estate deal that went bust. About five years later, in 2015, SEPH obtained a charging order against Harrell\’s interests in various companies, including Southern Land Brokers LLC (SLB\). The charging order did what charging orders do, which was to place a lien on Harrell\’s interests until the judgment was satisfied. However, the charging order also compelled SLB to \report and distribute to [SEPH] any amounts that become due or distributable.\
We now advance the clock forward another five years, to 2020, and find that SEPH filed a petition with the Alabama court to hold Harrell in contempt of court for violating the charging order, and also sanctioning Harrell for that violation. SEPH alleged that although SLB\’s operating agreement required that all distributions be made to members based on their respective ownership, Harrell as the managing member of SLB instead began making distributions only to the 50% interest owned by his wife, Carolyn, when those distributions should have been made to Harrell instead on his own 50% interest, and picked up by the charging order lien. SEPH further alleged that Harrell had been using SLB to make payments on his personal American Express
Harrell\’s argument in opposition is somewhat hard to figure out, but was along the lines that although tax distributions had been made to him and reflected on the K-1, he had not actually received any cash distributions (what is known in partnership tax practice as \phantom income\). The trial court agreed with Harrell, and denied SEPH\’s motion without even holding an evidentiary hearing. SEPH appealed, and the matter ended up in the lap of the Alabama Supreme Court which wrote the opinion that I shall next relate.
The Alabama Supreme Court started off with a discussion of the basics: A charging order places a lien on the debtor\’s \transferable interest\, which is defined as the debtor\’s right to receive distributions. The term \distributions\ does not include compensation for services paid to a debtor, or contributions made on behalf of the debtor to a retirement or benefits plan. The court also noted that because Harrell owned 50% and his wife Carolyn owned 50% each, that distributions should have been split evenly between the two, meaning that each should have received $415,000 in distributions, with Harrell\’s of course going to SEPH.
SEPH argued that Harrell was intentionally evading the charging order by not making equal distributions to himself. Harrell responded that since he did not receive the cash, but only the taxable distribution in his K-1, he was not in violation of the charging order. But this is where the court starts to turn on Harrell:
\He also did not attach any documentation or evidence to his objection showing that to be the case, and there is nothing in the record before us, other than his conclusory denial, supporting his assertion. There is nothing before us demonstrating that he did not intentionally avoid otherwise required disbursements. In fact, as demonstrated above, the evidence before us indicates that the opposite is true.\
The court then went on to note that the remedy for violating a court order is contempt, and the contempt remedy can be imposed where one fails to perform an act required by the order. The court then found that SEPH had presented evidence that Harrell was in violation of the charging order. However, Alabama law also requires that a person cannot be held in contempt without a hearing, and since the trial court had not held such a hearing, its decision in favor of Harrell would be reversed, and the matter remanded back to the trial court with instructions to hold exactly that hearing on whether Harrell was in contempt of the charging order.
Seems like I\’ve been in about a thousand meetings over the years where somebody says something like, \If a creditor gets a charging order, we\’ll just not make distributions to the charged interest and the creditor will be stuck.\ The same thought always goes through my mind, \Yeah, that may sound good while sitting in this conference room, but it really doesn\’t work like that in litigation.\ This is an opinion where the court explains in just a few sentences why it doesn\’t work like that at all.
Basically, there are two ways that a member can get money out of an LLC or partnership (I\’ll simply refer to both types of entities as LLCs for convenience), being either compensation or distributions.
The first way is compensation, such as wages or salary. Compensation is subject to garnishment by creditors, although theoretically subject to the limitations of state exemption laws and the Federal Wage Garnishment Law that limits garnishment to 25% of the debtor\’s disposable earnings, which is basically after withholdings. Thus, if a debtor earns a $100,000 annual salary from an LLC, and the disposable earnings are $80,000 then the creditor can garnish 25% of the $80,000 being $20,000. Thus, the creditor gets something, being the 25%, but the debtor gets three times that something, plus withholdings are paid.
The second way for a member to get money out of an LLC is by a distribution, and for which a creditor can take 100% through a charging order. While there is a theoretical position which I favor relating to distributions relating from the member\’s wages also being subject to the 25% limitation, this theory has not been tested and at any rate would not apply to any passive income which is distributed to the debtor although not part of any compensation.
The amount of the distribution to a member is determined by an allocation of the LLC\’s distribution to all members, then multiplied by the particular member\’s percentage. Thus, if ABC LLC makes a $100,000 distribution and a member holds a 25% interest, then the member should normally get $25,000. If a creditor holds a charging order against the debtor\’s interest, then the creditor will get (subject to my above pet theory) all of that distribution until the judgment has been satisfied.
Where this gets weird is that the partnership tax rules and partnership and LLCs laws allow for so-called special allocations whereby some members can get more and some members can get less in circumstances that are defined by the operating agreement. A debtor whose interest has been made subject to a charging order can probably have the LLC play around a little bit with the special allocation rules and not be slapped by the court, but to simply make special allocations such that the debtor\’s interest never receives anything like a normal distribution is quite likely to fail. The old saw that pigs get fat but hogs get slaughtered applies here with great force.
A significant downside to a debtor having their distribution paid over to a creditor is that the creditor will get the money, but the debtor will get stuck with the taxes on that money, i.e., the debtor goes even further into debt, and this time against the IRS who sometimes has special abilities as a creditor to get around state exemptions. Not until the creditor forecloses on the charging order lien does the creditor become an involuntary assignee who becomes liable for the taxes as well as receiving the distribution, but smarter creditors will almost never foreclose for this very reason ⸺ why take both the distribution and the tax liability when you can just get the distribution until the judgment is satisfied, and leave the debtor to suffer the taxes?
So, here SLB generated $830,000 in distributions, but Carolyn got 100% of it and Harrell got none when he should have received $415,000 as well. Assuming that SEPH can prove this up at the hearing ordered by the Alabama Supreme Court, Harrell can thus be held in contempt of court for not making the $415,000 distribution to himself.
It should also be noted that SEPH could have tried an alternative approach, which was to claim that Harrell implicitly received the $415,000 under a concept known as imputed income, and then fraudulently transferred $415,000 to Carolyn for which she could theoretically be liable for a money judgment in that amount. However, there is nothing quite like sending a debtor to the county lockup, a most unhealthy place in the best of times, to punish a debtor for his hijinks and in such events debtors often finally find their wallets and settle on some basis or another. At the very least, some jail time will usually have the effect of convincing a debtor not to do it again, and then SEPH can get going forward the distributions that it should have been getting all along.
The concept of imputed income would also apply to Harrell\’s payments on his American Express account, and theoretically SEPH could get a judgment directly against the LLC for those amounts. For that matter, it might be that SEPH can assert a theory of imputed income in a creditor\’s suit to make SEPH directly liable for the $415,000.
Changing gears, there is one place where I think the Alabama trial court also erred, which was in drafting the charging order in the first place so that SLB would have to provide information relating to its profits and distributions. While I don\’t claim to know anything about Alabama law, the uniform acts (ULLCA, ULPA and UPA) forbid that for LLCs and partnerships generally. Thus, a creditor can force a debtor to turn over whatever information that a debtor has received from an LLC, but it cannot force the LLC itself to turn over that information.
But that then brings up a different problem for Harrell, which is that he was the manager of SLB ⸺ a very bad idea. As the manager of SLB, Harrell has all the information relating to SLB, and as a debtor could then be forced to turn that information over. One might argue that one of Harrell\’s mistakes in this mess was to not immediately resign as a manager before the charging order was even entered. If Harrell was not the manager but only a member, and SLB\’s operating agreement had restricted his information rights, then SEPH would not have been able to get information about what was going on inside SEPH other than what information was contained in the K-1 that Harrell received, but that seemed to be enough for SEPH\’s purposes.
Which is actually a problem for LLCs and partnerships generally in the debtor context, being that a creditor can usually get a hold of the debtor\’s tax returns, including the K-1, and see from that a summary of the activity within the entity. From an asset protection planning perspective, there are probably ways to structure around that, but such is well beyond the purview of this article.
Finally, let us consider the matter of contempt. There are not just a few creditor\’s rights attorneys who would posit that an important strategy in the enforcement of large-dollar judgments is to maneuver the debtor into a position where the debtor faces contempt and jail time. Rare is the debtor who has the mental and physical fortitude to go into lockup for even the briefest period of time without considering trying to settle with their last few hidden moneys. In other cases, contempt may have important collateral benefits as well, just as defeating the debtor\’s appeal on the merits under the doctrine of disentitlement.
To get contempt against a debtor, there must be an order, the debtor must have been served with the order, and the debtor must have violated the order. As the Alabama Supreme Court notes here, a contempt charge is basically a quasi-criminal proceeding where the debtor must be afforded due process rights including a right to a hearing. Usually, the creditor must also prove the debtor\’s violation of the order by the criminal law standard of beyond reasonable doubt.
There are also two kinds of contempt in creditor-debtor cases, being coercive contempt where the court is trying to force the debtor to do something, such as bring back overseas funds, or punitive contempt where the debtor is simply being punished for having done something in the past. In either case, the debtor ends up in jail with the difference being that a debtor can expunge a coercive contempt simply by complying with the court\’s order, but with a punitive contempt the debtor gets locked away for some period that the court believes is reasonable under the circumstances. Harrell\’s case involves the latter, and it will be interesting to see how that pans out. Notably, coercive contempt can often be wiped out by a bankruptcy filing, whereas punitive contempt will usually survive a bankruptcy filing, i.e., that one later filed for bankruptcy does not excuse them from having violated a court order in the first place.
Again, what Harrell tried to do here is something that planning attorneys talk about quite often, i.e., simply not make distributions to the interest subject to the charging order, and, again, that is simply a wrong conclusion which may now bring unenjoyable consequences to somebody who actually tried to do it.
Thus does something that may sound so good in the conference room not sound so hot when one actually gets into court. Again.
Ex Parte SE Property Holdings LLC (SE Property Holdings, LLC v. Harrell), 2021 WL 5145446 (Ala., Nov. 5, 2021).