Debtor’s Use of LLC As ‘Personal Piggy Bank’ Leads to Turnover and Charging Orders

Golfwood Square, LLC v. O’Malley, 2018 IL App(1st) 172220-U, examines the interplay between a charging order and a third party citation to discover assets turnover order against an LLC member debtor.  The plaintiff in Golfwood engaged in a years’ long effort to unspool a judgment debtor’s multi-tiered business entity arrangement in the hopes of collecting a sizeable (about $1M) money judgment.

Through post-judgment proceedings, the plaintiff learned that the debtor owned a 90% interest in an LLC (Subsidiary or Sub-LLC) that was itself the sole member of another LLC (Parent LLC) that received about $225K from the sale of a Chicago condominium.

Plaintiff also discovered the defendant had unfettered access to Parent LLC’s bank account and had siphoned over $80K from it since the judgment date.

In 2013 and 2017, plaintiff respectively obtained a charging order against Sub-LLC and a turnover order against Parent LLC in which the plaintiff sought to attach the remaining condominium sale proceeds.  The issue confronting the court was whether a judgment creditor could get a turnover order against a parent company to enforce a prior charging order against a subsidiary entity.  In deciding for the creditor, the Court examined the content and purpose of citations to discover assets turnover orders and LLC charging orders.

Code Section 2-1402 empowers a judgment creditor can issue supplementary proceedings to discover whether a debtor is in possession of assets or whether a third party is holding assets of a debtor that can be applied to satisfy a judgment.

Section 30-20 of the Limited Liability Company Act allows that same judgment creditor to apply for a charging order against an LLC member’s distributional interest in a limited liability company. Once a charging order issues from the court, it becomes a lien (or “hold”) on the debtor’s distributional interest and requires the LLC to pay over to the charging order recipient all distributions that would otherwise be paid to the judgment debtor. 735 ILCS 5/2-1402; 805 ILCS 180/30-20. Importantly, a charging order applicant does not have to name the LLC(s) as a party defendant(s) since the holder of the charging order doesn’t gain membership or management rights  in the LLC. [⁋⁋ 22, 35]

Under Parent LLC’s operating agreement, once the condominium was sold, Parent LLC was to dissolve and distribute all assets directly to Sub-LLC – Parent’s lone member.  From there, any distributions from Sub-LLC should have gone to defendant (who held a 90% ownership interest in Sub-LLC) and then turned over to the plaintiff.

However, defendant circumvented the charging order by accessing the sale proceeds (held in Parent LLC’s account) and distributing them to himself. The Court noted that documents produced during post-judgment discovery showed that the defendant spent nearly $80,000 of the sale proceeds on his personal debts and to pay off his other business obligations.

Based on the debtor’s conduct in accessing and dissipating Parent LLC’s bank account with impunity, and preventing Parent LLC from distributing the assets to Sub-LLC, where they could be reached by plaintiff, the trial court ordered the debtor to turn all Parent LLC’s remaining account funds over to the plaintiff to enforce the earlier charging order against Sub-LLC.

The court rejected the defendant’s argument that Parent LLC was in serious debt and that the condo sale proceeds were needed to pay off its debts. The Court found this argument clashed with defendant’s deposition testimony where he stated under oath that Parent LLC “had no direct liabilities.” This judicial admission – a clear, unequivocal statement concerning a fact within a litigant’s knowledge – was binding on the defendant and prevented him from trying to contradict this testimony. The argument also fell short in light of defendant’s repeatedly raiding Parent LLC’s account to pay his personal debts and those of his other business ventures all to the exclusion of plaintiff.

The court then summarily dispensed with defendant’s claim that the plaintiff improperly pierced the corporate veils of Parent LLC and Sub-LLC in post-judgment proceedings. In Illinois, a judgment creditor typically cannot pierce a corporate veil in supplementary proceedings. Instead, it must file a new action in which it seeks piercing as a remedy for an underlying cause of action.

The Court found that the trial court’s turnover order did not hold defendant personally liable for either LLC’s debt. Instead, the turnover order required Parent LLC to turnover assets belonging to the judgment debtor – the remaining condominium sale proceeds – to the plaintiff creditor.

Afterwords:

This case presents in sharp relief the difficulty of collecting a judgment from a debtor who operates under a protective shield of several layers of corporate entities.

Where a debtor uses an LLC’s assets as his “personal piggy bank,” Golfwood and cases like it show that a court won’t hesitate to vindicate a creditor’s recovery right through use of a turnover and charging order.

The case is also noteworthy as it illustrates a court looking to an LLC operating agreement for textual support for its turnover order.

IL Supreme Court Expands on Shareholder Derivative Suits and Standing Doctrine in Att”y Malpractice Suit

Some minority shareholders in an LLC sued their former counsel for legal malpractice alleging the firm failed to file “obvious” breach of fiduciary claims against the LLC’s corporate counsel.

Affirming summary judgment for the defendant law firm in Stevens v. McGuirreWoods, LLP, 2015 IL 118652, the Illinois Supreme Court gives content to the quantum of proof needed to sustain a legal malpractice claim and discusses the type of legal interest that will confer legal standing for a corporate shareholder to sue in its individual capacity.

The plaintiffs’ central claim was that McGuirreWoods (MW) botched the underlying case by not timely suing Sidley Austin, LLP (Sidley), the LLC’s erstwhile counsel, in the wake of the LLC’s majority shareholders looting the company.  Sidley got the underlying case tossed on statute of limitations grounds and because the plaintiffs lacked standing.

The trial court found that even if MW had timely sued Sidley, the shareholder plaintiffs still lacked standing as their claims belonged exclusively to the LLC. After the First District appeals court partially reversed on a procedural issue, MW appealed to the Illinois Supreme Court.

Affirming judgment for Sidley, the Illinois Supreme Court considered the interplay between legal malpractice cases and shareholder derivative suits.

Dubbed a “case-within-a-case,” the legal malpractice claim plaintiff alleges that if it wasn’t for an attorney’s negligence in an underlying case, the plaintiff would have won that case and been awarded money damages.

The legal malpractice plaintiff must prove (1) the defendant attorney owed the plaintiff a duty of care arising from the attorney-client relationship, (2) the defendant attorney (or law firm) breached that duty, and (3) as a direct and proximate result of the breach, the plaintiff suffered injury.

Injury in the legal malpractice setting means the plaintiff suffered a loss which entitles him to money damages.  Without proof the plaintiff sustained a monetary loss as a result of the lawyer’s negligence, the legal malpractice suit fails.

The plaintiff must establish it would have won the underlying lawsuit but for the lawyer’s negligence.  The plaintiff’s recoverable damages in the legal malpractice case are the damages it would have recovered in the underlying case. [¶ 12]

Here, the plaintiffs sued as individual shareholders.  The problem was that Sidley’s obligation ran to the LLC entity.  As a result, the plaintiffs lacked individual standing to sue Sidley.

Under the law, derivative claims belong solely to a corporation on whose behalf the derivative suit is brought.  A plaintiff must have been a shareholder at the time of the transaction of which he complains and must maintain his shareholder status throughout the entire lawsuit.  [¶ 23]

Illinois’ LLC Act codifies this rule by providing that any derivative action recovery goes to the LLC; not the individual shareholder.  The individual shareholder plaintiff can recover his attorneys’ fees and expenses.  805 ILCS 180/40-15.

While a successful derivative suit plaintiff can benefit indirectly from an increase in share value, the Court held that missing out on increased share value was not something the shareholders could sue for individually in a legal malpractice suit.

Had MW timely sued Sidley, any recovery would have gone to the LLC, not to the plaintiffs.  And since the plaintiffs could not have recovered money damages against Sidley in the earlier lawsuit, they could not recover them in a later malpractice case.

Afterwords:

This case provides a thorough explication of the standing doctrine in the context of shareholder derivative suits.

The case turned on the nature of the plaintiff’s claims.  Clearly, they were suing derivatively (as opposed to individually) to “champion” the LLC’s rights.  As a result, any recovery in the case against Sidley would flow to the LLC – the entity of which plaintiffs were no longer members.

And while the plaintiffs did maintain their shareholder status for the duration of the underlying Sidley case, their decision to terminate their LLC membership interests before suing MW proved fatal to their legal malpractice claims.

 

LLC Stopped From Selling Member’s Residence In Violation of Prior Charging Order – Utah Federal Court

Q: Can A Court Stop An LLC That Pays the Monthly Mortgage of One of Its Members From Selling that Member’s Home Where A Charging Order Has Issued Against the LLC to Enforce a Money Judgment Against the LLC Member?

A: Yes.

Q2: How So?

A2: By selling the member’s property and paying off the member’s mortgage with the sale proceeds, the LLC is effectively “paying the member” to the exclusion of the plaintiff judgment creditor.

Source: Earthgrains Baking Companies, Inc. v. Sycamore Family Bakery, Inc., et al, USDC Utah 2015 (https://casetext.com/case/earthgrains-baking-cos-v-sycamore-family-bakery-inc-3)

In this case, the plaintiff won a multi-million dollar money judgment against a corporate and individual defendant in a trademark dispute.  The plaintiff then secured a charging order against a LLC of which the individual defendant was a 48% member.  When the LLC failed to respond to the charging order, the plaintiff moved for an order of contempt against the LLC and sought to stop the LLC from selling the defendant’s home.

The court granted the contempt motion.  First, the court found that it had jurisdiction over the LLC.  The LLC argued that Utah lacked jurisdiction over it since the LLC was formed in Nevada.  The LLC claimed that under the “internal affairs” doctrine, the state of the LLC’s formation – Nevada – governs legal matters concerning the LLC.

Disagreeing, the court noted that a LLC’s internal affairs are limited only to “matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders.”  The internal affairs doctrine does not apply to claims of third party creditors.  Here, since the plaintiff was a creditor of the LLC’s member, this was not a dispute between LLC and member.  As a result, the internal affairs rule didn’t apply and the Utah court had jurisdiction over the LLC since a LLC member lived in Utah.  (See Cosgrove v. Bartolotta, 150 F.3d 729, 731 (7th Cir. 1998)).

The Charging Order required the LLC to pay any distribution that would normally go to the member directly to the plaintiff until the money judgment was satisfied.  The Charging Order specifically mentions transfers characterized or designated as payment for defendant’s “loans,” among other things.

The LLC was making monthly mortgage payments on the member’s home and listed the home for sale in the amount of $4M.  Plaintiff wanted to prevent the sale since there was a prior $2M mortgage on the home.

In blocking the sale, the court found that if the LLC sold the member’s home and paid off the member’s mortgage lender with the proceeds, this would violate the Charging Order since it would constitute an indirect payment to the member.  The court deemed any payoff of the member’s mortgage a “distribution” (a direct or indirect transfer of money or property from LLC to member) under the Utah’s LLC Act. (Utah Code Ann. § 48-2c-102(5)(a)).

Since the Charging Order provided that any loan payments involving the member were to be paid to the plaintiff until the judgment is satisfied, the court found that to allow the LLC to sell the property and disburse the proceeds to a third party (the lender) would harm the plaintiff in its ability to satisfy the judgment.

Afterwords:

An interesting case that discusses the intricacies of charging orders and the thorny questions that arise when trying to figure out where to sue an LLC that has contacts in several states.  The case portrays a court willing to give an expansive interpretation of what constitutes an indirect distribution from an LLC to its member. 

Earthgrains also reflects a court endeavoring to protect a creditor’s judgment rights where an LLC and its member appear to be engaging in misdirection (if not outright deception) in order to elude the creditor.

[A special thanks to attorney and Forbes contributor Jay Adkisson for alerting me to this case (http://www.forbes.com/sites/jayadkisson/)]