The Illinois Appellate Court was recently faced with an appeal of a trial court’s charging orders against 72 LLCs and limited partnerships (LPs), where none of the entities were made parties to the lawsuit. The Appellate Court upheld the charging orders on the grounds that the LLCs and LPs were not necessary parties because their interests were not sufficiently affected by the charging orders. Bank of America, N.A. v. Freed, 1-11-0749 et al., 2012 WL 6725894 (Ill. App. Ct. Dec. 28, 2012).
Bank of America sued the guarantors of a $205 million loan on their guaranty. Before addressing the charging orders, the court dealt with a significant contract law issue.
Nonrecourse Guaranty Carveout. The guarantors’ liability was limited to $50 million, but with a carveout that removed the limit if the guarantors contested, delayed or otherwise hindered any action taken by the lender in connection with the appointment of a receiver or foreclosure of the mortgage. The guarantors contested the Bank’s foreclosure action, and the Bank accordingly claimed that the guaranty was no longer limited and covered the full $205 million. In their appeal, the guarantors contended that the carveout provision was vague, ambiguous, overly broad, and an unenforceable penalty.
The enforceability of carveout provisions in nonrecourse or limited recourse contracts was an issue of first impression in Illinois. Id. at *9. The defendants contended that there was no connection between the additional amounts they owed as a result of the full liability provisions and any actual damages suffered by the Bank, and that accordingly the sole purpose of the carveout was to secure performance of the contract. Id. at *8.
The court concluded otherwise, reasoning as follows. First, the carveout operated principally to define the terms and conditions of personal liability, and not to fix the probable damages. Id. at *9. Second, the carveout provided for only actual damages – the lender could recover only the damages actually sustained, i.e., the amount remaining on the loan at the time of the breach. And third, the carveout did not preclude the guarantors “from contesting the appointment of a receiver or filing defenses to the foreclosure action, but by taking those actions they forfeited their exemption from liability for full repayment of the loan.” Id. at *12. The trial court’s judgment against the guarantors was affirmed.
Charging Orders. After entering judgment against the defendants in the amount of $207 million, the trial court entered charging orders against the defendants’ interests in 72 LLCs and LPs. None of the LLCs and LPs were made parties to the lawsuit. The defendants argued that the charging orders were invalid because the LLCs and LPs were necessary parties, and the court did not have jurisdiction over them. (These 72 LLCs and LPs were apparently formed under Illinois law, although the court never clarified that.)
The charging orders were entered under the authority of Section 30-20(a) of the Illinois LLC Act and Section 703(a) of the Illinois Uniform Limited Partnership Act. Both sections refer to charging orders being entered by a court having jurisdiction, and the defendants contended that the court therefore had to have jurisdiction over the LLCs and LPs. Id. at *12.
The language of the two Acts is not clear about whether the court is to have jurisdiction over the judgment debtor, the LLC, or both. For example, the LLC Act says “[o]n application by a judgment creditor of a member of a limited liability company or of a member’s transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment.” 805 Ill. Comp. Stat. 180/30-20(a) (emphasis added).
The court determined that the statute referred to jurisdiction over the judgment debtor, not necessarily the LLC, and that a charging order on a debtor’s interest in an LLC or LP does not affect the rights of the LLC or LP to the extent necessary to require that it be made a party. Bank of America, 2012 WL 6725894 at *12. For an LLC, for example, the holder of the charging order has only the right to receive distributions to which the member would otherwise be entitled. Even if the charging order is foreclosed, the holder has only the rights of a transferee. In either case the holder of the charging order will not be entitled to vote or otherwise participate in the LLC’s management or affairs. “Hence, the LLC has no interest to be protected and need not be made a party.” Id. The result is similar for an LP. The court therefore concluded that “the trial court did not err in entering charging orders against the 72 LLCs and limited partnerships even though they were not named as parties.” Id. at *13.
Comment. The LLC in a charging order scenario is not a party to the dispute between its member and the member’s creditor. The LLC is merely a potential distributor of assets to the member. (Like corporate dividends, LLC distributions are made to the members generally, per the terms of the LLC’s operating agreement.)
Given the LLC’s lack of skin in the game, and given the inability of the holder of the charging order to interfere with the management of the LLC, the court in Bank of America reached what appears to be a sensible conclusion: the LLC does not have an interest to be protected by requiring its joinder to the suit between the creditor and the member.
So what happens next? How does the Bank ensure that it will receive any distributions from the LLCs or LPs that would otherwise go to the defendants? Presumably the Bank will give formal notice of the charging order to each of the 72 LLCs and LPs. Any LLC or LP that ignores the charging order and makes a distribution to one of the defendants would appear to be liable to the Bank for the amount of the wrongful distribution, just as it would be if it erroneously sent one member’s distribution to another member.