Many entrepreneurs would rather notÂ think of what could occur to their businesses if creditor troubles arise, however, it is often very important to structure the ownership of business assets to provide flexible and effective limited liability should something unexpected transpire.
In the United States, although many people are familiar with limited liability as it applies to the debts of a business, i.e. protection from creditors of the business (sometimes called inside liability), there is also limited liability for the debts of business owners, i.e. protection from creditors of other business owners (sometimes called outside liability).
Inside Liability Protection
Inside liability protection is somewhat basic. Unless a creditor can “pierce the corporate veil” because business owners engage in illegal/wrongful activities, personally guarantees the debts of the business, etc., creditors of the business cannot pursue the business’ owners’ assets to satisfy a judgment against the business. In contrast, outside liability is more complex and requires some background on two court-ordered remedies that creditors may seek to satisfy court-ordered judgments against a business: foreclosure & charging orders.
Possibly the most common means through which creditors can satisfy judgments against a person’s interest in a business is via court-ordered foreclosure. If a creditor successfully forecloses upon a person’s interest in a business, the creditor may seize that person’s ownership interest and the rights associated therewith including any control over the business’ operation.
In comparison, a charging order does not permit a creditor to exert control over the business’ operations or its assets and limits creditors to receiving distributions, if any, that the business makes to the owner.
Which Types of Limited Liability Interests are Subject to Foreclosure, Charging Orders, or Both?
While there are multiple types of entities that provide limited liability, two are of particular note: corporations and limited liability companies (LLCs).
If a business is a corporation, a creditor may seek to foreclose upon a shareholder's ownership interest in the corporation, which is represented by shares of stock, and thereby acquire some control over the corporation and the corporation’s assets. While many corporations’ bylaws prohibit the involuntary transfer of shares, without allowing the corporation to redeem the shares at their fair market value, such arrangements require that a corporation possess resources that are sufficient to redeem the shares.
If a business is organized as an LLC, however, in a state where charging orders are the only permitted remedies against an LLC, e.g. an Arizona LLC, an LLC owner’s (called an LLC member) creditors will not be allowed to seize the LLC member's interest and any control over the business' operations or assets.
Steve Cook is an attorney at Cook & Cook in the Phoenix, AZ area. He focuses his legal practice on forming limited liability structures to protect the assets of businesses and individuals. During his undergraduate studies, he co-founded a digital advertising business that received over $1 million in venture capital.