Charging Order Protection is Now Available for Small Corporations
The following article was written by David M. Grant and Jeremy K. Cooper and was originally published in COMMUNIQUÉ (May 2009, Vol. 30, No. 5), the official journal of the Clark County Bar Association.
“What’s good for the goose is good for the gander.” This timeless cliché accurately portrays the logic behind Nevada’s recent ground-breaking decision to extend charging order protection beyond the realm of partnerships and limited-liability companies (LLCs) to corporations operating as small businesses.
Closely-held corporations, until now, have never received the same charging order protection their partnership and LLC cousins have enjoyed, but because these entities share many commonalities, such as limited-liability protection, flow-through taxation, and ownership structures that typically consist of a small group of like-minded principals, one was often left wondering why their similarities ended at charging order protection. With the passage of Senate Bill 242, now codified as NRS 21.090 and 78.746, and enlarging the shield of charging order protection, Nevada has essentially proclaimed: if charging order protection is good enough for partnerships and LLCs, then it is certainly good enough for small-business corporations.
The charging order past and present. The charging order came about as a solution to the judicial remedy of forced partnership liquidation to satisfy a partner’s non-partnership (“outside”) liabilities. Forced liquidation often resulted in irreparable damage to the non-debtor partners and dissolution of the partnership business (J. Gordon Gose, The Charging Order Under the Uniform Partnership Act, 28 Wash. L. Rev. & St. B.J. 1, 5 (1953)). Furthermore, forced liquidations allowed creditors a measure of control and managerial rights in the partnership which resulted in forced partnership associations, a concept which is at odds with traditional legal philosophies holding partnerships to be voluntary relationships of trust between intended partners (Jay Adkisson, Understanding Charging Orders, The Southern California Tax & Estate Planning Forum (October 19-21, 2006); Black’s Law Dictionary 459 (8th ed. 2004)) To mitigate this result, many states instituted laws providing charging order protection to partnerships and other similar legal entities (limited partnerships, limited liability companies, etc.).
In Nevada, for instance, a charging order is the sole remedy available to creditors seeking to satisfy an outside liability judgment against an owner of a charging order protected entity with the entity’s business or investment assets. A charging order, however, merely allows the judgment creditor to assume the role of an assignee and await distributions from the charging order protected entity intended for the debtor owner against whom the judgment was issued. The judgment creditor cannot force distributions, maintain managerial rights as an assignee, or exercise any measure of control over the entity (Unif. P’ship Act § 28 (1914)). Thus, charging orders protect the equitable and economic policy considerations of sustaining the entity’s business or investment interests and non-debtor owners from the outside creditors of a debtor owner.
Most states provide some form of charging order protection for partnerships, LLCs and their offspring. However, for smaller closely-held corporations, where ownership and operational structure closely resemble partnerships and LLCs, these protections do not exist. Nevada has responded to this apparent irregularity by becoming the first, and currently only, state to provide closely-held corporations with the same charging order protection previously only enjoyed by their flow-through counterparts (See Minutes Nev. S. Comm. on Judiciary, Apr. 6, 2007).
Nevada’s new charging order protection for closely-held corporations. Because of its overtly business-friendly environment, it is hardly a surprise that Nevada makes the charging order the exclusive remedy available to creditors in actions against debtors’ interests in partnerships and LLCs (Nev. Rev. Stat. §§88.535 and 86.401). The passage of Senate Bill 242 has distinguished Nevada as the frontrunner in the race of states hoping to market themselves as the business-friendly jurisdiction of choice.
Small-business corporations, including family-owned businesses, stand to benefit from Nevada’s extension of charging order protection to closely-held corporations. In fact, the legislative history indicates that protection of family-owned businesses operating as corporations was central to the passage of Senate Bill 242 (See Minutes Nev. S. Comm. on Judiciary, Apr. 6, 2007). The legislative history also suggests that charging order protection was extended to closely-held corporations because of their similarities with partnerships and LLCs (See id.).
In its final form, this new legislation makes the charging order a creditor’s exclusive remedy in actions against debtors’ interests in closely-held corporations (Nev. Rev. Stat. §§78.746 and 78.756), thereby making the stock of a Nevada corporation exempt from execution under state law, as long as the corporation meets the following requirements:
- Has more than 1 but fewer than 75 stockholders of record at any time;
- Is not a subsidiary of a publicly traded corporation, either in whole or in part; and
- Is not a professional corporation as defined in NRS 89.020.
It should also be noted that this charging order protection does not apply to any liabilities of a stockholder that existed as the result of an action filed before July 1, 2007. Moreover, the protection will of course not supersede any private agreements between a stockholder and his or her creditors. While this new law appears to be fairly clear on its face, some interesting questions remain regarding both the quantity and class of “stockholder.”
What does more than 1 but fewer than 75 stockholders of record “at any time” mean? The language “at any time” creates some ambiguity. By failing to limit the timing element of the stockholder requirement, it is possible to interpret the statute as saying that any corporation that has had more than 1 but fewer than 75 stockholders of record at any time since its inception is eligible for charging order protection regardless of its current number of stockholders. The drafters may have created a significant loophole that might extend charging order protection far beyond its intended scope.
Should the statute limit the number of stockholders to 75? In 2004, President Bush signed the “American Job Creation Act” which increased the limit on the number of stockholders allowed for an S-corporation from 75 to 100 (I.R.C. § 1361(b)(1)(A)). Because the 75-stockholder limit of NRS 78.746 was tailored towards the S-corporation limit(See Minutes Nev. S. Comm. on Judiciary, Apr. 6, 2007), amending the statute to reflect the current law might be appropriate.
Should the statute preclude all single stockholder corporations from charging order protection? While the legislative history does not explain why the statute requires “more than 1” stockholder, this requirement likely has to do with the charging order’s intended purpose of safeguarding the interests of a business’s non-debtor owners. If the reason for precluding single shareholder corporations from charging order protection is that there are no non-debtor shareholders to protect, then the following issues should be considered:
Community Property. Nevada is a community property state. As such, absent a lawful agreement, all property earned from the time a couple legally marries is generally presumed to be property of the community in which the husband and wife possess an equal ownership interest (Nev. Rev. Stat. §123.220). Thus, because assets can be held in the name of one spouse, but are generally presumed to belong to the community, uncertainty arises as to the statute’s application in a community property context.
To illustrate, suppose a husband and wife wholly own, as community property, the stock of a Nevada corporation, but all of the respective stock certificates are titled in the husband’s name alone. Although there is only one stockholder of record for the stock, because the stock is community property, the wife also owns a 50% interest in it. On its face, the statute indicates that charging order protection is not available to the couple. However, because there are two parties with separate legal ownership interests in the stock, there are essentially two stockholders each of whom would likely derive substantial benefit from receiving charging order protection from the other’s separate, non-community, debtors.
Substantive versus Formal Ownership. Similar to the above, if the statutory provision requiring more than one stockholder is intended to protect non-debtor shareholders and not the debtor-shareholder, then issues of substantive ownership versus formal ownership of corporate stock should be considered. To illustrate, if an individual plans to operate a corporation as its sole stockholder, then the individual can set up the corporation and own its shares in his or her own name. Consequently, the individual will not benefit from charging order protection because of the sole stockholder preclusion. Conversely, the individual can form a separate single-member holding company in which he is the sole owner to act as a second stockholder. With two stockholders, the ownership requirement of having more than one stockholder of record is formally met resulting in charging order protection based on the plain language of the statute even if there is only one true owner in substance.
Conclusion. Although Nevada now appears to lead the flock of states providing expanded charging order protection to legal entities. As a result, other states hoping to provide similar increased charging order protection will likely fall into formation behind Nevada by crafting their own legislation in protection of the business and investment interests of closely-held corporations.