What if a debtor suffers a judgment, the creditor obtains a lien against the debtor’s interest in an LLC or partnership, and then the debtor is then able to vacate the judgment in bankruptcy? Most people would probably assume that the charging order lien is also canceled in bankruptcy, but as we shall see this is not necessarily the case, and in fact there is a very confusing analysis ( at least for those who do not regularly practice in bankruptcy) to be followed in determining whether the charge order lien survives bankruptcy.
The case arises in the Milwaukee area, where a man named Kleynerman convinced another man named Smith to transfer Smith’s valuable patent to Red Flag Cargo Security Systems, LLC. Later, suffering from seller’s remorse, Smith sued Kleynerman for taking advantage of him while Smith was in an emotionally vulnerable position, and ultimately won judgment against Kleynerman for $499,000. To recover his judgment, Smith later obtained an arraignment order against Kleynerman’s interest in Red Flag, which created a lien on Kleynerman’s rights to receive distributions from Red Flag.
Seeking to clear Smith’s bankruptcy judgment, Kleynerman filed for Chapter 7 relief. Smith attempted to have his judgment rendered non-dischargeable by filing adversarial proceedings, but lost. Finally, on December 19, 2019, Kleynerman was granted his release and Smith’s judgment was over. What all of this left behind, however, was the privilege of Smith’s impeachment order against Kleynerman’s interest in Red Flag.
Here we come to a particular quirk of Wisconsin law, which exempts a debtor’s interest (like Kleynerman’s in Red Flag) up to $15,000 for a private business that employs the debtor or is involved in the debtor’s business. The Chapter 7 bankruptcy trustee had, in fact, deemed Kleynerman’s Red Flag interest worthless – which of course is less than $15,000 – and had dropped the interest, and of course Kleynerman himself. had claimed his Red Flag interest as an exempt asset. An interest in an LLC is almost never exempt to any degree, but it can be up to $15,000 in Wisconsin.
Kleynerman moved the bankruptcy court to avoid Smith’s writ privilege over Red Flag. The parties argued over whether Kleynerman’s motion was timely, and the court devoted a great deal of space in its notice to this issue, but since it doesn’t really concern us here, I’ll cut to the end of this issue and to say that the bankruptcy court ultimately allowed Kleynerman’s petition to proceed, although Kleynerman had to compensate Smith with approximately $20,000 in costs and expenses because the petition was late. Anyway, now back to Smith’s command privilege.
A charge order lien is known as judicial privilege, and Section 522(f) of the Bankruptcy Code avoids a judicial lien where it impairs the debtor’s right to an exemption. As a creditor, Smith argued that the correct procedure Kleynerman would have followed was to have filed a counterclaim in Smith’s opposing action to declare Kleynerman’s debt non-dischargeable (which, recall, Smith lost), and sought redress in that action. Kleynerman disagreed and argued that the lien could be avoided by a simple motion under Section 522, and the court agreed with Kleynerman. The question then was whether Smith’s privilege should be avoided.
A judicial lien may be avoided (“stripped” in bankruptcy parlance) under § 522(f) if it is said to “infringe” the debtor’s exemption, if the value of the property making the object of the lien is worth less than the aggregate of any exoneration and any other lien on that property. Here, there was only one lien on Kleynerman’s interest in Red Flag, which was Smith’s lien, and the value of Kleynerman’s interest in Red Flag had been determined by the Chapter 7 trustee. as worthless – which, of course, was less than the $15,000 exemption. Critically, Smith didn’t object to that assessment at the time, which seemed to be his main mistake, as Red Flag’s interest was worth at least enough for Kleynerman to fight for. In any event, the court avoided Smith’s lien on Kleynerman’s interest in Red Flag.
What’s not said in the court’s opinion is that if Wisconsin hadn’t had its awesome $15,000 exoneration, then Smith’s charge order lien would have survived the release of Kleynerman and Smith could have received any distribution up to the now discharged bankruptcy amount. If this result seems strange to you, then welcome to the often counterintuitive world of bankruptcy law.
In another aspect, Wisconsin’s awesome exemption also skews another part of this case. Normally, when an asset is subject to any authentic lien, whether it is a typical consensual security lien or, as here, a non-consensual judgment lien, then the asset does not pass into the debtor’s estate with the rest of the debtor’s assets at administer, but rather remains outside the debtor’s estate. Thus, if a creditor obtains a charge order lien against a debtor’s interest in an LLC or partnership, that interest would not normally pass through the debtor’s estate at the outset of bankruptcy proceedings. Here it is, and somewhat ironically because it is an exempt asset.
Wisconsin’s awesome exemption also had another effect, which was that the interest was listed in Kleynerman’s listings as an exempt asset, whereas normally a debtor’s interest in an LLC or partnership would be listed. like a enforceable contract, similar to a car rental agreement. This is because LLCs and partnerships are fundamentally contract law entities, as opposed to, for example, shares which are purely a statutory creation. Whether an LLC or partnership is treated as an enforceable contract under bankruptcy law normally involves a very complicated analysis as to what happens to the interest of the debtor and for which I have collected my own thoughts hereand with which bankruptcy courts have generally struggled.
From an asset protection planner’s perspective, it is probably impossible to predict in advance with any consistency what might happen to a client’s LLC or partnership in the event of the client’s bankruptcy. Thus, good asset protection planning generally provides that an LLC or partnership interest will always be held in some form of an irrevocable trust, so that the interest remains both outside the bankruptcy to begin with, and that a creditor cannot obtain a charge order lien against interest and thus becomes a secured creditor who has a lien that survives the discharge of the judgment. Yet you still see people offering asset protection plans where the debtor holds an LLC or partnership in their own name, seemingly in blissful ignorance of these issues.
Anyway, what happens in the event of bankruptcy to an LLC interest subject to charge order lien has been the source of much speculation for the past twenty years or so, and now we know it because this case tells us. However, I would still like to see a court opinion on the matter that did not involve Wisconsin’s $15,000 exemption for interest, because that would be even clearer.
In re Kleynerman2022 WL 243215 (Bk.EDWis., 26 January 2022). https://chargementordre.com/opinion-2022-wisconsin-kleynerman-chargement-ordre-bankruptcy-link.html