The Ky LLC Act and Foreclosure of a Charging Order

In Stich v. Mattingly, the court was called upon to determine whether a trial court’s foreclosure sale of the charged interests in a SMLLC was proper; specifically, was for foreclosure sale of the entire interest including the right to manage the LLC, or was it restricted to the distributional rights that were liened by the charging order prior to the foreclosure sale.  The court cited this treatise for the application and effect of a charging order prior to foreclosure:

The charging order itself only placed a lien on Stich's interest in Haunt Brothers up to the amount of the judgment. It did not operate as an actual assignment. While the charging order was in effect, Stich still had the right to participate in the company as a member subject only to the limitation that his distributions were to go to the receiver to satisfy Mattingly's judgment against him. Assuming distributions had been made sufficient to satisfy the judgment, the charging order would have been lifted giving Stich the right to receive the distributions going forward. Implications of foreclosure for the LLC, 1 Ribstein and Keatinge on Ltd. Liab. Cos. § 10:19. In this instance, Stich would have been freed of the effect of the charging order and distributions thereafter made with respect to his Haunt Brothers' interest would have been paid to him as a member in the normal course. Id. at § 10.17.

Turning to the effect of a foreclosure, Stich, the judgment debtor, argued that Mattingly could not by virtue of a foreclosure come into the management rights of the LLC, a proposition rejected by the Court of Appeals:

Stich asserts that the foreclosure order entered by the circuit court was in error   because it ordered his entire interest in Haunt Brother to be sold instead of limiting the foreclosable interest to the right to receive distributions up to the amount of the judgment. This interpretation ignores the fact that Mattingly already had a right to receive the distributions up to the amount of the judgment under the charging order pursuant to KRS 275.260(2). Adopting Stich's interpretation would render KRS 275.260(4) essentially meaningless and hollow, a result which we cannot countenance. Lewis v. Jackson Energy Co-op. Corp., 189 S.W.3d 87, 91 (Ky. 2005) (“Statutes should be construed in such a way that they do not become ineffectual or meaningless.”).

Having examined all sections of KRS 275.260 within the greater context of the Kentucky Limited Liability Company Act we are confident that "the limited liability company interest subject to the charging order" referred to in KRS 275.260(4) is the judgment debtor's entire transferable interest in the subject company. Thus, the circuit court did not err when it refused to limit the foreclosure to Stich's rights to distribution up to the amount of the judgment.

The error the court here made is that it assumed that the judgment-creditor would be the successful bidder that the foreclosure sale - in which instance it is in part true that the successful bid as to the foreclosed interest would not yield anything more to the judgment-creditor.  However, change the facts and assume that a third-party prevails - the amount paid at the foreclosure sale goes to the judgment-creditor and satisfies to the extent of those proceeds (and here assuming no third-party with superior claim thereon) the judgment.  

Curiously the court went on to properly state the effect of the foreclosure sale of a charge against all of the interests in a SMLLC, observing (and again citing this treatise):

The purchaser of the interest at the foreclosure sale would then receive "the rights of an assignee." Id. When the sole member of the limited liability company's interest is auctioned off via foreclosure, the sole member ceases to be a member. KRS 275.280(1)(c)3.; Implications of foreclosure for the LLC, 1 Ribstein and Keatinge on Ltd. Liab. Cos. § 10:19. This in turn would trigger dissolution pursuant to KRS 275.285(4).

Which explains away the court’s rational for treating the foreclosure sale as extending to the entire interest in the LLC rather than limiting it to the right to receive distributions - in fact even in that limited circumstance the judgment-creditor, now holding all of the economic interests in the LLC that is to dissolve, is able to access the proceeds of its assets (i.e., capital lock-in ceases) and can benefit therefrom, a position notably different that is that of the mere holder of a charging order.  I here must note that on this point the court made a common but significant error, namely assuming the purpose of the charging order is to protect the “pick-you-partner” principle of partnership law as carried forward into LLC law.  While this error is quite common it is still an error. The purpose of the charging order is to protect the asset partitioning effect of the LLC, and not pick your partner {member}; I reviewed this point in Thomas E. Rutledge, I May Be Lost But I’m Making Great Time: The Failure of Olmstead to Correctly Recognize the Sine Qua Non of the Charging Order, 13 J. Passthrough Entities 65 (Nov./Dec., 2010).

True, a third-party (even a lieutenant of the judgment-debtor) might prevail at the foreclosure sale, in which instance the judgment-creditor would not have the ability to unlock the value of the LLC’s assets, but presumably the order directing the sale could (and should) provide partitions against abusive sales, and if the judgment-creditor credit bids the full amount of the judgement, and a third-party bids more, all else being equal the judgment-creditor is made whole and cannot complain that she/he did not enjoy a windfall. 

Stich v. Mattingly, No. 2023-CA-0032-MR, 2024 WL 2788210, 2024 Ky. App. LEXIS 42        (Ky.App. May 31, 2024).