Internal Affairs Doctrine, Asset Protection, and State of Formation for Legal Entities Pt. 2 of 2

“Internal Affairs Doctrine, Asset Protection, and State of Formation for Legal Entities: Pt. 2 of 2,” that is the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is ACTEC Fellow Connie Tromble Eyster of Boulder, Colorado.

The internal affairs doctrine deals with the choice of jurisdiction informing entities and the ability to bind creditors to that choice. Typically, the internal affairs of an entity are controlled by the laws of the state of formation. For charging orders, though, the laws of the state enforcing the remedy may apply. This leads to the question of whether there may be a reason to form entities and states with protective charging order statutes.

ACTEC Fellows  Gray Edmondson of Oxford, Mississippi, and George Karibjanian of Boca Raton, Florida,  join us today to help us understand this topic. In Part 2 of this two-part series, Gray and George will provide a deeper analysis of the relevant case law and provide some practical illustrations of how the internal affairs doctrine can impact our clients. Welcome again, Gray and George.

Recap of Podcast 1

Gray Edmondson: Thanks, Connie. And I think picking up from where we left off in Part 1, you know, I had sort of discussed where this issue arises in multi-jurisdictional LLCs where you have, say, a member in one state and an LLC, for example, formed in another state that have different remedies available to creditors of a member in their interactions with the LLC and how and to what extent the internal affairs doctrine may apply. And George discussed some of the case law that’s out there and how that’s been reconciled differently in different jurisdictions. I think what we want to discuss together in Part 2 is – How does this apply in different multi-jurisdictional potential fact patterns and how does this overlay with other general concepts in the law that we have seen and particularly in certain trust cases as well?

LLC Interest is Intangible Personal Property That Travels With the Debtor

So, with that, I’d kick it off to say, and get George’s input on, you know – Do we think these cases are right? You know, obviously, they’re different in different jurisdictions. So maybe, you know, which one do we think is right? From my perspective and what’s been raised by the court; and this was discussed in the Wright case, which is a New York case that, you know is Wright v. Shenandoah Investors. It’s a New York state court case. And what the court there said was that an LLC interest is intangible personal property that travels with the debtor. It travels with the member of that LLC. And so any court that has personal jurisdiction over that LLC member also has jurisdiction over their intangible assets that are movables that travel with them. And I guess the question then becomes, is that right? Is that the proper answer? And I don’t know, George, what are your thoughts on that?

Application of the Laws Governing LLCs Across State Lines

George Karibjanian: I’ve taken a very objective view of both opinions. So, I’m going to go back to the Uniform Act, and I’m going to ask this question – If the act is only meant to apply to the law governing the internal affairs of the company, or if the law only applies to the internal affairs, then why have the charging order statute? Because that does not involve the internal affairs. That is a third party trying to take an interest.

Further, when you form these LLCs, it’s a group of people getting together to form a business. What the internal affairs doctrine is seemingly saying is a creditor can come in and become your – for lack of a better phrase – your partner in the business by taking the interest with a judgment. Somehow I can’t reconcile that with the way the Earthgrains (Earthgrains Baking Companies v. Sycamore Family Bakery, Inc.) court was doing it. I kind of think I’m leaning the other way.

And, also, to apply this to another area where I’ve previously spoken on podcasts, this is very much like a situation that is found in the Uniform Voidable Transactions Act. And I have mentioned this before, the purpose of the UVTA was really to try to eradicate the domestic asset protection trust. But what they do in the comments is they make this leap – paragraph eight to comment four of the UVTA – where they try to make the statement, if you go to another jurisdiction to gain a benefit that you don’t have in your home jurisdiction, that transfer is basically voidable. There’s no reason for that. There’s no valid law. That’s just a statement that they’re making.

So here, it’s almost like you’re making a quantum leap, Gray, when you’re trying to argue “well, of course, we’re going to let a creditor take your interest in the LLC.” And they’re now going to become a member with the other people that have no business whatsoever. And Gray, take it from there. So, the creditor gets the interest. What’s going to happen next?

Gray Edmondson: Well, I think that’s the right segue there, because at the end of the day, even if the right analysis is different than what you proposed, George, which is that they shouldn’t be limited to the laws of the state of formation. They didn’t do anything to limit themselves to that. The court in another state that allows foreclosure has jurisdiction. That’s where the harm occurred to them. That’s where they pursued their remedy. Why should they be limited to some state they never voluntarily limited themselves to? But if you play that out, this creditor gets a judgment that allows them to foreclose on an interest, requires a distribution of assets to them, or requires the sale of assets and payment on their claim, or something that’s beyond the scope of what the state of formation would have allowed, at least if this is a non-controlling interest in the LLC that they get this judgment with respect to, in order to mandate or force the other members or the LLC to do that. Presumably they’re going to have to go in and domesticate that judgment in the state of formation to compel these acts to be undertaken. And the state of formation is probably going to follow their own laws.

And so, yes, you may get a court in another state that says “Delaware LLC X, you’re required to sell these assets and distribute the proceeds in satisfaction of this judgment.” But if the member against whom this judgment has been granted is not a controlling member, that creditor may have to go into Delaware to enforce it, and Delaware may refuse to do so. And maybe rightfully so. You know, that’s another question.

So, I think when you play this out factually and procedurally, it’s not as straightforward as “does the state where the judgment is granted enforce the remedies available to the creditors based on their statutes or the state of formation statutes?” It’s once they choose which route to take, how then do you effectively go and get that enforced? And if you have to go back to the state of formation to do so, or another state to do so that also limits judgment creditors to a charging order, you may not be able to effectively accomplish what you’ve got in the state where the judgment was granted.

Single-Member LLCs Across State Lines

I think that may be different where you have a single-member LLC. For example, if you’ve got a single-member LLC formed in, you know, pick on Wyoming, but the single member is located in a state that allows foreclosure, there’s really no third party rights that you’re affecting. There’s no one else out there. The court in the other state has personal jurisdiction over that sole member. And that sole member has the authority to force a distribution of these assets or force a sale of assets that, if they don’t, they may be in contempt back in their home state. But if they don’t have a controlling interest or there are – even if it is a controlling interest – if there are third-party members whose rights would be affected, you have a different fact pattern than say a single member LLC. So I think it’s not as cut and dry as one way or the other.

George Karibjanian: I have to think – and let’s use a single-member LLC example because, in Florida, we specifically do not grant charging order protection as the exclusive remedy to single-member LLCs – the statute’s very clear, it must be more than one member.

Many real estate people, such as developers, will go buy a tract of land and they will buy it through a single member LLC that they may create, say, in Delaware. If the creditor gets the interest based on a judgment in Florida and now tries to liquidate the LLC, I can’t imagine – if there’s anyone who also has a right – they’re not going to go run to Delaware. And Delaware is going to take great offense to that because they’re basically usurping Delaware law by basically trying to force a sale. And that’s something I have not read in the cases. We have not seen what happens to that degree, but that to me is an issue. And, I think you’re going to bring up, there’s a trust case where you can make that analogy.

Gray Edmondson: That’s right. And I think at the end of the day, the question then becomes – “Does the judgment creditor, say you’ve got a real estate developer in Florida that owns an LLC as a sole member, and its sole asset is real estate in Florida, and the judgment from a court in Florida against that member to sell this property in Florida: do they have to take anything to Delaware to have a Delaware court intervene whatsoever?” So I don’t know. I mean, again, we haven’t seen that necessarily play out. But the point is, it’s not as cut and dry as those who would tell you to form in X state and that’s going to control – it may or may not. And so you can’t promise clients that you’re going to get the benefit of that.

George Karibjanian:   And actually, ask yourself, does Delaware have an interest? Can Delaware bring an action? Because now Delaware wants to, it’s state law. Its state laws are being violated theoretically. Does Delaware now, the Delaware attorney general, have an action to come in and bar this from happening?

Administration of the Law May Differ in Another State

Gray Edmondson:  And I think that’s a good segue into this trust case because what, and the trust case I’m referring to is the matter of Cleopatra Cameron Gift Trust out of South Dakota, where you had a California judgment that had been entered requiring a trustee to make a distribution of trust assets to satisfy marital claims because California recognized that as an exception to spendthrift protections. South Dakota, on the other hand, does not. So this California judgment got taken to South Dakota, where the trust was administered, to be enforced. And the South Dakota court said they weren’t going to enforce it because marital claims – family law claims – are not an exception to their spendthrift statute.

And what the South Dakota court said is, and there were full faith and credit issues – constitutional full faith and credit issues – that were raised in that case, and you have to give full faith and credit to the California judgment. So if that California court has said “take these trust assets out,” and the California court had jurisdiction over the parties, trustee, you have to do that now under full faith and credit. And what the South Dakota court said was “yes, full faith and credit prohibits one state from disregarding another state’s order, but it doesn’t mean that their remedies have to be the same.” The procedural mechanisms by which you enforce that judgment have to be the same. And since you’re bringing that judgment into South Dakota to enforce it: “Yes, we recognize the judgment. We’re not saying that’s an invalid judgment or it doesn’t get recognized in this state. We’re giving it full faith and credit. But that doesn’t mean California law applies in enforcing that judgment in this state.”

Those concepts, at least conceptually to me, could apply in the LLC context as well – saying that just because a court in one state has issued a judgment doesn’t mean that another state has to enforce that judgment the same way the other state would. We just have to recognize it as a valid judgment under full faith and credit.

Gray Edmondson: I agree with you on that.

Final Recommendations to Planners

I think that at the end of the day, the sort of question then becomes – client comes to you and says: “What state should I form my LLC in? I’m going to be forming an LLC. I want it to be as protective as possible. I hear State X – again, pick on the name states you hear all the time: Delaware, Nevada, Wyoming, Alaska – that’s where I need to form my LLC because it has this protection or that protection. Let’s form there.” What do you tell a client, George? I mean, what’s the analysis there?

George Karibjanian: I think you say you have to be upfront and say “It seems like you get protection, but the law is unclear.” And I think that’s something most practitioners of which I’ve spoken are not aware that that is happening. Everybody seems to think Delaware is bulletproof. It may be, but we don’t know. And I think that’s what you have to tell clients and put full disclosure and the client could take the risk and say “we could do it, but the case may come down where it may happen.” Then it’s up to Delaware to decide what happens if you, if they take the judgment to Delaware.

Gray Edmondson: That’s right. And at the end of the day, part of my view is it’s better to have the argument than not, sometimes. So don’t concede the issue before you fIght the fight, so maybe it’s better to go ahead and form in those states. But I do think you have to be clear that that’s not necessarily controlling.

Connie Tromble Eyster: Well, thank you, Gray and George. What a wonderful way for you to end your podcast with such terrific advice for practitioners. We hope to have you back when that Delaware case comes along, and we have more information. Thank you again.

Additional Resources:

• Internal Affairs Doctrine, Asset Protection, and State of Formation for Legal Entities Pt. 1 of 2 (Feb 2025)
• What Estate Planners Need to Know About the Uniform Voidable Transactions Act (Apr 2018)