Ohio Practical Business Law : Columbus Ohio Business Lawyer & Attorney : Teri Rasmussen : Plunkett Cooney Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

Let’s say your debtor has some ownership interests in a family business which you think might have some value.  And if nothing else, the threat that you the creditor might soon be running that business ought to be worth some leverage, right?  How can you get to those? The answer depends upon whether the business is set up as a corporation or as a partnership or limited liability company.

Partnerships and LLCs.  If the business is a partnership or a limited liability company, the best you can do, whether by way of a charging order or through enforcement of a security interest, is get to the ECONOMIC aspect of the ownership interest.  That is, you as creditor CAN start receiving whatever distributions and payments to which your debtor is or becomes entitled.  

What you CANNOT do, however, is exercise any control whatsoever on when those distributions or payments are made.  Nor can you vote or exercise any other control over the business and financial affairs of the company in which your debtor has the ownership interest.  Can’t be a partner or member with anything other than the rights of an assignee unless the other partners or members decide you are.  That’s just the way it is - the nature of what it means to be a partnership or a limited liability company. 

For the initial creditor, the receipt of payments continues only so long as there is an outstanding amount owed to the creditor. However, if the creditor goes so far as to “foreclose” its charging order or otherwise sell its place as an assignee, any purchaser will continue to receive payments so long as the partnership or LLC is in existence. 

Corporations.  So what happens if the company in which your debtor has an ownership interest is set up as a corporation?  Well, this is a horse of a different color indeed.  Whether it’s enforcing a security interest in stock owned by your debtor or proceeding by way of execution or attachment, once that legal proceeding has been accomplished, you the creditor have wound up with ALL the accoutrements of ownership. 

What does this mean?  Well, you as creditor get the same ECONOMIC aspects of ownership as with partnerships and LLCs which would entitle you to receive dividends.  However, unlike the partnership/LLC situation, the creditor also automatically gets the ability to vote as a shareholder.  Although that doesn’t give full control of the company – unlike a partnership or LLC, it’s the directors and officers that actually oversee and run the business and financial affairs -- it is a start.  In a small and/or closely held corporation, the number of directors and officers is usually small and shareholders have the ability to replace directors.

            >>> so, side note to businesses and their owners concerned about “asset protection" - yet another reason to go with a limited liability company aka LLC as your preferred type of entity.

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If you have an ownership interest in an LLC or partnership and are having financial difficulties or if someone owes you money and you are concerned about getting paid back, then you want to know about "charging orders".  A charging order is a way for creditors to get to dividends, distributions, or other payments that would otherwise be paid to a person owing the creditor money.

The first thing to know about charging orders is that they don't come into play until AFTER the creditor has obtained a judgment.  In essence, a  charging order “charges” .the judgment debtor’s membership or partnership interest with the payment of the unsatisfied judgment previously obtained by the creditor.  It allows judgment creditors of a partner or LLC member that permits the creditor to receive the profits and distributions otherwise due to the judgment debtor partner or LLC member.  

Because Ohio has recently adopted the Revised Uniform Partnership Act, Ohio Rev. Code §1775.27 which governed charging orders with respect to partnerships has been replaced by Ohio Rev. Code §1776.50 .   Charging orders may also be obtained against members of a limited liability company organized in Ohio and are governed by Ohio Rev. Code §1705.19 which is much less detailed:

To obtain a charging order, the creditor need only file a motion in the case where the judgment was obtained and obtain the appropriate Order.  It is also advisable to include an Affidavit along with the Motion setting forth the amount of the judgment and the equity interest to be charged. Larson v. Larson, 2000 WL 1566522 (11^th App. Dist. 2000).  Ohio, unlike many states, does not make a charging order an exclusive remedy so the creditor may still pursue other remedies against the judgment debtor.

Once the charging order has been obtained, the creditor should specifically notify in writing the partnership and partners or the LLC and its members, as applicable.  The notice should inform them that no further payments should be made to the judgment debtor. The creditor may also proceed with a foreclosure sale of the equity interest and the charging order itself should contain language authorizing the creditor to do so.    

Charging orders are powerful weapons for creditors because if the creditor does foreclose on the partnership or membership interest, the purchaser will be entitled to the judgment debtor’s share of profits and distributions indefinitely, thus potentially resulting in a windfall to such a purchaser.

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Suppose you've made an investment in an LLC running, say, a nightclub.  It's a manager-managed LLC so someone else is handling the day to day affairs of the company.  Then, what was once a popular hot spot becomes passe and the business becomes less profitable.  So you start to worry about how things are being done and may even suspect that there has been some financial mismanagement.  You decide to take a look at the company's books yourself, but are surprised to find that the manager of the LLC refuses to give you access.  Can he do that?  

Peter Mahler over at the New York Business Divorce blog (which has a terrific and very appropriate masthead of two hands engage in a tug-of-war) posted last week on divergent results reached in two New York cases concerning the right of non-managing LLC members to inspect the books and records of the company.  He also pointed out that the New York statutes governing access to a company's books and records differed depending upon whether the entity was formed as a corporation or a limited liability company.  

What LLC Members Have to Do to Get Information.   Because the pertinent Ohio statute (Ohio Rev. Code 1705.22) is similar to the New York statute, I became interested.  Like New York, Ohio law provides LLC members  with a right of access to certain specified types of information, including financial information "upon reasonable demand for any purpose reasonably related to [the member's] membership interest in the company".  In both states, one of the categories of information includes a catch-all "other information regarding the affairs of the company that is just and reasonable".  And what does that mean?

Peter describes two recent New York cases reaching opposite results, with one holding that the member was entitled to the documents sought and the other concluding that the request was too vague.  To be fair, in the case denying the member access to LLC records, there was already litigation pending and the member was refusing to pay for the expense of copying.  In dicta, however, the court said that the desire to obtain documents to determine if the LLC manager had engaged in fraud or other wrongdoing went "well beyond the scope of the type of documents detailed in the Limited Liability Company Law." 

In the other case described by Peter, the LLC members seeking access wanted to determine if the LLC manager had caused the LLC to improperly enter into a management contract with a certain third party in violation of Department of Health regulations.  The court determined that access to the books and records sought was required.  In contrast to the first case, the court chose to interpret the statute broadly, placing the burden on the company to justify the restrictions rather than on the member to justify inspection rights:

Respondent's assertion that petitioners must demonstrate a need to review the records before such records are made available is without merit.  The only statutotry requirements for obtaining full access to the records is that the person demanding access is a member at the time the demand is made and that the demand is reasonably related to the member's interest.

I didn't find any Ohio caselaw interpreting its version of the statute.  Ohio law in the analogous situation of shareholders seeking access to corporate books and records has been to place the burden on the company to demonstrate the sound basis for any restrictions.  However, to be certain access to company records is at the level desired, it is best to spell it out in the Operating Agreement.  

Comparison with Access to Books and Records of Corporation or Partnership.  Which brings me to Peter's other interesting point - namely, the statutes governing access to a company's books and records are not identical to one another, regardless of whether the entity has been formed as an LLC, corporation. or partnership.  In New York, there is apparently a statute that makes obtaining access to the books and records of a corporation a bit more complicated to obtain than in the LLC context.  Ohio doesn't have this sort of procedure, but Ohio Rev. Code 1701.37(C) does seem to establish a slightly different standard for shareholders seeking access to the corporation's books and records.  Here, the shareholder "upon written demand stating the specific purpose thereof" may have access "at any reasonable time and for any reasonable and proper purpose."  

Limited partners in Ohio are entitled pursuant to Ohio Rev. Code 1782.21 to access to partnership books and records "upon reasonable demand for any purpose reasonably related to the limited partner's interest as a limited partner."  This is quite similar to the LLC statute's language.  However, unless prohibited by the partnership agreement, the general partner does have the right under Ohio law

... to keep confidential from limited partners, for the period of time that the general partner considers reasonable, any information... which the general partner in good faith believes is not in the best intersts of the limited partnership or could damage the limited partnership or its business...

There is no similar provision with respect to LLCs.

Do these language differences mean anything?  Francis Pileggi of the Delaware Corporate and Commercial Litigation blog also recently noted a difference in the access to records in Delaware statutes governing LLCs and corporations.  He describes a recent Delaware case involving an LLC in which the Delaware Chancery Court chose to turn to caselaw regarding the question in the context of corporations.

Whether access to the books and records of a company is given to equity holders will undoubtedly be determined on a case by case basis.  However, to me, it makes little sense to distinguish among types of entities regarding the level of access equity holders should have to the books and records of the company.  Why should an equity holder in a 3 person manager-managed LLC have different rights than the shareholder in a close corporation with three shareholders? 

  On the other hand I can see logic in distinguishing between entities depending on the sopistication of the company and number of equity holders.  In the case of "closely held" entities with only a few owners, the presumption ought to favor the equity holder.  As the entity grows larger, and is perhaps even a public company, the burden on the company and the possiblity of abuse of the right by dissident equity holders seems greater.  So here I would tend to support placing more of a burden on the equity holder to justify the need and purpose for seeking access.   

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While it is by no means the only important legal decision to be made when buying or starting a business, would-be entrepreneurs tend to focus on what sort of legal entity that company should be - corporation, partnership, limited liability company, etc. The basic options are fairly clear:

• If you will be the only owner, either a corporation or a limited liability company (sometimes called an LLC) are possibilities. An individual can also operate his or her business without forming either, becoming a sole proprietorship by default.

• A business with multiple owners can be a general or limited partnership, a corporation, or a limited liability company. If no conscious decision is made, a business with two or more owners will automatically be a general partnership.

There are still other more esoteric options, but these are the basic entities available. Making the proper choice among these options requires both a fundamental comprehension of the characteristics of each and an ability to understand how you want to handle and respond to the inevitable challenges ahead for the business. In today's post, I will highlight the basic characteristics of these various entities. In my next post, I will discuss some of the factors to consider when making the choice between them.

Sole Proprietorship Disadvantages. For businesses owned by a single individual, remaining a sole proprietorship has a number of drawbacks. Unless the business is very small and very new, and perhaps even then, operating a business as a sole proprietorship is generally not the best choice. The legal costs of incorporating a business or forming an LLC with a single owner are relatively small (less than $1000) and a more formal business structure can enhance a company's credibility with both vendors and customers, thus leading to growth. At the same time, incorporation or forming an LLC can also offer protection from personal liability for company debts to vendors, for accidents not covered by insurance, and from other creditors if the business ever becomes unable to pay. In addition, transferring ownership of the company, especially for anyone hoping to eventually sell out to investors, is greatly simplified with a corporation or LLC.

If you choose to remain a sole proprietorship "for now", you should still open a separate business checking account to help you keep track of business revenue and especially expenses. In addition, this will help you form good habits regarding keeping business and personal financial affairs separate that will serve you well as your business matures and does require more formal structure.

Corporations as an Option. Corporations are the most established choice for those wanting the benefits of limited liability for their business. In Ohio, corporations are governed by the provisions of Chapter 1701 of the Ohio Revised Code. Corporations are rather easy to form, although contrary to some popular belief, it does require some additional steps beyond merely filing a 2-page Articles of Incorporation with the Secretary of State. Corporations formed in Ohio have Articles of Incorporation and are governed by a Code of Regulations which is analogous to what is sometimes called Bylaws in other states.

Corporations are managed by officers such as a President and Treasurer who answer to directors who are in turn elected by shareholders, with the exception of "close corporations" in which the shareholders act as the directors. While in smaller privately held owner-operated corporations these may all be the same people, technically shareholders - unless they are in a "close corporation" which has affirmatively made such a choice - do not participate in the management of the company's day-today business and financial affairs.

Ownership in the corporation is conferred by the issuance of shares of stock evidenced by stock certificates; in Ohio, technically you have shares - not stock -- in a corporation. Everything from voting influence to the amount of dividends received is directly dependent upon the number of shares one has relative to other shareholders; if one holds 35% of the stock, one has 35% of the voting power and the right to receive 35% of whatever dividends are being distributed. (This can be made modified and become more complicated in corporations with "preferred" stock or other classes of stock.) Ownership can also be diluted if additional shares are issued to others.

By statute, corporations are generally required to observe many formalities and do considerable recordkeeping in order for shareholders to enjoy the benefits of limited liability. Directors and officers must be appointed, even if they are also already in the role of shareholder. Shareholder and director meetings must be held periodically and minutes of those meetings maintained. Ledgers reflecting share ownership allocations must be kept up to date at all times.

To dispense with the necessity of complying with some of the statutory record-keeping and other requirements, shareholders of an Ohio corporation can enter into a written Close Corporation Agreement complying with Ohio Rev. Code §1701.591 if they make an affirmative decision to do so. This agreement can also include provisions sometimes found in a Buy-Sell Agreement dealing with circumstances and conditions under which ownership can be transferred or owners wishing to sever their ties to the business can receive the benefit of their investment.

S-Corp or C-Corp. Businesses considering the corporation form must further choose between being an S-Corporation or a C-Corporation. This is primarily a taxation decision, but the choice does carry certain consequences with it. S-Corps can later convert to C-corps fairly easily, but generally C-corps cannot convert to S-corps later without tax consequences.

S-corporations are designed for smaller businesses. Under federal law, they are restricted to 100 shareholders who must be individuals (or their estate planning trust) who are either U.S. citizens or permanent resident aliens; partnerships, LLCs, or other corporations cannot be shareholders of an S-corporation. In addition, if there will be more than one class of stock or owners will otherwise have differing rights to manage or receive distributions, S-corps are off limits. Entitlement to dividends and voting rights must directly correlate to the corresponding ownership interest.

C-corporations, by contrast, tend to be larger more mature companies. Many, if not most, of America's best known companies are C-Corporations. There are no limitations in a C-corporation as to the number or type of shareholders; LLCs, S-corporations, C-corporations, partnerships, and foreign nationals or companies can all be shareholders of a C-corp. Nor are there any restrictions on the number of classes of shareholders or the types of voting and economic rights shareholders can be given. However, because profits of a C-corp are taxed twice (once as corporate income and once as dividends) and losses must remain at the corporate level rather than being utilized by shareholders, C-corps are generally not appropriate for small and medium sized privately held businesses, especially ones just starting out or ones that are sometimes referred to as "lifestyle" companies.

General and Limited Partnerships Both Largely Obsolete. Partnerships provide some level of limited liability and come in two flavors - general partnerships and limited partnerships. Because of the flexibility of the LLC structure, partnerships have largely been replaced by LLCs as a business form. Consequently, both limited and general partnerships are now obsolete choices except in some very specific and unusual circumstances such as certain estate planning situations.

In a general partnership, all partners participate in the management of the business venture and each is liable for the partnership's debts in proportion to their respective partnership interest (e.g. if three people are equal partners, they are each liable for one-third of the partnership's debt if the partnership has insufficient assets; if A has a 50% partnership interest while B and C each have a 25% partnership interest, A would have liability for 50% of the partnership debt if the partnership has insufficient assets). In a limited partnership, there is a general partner who is responsible for the day-to-day management of the partnership's business and who is likewise liable for the debts of the partnership in the assets of the partnership are insufficient. A limited partnership also has limited partners who must not participate in the management of the partnership's business and are protected from personal liability for partnership debts in return.

Limited Liability Company. The impetus for the emergence of the LLC alternative was the desire of owners to participate directly in management of a business as in a general partnership while retaining the protection from personal liability found in corporations. An LLC has members instead of shareholders and, if desired, managers instead of officers and directors. Instead of shares, members hold Membership Interests which in some cases are also called membership units.

Basically, an LLC is a cross between a partnership and a corporation, allowing owners to have the best of both. Instead of a partnership agreement or a Code of Regulations (or bylaws), LLCs have Operating Agreements. A Limited Liability Company, also known as a LLC, can be structured to include all of the informal decision-making, tax advantages and other benefits of either a General Partnership or a Limited Partnership. In addition, LLC Members do not have to forgo participation in managing the business (as they would need to do in a partnership) to enjoy the limited liability protection against company obligations to suppliers, vendors, and other creditors which is normally associated with corporations.

LLCs are a fairly new entity, first appearing in 1977 in Wyoming, but are now available in all states. Some states such as Delaware also have statutes permitting certain specialized versions. In Ohio, LLCs have only been an available option since 1994 and prior to 1997, Ohio law did not permit one member LLCs. Chapter 1705 of the Ohio Revised Code governs limited liability companies formed in Ohio and provides certain default provisions which will govern if not otherwise determined by the members of the LLC. LLCs can be structured like a limited or a general partnership, or even a corporation with respect to the management of the business. Under the IRS Check-the-Box Regulations adopted in 1997, LLCs can choose to be taxed as either (1) a partnership or sole proprietorship as applicable; or (2) a corporation.

Virtually unlimited flexibility is the hallmark of a limited liability company; essentially, virtually any business arrangement among owners can be easily accommodated. There are also fewer statutory recordkeeping requirements than are imposed on corporations. In addition, allocations and distributions of profits and losses, as well as management and voting rights, need not mirror and conform to the relative ownership interests held in the company. Typically, however, member-managed LLCs tend to duplicate the essence of a partnership, involving participation by all owners in management without giving up limited liability protection. Alternatively, a manager-managed LLC business operations may more closely resemble a limited partnership or corporation with day-to-day management being reserved for the manager(s).

Choice Narrowed to LLC or Corporation. Given the disadvantages of operating a sole proprietorship and the general obsolescence of the partnership alternative, the real choice for most business owners comes down to incorporating the business or organizing it as an LLC. Whether the corporation structure or the LLC alternative is better for a particular business depends on a number of factors. Those factors include the number and type(s) of owners and under what conditions, if any, there will be other owners. In addition, subjective complexities such as whether distinctions in the owners' respective equity and management rights are necessary or appropriate are important.

What really matters, regardless of the legal form chosen, is deciding more personal questions which will arise in every business. What will be the responsibilities of each owner with respect to the business? If a decision has to come to a vote, will each owner have one vote or will votes be by the level of ownership interest or some other formula? Will different kinds of decisions be decided by different kinds of votes, and if so, what will that be? How will profits (and losses) be allocated among owners? What happens if owners want to leave the business; how (and under what circumstances) will transfers of ownership be allowed?

For more details on all of these choices, view my PowerPoint seminar presentation The Legal Side of Getting a Business Up and Running.

For other perspectives focused on other states, see

• Michael Hamblin of the Michigan Business Lawyer blog has made a number of interesting posts recently on the subject of entity selection:

  • Michigan State Law: Choosing the Appropriate Corporate Entity is Crucial for Success of Your Business

  • Instead of Operating Your Business as a Michigan Partnership, Consider Forming a Michigan Limited Liability Company

  • A Michigan Corporation Could be the Right Entity for a New Michigan Business

  • The Basics of a Michigan S Corporation

• Illinois Business Law Journal blog - The Art of Registering a Business: Picking the Right Method of Registration for Your New Business

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