Debtor’s Law Firm Fees Lien Takes Priority Over Charging Order In Rice

A charging order is a post-judgment enforcement tool that places a lien on a debtor/member’s right to distributions from an LLC or partnership, or what is referred to (not quite accurately) as the debtor/member’s “membership interest” or “partnership interest”. The best way to think of a charging order is as a can of spray paint, with the paint being the lien. A creditor uses the charging order to spray the lien all over the debtor/member’s interest. At the end of the day, what the creditor ends up with is a lien on that interest. This lien is pretty much like all other liens in that it competes for priority with other liens to receive distributions from the debtor’s interest. Whoever’s lien goes down first has priority on receiving distributions from all subsequent lienholders, and then the second-in-line gets paid, and so forth and so on, until all lienholders are paid up.

In California, where the case that I shall next describe takes place, the mere filing of a motion for charging order creates a temporary lien on the debtor’s interest in an LLC or partnership. This temporary lien lasts until the hearing on the motion, at which point the lien either becomes permanent if the charging order is granted, or the temporary lien immediately dissipates if the motion is denied. Keep that in mind as we consider the following.

A fellow by the name of Downs was the attorney of another fellow by the name of Rice, and the two of them and a third guy joined together to form a company that had as its goal to develop affordable housing. Proving the old adage that your client should not also be your business partner, when the deal became problematic Rice sued Downs for malpractice and similar stuff, and Downs moved compel arbitration. In the ensuing arbitration, Downs won and Rice ended up having with a judgment against him for hundreds of thousands of dollars for the attorney’s fees and costs expended by Downs. That caused Rice to appeal, and in this he was partially successful, getting to litigate some of his claims in court as opposed to arbitration, but the California Court of Appeals still stuck him with the judgment for Downs’ attorney’s fees and costs. Thus, back to litigation the two went.

While the resumed litigation started back up again, Rice began pursuing his non-arbitrated claims against Downs, and Downs again sought to send certain of those claims to arbitration. Downs lost on this motion, filed his own appeal, and on January 30, 2018, won an order from the Superior Court that the litigation be stayed until his appeal had concluded.

Meanwhile, Downs also started trying to collect on his fee and costs judgment, and on April 11, 2018, Downs moved for a charging order against Rice’s interests in a number of LLCs in which was Rice was a member, including a company called Triton in which Rice was the sole managing member. But because Downs had filed this motion for charging order only after the case was stayed by Down’s own motion, on June 19, 2018, the Superior Court denied this first attempt by Downs to get a charging order against Rice’s interests in the various LLCs.

Ultimately, Downs lost his appeal, meaning that Rice’s litigation of his non-arbitrated claims could move forward, but that also ended the stay of the litigation. Downs thus filed a new motion for charging order on October 3, 2019. This second motion for a charging order by Downs was granted by the Los Angeles Superior Court on October 30, 2019.

A few months later, on January 27, 2020, Rice filed for bankruptcy and in his schedules disclosed that Triton has paid the law firm of Glaser Weil, et al., the amount of $450,000 for its work in representing Rice in the litigation against Downs. Just a few months later, on April 14, 2020, the bankruptcy court dismissed Rice’s case on the grounds that the matter would be better litigated back in the state courts. Just a couple of weeks after that, Downs moved the Superior Court to enforce the charging order against Triton, alleging that the $450,000 payment to Glaser Weil violated the charging order.

Rice’s opposition to the motion to enforce the charging order argued that in the interim between Down’s first and second motions for charging order, and more specifically on June 27, 2019, Rice’s company Triton had entered into an agreement with the Glaser Weil firm under which Triton became a co-obligor for Rice’s legal bills owed to the law firm. Triton also gave Glaser Weil a security interest on Rice’s interest in Triton, and Glaser Weil perfected that interest by filing a UCC statement with the Secretary of State ⸺ all of which was accomplished before Downs filed his second motion for the charging order. Finally, Rice and Glaser Weil had entered into a “Pledge and Security Agreement” whereby Rice granted the law firm a security interest in his interests in Triton not just for past fees owed to the law firm, but to also secure Glaser Weil for its future services performed on behalf of Rice.

Downs’ argument in reply was that Triton’s payment to Glasier Weil was really just a distribution to Rice and should have been picked up by Downs’ charging order lien. Downs also hotly disputed that Glaser Weil’s lien had priority over his, including that Glaser Weil had performed no services for Triton such as to support any security interest in favor of the law firm, that the lien amounted to a fraudulent transfer, and that it would be otherwise inequitable for Rice to escape the consequences Downs’ judgment through Rice’s law firm encumbering Rice’s interest in Triton with a lien.

The second charging order motion of Downs was heard on June 25, 2020, and the Superior Court granted the motion and ordered payment Rice to pay by August 14, 2020. But the payment was not made, and at the hearing on August 17, 2020, Rice claimed that he simply did not have the funds to make the payment. Downs suggested that instead Glaser Weil should be ordered to pay the $450,000 that the law firm had received from Triton, and the Superior Court agreed. However, since Glaser Weil was not a party to the litigation, the court first had to hold an evidentiary hearing, which was set for August 27, 2020. At that hearing, Rice testified that he had asked Glaser Weil to return the $450,000 to Triton so that he could make the required payment to Downs, but Glaser Weil had refused to do so.

For its part, Glaser Weil argued at the hearing that it had a superior right to the $450,000 than Downs, since the law firm held a priority security interest over Downs’ charging order lien. This did not persuade the Superior Court, however, which ordered Glaser Weil to return the $450,000 to Triton so that Rice could make the payment to Downs. The court also found that Triton was Rice’s alter ego, and amended the judgment so that Triton also became directly liable to Downs for the moneys owed on the judgment to Downs. As to the lien priority issue, the Superior Court held that Downs’ first (albeit, unsuccessful) motion for a charging order had created a lien against Rice’s interest which pre-dated Rice’s security agreement with Glaser Weil, and thus Downs had priority and Glaser Weil did not. The law firm then appealed.

The California Court of Appeals began its opinion by rejecting Glaser Weil’s argument that Triton’s payment to it of the $450,000 was not a distribution, but instead was Triton’s own payment to Glaser Weil of Rice’s attorney fees:

“By emphasizing the statutory language referring to the LLC’s operating agreement, Glaser Weil appears to be limiting the reach of a charging order to distributions formalized under that agreement, such as dividends or other entitlements granted to members. This narrow reading disregards the reality that many LLCs, like Triton, are completely controlled by a single person who may distribute funds at his or her discretion. [citation omitted] Under Glaser Weil’s interpretation, such entities easily could evade charging orders by eschewing formal distributions and instead taking funds out of the LLC as the need arose.”

What happened here, observed the court, was that Rice as the sole member of Triton caused Triton to make a distribution to himself of the $450,000 that he owed to Glaser Weil, and that distribution, and that distribution was subject to whatever liens were on Rice’s interest. However, in a footnote, the court was careful to state that it was expressing no opinion on how a charging order might affect other moneys passing from the LLC to a debtor, such as by payment of salary, or whether a charging order compelled a managing member to make any distribution at all.

Additionally, the court noted that since the Superior Court had determined that Triton was Rice’s alter ego, Triton’s payments of legal fees to Glaser Weil was simply the same as if Rice himself had paid the legal fees directly to Glaser Weil, and which the court thought also bolstered its conclusion that the $450,000 was in the nature of a distribution.

That the payment from Triton was Glaser Weil was a distribution only lead to the issue of whether Glaser Weil’s security interest and UCC filing gave it priority over Downs’ charging order lien. On this issue, the court noted that the UCC governs priorities over consensual security interests, and accords that priority based on the time of filings, and that the California Enforcement of Judgment Laws (commonly referred to as the “EJL”) similarly looks to the time that nonconsensual security interests were placed on the debtor’s assets. However, the court noted that:

“We have not found, nor have the parties identified, a statute specifically addressing the priority of charging orders in relation to other liens and security interests.”

In other words, the court noted that this issue is one of first impression in California. However, California also has a general first-in-time priority rule found in Civil Code § 2897, and thus ⸺ to the extent that there even is a conflict between the UCC and the EJL (of which I am doubtful) ⸺ the court decided that the correct rule to be applied here is simply that of the first party to perfect their interest in an LLC interest should have priority.

The question then become one of who between Glaser Weil and Downs first perfected their security interest in Rice’s interest in Triton. The date of Glaser Weil’s UCC lien was easy to figure out: They filed their UCC statement in June, 2019. The date of Downs’ charging order lien was a little bit more tricky, but not much. Although Downs first moved for a charging order in April, 2018, which created a temporary lien on Rice’s interest pending the hearing on the charging order motion, that first motion of Downs was eventually denied (because of Down’s own argument that the case had been stayed pending his appeal) and so that lien was extinguished. By the time that Downs filed for and obtained his second charging order in October, 2019, it was too late because the Glaser Weil lien was already in place. Here, the court goes through an extended discussion to make its point, but what was just described is the important gist of its ruling.

This does not mean that Glaser Weil won outright on the priority issue, for reasons that will be discussed below, so hang on for now.

In a curious move, the court decided not to publish the next part of its opinion which related to Downs’ claim that an equitable basis existed to override Glaser Weil’s priority interest. The court began this section by noting that since there was a legal reason why Glaser Weil’s interest had priority over Downs’ interest, the court would not even reach the question of whether there was such an equitable basis.

In addition to other arguments, Downs basically argued that Glaser Weil was simply just another of Rice’s creditors (for the law firm’s own legal fees), and “jumped the line” through its security agreement to get ahead of Downs. Importantly, at least for debtor’s counsel who want their fees assured from a financially-distressed client, the court stated that:

“Glaser Weil jumped no line. At the time it obtained its security interest, there was no competing lien or charging order in place. Nor does Downs or anyone else suggest it is inappropriate for a law firm to obtain a security interest to ensure payment of its fees, assuming the firm complies with all ethical and other requirements concerning contracts with clients.”

Downs also argued that Glaser Weil had no justification for contesting his first motion for charging order, but that of course overlooked that Downs himself had claimed that the entire action had been stayed upon the filing of his own appeal. Moreover, Downs basically slept on his rights by not moving for a charging order immediately upon the lifting of the stay when he lost his appeal. Downs’ argument that Glaser Weil should have disclosed its security interest at the time of the second charging order motion, received a more receptive response. The court basically stated to the effect that while it was preferable that Glaser Weil had informed the Superior Court of its existing security interest, and thus perhaps saved the Superior Court some time for its later troubles, that was not sufficient to rise to an equitable argument for re-ordering the priorities in favor of Downs.

That ended the unpublished portion of the opinion. Why the Court of Appeals decided not to publish that portion, and thus make it available as precedent, is quite unhelpfully not stated in the opinion, and one can only presume that the Court of Appeals wanted to keep its options open in case it decided that an equitable re-ordering of priorities should be allowed in some later case to come before it. Now back to the published part of the opinion, which closes out the priority issue and the appeal in general.

The court noted that the Superior Court had never made any finding in regard to determine the nature and extent of Glaser Weil’s security interest and lien, and so remanded the case for that purpose.

ANALYSIS

The result in this case came about because Downs apparently never considered that arguing for a stay of the case while on appeal would mess up his first charging order motion, and then for whatever reason delayed re-filing his charging order motion for some period of time which allowed Glaser Weil to slip in before him in lien priority. It is hard to criticize this, however, since there was a lot going on in the case, including Rice’s abbreviated bankruptcy proceeding, and it is quite rare that a creditor does everything with complete perfection.

Arguably, while Downs lost the lien priority battle, he won the Triton war by having it determined to be Rice’s alter ego. This should allow Downs to enforce his judgment directly against Triton’s assets, such that the LLC never makes a distribution which is picked up by Glaser Weil’s lien, but that will have to be determined on remand by the Superior Court.

One can presume that one of the issues that will be determined on remand will be the extent to which Glaser Weil’s consensual lien against Triton will extent not only to Triton’s assets, but the priority of their lien as to future attorney’s fees. Generally, a lien is only operative in terms of priority as to an existing liability, but a future liability incurred by a lienholder goes in priority behind other lienholders. So, assuming that Glaser Weil wins on its priority for the $450,000 that it was owed on the date that the law firm put its lien in place, Downs’ lien might then have superior priority over future law firm billings incurred by Rice after the date that Downs’ filed its motion for charging order, and then Glaser Weil would come in third-place as to those future billings. In other words, Glaser Weil might have been able to use its lien to protect its past billings, but perhaps not any future billings going forward. The resolution of this issue is dependent upon a complicated interpretation of the Uniform Commercial Code, and is thus beyond the scope of this article, but it is important to point out.

This is what makes the representation of debtors very dangerous for counsel, because if a creditor is savvy and gets all their liens down quickly, then counsel for a debtor may have to start wondering about whether attorney’s bills will be paid going forward, and the last thing that debtor’s counsel will want to find is that their ability to satisfy their invoices against a debtor’s assets has moved to the last in line because that then means that their representation might be characterized as one pro bono deadbeatus. What this means in practice is that a debtor and their counsel must figure out very early on in the post-judgment litigation, if not well before, how the debtor can create some secure payment source such that legal bills can be funded until some settlement is reached.

It should also be noted that an attorney who attempts to tie up the debtor’s assets by putting a lien on the debtor’s assets to secure future billings can be subject to ethical sanctions, which is exactly what happened in California in the Morris case that I wrote about back in 2013. Thus, Glaser Weil is going to have to tread very carefully in seeking to have its lien apply to its future billings, if indeed it chooses to go down that dangerous path at all.

Maybe we will see how all this shakes out in a future opinion, since both of these parties do not seem adverse to filing appeals. Stay tuned.

CITE AS

Rice v. Downs, 2021 WL 6111750 (Cal.App., Distr. 2, Dec. 27, 2021). https://chargingorder.com/opinion-2022-california-rice-charging-order-lien-priority.html