Perfected Security Interest And Charging Order Against Same Property Prioritized Based On Creation Dates

Dear members of the constituency list of the Commercial Transactions Committee:

The following is an update analyzing a recent case of interest.

Summary:

A California court of appeal held that two competing liens, a perfected security interest and a charging order, obtained against the same property are prioritized strictly based on the dates of their creation and that a payment to counsel for the judgment debtor made by an LLC that was wholly owned by the debtor amounted to a “distribution” under California law and, therefore, subject to the judgment creditor’s charging order. See Rice v. Downs, 2021 WL 6111750 (2nd Dist. 2021). To read the full opinion, click here.

Facts:

Attorney Gary Downs represented William Rice and was his partner in a failed business venture. Rice sued Downs for legal malpractice, among other claims, and the action was referred to arbitration. Downs prevailed and obtained a large attorneys’ fees and costs award against Rice. The award was confirmed by the trial court in mid-2015. An appeal ensued (Rice I), resulting in a slightly modified judgment in Downs’ favor, but reviving certain tort claims Rice had asserted against Downs. When Rice filed an amended complaint, Downs again moved to compel arbitration, which the trial court denied. Downs appealed this ruling (Rice II).

In April 2018, Downs moved for a charging order directing certain Rice-owned LLCs, including Triton Community Development LLC (Triton), to turn over all distributions Rice was entitled to receive. The requested charging order related to the no-longer contested attorneys’ fees and costs award. The trial court denied the motion, holding that the “entire action” was stayed by the Rice II appeal. In July 2019, the Court of Appeal affirmed the order denying Downs’ motion to compel arbitration. That ruling became final on September 23, 2019.

On October 3, 2019, Downs again moved for a charging order against Rice’s interest in several LLCs. The Motion was granted on October 30, 2019. The charging order required Rice’s companies to, pay any money or property due or to become due to [Rice] directly to [Downs] until the amount remaining due on the judgment, plus all accrued interest and costs thereon, is paid in full.

Rice filed a chapter 11 bankruptcy on January 27, 2020. In his operating reports, he disclosed that in February 2020, his wholly owned entity Triton paid $450,000 to Glaser Weil Fink Howard Avchen & Shapiro, LLP (Glaser Weil), which represented Rice in the litigation against Downs. The bankruptcy case was dismissed in April 2020. On May 1, 2020, Downs moved in the superior court to enforce the charging order, which he alleged Triton’s payment to Glaser Weil violated.

Rice opposed the motion, arguing that months before the charging order was issued Triton entered into an agreement with Glaser Weil under which Triton became a co-obligor on Rice’s debt to the law firm. He therefore asserted that Triton’s payment to Glaser was not a “distribution” subject to the charging order. Rather, it was payment of Triton’s independent financial obligation. In the alternative, Rice argued that the payment was made to satisfy a security interest that Glaser Weil perfected by filing a UCC-1 financing statement on July 15, 2019, prior to issuance of the charging order.

Downs responded that the payment to Glaser Weil was in fact for legal services provided to Rice, not Triton. He further asserted numerous arguments as to why the security interest did not come ahead of the charging order, including that it was conditioned on default by Rice on his obligations to Glaser Weil, which was not established. Downs also argued that it would be inequitable to give Glaser Weil’s lien a priority, as Triton was Rice’s alter ego. The trial court granted Downs’ motion and ordered Rice to pay Downs $450,000. When payment was not forthcoming, the Court scheduled an evidentiary hearing as to whether Glaser Weil should be required to disgorge the $450,000 it received from Triton.

At the evidentiary hearing, the trial court agreed that legally Glaser Weil’s lien had priority over the charging order. However, finding that Triton and Rice were one and the same, it ultimately utilized its equitable powers under Code of Civil Procedure 187 and amended the charging order to make Triton jointly and severally liable for Rice’s obligations to Downs. It further found that Downs’ original unsuccessful motion for a charging order, filed on April 11, 2018, created a lien under Code of Civil Procedure section 708.320, giving Downs’ lien priority over Glaser Weil’s lien. The court concluded that Triton’s payment to Glaser Weil violated the charging order and ordered the law firm to disgorge the funds to Downs. Glaser Weil appealed the trial court’s order.

Reasoning:

The Second District Court of Appeal reversed the disgorgement order and remanded to the trial court for further determination of whether Glaser Weil’s security interest attached to the funds Triton paid on Rice’s behalf.

The Court initially rejected the argument that Triton’s payment to Glaser Weil was not a distribution, and therefore not subject to the charging order. It relied on Corporations Code section 17705.03(a), which states in relevant part:

A charging order constitutes a lien on a judgment debtor’s transferable interest and requires the limited liability company to pay over to the person to which the charging order was issued any distribution that would otherwise be paid to the judgment debtor.

According to Corporations Code section 17705.03(f), a distribution is “a transfer of money or other property from a limited liability company to another person on account of a transferable interest.” The Court disagreed that a charging order only reaches formal distributions identified as such under an LLC’s operating agreement, such as dividends or profit allocations. It expressed a concern that such interpretation of “distribution” could result in “entities easily [evading] charging orders by eschewing formal distributions and instead taking funds out of the LLC as the need arose.”

Here, Rice was the sole owner and operator of Triton, which made payments to Glaser Weil strictly for the benefit of Rice. By paying his legal fees, Triton was relieving Rice of his own obligations, thereby resulting in “money in Rice’s pocket.” The Court also agreed that Triton was Rice’s alter ego and therefore the payment to Glaser Weil was effectively from Rice.

However, while the Court agreed that the funds paid to Glaser Weil were subject to the charging order, it disagreed with the lower court’s ruling that the charging order had priority over the law firm’s security interest. Assuming for the purpose of this opinion that the security interest attached to the payment to Glaser Weil, the Court concluded that, “’Other things being equal, different liens upon the same property have priority according to the time of their creation ….’ (Civ. Code, § 2897.)” Identifying no statute specifically addressing the priority of a charging lien versus other liens, the Court adopted the general “first-in-time rule.”

Here, Glaser Weil perfected its security interest in July 2019, which preceded the October 2019 issuance of the charging order, giving priority to the law firm’s lien. The Court rejected the trial court’s conclusion that the charging order dated back to the April 2018 notice of the first charging order motion, holding that the earlier lien was extinguished when the trial court denied Downs’ motion. The Court noted that, “’[p]riority can exist only if the lien exists.’ (Messerall v. Fulwider(1988) 199 Cal.App.3d 1324, 1330, 245 Cal.Rptr. 548.)”

The Court further rejected Downs’ argument that denial of the original charging Order motion on procedural grounds did not affect an extinguishment of the charging order lien, which could only be extinguished by denial on the merits. The Court disagreed with the argument that the original charging order lien had priority under Code of Civil Procedure 697.590(b), which it noted applies to a judgment lien where a notice of the lien was filed with the Secretary of State. Neither of these requirements were present in this case.

In an unpublished part of the decision, the Court further rejected the trial court’s reliance on its equitable authority to place the charging order ahead of the security interest. While it declined to decide whether the trial court even had the authority to override the statutory priority of liens, it concluded nonetheless that “there was no basis to exercise [such authority] here.”

As the trial court never considered whether Glaser Weil’s security interest in fact attached to the funds paid to Glaser Weil and the record on appeal being vague on this point, the Court remanded the case to the lower court to evaluate the property to which the security lien attached.

Author’s Comments:

This case contains a complex set of facts involving multiple motions, hearings, appeals and potential lien dates. However, while the parties raised creative competing arguments, at the heart of the case is a simple question, does the first-in-time lien priority rule apply to charging orders? The Court of Appeal’s resounding answer is “yes.” Left unanswered is whether trial courts can utilize their equitable powers to set aside the lien priority rule. Declining to answer this question, the Court chose to analyze the facts in this case and held that even if such authority existed it was abused. Practitioners and trial judges alike may have liked the Court to answer the equitable authority question now, which could serve as a future guide.

The Commercial Finance Newsletter is written by an ad hoc group of the California Lawyers Association’s (CLA) Business Law Section. These materials were written by Uzzi O. Raanan, a partner at Danning, Gill, Israel & Krasnoff, LLP, located in Los Angeles, California, who is a member of the ad hoc group and the representative from the Business Law Section (BLS) to the CLA’s Board of Representatives. Editorial contributions were made by the Honorable Meredith Jury (United States Bankruptcy Judge, C.D. Cal, Ret.), also a member of the ad hoc group. The opinions expressed herein are solely those of the author. Thomson Reuters holds the copyright to these materials and has permitted the Commercial Transactions Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.

This ebulletin was prepared by Walter K. Oetzell, Walter K. Oetzell, APC, wkoetzell@oetzelllaw.com.