Overview of When the Charging Order Fails
The statutory limitations of the charging order were once thought to be
insurmountable. However, there exist a few instances where a creditor
of a limited partnership's or LLC's partner or member was able
to gain ownership of their company interest, notwithstanding the statutory
limitations of the charging order. Three cases are relevant to this topic.
(Because the charging order statutes for LLCs are very similar or even
identical to those of limited partnerships, this section applies equally
to both types of entities.) The first two cases were decided in California
district courts. In both these cases, the court decided to ignore the
limitations of the charging order because, the court ruled, charging order
protection was originally enacted as a means of protecting the non-debtor
partners in the partnership and to insure that partnership business remains
uninterrupted, not so that a debtor-partner can escape paying his debts.
Because in both cases the partnership interest could be transferred to
the creditor without causing an interruption in business, the courts on
both occasions decided that charging order restrictions did not apply
and the partnership interest was transferred to the creditor. Although
the court in one case only allowed this transfer with the other partners'
consent, in the other case the transfer was allowed without the consent
of the other partners. Despite the fact that these cases technically should
only hold weight in California, they set a precedent that may be imitated
by other courts nationwide.
Another situation in which charging order protection may fail is found
in a recent bankruptcy proceeding. In this proceeding, the court ruled
that the debtor's LLC membership interest was forfeited to the bankruptcy
estate, due to the fact that the LLC's operating agreement was deemed
a non-executory contract. Under bankruptcy law, an executory contract
would include an agreement wherein the company's partners have ongoing
obligations towards the company, such as the requirement to act as advisors
or to periodically contribute cash or other capital. Such an executory
contract would be subject to a certain section of the bankruptcy code,
which section would uphold the limitations of state or other applicable
law (thus allowing the limitations of the charging order remedy to apply).
The court makes it clear, however, that if a partnership or operating
agreement is non-executory, the company interest would instead be subject
to another section of the bankruptcy code, which section would override
any other statutory limitations on the bankruptcy trustee's right
to the debtor's assets.
In light of these cases, there is yet another situation wherein charging
order protection may be circumvented. That is where all members of the
company are debtors to the same creditor. In this situation, the underlying
reasons for charging order protection would not apply to the situation
at hand, and therefore a court could conceivably disregard charging order
To summarize, the following factors may jeopardize the charging order component
of an Asset Protection plan:
- An LLC's or limited partnership's operating/partnership agreement
is non-executory (which is probably only important if the company's
owner files or is forced into bankruptcy)
- The forfeiture of a debtor's membership interest to a creditor would
not interrupt partnership business
- All members/partners of the LLC/limited partnership become a debtor of
the same creditor
The solution is to ensure that the operating or partnership agreement is
executory in nature. Such an executory agreement, if carefully drafted
by a skilled professional, will also cause an interruption in ongoing
member obligations towards the company to also cause an interruption in
the company's business. This would allow the debtor-member to argue
that such an interruption in business prohibits any court from transferring
his company interest to a creditor.
There are many considerations that must be made when drafting such an agreement.
Such considerations are without the scope of this website and are best
left to a competent attorney or Asset Protection consultant. However,
we can broadly state that the following obligations will effectively reinforce
charging order limitations:
- Ongoing obligations to contribute cash or other capital to the entity
- Ongoing obligations to contribute non-managerial services (such as advisement services)
- Ongoing obligations to manage the entity, if appropriate
Lastly, we must make sure that never, under any circumstance, could all
members of the LLC personally become debtors of the same creditor. We
accomplish this by one or more of the following:
- At least one of the LLC members is not exposed to liability. This is best
accomplished by making one of the members a trust, LLC, or other entity
that only engages in safe activities
- At least one member is not an insider or affiliate of any other member
under the U.F.T.A. Also, it is best for this member to live in a different
state than the other members. This would make it highly unlikely that
this member would ever be personally listed as a defendant on the same
lawsuit as another member. With this in mind, make sure that the LLC or
LP is not member-managed. Otherwise, a plaintiff suing the LLC or LP could
name all of the members as co-defendants, claiming each was responsible
for mismanagement of the LLC, which led to the tort offense.
YES, YOU CAN LOSE EVERYTHING!
You may think that your wealth is safe and that you don't need protection.
But don't delude yourself and accept reality — for every 60
minutes you spend making money, spend 60 seconds thinking about how to