Charging Order Failure

The charging order has long been considered to be the utmost creditor protection with its tough statatory limitations. Several cases exist, however, where a creditor of an LP or LLC was able to gain ownership of a company interest despite the statutory limitations of the charging order. Three cases in particular are important to this discussion, two of which were decided in the district courts of California where rulings were issued that challenged the notion that a limited partnership cannot be disrupted because of a single partner's debts. On both occasions the court sided with creditors citing that the intention of LP law was not to help a debtor avoid payment to a creditor, and assets were transferred to the creditor (in one case with consent of the other partners, in another without consent). These California cases may set precedent in other states and pave the way for creditor claims to receive selective interpretation.

The third court precedent involved a case in which the court ruled that a debtor's LLC membership interest was forfeited to a bankruptcy estate due to the fact that the LLC's operating agreement was deemed a non-executory contract and exempted from certain protections that, in turn, allowed a bankruptcy trustee to gain access to the debtor's assets.

Another area of concern to limited partners should be a situation in which all of the partners were debtors to the same creditor and a charging order was obtained by a creditor, in which case limited partnership protections could be deemed to be susceptible to the charging order.

These unusual precedent-setting cases underscore the importance of designing an Asset Protection program with multiple layers of protection and seeking the advice of legal counsel in the design of a company structure.

A key factor in the design of an operating or partnership agreement is make sure that it is executory in nature and drafted by a skilled professional to assure all parties that an interruption in ongoing member obligations towards the company (that also causes an interruption in the company's business) would encourage a court to honor the fundamental principles of a charging order and not allow a creditor to interrupt the business to recover an asset against an individual member of the partnership.

A quality partnership agreement will take into consideration a sweeping range of legal matters and at the very least incorporate these essential components that will effectively reinforce the limitations of a court-issued charging order against a partner:

• A perpetual, ongoing obligation to contribute cash or other capital to the entity.
• An ongoing commitment and obligation to contribute non-managerial services (such as advisement services).
• An ongoing obligation to manage the entity, if appropriate and required.
• A careful strategy to make sure that all of the members of the entity are never a creditor to the same debtor by engineering at least one of the LLC members to be unexposed to a creditor. This can be easily achieved by making one of the members a trust, LLC, or other entity that only engages in safe activities and, preferably, registering the outside entity in another state and—even better—making the partner an out of state resident. This would make it extremely unlikely for a suit to be brought by a creditor. It would also be important to ensure that the LLC or LP is not member managed to prevent a plaintiff from suing the entity and naming all of the members as co-defendants, claiming that each was responsible for mismanagement of the LLC, which led to the tort offense.

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