In This Issue

• Efficacy of Charging Order Protection
• How Protective Is the Charging Order?
• Series LLCs
• Umbrella Insurance
• Alter Ego: Tales from the Dark Side
• Report from Quatloosia
• New Bankruptcy Act to House
• Supreme Court Protects IRAs

Limited partnerships have long been a staple for asset protection planning because of the unique charging order protection afforded to such entities. Relatively new statutory creations such as limited liability companies (LLCs) and similar entities have enhanced the opportunities for using charging order protection in even ordinary business planning.

In this issue, we focus on the concept of charging orders and outline the parameters of ownership in an LLC or limited partnership. We review landmark cases involving charging order protection and discuss the planning possibilities involved with the latest innovation, the”series” LLC.

We also welcome two guest writers. Jeff Curran, a commercial litigator in Oklahoma City and “America’s Funniest Legal Writer”, contributes a humorous look at two alter ego cases. Bill Campbell is an aviation insurance specialist whose article addresses umbrella insurance, which is often a necessary tool for a solid asset protection plan.

We hope that you enjoy these articles, and, as always, we look forward to your comments and suggestions.

Editor

April Feature Article

EFFICACY OF
CHARGING ORDER PROTECTION

by Jay D. Adkisson

Business entities are created by state legislatures primarily to allow individuals to group together to invest capital for new ventures. The primary statutory goal of most entities is to shield the investors from the liabilities of the business, so that their risk is limited by the amount of the capital investment. Thus, if the business itself has a creditor, the creditor’s relief is limited to the assets of the business, and, except in extreme cases, the creditor cannot pursue any assets other than those of the business itself.

The liabilities of the business are known as “inside liabilities,” and the claims of creditors against the business are known as “inside creditors”. As long as the entity is distinct from its owners, is adequately capitalized, and is not used to perpetuate a fraud, then, the entity should protect its investor-owners from inside liabilities and inside creditors. The exception is the general partnership. In a general partnership, general partners are liable for the debts and liabilities of the partnership. Similarly, general partners of Limited Partnerships and related entities are also liable for the liabilities of the partnership.

The flipside is where an investor-owner attempts to protect partnership from personal creditors of the investor-owner. The creditors of an investor-owner are known as “outside creditors,” and the claims giving rise to those creditors are likewise called “outside liabilities”.

From a statutory perspective, the creditors of an investor-owner are treated much differently than the creditors of the business itself. The hard truth is that most state legislatures have no desire to protect a debtor’s interest in a business entity from creditors. To the contrary, if an investor-owner has debts, then he or she should pay those debts from whatever non-exempt property is available, including shares of stock and interests in partnerships and like entities.

In a corporation, a creditor may simply attach the shares of the debtor’s stock to gain all the rights that the debtor had in the corporation, including rights to sell the shares, voting rights, the right to view books and records, and rights to bring derivative actions against errant corporate officers and directors.

Note that if the corporation is an “S” corporation, and the creditor is not an individual, then the creditor’s attachment of the stock may cause the “S” election to be terminated, which would possibly result in unwanted tax consequences to the remaining shareholders.

Legislatures are not concerned with interference of corporate business when a creditor has attached interest in stock because shareholders are two full steps removed from business operations. Shareholders elect the directors, directors elect the officers, and officers run the business. Allowing a creditor to attach the shares of a corporation only indirectly affects the corporation in the election of directors.

Partnerships and pseudo-partnership entities, such as the Limited Liability Company (LLC), are different from corporations. In a partnership or LLC, the investor is a partner and may directly affect the entity’s business operations. A change in ownership may disrupt the operations of the partnership and force non-debtor partners into an involuntary partnership with the creditor.

Thus, state legislatures have not allowed creditors to attach partnership interests and become the partners themselves. Instead, legislatures have only allowed creditors a limited form of relief against the debtor’s partnership interest through a “Charging Order”.

Of Interests and Charging Orders

The charging order and its function can only be examined in light of the character of the partnership interest itself. This leads to the fundamental question of what a partnership interest constitutes.

A partnership interest is unlike holding shares in a corporation. With the latter, the shareholder has no duties and all of his or her rights are bound into the share certificates (whether physically issued or not). For instance, a shareholder may lend his voting rights to others and these rights remain part of the rights that are bound into the share certificates.

On the other hand, in exchange for the partner’s investment, the partner receives a bundle of rights that includes the rights to distributions and the rights that are set out in the operating agreement. The partner may or may not be required to perform certain duties in order to receive the rights outlined in the partnership’s operation agreement.

A charging order is held against the partner’s right to distributions from the entity. The comments to the Uniform Partnership Act and LLC Act describe the charging order as “in the nature of a garnishment.” To define a charging order as a “business garnishment” would closely describe the charging order. However, one could also characterize a charging order as being an “assignment of income” or as an assignment of the partner’s economic right to distribution from the partnership.

Charging Order Protected Entity (COPE) is the term used to describe entities for which external creditors are usually limited to the charging order remedy, meaning that the creditors cannot simply attach the partner’s interest as if they were shares in a corporation. The best known COPE entities are the Limited Partnership (LP) and the Limited Liability Company (LLC). However, COPES also include Limited Liability Partnerships (LLP) and Limited Liability Limited Partnerships (LLLP), as well as the new Series LLC.

“Charging Order Protection” is somewhat of a misnomer. A charging order is a remedy that is affirmatively sought by a creditor. A better term may be “anti-invasion protection” because the benefit sought from a charging order protection is making invasion of the entity by a creditor difficult.

Barbarians at the Gate:
Creditors’ Remedies

A creditor must usually follow this path to relief when seeking to obtain assets from a COPE:

1. Obtain a judgment.

2. Charge the interest.

3. Foreclose the charging order.

4. Appoint a receiver.

5. Partition the entity.

Each step and its role in protecting the assets of the LLC from the creditor is discussed in detail below.

First, the creditor must obtain a judgment, since the charging order is only available to “judgment creditors”. Thus, on the defense side, there is often time for additional structuring or drafting to make sure that the structure is rock solid. Sadly, many planners do not take the opportunity to fix slight flaws in the entity structure or drafting before the creditor obtains the charging order.

After obtaining a judgment, the creditor must obtain a charging order. The charging order is against the debtor’s economic rights to distribution from the entity. A limited partner or member in an LLC does not own shares of stock as in a corporation. Partners own a bundle of rights as defined by the entity’s operating agreement, including certain economic rights to distribution. However, partners do not own a direct interest in the assets of the entity.

The creditor may also garnish or obtain a forcible assignment of the debtor’s right to distribution from the partnership. That is, the partnership must pay the creditor instead of the debtor until the judgment is satisfied. However, the right to payment does not make the creditor a partner or member and does not give the creditor any voting rights.

If the entity is formed in the same state where the creditor obtained the original judgment, obtaining a charging order from the court is not difficult. However, if the entity is formed in another state, the creditor may have to register the judgment in the other state and ask the courts of that state to issue the charging order. This is discussed more fully in “Conflicts & Koh” below.

The creditor may also foreclose on the debtor’s partnership interest. The foreclosure is on the interest in the partnership, not on the entity itself or on the entity’s assets. Foreclosure of a charging order is one of the most misunderstood and misrepresented concepts in asset protection. Contrary to the oft-repeated (including at seminars and in poorly researched articles) but false belief, the foreclosure of the interest is not a foreclosure of the entity’s assets. The foreclosure is of the charging order against the debtor’s economic right to distributions.

The difference between a creditor holding a charging order and a creditor foreclosing on the charging order is the permanence of the creditor’s interest. A charging order is a temporary remedy that has the effect of assigning income to the creditor until the judgment is paid. After the assignment of income (or garnishment, if you want to look at it that way) terminates, the debtor regains the right to distributions.

By contrast, foreclosure of the interest makes the assignment (or garnishment) permanent, which means that the creditor becomes the owner of the distributional interest. The creditor may then attempt to sell the interest to an interested buyer. If a limited partnership or LLC has few members and is controlled by persons friendly to the interests of the debtor, the creditor attempting to sell the foreclosed interest may have a very tough time finding buyers.

In real life litigation, the most common result after a foreclosure of the interest has occurred is that the entity offers to redeem the creditor’s interest at some value that is much less than the percentage interest in distributions held by the creditor. However, redemption is not a sure thing for either the creditor or the entity.

The disadvantage to a foreclosing creditor is that after foreclosure, the creditor is responsible for the tax liabilities generated to the partners or members by the entity (there is substantial doubt as to whether this occurs at the charging order stage). Thus, the creditor risks receiving K-1 distributions of “phantom income.” That is, the creditor has to pay a share of the entity’s taxes even though the creditor does not receive actual income.

A disadvantage to the entity after is foreclosure of an interest by a creditor is that the creditor may be entitled to certain derivative rights from the entity, depending on how well the operating agreement for the entity is drafted. The derivative rights may include the rights to inspect books and records, request distributions, and request the appointment of a receiver.

The creditor may ask the court to appoint a receiver in order to ensure that the entity makes distributions to the creditor’s interest. Normally, the creditor is able to obtain the appointment of a receiver, which is possible when the operating agreement is not immaculately drafted to hinder the possibility of giving the creditor derivative rights to involuntary distributions from the entity. Like most derivative rights issues, the possibility of obtaining a receiver is more likely if the creditor has foreclosed upon the majority interest in the entity. However, appointment of a receiver is less likely if the creditor holds only a minority interest.

Finally, the creditor may attempt to request the court to partition the entity’s assets and place the creditor in charge of the entity’s assets equal to the interest the creditor holds. This is a long shot for the creditor, but it is theoretically possible in extreme cases in where the entity has not been structured correctly, and the operating agreement has been poorly drafted.

State Restrictions of Remedies

In response to misperceptions about what the role of charging orders, some states have attempted to limit creditors’ remedies to a charging order by forbidding the foreclosure of the interest. Although such laws are attractive on the surface, under some circumstances, these limitations are less attractive from an asset protection standpoint.

A creditor who holds a mere charging order is probably not liable for the taxes of the entity. Even though this belief is preached at asset protection seminars, there is not any substantial basis for believing that a charging creditor is liable for the taxes of the charged entity. To the contrary, many tax planners have concluded that a creditor holding a charging order is not liable for the taxes of the entity.

On the other hand, there is little doubt that a creditor who forecloses on a charging order is treated as an owner of the charged entity for tax purposes. Foreclosure becomes a potential trap for a creditor to be “K.O.’d by the K-1”. The tax liability (which is not something that creditors’ attorneys are typically even aware of) can sometimes facilitate a quick and cheap redemption of the foreclosed interest from the creditor. Or as we litigators say, “They no longer want the cheese; they just want out of the trap.”

From the asset protection perspective, foreclosure is sometimes good, and the states that have eliminated the foreclosure remedy in order to attract asset protection work may have unwittingly taken a step backwards. However, some would argue that the fact that the creditor is stopped at the charging order stage may facilitate settlement by the creditor even without the surprise leverage of the “thank you for foreclosing, here’s your K-1”.

Conflicts & Koh

In which state should the creditor apply for a charging order?

Consider the following hypothetical. Hubris LLC is formed in Delaware, has its offices and principal place of business in Kansas, is qualified to do business and owns real property in Oregon. Hubris does not do business or hold assets in Alabama. However, a member of Hubris LLC lives in Alabama, where he is successfully sued. The Alabama creditor seeks to charge the debtor’s interest in Hubris LLC to satisfy the Alabama judgment. Where does the Alabama creditor apply for the charging order?

This is a trick question, because nobody really knows where the application for the charging order should be filed. In particular, the drafters of the Revised Uniform Limited Partnership Act (RULPA) and the Uniform Limited Liability Company Act (ULLCA) have not addressed the issue. Therefore, it is left to the courts to decide.

While an Alabama court can issue a charging order, Hubris LLC has no minimum contacts in Alabama; thus, Alabama has no personal jurisdiction over Hubris LLC. If Hubris LLC ignores the Alabama court’s order, the court does not have jurisdiction if Hubris is not within its borders.

In order to obtain a charging order, the Alabama creditor should register the judgment in a state where Hubris LLC has minimum contacts and obtain the charging order against Hubris under that state’s laws. This issue was addressed by a Washington appellate court in Koh v. Inno Pacific Holdings Ltd, 114 Wash App 268, 54 P.3d (Wash App Div 1 2002), which halfheartedly concluded a California creditor did not violate due process by bringing an application for a charging order in the state in which the LLC was located.

The Debtor in Bankruptcy

Chris and I have said many times in relation to many asset protection strategies, “In bankruptcy, all bets are off.” Where debtors hold interests in limited partnerships and LLCs and are forced into bankruptcy, there is a possibility that a court will allow a creditor to attach the assets of the partnership or LLC itself.

Interests in limited partnerships and LLCs are held by the members in a contractual nature, as defined, first by applicable state law, and then by the partnership’s operating agreement. For bankruptcy purposes, interests can be defined two ways: executory interests and non-executory interests.

Executory interests require the partner or member to execute some affirmative act that benefits the entity in order for the partner or member to receive distributions. One might define executory interests as “active” interests.

Non-executory interests are do not require the partner or member to do anything. Distributions are made without any further act of the partner or member. Non-executory interests are “passive” interests.

When a partner filed bankruptcy, whether his interests are as executory or non-executory determines the parameters of the bankruptcy trustee’s powers. If the interest is non-executory, then the court-appointed Trustee is not bound by limitations in the entity’s operating agreement. That is, the Trustee may invade the assets of the entity and sell the assets in order to satisfy judgments against the debtor. Such was the precise result in a recent Arizona bankruptcy case, In re Ehmann, 2005 WL 78921, Bkrtcy.D.Ariz. (Jan 13, 2005).

By contrast, if the debtor’s interests are executory, the Trustee is probably bound by the entity’s operating agreement, including any limitations on creditors’ remedies. Thus, it is critical that the operating agreement is immaculately drafted to ensure that the interest is treated as executory, so that the Trustee cannot argue for treatment of the interest as non-executory.

From the debtor’s perspective, the key to keeping creditors from the assets of the entity is intelligent structuring and meticulous drafting, which is the very essence of good asset protection planning.

Single Member LLCs

Recall that with a corporation, shareholders are twice removed from the operations of the corporation because the shareholders elect the directors, and the directors elect the officers who actually run the corporation. Thus, if the creditor attaches shares of a corporation, the creditor will not directly influence operations until there has been at least one meeting of directors at which new officers can be elected.

In a limited partnership or LLC, however, the change of ownership from the debtor to a creditor could directly impact the operations of the entity and affect the remaining non-debtor members. The primary purpose of the charging order is thus to protect the non-debtor members from being involuntarily forced into a partnership with a the debtor member’s creditor.

However, there is only one member in a SMLLC, so there are no non-debtor members to protect. It also defies common sense that a creditor would not be able to get at the assets of an entity where the debtor is the only owner.

Some planners argue that even though it may not make any sense to have charging order protection where there is only one member, the language of the statute is nonetheless protective. Some states, such as Arizona, have modified their LLC acts in such a manner that suggests protection of the debtor’s indirect interest in the assets of the entity, even if the creditor has charging order.

Planners who believe that SMLLCs are protected by charging orders in the same manner as other LLCs and partnerships argue that, unless it is apparent that the creditor’s judgment may never be satisfied by distributions from the SMLLC, the creditor should not be allowed to invade the LLC.

After years of speculation and the lack of any solid case law, the issue of whether SMLLCs are afforded the protections of the charging order was finally addressed by a U.S. bankruptcy court, In re Albright, No. 01-11367 (Colo. Bkrpt. April 4, 2003). The judge in Albright held that charging order protection does not exist for a SMLLC because there are no non-debtor members to protect. The court granted full economic and non-economic rights to the trustee, allowing the bankruptcy trustee to manage the debtor’s LLC. The trustee subsequently sold the LLC’s property and distributed the net proceeds to the bankruptcy estate for satisfaction of creditors’ claims.

Thus, until Albright is overturned or rejected by other courts, the safe presumption will be that SMLLCs probably do not provide charging order protection.

Based on Albright, sometimes I hear planners blurt out, “Single Member LLCs provide no asset protection!” This is wrong. The lack of charging order protection is a far cry from concluding that SMLLCs are “worthless” as asset protection vehicles. SMLLCs may still provide substantial protection for owners against the liabilities of the entity itself, which are so-called “internal liabilities”.

For example: SMLLC owns a strip mall and is successfully sued by one of the tenants. If the SMLLC is adequately capitalized, is not the alter ego of the sole member, and is not used to perpetuate a fraud, the tenant may not assert liability against the member.

There is no reason that a SMLLC should be treated much differently from a sole shareholder corporation. Historically, sole shareholder corporations have contained liability within the entity and shielded the liability away from its owners.

To summarize, even if SMLLCs do not offer the same charging order protection as multiple-member LLCs, they can still be very valuable business planning vehicles. Certainly, it is preferable from a liability standpoint to own one’s business in a SMLLC than to run it as a sole proprietorship. But of course, where external liability is a concern and it is feasible to add another member, that should be done so that charging order protection arises.

SMLLCs and LAMBs

An interesting question regarding SMLLCs is the consequences of the partial sale of a debtor’s interest in a single member LLC’s to a third party (sometimes referred to as a “LAMB” for “Late Arriving Member”). Does the sale of the debtor’s interest to a LAMB invoke charging order protection in an SMLLC, even if there were no other members at the time the claim arose?

The answer depends on when that the court tests the single member status for charging order purposes. My gut feeling is that this should be at the time that the application for the charging order is made because the purpose of the charging order is to protect non-debtor members. If this is true, then it means that you can maintain an LLC with a single member, but later add a member and charging order protection will arise. Although a sophisticated creditor may argue that the post-claim transfer of the LLC interest was a fraudulent transfer, I’m not convinced that is a winning argument so long as the transfer is not done at the last minute, was for value, and can be justified on other straight-faced business grounds.

Reverse Veil Piercing

It is unclear whether creditors are permitted to assert a “reverse veil piercing” theory in order to circumvent charging order protection. In the case of a SMLLC, the application of such a theory is practical. However, the application of reverse veil piercing in an SMLLC may contradict the clear text of the RULPA and ULLCA.

Otherwise, as with corporations, the more members you have the less likely it is that a reverse veil piercing theory will be successful.

Summary

Charging order protected entities are some of the strongest and most acceptable asset protection tools available. These entities afford a significant degree of protection for the partners or members against the internal liabilities of the entity, yet they also severely restrict the collection rights of the creditors of a partner or member.

But as shown by Ehmann and other cases, merely forming a limited partnership or LLC isn’t going to protect assets. The key to the success of these entities is intelligent structuring and meticulous drafting that addresses the several potential avenues of creditor attack. But such is the very nature of good – as opposed to cookie-cutter – asset protection planning.

The problem is that many people have COPES, predominantly in the widely-sold “Family Limited Partnership” form, but these entities are often not structured correctly for asset protection purposes (which may not mesh entirely with estate planning purposes) and their operating agreements are an open invitation to creditor attack.

Even if initially correctly structured, the operating agreements of COPES must be updated to keep up with the discovery of new landmines. Yet, in practice, these entities tend to suffer from the same neglect that often brings corporations to grief, which is that their books and records are not updated and they fall into disrepair.

People wouldn’t even think about letting their car go for a year without service, but somehow they think that they can go for years and years without updating their Family Limited Partnership and that it will work anyhow. Especially as creditors become more organized and aggressive in attacking such structures, this is very dangerous.

There are sundry other issues relating to the drafting and operation of partnerships and LLC that are critical for these entities to maintain their legal separateness and to keep creditors and disgruntled members at bay. We will explore those issues at depth in future issues of Developments.

-- Jay

____________________

PERCEPTION - v. - CASE LAW:
JUST HOW PROTECTIVE FOR
ASSETS OF THE ENTITY IS THE
CHARGING ORDER LIMITATION?

Even though there is concern that partnership management rights may be reached by creditors of individual partners through a charging order, case law indicates that the partnership as an entity is well-protected from creditors pursuant to the Uniform Partnership Act (UPA) and the Uniform Limited Partnership Act (ULPA).

The charging order was created in order to balance the interests of creditors and partnerships. Prior to the enactment of the UPA in 1914 and the UPLA in 1916, when a debtor had an interest in a partnership, his creditor could attach the interests of the entire partnership with a writ of execution. Such an attachment often created confusion and chaos, forcing the partnership to halt business operations.

With the enactment of the UPA and UPLA, the charging order allowed creditors to obtain only an individual debtor partner’s interest in profits and surpluses of the partnership, not the assets of the partnership. Section 703 of the Revised Uniform Limited Partnership Act (RULPA)(1976) states, in part, “the judgment creditor [with a charging order] has only the rights of an assignee of the partnership interest.” However, the creditor does not actually have the rights of an assignee because the creditor owns no part of the charged interest. Under RULPA, even an assignee of a partnership interest is not a partner and may not exercise a partner’s management rights or meddle in the affairs of the partnership. §702. The latest version of RULPA (”Re-RULPA”) substitutes the word “transferee” for “assignee,” but, nonetheless, provides that a creditor does not have the right to manage operations of the partnership. Comment to UPLA § 703. Thus, the operations of a partnership may remain intact despite the obligations of individual partners.

Although every version of the UPA or UPLA prohibits the creditor from stepping into the shoes of the debtor partner as a manager or to vote, the statutes nonetheless give the court issuing a charging order broad discretion to enforce satisfaction of the judgment. The language of Maryland’s version of the UPA about the court’s authority with regard to charging orders is a good example of what most jurisdictions have adopted:

On due application to a competent court of any judgment creditor of a partner, the court which entered the judgment, order or decree, or any other court, may charge the interest of the debtor partner with payment of the unsatisfied amount of the judgment debt with interest thereon; and may then or later appoint a receiver of his share of the profits, and of any other money due or to fall due to him in respect of the partnership, and make all other orders, directions, accounts and inquiries which the debtor partner might have made, or which circumstances of the case may require.

91st Street Venture v. Goldstein, 114 Md.App. 561 (1997), quoting § 9-505 of the Corporations and Associations Article (1995 Repl. Vol., 1996 Supp.) (court held UPA gives court issuing charging order broad enough discretion to order a judicial sale of debtor’s partnership interest subject to a right of redemption).

Protective Nature of Charging Orders

An earlier charging order case, Windom National Bank of Windom, et. al., v. Charles H. Klein, et. al., 254 N.W. 602 (Minn. April, 27, 1934), emphasized that individual partners may not assign the partnership’s interests to their individual creditors, indicating the charging order’s protective origins.

The Minnesota Supreme Court held that the charging creditor of a debtor partner’s interest in a partnership may obtain an annulment of a mortgage on partnership property that was assigned by individual partners without the agreement of the entire partnership. Pursuant to the Minn. UPA, individual partners may not assign partnership property, except for the partnership purposes.

Howard and Gottlob Bender were debtors and two of four partners in the Bender Brothers Partnership. Windom National Bank obtained a charging order against the debtors, and a receiver was appointed to collect the judgment. Charles Klein was the mortgagee of partnership real and personal property. Both mortgages were executed by Howard and Gottlob Bender individually and not by the partnership.

Windom brought this suit to annul the mortgages given to Klein by the two individual debtors. Klein objected to Windom’s complaint, and the trial court sustained it. Windom appealed.

The appellate court ruled that the two individual debtor partners had no right to dispose or assign partnership property under the Uniform Partnership Act, which was adopted in Minn. The court noted that the purpose of the UPA and the charging order was to eliminate the confusion and fraud linked with regarding partners in partnerships as joint tenants with the partnership in real property. Under the UPA, the partners only have the right to assign partnership property for partnership purposes, not for individual purposes.

Thus, the charging order pursuant to the UPA began as a tool for creditors to reach the interests of debtors in a partnership while continuing to protect the partnership itself from creditors.

The charging order also protects a partnership from dissolution by allowing the creditor to reach only the debtor’s individual interest in the partnership.

The New Hampshire Supreme Court held pursuant to the New Hampshire ULPA and UPA, that dissolution of a limited partnership is not a remedy for charging creditors. Baybank v. Catamount Construction, 1997 N.H.36 (N.H. April 24, 1997). The court explained that the purpose of charging orders is to allow creditors to reach the debtor partner’s economic interests in a partnership without causing dissolution of the partnership.

The creditor, Baybank, obtained a charging order against debtor’s interest in two limited partnerships. The trial court issued a charging order, granted dissolution of one of the limited partnerships if the judgment was not satisfied within fourteen days of the order, and appointed a receiver for dissolution.

The debtors appealed. The appellate court reversed the trial court’s order of dissolution and appointment of a receiver. The appellate court held that Baybank has no standing to seek judicial dissolution of the limited partnership because the purpose of the charging order under the ULPA and UPA is to allow creditors to reach the debtor partner’s interest in distributions and profits without changing the partnership.

Management Rights Granted to Creditors

While most courts have adhered to the protective nature of the charging order by allowing the appointment of a receiver to force a judicial sale on a partner’s economic interest, some courts have gone as far as giving the receiver management powers of the debtor in order to satisfy the judgment. However, cases where courts have granted management rights to the creditor involve unusual circumstances, where the creditors are often also partners in the same partnership with the debtor. Thus, despite the appearance of a breach of the protections of the charging order for the partnership, these cases prove unique and rare in their grant of unusually broad powers to creditors.

The Missouri Court of Appeals granted the receiver management rights to collect a judgment on behalf of the creditor where the debtor was a general partner who engaged in fraudulent acts against the limited partner and the partnership. Deutsch v. Wolff, 7 S.W.3d (Mo.App.W.D. 1999).

In Deutsch v. Wolff, Eugene Wolff and Marvin Deutsch entered into business ventures together, including the formation of D & W Scheutz Road Limited Partnership (D&W). After Deutsch’s death, Wolff and a Deutsch family trust were partners in D&W. Wolff was the general partner, and the trust was the limited partner. Wolff was also the co-trustee of the trust and used his powers to engage in self-dealing.

The Deutsches obtained a charging order from the trial court against Wolff’s interest in D&W with a receiver to administer Wolff’s interest in D&W and to assume any management duties with respect to the partnership. Wolff appealed.

The appellate court affirmed the trial court’s decision, reasoning that the UPA gives the court broad discretion to order a sale of a debtor-partner’s interest in profits and surplus of a partnership to satisfy the partner’s debt and appoint a receiver for the administration of the sale. The court noted that the UPA statute empowers a receiver to “make all orders, directions, accounts and inquiries which the debtor partner might have made, or which the circumstances of the case may require.”

The court acknowledged that, normally, charging orders do not entitle the creditor to assume any management rights in order to protect the remaining partners. However, the court distinguished Deutsch by explaining that the debtor is the sole general partner who breached his fiduciary duty to the partnership and to the limited partner-creditor. Thus, the limited partner-creditor here would want the receiver to have management powers to ensure that the debtor will not use his management powers to vote against paying the creditor. In other words, the limited partner seeks protection from the general partner by asking the receiver to manage the partnership.

Finally, the court noted that, even though management rights may not be transferred to the receiver as an assignee, the management rights may be given to the receiver as an agent of the court for the purpose of satisfying the judgment to the creditor.

Similarly, the Nevada Supreme Court held that when a the creditor is a limited partner in the same partnership with the debtor, a general partner, a court may issue a charging order with the appointment of a receiver to sell and collect the proceeds of the debtor partner’s interest in the partnership (profits and surplus) and manage the profits and surplus. However, when the receivership terminates, the debtor partner’s non-economic interests, including his management rights, are restored. Tupper v. Kroc, 88 Nev. 146 (Nev. March 2, 1972).

Lloyd Tupper was the general partner of three limited partnerships. Ray Kroc was the limited partner in the same three partnerships. Each partner had a 50% interest in each limited partnership. Kroc paid some of the partnerships’ liabilities in exchange for promissory notes from Tupper, which Tupper failed to pay. Kroc obtained a charging order from the district court that ordered a sale of Tupper’s interests in the partnerships which were to be conducted by the sheriff. The sale was conducted by the sheriff and the partnership interests were purchased by Kroc for $2,500. Subsequently, the receivership was terminated. Tupper appealed, arguing that his interest in the partnership was not subject to sale, and, because Tupper retained equity in the partnership, the receivership needed to continue to protect Tupper’s interests.

The appellate court affirmed the trial court’s decision, reasoning that the court was authorized pursuant NRS 87.280(1) to make all orders necessary to satisfy the judgment through the charging order, including sale of Tupper’s partnership interests. Further, the court found it unnecessary to reinstate a receiver to protect Tupper’s non-economic interests. The court stated that, even though Tupper did retain a right to participate in management of the partnership, a receiver was not necessary to protect those rights because Tupper’s management rights were restored as soon as the receivership was terminated. Thus, when the receiver was given the authority to sell Tupper’s partnership interests in profits and surplus, the receiver probably also had the management powers necessary to ensure the profits and surplus were paid to Kroc.

Just as in Deutsch and in Tupper, the Ohio Court of Appeals granted management rights to the creditor in Webster v. Dalcoma Limited Partnership. No. CA2000-11-028 (Ohio App. Oct. 17, 2001). However, the creditor in Webster was a third party, and the debtors owned 100% of the partnership interests in the partnership. Thus, all three partners in the partnership were debtors to the same creditor, and the creditor obtained a charging order against all three debtor-partners. The court held 100% of the partnership’s management rights were assignable through a charging order because the 1/3 interest of each partner was transferable to the creditor, thus giving the creditor interest in the entire partnership

No Management Rights Granted

Unlike the previous cases, most courts have outright refused to allow creditors to step into the shoes of the debtor partner by receiving management rights.

For example, the Maryland Court of Appeals outlined the parameters of a charging creditor’s rights by holding that the general partners of a limited partnership do not have the duty to notify a receiver for a charging creditor, who has the interest of the debtor partner in the partnership, about the opportunity to purchase the partnership’s debt. Green v. Bellerive Condominiums LP, 135 Md.App. 563 (Nov. 3, 2000). Further, the court ruled that the receiver for the charging creditor, even if assigned the interest of a partner in the partnership, does not have standing to assert the partners’ management rights to participate in or object to such a purchase.

In Green, Arnold Wolfe was a limited partner in Bellrive Condominiums limited partnership. A corporation controlled by Wolfe, the U.S. Investment Group, Inc. (USIG), was one of three of Bellrive’s general partners. Wolfe borrowed $50,000 from the creditor, who obtained a charging order against Wolfe and USIG’s interests in the Bellrive partnership. Plaintiff in this case, Carlton Green, was appointed as receiver for the creditor.

The partnership’s asset was a piece of real property, which it planned to develop and sell. Bellrive was also indebted to another creditor, a bank. The bank sought to foreclose, and the FDIC scheduled a foreclosure date. Two general partners of Bellrive, wanting to stop the foreclosure, offered to purchase the debt from the bank. They sent out a letter notifying all the partners of the opportunity to buy the debt, including Wolfe and USIG. Wolf and USIG did not respond. Several partners participated in buying the debt. Finally, the partnership successfully sold the property, and paid off the debt.

Green, the receiver, brought suit against Bellrive, seeking repayment of the $50,000. Green alleged that Bellrive breached its fiduciary duties by failing to notify him of the opportunity to purchase the note and failing to obtain the consent of Wolfe and USIG to the purchase. The trial court held that Green did not have the right to receive notice of partnership opportunities and did not have standing to demand consent on behalf of Wolfe and USIG. The appellate court affirmed.

The court reasoned that the charging order only transfers collection or distribution rights to the creditor, but does not confer management rights to the creditor. Relying on case law and the RULPA §§ 10-702 and 10-705, the court determined that a receiver has the rights of an assignee, and the fundamental rights to obtain partnership information are not transferred to a creditor by a charging order. The only rights transferred by a charging order are financial rights. The court also relied on this provision of the RULPA, “An assignee who does not become a substituted limited partner has no right to require any information or account of the partnership transactions.” § 10-118.

Broad Economic and Foreclosure Rights Granted,
but Management Rights Denied

Typically, courts have only allowed creditors to receive economic rights in partnerships via a charging order. That is, the creditor may only receive profits and distributions. While most courts allow creditors to reach the profits of a partnership interest through a foreclosure sale, other courts do not allow foreclosure on a partnership interest if it unduly interferes with the partnership’s business. Further, even if foreclosure is allowed, most courts do not allow management rights to be transferred to the creditor.

The California Court of Appeals held that, although foreclosure of a charged partnership interest (share of profits and surplus) is statutorily lawful without the consent of the innocent partner(s), under the California UPA, a creditor may not foreclose on a debtor’s interest in a partnership to enforce a money judgment against debtor in his individual capacity if such foreclosure unduly interferes with the partnership business. The court ruled that whether a foreclosure sale unduly interferes with the partnership business should be determined on a case-by-case basis. Hellman v. Anderson, 233 Cal. App. 3d (Aug. 26, 1991).

The debtor, John Anderson, owned a partnership interest in Rancho Murieta Investors(RMI). The creditor, Fred Hellman, obtained a charging order against Anderson’s partnership interest in RMI. However, since the charging order, Hellman has not received any monies in satisfaction of the judgment. Thus, Hellman obtained an order from the trial court in this case authorizing and directing a foreclosure sale of Anderson’s charged partnership interest. The trial court ordered that Anderson’s partnership interest in profits and surplus of RMI would be sold at a public sale.

Anderson and his partner, Eric Tallstrom, appealed by arguing that foreclosure of a partnership interest is exempt under California law, and, even if foreclosure were an option, the consent of the nondebtor partner is required in the foreclosure. Eureka, Anderson’s largest debtor, also appealed the trial court’s order. The appellate court disagreed with the appellants, but the court remanded the case to the trial court in order to determine whether foreclosure in this case would unduly interfere with the partnership business because the court decided interference should be determined on a case-by-case basis.

The Connecticut Court of Appeals went even further than the California court by holding, pursuant to the Connecticut ULPA, that a limited partnership may enforce a charging order against a partner’s interest in the limited partnership through strict foreclosure. Madison Hills LTD v. Madison Hills, Inc., 644 A.2d 363 (Conn.App. June 6, 1994. The court noted that even though the ULPA does not expressly provide strict foreclosure as a remedy for charging creditors, the UPA does provide so and may be applied to cases governed by the ULPA.

Plaintiff Madison Hills LTD was a limited partnership that obtained a judgment against defendant Madison Hills, Inc., a general partner of plaintiff partnership, after Madison Hills Inc. defaulted on several promissory notes held by plaintiff.

Plaintiff moved for a charging order against defendant and immediate strict foreclosure of defendant’s partnership interest. The trial court granted plaintiff’s motion and charged defendant’s partnership interest with the judgment of $186,841.54. However, the court denied plaintiff’s motion for immediate strict foreclosure, but ordered that the partnership interest be foreclosed unless redeemed by defendant prior to a certain date. The Appellate Court of Connecticut affirmed.

After evaluating the language of both statutes, the appellate court ruled that the UPA and the UPLA are not inconsistent with one another. Thus, the appellate court applied the remedies provision under the UPA allowing strict foreclosure as a remedy to charging creditors to this case (which involves a limited partnership and is governed by the ULPA).

Just as in Madison Hills, the Maryland Court of Appeals noted that the UPA may supplement gaps in RULPA. Lauer Construction Inc. v. Schrift, 123 Md.App. 112 (Md.Sp.App. Sept. 2, 1998). In Lauer, the court held that a charging creditor has the power to force a sale of the debtor general partner’s interest in a limited partnership, pursuant to the UPA.

Lauer Construction had a charging order against the debtors, Claude and Carol Schrift’s, interest in Gibsons Lodging Limited Partnership. The Schrifts were the general partners of Gibsons Lodging. Lauer sought to force sale of the Schrifts’ partnership interest. The trial court denied Lauer’s request, and Lauer appealed.

The appellate court ruled that the UPA and the RULPA allows a forced sale of debtors’ interests in limited partnerships as a remedy to creditors. Pursuant to both the UPA and the RULPA, a creditor may charge the partnership interest of a debtor partner. The UPA allows force sale of the debtor’s partnership interest as an enforcement mechanism. However, the RULPA is silent as to whether a force sale of the partnership interest is a method of enforcing the charging order. A Maryland statute, CA-10-108 provides that the UPA shall apply to limited partnerships, except to the extent that the provisions are inconsistent. Because the RULPA and its predecessor gave courts broad powers to issue and enforce charging orders and the court found no inconsistencies between the UPA and RULPA, the court applied the section of the UPA that allows force sale to satisfy the judgment of a charging creditor.

Similarly, the Georgia Court of Appeals held that a charging creditor may obtain his charged interest in a limited partnership pursuant to a foreclosure by sale. Nigri v. Lotz, 453 S.E.2d 780 (Ga.App. Feb. 1, 1995). The court noted that the foreclosure sale does not place the creditor-purchaser (if the creditor under the charging order is the purchaser) in the position of a limited partner because the creditor only has rights of an assignee, and the sale only entitles creditor to receive distributions to which the debtor limited partner would have been entitled. That is, the creditor owns all of the partner’s financial interest in the partnership, including all amounts ultimately due to the partner on dissolution after settlement of liabilities.

In Nigri, the creditor sought to charge Lotz’s partnership interests in two limited partnerships through an order transferring Lotz’s partnership interests to him as a partial satisfaction of debt.

The trial court entered an order charging Lotz’s partnership interest and provided Nigri be paid with distributions from the partnership to satisfy the debt. However, the court refused to transfer Lotz’s partnership interests to Nigri. Nigri appealed, claiming that the trial court erred in holding that Lotz’s interests in the partnership were isolated from Nigri’s claim as creditor and by refusing to transfer Lotz’s partnership interests to him in satisfaction of the judgment debt.

The appellate court affirmed the trial court’s judgment. The court stated that Nigri should have asked for a transfer of interest through a foreclosure by sale pursuant to the ULPA, instead of an outright transfer of interest in the partnership to Nigri, which is not a remedy under the ULPA.

No Right to Foreclose Granted to Creditor

Unlike most jurisdictions, Florida courts have held that a creditor may not foreclose on a debtor-partner’s interest in a partnership in order to satisfy a judgment.

The Florida Court of Appeals held, pursuant to Florida’s RULPA, a creditor with a charging order against a debtor’s interest in a limited partnership does not have the right to foreclose against the debtor partner’s interest in the limited partnership. Givens v. National Loan Investors, L.P., 724 So.2d (Fla.App. Dec. 18, 1998).

In Givens, National Loan Investors was the creditor that obtained a charging order against Charles Givens’ interest in two limited partnerships. National Loan sought an execution of sale of the limited partnership interest. The trial court ruled an execution of the sale of a limited partnership interest is lawful under Florida law.

The appellate court reversed, ruling that Florida RULPA does not allow charging creditors to foreclose on the debtor’s interest in a limited partnership because the RULPA only gives creditors the rights of an assignee. The court noted, however, that a creditor with a charging order in the interest of a general partnership may foreclose on a debtor partner’s interest in the partnership.

Further, the court noted that practitioners who are concerned with asset protection generally should counsel their clients to consider operation as a limited partnership rather than a general partnership because a judgment creditor’s rights against a debtor partner’s interest in a general partnership are greater than the rights against a partner’s interest in a limited partnership.

Similarly, the North Carolina Court of Appeals held that a charging creditor may receive distributions and allocations from the limited liability company of a debtor-partner in order to satisfy a judgment debt. However, pursuant to N.C.G.S. § 57C-3-03, a creditor may not force the sale of a debtor-partner’s membership interest in a limited liability company to satisfy the debt. Herring v. Keasler, 563 S.E.2d 614 (N.C.App. June 4, 2002).

Court’s Power to Terminate Receiverships

Just as courts may grant foreclosure and other economic powers to creditors, courts also have the broad discretion to terminate powers given to a receiver when the judgment is satisfied.

In 91st Street Joint Venture v. Goldstein, 691 A.2s 272 (Md.Sp.App. March 1997), the Maryland Special Court of Appeals held that a trial court has the discretion to set aside a previous transfer of debtor’s partnership interest to creditor by the receiver and vacate a previous charging order, if the debtor has satisfied the debt by posting a cash bond. The court stated that a trial court has broad discretion to charge a debtor partner’s interest in a partnership, appoint a receiver of monies, and make all other orders, directions, accounts, and inquiries which the debtor partner might have made on his/her interest, or which circumstances may require.

Edward Goldstein was the debtor and had a 0.2022% interest in the 91st Street Joint Venture. 91st Street was Goldstein’s creditor with a charging order from the trial court against Goldstein’s interest in the joint venture.

The trial court appointed receiver for the purpose of effectuating a transfer, assignment, and/or conveyance of Goldstein’s interest to the joint venture if the judgment remained unsatisfied for fifteen (15) days after the charging order was served on Goldstein. Goldstein appealed the charging order within the fifteen days, and the court stayed enforcement of the judgment and fixed a bond of $56,000. Thereafter, the trial court amended its order staying the judgment and increased the bond to $61,600. Goldstein posted a cash bond in the amount of $61,600, and the trial court dismissed Goldstein’s appeal.

Subsequently, the joint venture obtained an order dissolving the stay of enforcement on the judgment, and the receiver transferred Goldstein’s interest in the joint venture, amounting to $28,950 to the joint venture, in partial satisfaction of the judgment. The joint venture filed a petition to release part of Goldstein’s bond to satisfy the rest of the judgment. Goldstein filed an opposition to the joint venture’s position, asking the court to release the bond, distribute the funds, and vacate the charging order and receivership. The trial court granted Goldstein’s motions.

The joint venture appealed, presenting the issue of whether the trial court abused its discretion by setting aside the receiver’s transfer of Goldstein’s partnership interest and in vacating the charging order and terminating the receivership. The appellate court ruled that the trial court has broad discretion to revise the charging order, and the receiver’s assignment was subject to ratification by the trial court. Further, the court found that Goldstein was free to challenge the charging order under Maryland law.

As demonstrated by the cases above, the charging order is an effective tool for creditors to satisfy judgments against debtors by obtaining debtors’ interests in partnerships and LLCs. Despite its usefulness for creditors, the charging order also balances out the interests of the so-called “innocent” non-debtor owners and entities by preserving management rights and restoring any rights transferred to a receiver after a judgment is satisfied.

____________________

WHEN ONE IS BETTER THAN MANY:
THE SERIES LLC

by Chris Riser

Segregating “dangerous” assets and businesses into separate entities away from other assets, especially “safe” assets, is always a good idea from an asset protection point of view. For example, an individual who owns a gas station and a rental home should not own both within the same entity. Further, an individual with a large amount of liquid assets (cash, securities, etc.) to protect should not hold those assets in the same entity as a business.

Best practices would dictate that every distinct business or major business asset be segregated into a different limited liability entity. In an ideal situation, someone with 25 rental properties would have 25 separate LLCs, one for each property. However, this is not always practical because of administrative costs and government fees that must be paid for each LLC. What can such a business owner do to protect his assets from liabilities unrelated to those assets in a cost-effective way?

Enter the series LLC. The LLC acts of Delaware, Iowa and Oklahoma provide for the creation of separate protected “cells” (‘series’) within one limited liability “container” (the series LLC) without the need to create separate entities, thus avoiding the inefficiencies associated with multiple related entities. [1] The Delaware LLC Act is the LLC act most often used for series LLCs and is the act used for discussion purposes in this article.

The Delaware LLC Act provides that the liabilities of a particular series are enforceable only against the assets of that series. The Act also provides that classes or groups of members can be established, having whatever rights the LLC agreement says they have.

The combination of these two provisions