Charging Order Wrinkles

My esteemed colleague Bob Spurlock did a brave thing recently. He used his noodle to come up with an imaginative theory of recovery; and, it appears to have succeeded! Fine lawyers like Robert uniformly are envelope-pushers. His case involved the interpretation of application of a charging order’s reach.

Charging orders are about as unsexy as anything in the law. Here’s a procedure that a creditor of a partner or member of a partnership-type firm structure (these unincorporated enterprises include general and limited partnerships, LLCs and LLPs, which I’ll just call “firms” collectively for the rest of this post) must use to reach the partner or member’s interest in the firm. Significantly, the charging creditor can reach only the debtor-member’s interest in the firm’s distributions, somewhat like a garnishment of wages. You cannot reach any specific firm property. As in corporations, partnership-type statutes prohibit individual members from transferring the firm’s specific property. Partnership-type statutes go yet further, providing that, in the absence of contrary agreement among members, members can transfer only their economic rights, and not their management rights. This limitation reflects the traditionally “collective” nature of a firm--an association of individuals who care about the identity of their co-members. So, a charging order holder can pursue its debtor via the order--but no upsetting the firm’s direction by injecting yourself into the mix, if you please.

In some states, such as North Carolina and Georgia, you can foreclose on a charging order entered with respect to a firm. No so in the State of Arizona (well, unless you’re in bankruptcy court here, and you’re assigned to a judge who thinks a partnership/LLC member agreement is not an executory contract, so that Code Section 541(C) trumps Code sections that prohibit seizure of the member interest). The order just hangs fire, poised passively for distribution-grabbing, and therein lays the rub. The limited virtue of a charging order in Arizona assumes both that firms will make distributions that can be reached by the charging order and that there’s a need to reconcile firm creditors’ interests with those of non-debtor partners or members.
(But since neither of those conditions holds true in single-member LLCs [the stealthy, “disregarded” entities which can play “zero-sum footsie” with outsiders], they have lately become ersatz asset protection vehicles—but I digress.) A creditor of a partner or other member of a firm therefore has only the right to receive distributions that the non-debtor partners or managers choose to make, and not the right to compel the firm to make distributions. So, firms that are managed by collusive, clever folks become creative in avoiding, where there are no tax incentives to distribute to members, making any distributions directly to the members.

Bob’s client obtains a charging order against a limited partnership, and then Bob files a motion to seize payments emanating from the Company’s accounts. It seems that the Company general partners never made any cash distributions to partners, including the debtor. Instead of paying them, you see, management just picked up their laundry and bought their groceries. Well, actually the general partners signed checks to pay partners’ home mortgages and installments on fancy car leases—via reimbursement for the payments of such “obligations.” Bob argued that these reimbursements are de facto distributions. The debtor did nothing to prove that his house and vehicle lease payments were essential to the operation of the partnership. That was the factual, final coffin-nail for the debtor; the trial court found specifically that the payments were distributions, even though the funds had been previously committed to obligations incurred by the limited partners.

The judge cited a Connecticut case, PB Real Estate Inc. v. DEM II Properties, 719 A.2d 73 (1998), where the appellate court held that “company expense”-style payments to the members, who were lawyers (defendants alleging they were lawyering for the company), were distributions of profits—and therefore subject to a charging order against the limited liability company: “Although the defendants at trial presented a profit and loss statement for 1996 showing a net profit of only $23.44, that result was achieved only by treating the payments of $28,000 to each of them as expenses for wages. If those payments were neither distributions, as the defendants contend, nor wages, as the trial court found, they would have to be considered profits.” So, it behooves the practitioner (or the creditor) to do a bit of ongoing industrial spying, monitoring the behavior of the firm subject to the charging order after its service upon its management, to ensure that there’s no “gaming” of the charging order system. But I wonder: What if in Bob’s matter, the debtor had offered proof that the mortgage payment reimbursed was on the residence housing the “home-office” of the partnership in the basement? Or that the Lincoln Town Car was used only for sales calls by its debtor-lessee?

-MNW