Defalcation

It appears that I struck a chord a couple of weeks ago when I wrote about how limited partnerships aren’t as indestructible as everyone believes they are.

In the article I talked about how a bankruptcy trustee was able to use the withdraw language in the partnership agreement to get at the assets of the partnership. I was really impressed with the trustee’s tenacity and creativeness, but the reality is LPs, and LLCs for that matter, really don’t have much protection to begin with.

I was on the phone with a potential client this week. He had set up a limited partnership whereby he was the limited partner and a corporation, owned 100 percent by him was the GP. By the way, those of you with LPs, how many of you have the same structure?

Let’s analyze what is going to happen in the event of a Code Red. The creditor is going to try to take away your ownership in the LP. While it is possible, they are going to have a tough time of it, because you’ve got that mythical charging order protection protecting you. A better solution for the creditor would be to try to take over your ownership in the corporation. There is no charging order protection for most corporations, so taking over the corporate shares is probably going to be incredibly simple.

Once they take over the ownership of the corporation they will have the keys to the kingdom. Look over your partnership agreement. You probably gave the GP the power to dissolve the LP, and you probably have some language to the effect that no transfers of the LP can be made without the approval of the GP as well. If the bad guys are now the GP, what protection do you have?

Example 2

You are a real estate wizard. You’re so good you negotiate to purchase a 1,000 acre parcel for only $400K with the bank willing to finance most of the purchase. The challenge is that while you are now RE rich, you are also cash poor, so you ask your buddy to form an LLC with you so you can use some of their cash and their credit. Your buddy agrees and you transfer the parcel into an LLC, of which you and your buddy own 50/50.

A couple of months later you get a smoking offer of over $3 million for the property. Since you found the property, and your buddy has only put a few thousand into the LLC, you think it’s only fair to charge a finder’s fee/commission to the LLC. After all, your buddy is going to get hundreds of thousands of dollars for nothing, isn’t he?

As part of the deal, the buyer asks the LLC to carry back the note, and you are more than willing to do so as the first payment exceeds the amount you paid for the property. What a home run! Since you knocked that deal out of the park, there is no question that everything you touch will turn to gold, and you start doing some personal deals. At the same time, you use some of the LLC’s money for your personal expenses. You know it’s alright with your partner because you did just make him a hell of a lot of money.

Unfortunately, about this time the real estate market collapses, and you find that you have to file bankruptcy. All of the above is taken directly from a bankruptcy case. The Bankruptcy Court decided that the commission charged and the personal use of LLC assets were non-dischargeable.

Why?

One section of the bankruptcy code denies a discharge for, “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny”. Let’s look at, “defalcation while acting in a fiduciary capacity,” but let’s look at it in reverse order.

The first big surprise you might receive is the fact that, in a number of states, partners owe a fiduciary duty to each other. Even if you didn’t form a “formal” entity like an LLC or LP, you could still be considered partners, thus fiduciaries to each other.

Next let’s tackle the big fancy word, defalcation. Black’s Law Dictionary defines it as, “misappropriation of trust funds or money held in any fiduciary capacity; [the] failure to properly account for such funds”. Going further, an individual may be liable for defalcation without having the intent to defraud.

Translation: If with pure heart but empty head you do something stupid with the partnership’s money, you can be held liable and the debt probably isn’t dischargeable in bankruptcy.

So let’s get to the dramatic conclusion.

Just imagine the consequences if you had an LP, LLC, and even just an informal partnership. At first the partnership was with either your own entities and/or people who you trusted. The partnership flipped a few houses and it made some great money, and you spent it. The challenge is you didn’t do the formal paperwork of showing capital accounts, distributions, etc. … you just spent the money for a shiny red Ferrari.

Fast forward a few years. All of your properties are upside down and you or your partner have to file bankruptcy. If the creditor’s attorneys are crafty, they are going to purchase from the bankruptcy trustee ownership in the entity, and then file a claim based on either defalcation or fraudulent conveyances. A claim that is not going to be dischargeable.

Far-fetched? Maybe, but I think that as more and more people file bankruptcy to get out of their crushing debts, more and more people are going to try to figure some way to profit from those bankruptcies.