Is Your Operating Agreement Worth the Paper It’s On?

The other day I was researching a subject and had to read a ton of bankruptcy cases. One case in particular really made my jaw drop. The ruling was so incredibly simple and yet, at the same time, pretty devastating for someone who has not done proper planning.

The facts of the case were that Dad’s living trust created a limited partnership and funded the LP with real estate worth about $400,000.

As part of Dad’s estate planning he gave his daughter 99% ownership of the LP, with all of the interests gifted, being as a limited partner. The 1% general partner interest was retained by Dad’s living trust, thus the LP was effectively controlled by Dad acting as trustee of the living trust. Pretty standard stuff so far.

The bankruptcy trustee then brought an action to determine if the bankruptcy trustee was the owner of the daughter’s 99% interest, and if so, could the bankruptcy trustee dissolve the LP and get the booty within.

An often cited axiom of bankruptcy law is that the bankruptcy trustee “steps into the shoes” of the bankruptcy debtor, and the trustee has the exact same rights in the property that the debtor had.

In this particular case, the court determined that while the bankruptcy trustee did in fact become the owner of the 99% LP interest, they really couldn’t get anything as:

1. The state charging order protection (it was an exclusive remedy statute).
2. A stringent operating agreement that said Dad was in full control and limited partners had no right to force either a distribution or dissolution of the LP.

( Funny side note: The attorney who drafted the LP was called as an expert witness, with the gist of his testimony being that the LP was created as an estate planning device. I’m sure IRS estate and/or gift tax auditors would have loved to hear that testimony.)

Well, this was a bit of a mixed verdict for the bk trustee. Yes, they were the owner of the 99% interest, but what good was it, a fancy paperweight?

Well, my Mom told me persistence is everything, and it appears the bk trustee was taught the same lesson. For the second bite of the apple, the bk trustee sent Dad/GP a letter stating it was the trustee’s intention to “withdraw” from the LP.You see, the operating agreement had a provision allowing a partner to “withdraw” from the partnership. No need for a liquidation, transfer or sale, the trustee merely exercised their right to withdraw.

This action was pretty darn sharp. Keep in mind the charging order limitations only apply to non partners. In this case the bk trustee was in fact a partner, thus charging order provisions did not apply to him.

Additionally, any stringent transfer restrictions in the partnership agreement wouldn’t apply either as the trustee wasn’t trying to transfer their interest, rather they were merely withdrawing.

The bottom line is that the bankruptcy trustee is going to end up with 99% of the assets inside the partnership, and the attorney who drafted the partnership agreement is going to have some explaining to do.

I think there are 2 very important points to be learned from this case:

1. Know what is inside your operating/partnership agreement. Too many people are buying boilerplate templates off the internet or elsewhere. When you do so you are running the very large risk that there is going to be some “gotchya” provisions inside your agreement. The geek in me equates these provisions to “back doors” in computers. Various experts guess there are millions of zombie computers that can be taken over by some pubescent kid in a foreign country, just because there is some bad software on the computer. Same with your LLCs and LPs: A lot of them are zombie entities that can probably be taken over fairly easily by creditors and or bankruptcy trustees if something bad happens. Which brings up:

2. Never, ever, ever (add five more evers for good measure) give an asset outright to someone. Wrap it up in a trust instead. Sure you might save a few pennies initially, and yeah, it might be more convenient to give it to them outright, but a trust is going to provide a lot more protection. Just imagine what would have happened in this case if Dad set up a proper trust for his daughter, and then put her 99% ownership inside the trust. Even if she declared bankruptcy the next day, these cases would have never happened.

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