Creditor vs. Family Limited Partnership

Originally published: Oct-21-2004

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Attacking Assets in a California
Family Limited Partnership

by Bruce W. Hogan
Kingston, Martinez & Hogan

PART I: The Charging Order

The Family Limited Partnership (FLP) is a common estate planning device. A Wall Street Journal article described the technique as follows: "Family limited partnerships are designed to curb estate and gift taxes by moving assets out of someone’s estate and into a partnership. A parent transfers business or investment assets - usually a family business, real estate or securities - to a partnership formed with his or her children. Most of the shares in the partnerships are given back to the kids, though the parent retains a small ownership stake.

"Parents, however, can designate themselves as a general partner. That means that, despite transferring the assets into the partnership, they can continue to make investment and management decisions. The kids, meanwhile, are only limited partners, with less control. The upshot: The parents can still manage the assets while avoiding hefty estate and gift taxes." R.W.Silverman (from the Wall Street Journal) L.A. Daily Journal, Dec. 3, 2003, page 4.

Aside from its potential benefits as an estate planning vehicle, the FLP is also promoted as an asset protection device. This two part article discusses various methods available to a creditor to reach assets which have been transferred into a FLP. Part One considers the use of the charging order and its associated remedies against a partner’s FLP interest. Part Two discusses whether a creditor may successfully attack the transfer of property into the FLP as a fraudulent conveyance.

The Charging Order may be used to attack a debtor's partnership interest in a family limited partnership.

What Is a Charging Order?

General and limited partnerships are treated as separate entities in California. A partner’s interest in a partnership is not subject to execution or attachment unless the partnership is also a debtor. Evans v. Galardi, 16 Cal. 3d 300, 310-311, 128 Cal. Rptr. 25, 546 P 2d 313 (1976), CCP § 699.720 (a)(2). Creditor remedies for reaching assets of a partner in a partnership are set forth in the Uniform Partnership Act of 1994 (RUPA) which is incorporated in Corporations Code Sections 16100 through 16962 and has governed California partnerships since 1998. Under these sections, and the corresponding provisions of the Code of Civil Procedure, the sole remedy available for direct attack on a partner’s interest is the charging order and its associated remedies. (Corp. Code § 16504; CCP § 708.310) The reason for this limitation on creditors is to prevent a claim against a partner from disrupting or interfering with the business of the partnership.

The charging order acts as a lien against the partnership interest of the debtor partner, and directs that all distributions attributable to the partner be made instead to the creditor. The lien arises once the motion for a charging order is granted and relates back to the date the motion was served. CCP § 708.320(a). It is important to note that the charging order acts solely against the interest of the partner and reaches only the partner’s proceeds or surplus distributions. The creditor holding a charging order has no right to participate in management and has no claim to specific partnership assets.

Remedies Associated With the Charging Order

Under RUPA, there are three supplemental remedies which may be used in conjunction with the charging order. The issuance of the charging order is generally required before these other remedies may be employed and each is "progressively more drastic, ... consistent with the underlying rationale of the charging order which is to minimize the disruption of a partnership business." 1 P. Spero, Asset Protection, Partnerships § 9.02(1) (2001).

The creditor must first obtain a charging order which in effect garnishes all distributions available to the partner whose interest is charged. The issued charging order should be served on both the debtor partner and the partnership. See CCP § 708.320(b).

The next available remedy is appointment of a receiver to collect the funds due to the debtor partner and conserve partnership property. This remedy is sometimes requested at the same time as the motion for a charging order. While the receiver can conserve partnership property and prevent fraudulent transfers of its property, he or she can neither seize partnership property nor participate in management of the partnership.

If issuance of the charging order and appointment of a receiver are ineffective in satisfying a creditor’s claim, two other remedies remain, each progressively more severe. The first is foreclosure upon and sale of debtor’s partnership interest. If the foreclosure is successful but the debt still remains unpaid, the creditor may then seek the final remedy, dissolution of the partnership. See Corp. Code § 16504(b). These drastic remedies, however, are only available under restricted conditions, consistent with the goal of RUPA to prevent the creditor of one partner from unduly interfering with partnership business.

Foreclosure of a Partnership Interest in California

In California, the foreclosure and sale proceedings, under appropriate circumstances, are available to creditors of both general partners and limited partners, including members of family limited partnerships. 2 R.L. Enkelis, et al., Debt Collection Practice in California 2d (Cont. Ed. Bar 1999; F.D. Brooke, et al., Advising California Partnerships 2d (Cont Ed. Bar 1988). At least one commentator, however, has argued that the rules are different for limited partnerships, and that foreclosure and sale are not available as remedies to creditors of a limited partner. 1 P. Spero, supra at Partnerships § 9.02 (1)(b). He points out that the Revised Uniform Limited Partnership Act (RULPA) differs from ULPA in that it does not include the language authorizing foreclosure and sale of the limited partnership interest (when a charging order against that interest remains unsatisfied). California law, however, does not recognize this distinction and applies the same rules to both general and limited partnerships.

Two California cases, Crocker Nat’l Bank v. Perroton, 208 Cal. App. 3d 1, 255 Cal. Rptr. 794 (1989) [hereafter cited as Perroton] and Hellman v. Anderson, 233 Cal. App. 3d, 852 (1991) [hereafter cited as Hellman], describe the limited circumstances under which a creditor with an unsatisfied charging order may foreclose upon and sell a debtor’s partnership interest as authorized by Corp. Code § 16504(b). No distinction is made in these cases between general and limited partnerships.

In Perroton, decided in 1989 and involving a limited partnership, the court determined that a judgment creditor holding an unsatisfied charging order against a limited partner could proceed with foreclosure of the partner’s interest, but only after obtaining the consent of the non-debtor partners. Perroton is helpful to California creditors of limited partnerships because it confirms that the foreclosure procedure is available to creditors of both general and limited partnerships. The restriction established by the court, however, requiring consent from the other partners, is likely to be unavailable in a family limited partnership setting.

In Hellman, a general partnership case decided two years later, the restrictions on foreclosure and sale were further relaxed. The Hellman court held that even if consent of the non-debtor partners is unavailable, the foreclosure sale can go forward if sale of the debtor partner’s interest would not disrupt the partnership business. The court further held that the burden of proof to show that the foreclosure sale would disrupt partnership business was on the debtor partner.

If the FLP being attacked by the creditor is merely holding passive assets such as residential property or investments, it may be difficult for the debtor partner to sustain that burden. The result may well be different, however, if the FLP holds an active business as one of its assets, especially if the debtor partner is essential to its operation.

Both cases reconfirm that the foreclosure sale operates only on the debtor partner’s "interest in the partnership," meaning the debtor’s share of profits and surplus, and that a purchaser at foreclosure does not acquire either a right to the partnership property or a right to participate in management.

Dissolution of the Partnership

If the foreclosure of the debtor partner’s interest is completed, dissolution of the partnership is possible, but only if 1) the consent of the other partners is obtained, 2) the term specified in the partnership agreement has expired or 3) the partnership was a partnership at will when the charging order was issued. Corp. Code § 16801.

Conclusion

In the event that use of the charging order does not result in payment of a creditor’s claim, it may also be possible for the creditor to pursue assets that have been placed in the FLP. Part Two of this article discusses whether transfers into FLP’s may be attacked as fraudulent conveyances.

PART II: Fraudulent Transfers

Part One of this article considered creditor use of the charging order and associated remedies to recover directly from the proceeds of a debtor’s FLP interest. This Part Two discusses whether debtor assets may also be reached indirectly by attacking the manner in which those assets were transferred into the FLP.

Transfers to the FLP may be attacked as fraudulent conveyances

In addition to charging order remedies which may be employed to reach the debtor’s FLP interest, creditors may also attack the FLP itself if partnership assets were fraudulently transferred into the partnership.

The California Uniform Fraudulent Transfer Act

The California version of the Uniform Fraud Transfer Act (UFTA) is contained in Civil Code §§ 3439 through 3449. These sections are designed to prevent debtors from placing property beyond the reach of their creditors when those assets should legitimately be made available to satisfy creditor demands. See Chichester v. Mason, Cal. App. 2d 577, 584, 11 P. 2d 362 (1941). If a debtor makes a transfer subject to the UFTA, the creditor has the right to have the interest of the debtor in the property transferred subjected to the creditor’s claim. See Ahmanson Bank & Trust Co. v. Tepper, 269 Cal. App. 2d 333, 343, 74 Cal. Rptr. 774 (1969).

Actual Fraud

There are two types of fraudulent transfers: those made with actual intent to defraud and those made under circumstances which constitute constructive fraud. When actual fraud is shown, neither the solvency of the transferor nor the amount of consideration received in exchange for the transfer is material (Fross v. Wotton, 3 Cal. 2d 384, 388, 389, 4 P.2d 350 (1935)), though evidence of insolvency may be relevant to the issue of actual fraud. Hansford v. Lassar, 53 Cal. App. 3d 364, 378, 125 Cal. Rptr. 804 (1975). Such a transfer is fraudulent as to both existing and future creditors. Civil Code § 3439.04(a). "Future creditor" has a narrow definition in this context, however. As noted by Spero (1 P. Spero, supra at Fraudulent Transfer Laws § 3.04 (1)), "the term may be a misnomer, because it generally means a creditor who presently holds contingent, unliquidated, or unmatured claims, all of which are included in the definition of the term "claim" under the various fraudulent transfer laws, or one who holds a claim that is reasonably foreseen by the transferor [non-California citations omitted]." See, also, Severance v. Knight-Counihan Co., 29 Cal. 2d 561, 567, 568, 177 P2d 4 (1947).

The creditor has the burden to prove that a transfer is actually fraudulent (Vaughn v. Cocciniglio, 241 Cal. App. 2d 676, 679, 50 Cal. Rptr. 876 (1966)), but that burden may be met by circumstantial evidence. Aggregates Associated, Inc. v. Packwood, 58 Cal. 2d 580, 588, 25 Cal. Rptr. 545 (1962). In fact in most cases there is no direct proof of actual fraudulent intent, which must be inferred from the surrounding circumstances. Neumeyer v. Crown Funding Corp. 56 Cal. App. 3d 178, 183, 128 Cal. Rptr. 366 (1976).

Badges of Fraud

The UFTA has a list of the 'badges of fraud' which can be used to establish actual fraud, but that list was not included in the California version of the UFTA set forth in Civil Code §§ 3439 through 3439.12. Similar standards, however, have developed in California case law.

An inference of fraud may arise, for example, when a confidential relationship exists between the transferor and the transferee, and in particular when the transfer takes place between family members. Under such circumstances, the parties are held to higher standards when showing adequate consideration and the fairness of the transaction. Wood v. Kaplan, 178 Cal. App. 2d 227, 230, 231, 2 Cal Rptr. 917 (1960). Other factors which may be considered are the solvency of the transferor before and after the transaction (see Hansford v. Lassar, supra), and whether the transfer included a large portion of the transferor’s non-exempt property. Burrows v. Jurgenson, 158 Cal. App. 2d 644, 648, 323 P2d 150 (1959). Another similar factor included as one of the UFTA’s badges of fraud is whether the transferor retained possession or control of the property transferred.

Actual Fraud and the FLP

Many of the badges of fraud are likely to be present when most FLPs are formed. The transfers are commonly between family members and are made with little or no consideration passing. Often a significant portion of the transferor’s assets are placed within the FLP, which will reduce the assets available to establish his or her solvency. The creditor can argue that there are insufficient non-partnership assets remaining for the transferor to maintain the standard of living he or she enjoyed prior to the transfer. If the transferor is the general partner of the FLP, as is common, he or she will retain control of the property transferred, and the creditor may be able to establish that personal and partnership assets have been commingled. Furthermore, if title to the family residence is placed within the FLP, the creditor may be able to show that the transferor retains control and use of partnership property while he or she fails to pay the fair rental value of its use to the partnership. Circumstantial evidence of this type will assist the creditor in proving actual fraud.

Can Actual Fraud Be Shown if the FLP is Formed When No Creditors Exist?

Under such circumstances, assuming the transferor had present or "future" creditors at the time of the transfer, the attacking creditor is likely to prevail. If, however the FLP is formed when the transferor is debt free, it will be much more difficult for the creditor to prevail. The transferor will argue that the FLP was formed as part of an estate plan rather than as an attempt to avoid creditors, and may be able to successfully defend the fraudulent conveyance action by showing a proper purpose for the transfer of assets into the FLP. See Hedden v. Waldeck, 9 Cal. 2d 631, 636, 72 P 2d 114 (1937) [no finding of actual fraud if other, valid reason for transfer is also present]. Indeed, Spero suggests that "when the [transferor] has no creditors ... transfers cannot be made with fraudulent intent." 1 P. Spero, supra at Fraudulent Transfer Laws § 3.04 (1).

Constructive Fraud

The proof required to show constructive fraud is more objective than that needed to show actual fraud. There are three categories of constructive fraud, each of which requires that the transfer be made without adequate consideration. Those three categories are:

1. Transfers made when the debtor engages in a transaction or is about to do so with unreasonably small assets, as when an individual transfers most of his assets immediately before engaging in a risky business venture (Civil Code § 3439.04(b)(1));
2. Transfers made when the debtor intends to incur or believes that he will incur debts beyond his ability to pay such debts; for example, when a debtor transfers assets immediately before entering a program of business expansion that will require substantially more capital than the debtor will have after the transfer (Civil Code § 3439.04(b)(2); only existing creditors are protected); and
3. Transfers made when the debtor is insolvent or will be rendered insolvent as a result of the transfer; for example, a debtor who transfers a family residence to his spouse during business difficulties and has a negative net worth as a result of the transfer (Civil Code § 3439.05).

Constructive and actual fraud often compliment each other. For example, if a transfer is made with the actual intent to defraud a specific creditor, it will be voidable regardless of the transferor’s financial condition and regardless of whether the transferee paid fair and adequate consideration. Conversely, where the elements of constructive fraud are established, the transfer will be voidable regardless of the transferor’s intent (1 P. Spero, supra at Fraudulent Transfer Laws § 3.04}.

A creditor attempting to reach FLP assets should examine each of the three types of constructive fraud as well as actual fraud as a possible basis for setting aside the transfer of property into the FLP as a fraudulent transfer. Often more than one of the four different types of fraudulent transfer may apply to the circumstances, and more than one theory for recovery should be alleged in the pleadings which attack the FLP property.

Conclusion

Creditors of a partner in a California FLP can attack the partner’s interest directly by way of the charging order and its associated remedies. If the charging order remains unsatisfied, foreclosure and sale of the partnership interest may be available if those procedures will not disrupt partnership business.

Creditors may also seek to reach FLP assets by attacking the transfer of property into the partnership as a fraudulent transfer. Since many FLPs are formed under circumstances which raise the inference of fraud upon creditors, such an attack may well be successful unless the FLP was formed at a time when the transferor had no creditors.

In any event, a creditor pursuing assets which have been placed in a California FLP should carefully examine both the structure of the FLP and the circumstances of its creation to determine whether those assets are subject to recovery.

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Bruce W. Hogan is a partner is the law firm of Kingston, Martinez & Hogan, located in Santa Barbara, California. He specializes in commercial collection matters and can be contacted at bhogan@101freeway.com.

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