Foreclosure of FLP Interest
Although it would be attractive to have a single, simple entity solve all of our asset protection issues, the law is more complex than that. In California, for example, case law and the statutes specifically allow a creditor to foreclose on a limited partnership interest, in addition to the charging order remedy. California Corporations Code Section 15907.3 (b) states: (b) A charging order constitutes a lien on the judgment debtor’s transferable interest. The court may order a foreclosure on the membership interest subject to the charging order at any time. The purchaser at the foreclosure sale has the rights of a transferee.
Similarly, California also permits foreclosure of an interest in a limited liability company under California Corporations Code Section 17705.03. See also (Hellman v. Anderson; Foreclosure of partnership interests); Olmstead, et. al., vs. The Federal Trade Commission, Supreme Court of Florida (Single member LLC’s).
California Asset Protection and Foreclosure of FLP Interest
What does this mean? As distinguished from a mere charging order, which allows a creditor to only reach actual distributions to a debtor-partner, a foreclosure of a limited partnership interest has some powerful teeth as a remedy. For example, you may own all of the interests in an FLP holding assets worth $1 million. Sometime later a judgment is entered against you for $200,000. A creditor with a judgment can foreclose on the limited partnership interest—worth ostensibly $1 million—substantially more valuable than the judgment itself. If the creditor’s remedy is limited to a charging order, he would be entitled to distributions equal to the amount of the judgment. When and if he is paid this amount (plus interest), the creditor’s judgment is satisfied. A creditor who is permitted to foreclose on the partnership interest gets more than that. He is legally entitled to distributions without regard to the amount of the judgment. He could ultimately get paid the full $1 million of value. In this situation, you will be forced to pay off the judgment at its full amount. You have little to negotiate with and certainly no leverage to attempt to settle the claim at some reduced amount. The creditor holds all the cards because he has security for his claim far more valuable than the actual amount of the judgment. By relying on the Family Limited Partnership and the charging order protection, the potential loss for you is now far greater than it would otherwise be. Note that the partnership or LLC interest may be redeemed by paying off the amount of the judgment prior to foreclosure.
In states other than California, case law and ambiguities in the interpretation of existing laws make a reliance on the charging order protection speculative and, therefore, dangerous. When we talk about Limited Liability Companies in the next chapter, you will see that recent cases have severely limited charging order protection and that seems to be the trend of the cases. Even when the state where the partnership is formed specifically bars foreclosure, rules regarding jurisdiction may dictate that the law of the plaintiff ’s home state may control the applicable law. In other words, there is no guarantee that a lawsuit against you will end up in a state with favorable laws. Many factors are considered by the courts in determining jurisdiction and the applicable law, and we would not bet the farm (literally) that your choice of law will prevail in any litigation.
Having said all this, the FLP may still be a valuable tool for asset protection. The FLP agreement can sometimes be drafted to avoid a creditor’s foreclosure remedy by limiting the transferability of the interests in the FLP. Additionally, a Family Savings Trust can be designed to own limited partnership interests so that neither a charging order nor a foreclosure can be applied and the goal of asset protection will be accomplished.