The Monthly Tax and Asset Protection
Newsletter of Klueger & Stein, LLP

August 2009

Advanced Pointers on Drafting Partnership/LLC Agreements

Everyone knows how to draft a partnership or LLC agreement. At least that is the sense one gets from talking to lawyers. Unfortunately, many attorneys are lulled into a false sense of security by the wonderful forms that everyone has access to. When copies of LP and LLC agreements became available on EDGAR online, every attorney received access to the documents drafted by the big law firms. Don't get me wrong. Getting some white shoe NY law firm to do the bulk of the drafting work for you is wonderful, but not enough. Here are some important drafting pointers to consider from an asset protection standpoint.

Most LP and LLC agreements provide that the GP or the manager shall control the timing and the amount of the distributions. However, once the GP/manager decides to make a distribution, the distribution must be made pro rata. That works in most cases, but can lead to a bad result. If Jack and Jill are 50-50 members of an LLC and a judgment is entered against Jack, the LLC charging order protection works only if Jack can cease making distributions to himself. But Jill wants to continue getting cash out. If the LLC provides for a pro rata distribution, then Jack must either distribute to both Jack and Jill or to neither. The first option makes Jack unhappy (his distribution now goes to his creditors) and the second option makes Jill unhappy.

We commonly insert a provision in the distribution clauses allowing the GP/manager to cease making distributions to a partner/member pursued by a creditor in a collection action. This way distributions are generally made pro rata, but an exception is carved out.

California law, similar to other states, allows the partnership/operating agreement to trump default state statutes governing LPs and LLCs. This allows the drafter to make partner/member interests non-assignable (with the non-assignability, preferably, subject to a trigger, like a collection action), or to include clauses like a poison pill.

A poison pill, in this context, is just a buy-out clause, triggered by a specified collection action, that grant the right to the non-debtor partners/members to buy out the debtor partner/member's interest at a preset price. The price is usually nominal. This allows the debtor to dump his partnership/membership interest if all else fails. For obvious reasons we will use poison pill clauses only if the other partners/members are family members of the debtor. There is no sense in having Jack lose his partnership/LLC interest to a stranger who happens to be invested in the same deal.

Because there are almost no state law restrictions on how an LP/LLC may be structured, there are almost no restrictions on how the corresponding agreement may be drafted. Your imagination is the only limitation. Out of inertia a lot of practitioners simply follow the language of the agreements they found elsewhere or follow the language of the default state statutes. What a lazy and boring approach to practicing law!