SOME OBSERVATIONS ON DRAFTING DISTRIBUTION PROVISIONS FOR PARTNERSHIP AGREEMENTS

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1 SOME OBSERVATIONS ON DRAFTING DISTRIBUTION PROVISIONS FOR PARTNERSHIP AGREEMENTS Terence Floyd Cuff Loeb & Loeb, LLP Los Angeles, California Copyright 2009, Terence Floyd Cuff The heart and soul of most partnership agreements is the provision for the distribution of cash. Distribution provisions typically are of two types operating distributions and liquidating distributions. Operating distribution provisions may be divided into three or more types distribution of cash from normal operations, distribution of cash from financings or refinancings, and distribution of cash from capital events. This article considers simple provisions for the distribution of cash from normal operations. Simple Distribution Provisions. Example 1. Fred and Don are optometrists operating Fred and Don Optometric, a general partnership. They agree that all regular cash distributions from the partnership should be made 70% to Fred and 30% to Don. Our task is to draft the cash distribution provision. A good starting point is to draft the provision government what is distributable. This may be named Cash Flow, Distributable Cash Flow, Distributable Cash, Cash Available for Distribution or any of a number of similar terms. These terms generally mean about the same thing. Here are some examples of definitions of cash from operations. There is no ideal or correct definition. You need to use one that works for your situation. This definition lumps all net cash flow into Distributable Cash: Clause 1. Section x.x. Distributable Cash at any time means that portion of the cash then on hand or in bank accounts of the Company which the Members, in their discretion, deem available for distribution to the Members.

2 This is a similar definition: Clause 2. Section x.x. Distributable Cash means all cash funds (including (without prejudice to generality) interest received on reserves) of the Partnership without reduction for any noncash charges, but less cash funds used to pay current operating expenses (including (without prejudice to generality) debt service) and to establish reasonable reserves for future expenses, debt payments, capital improvements, and replacements (as determined by the General Partner in his sole and absolute discretion). This is a more detailed definition that lumps together all net cash in Distributable Cash: Clause 3. Section x.x. Distributable Cash at any time means that portion of the cash then on hand or in bank accounts of the Company which the Members, in their Discretion, deem available for distribution to the Members, taking into account (a) The amount of cash required for the payment of all current expenses, liabilities and obligations of the Company (whether for expense items, capital expenditures, improvements, retirement of indebtedness or otherwise) and (b) The amount of cash that the Members, in their Discretion, deem necessary to establish prudent reserves for the payment of future capital expenditures, improvements, retirements of indebtedness, operations and contingencies; these items may include, without prejudice to generality, reserves for contingencies known or unknown, liquidated or nonliquidated, and liabilities that may be incurred in litigation and liabilities undertaken under the indemnification provisions of this Agreement. This is another example: Clause 4. Section x.x. Distributable Cash means the excess of (a) The Partnership cash then in hand or in bank accounts of the Partnership over (b) The sum of (i) The cash required for the payment of all current expenses, liabilities and obligations of the Partnership (whether for expense items, capital expenditures, improvements, retirement of indebtedness or otherwise) (as determined in the sole and absolute discretion of the General Partner), and (ii) The reserves established (in the sole and absolute discretion of the General Partner) for the payment of future Partnership capital expenditures, improvements, retirements of indebtedness, operations and contingencies. This includes amounts known or unknown, liquidated or nonliquidated, and liabilities that may be incurred in litigation and liabilities undertaken under the indemnification provisions of this Agreement. 2

3 Some partnership agreements use much more complicated definitions of Distributable Cash. This is a simple formula definition of Distributable Cash. This formula assumes that Net Profits and Net Losses are determined on a cash basis. Formula definitions of Distributable Cash can be considerably more complicated. Clause 5. Section x.x. Distributable Cash means (with respect to any period for which the calculation is being made) means: (a) The sum (without duplication) of: (i) The Partnership s Net Profits for the period; (ii) Depreciation, amortization, and all other noncash charges to the extent deducted in determining Net Profits or Net Loss for the period; (iii) The amount of any reduction in the reserves of the Partnership; (iv) All positive items of Partnership Cash Flow not included in determining Net Profits and Net Losses (including Partnership borrowings and insurance proceeds); (b) Less the sum (without duplication) of: (i) The Partnership s Net Loss (as the case may be) for the period; (ii) All cash payments made by the Partnership during the period not included in the computation of Net Profits or Net Loss (such as loan principal payments, capital expenditures, Partnership loans, and investments in any entity); and (iv) All increases in Partnership reserves. Other definitions are based on net income or net loss determined under generally accepted accounting principles (what might be considered financial statement income and loss). Clause 6. Section x.x. Distributable Cash (with respect to any period for which the calculation is being made) means: (a) Net income of the Company as determined under generally accepted accounting principles, consistently applied, as applied in the United States, increased by (b) Depreciation and amortization as determined under generally accepted accounting principles, consistently applied, as applied in the United States, increased by (c) Other noncash deductions included in the computation of income and loss under generally accepted accounting principles, consistently applied, as applied in the United States, increased by (d) Decreases in reserves for the payment of future capital expenditures, improvements, retirements of indebtedness, operations and contingencies; these items may include, without prejudice to generality, reserves for contingencies known or unknown, liquidated or nonliquidated, and liabilities that may be incurred in litigation and liabilities undertaken under the indemnification provisions of this Agreement, decreased by 3

4 (e) Net loss of the Company as determined under generally accepted accounting principles, consistently applied, as applied in the United States, decreased by (f) All cash expenditures of the Company (other than distributions to Members) that are not included in the computation of income or loss as determined under generally accepted accounting principles, consistently applied, as applied in the United States, and decreased by (g) Increases in reserves for the payment of future capital expenditures, improvements, retirements of indebtedness, operations and contingencies; these items may include, without prejudice to generality, reserves for contingencies known or unknown, liquidated or nonliquidated, and liabilities that may be incurred in litigation and liabilities undertaken under the indemnification provisions of this Agreement. These items shall be applied without duplication. You will have to make your own judgment concerning what definition of Distributable Cash works for you. These definitions at least should give you some ideas. Distributable Cash is difficult to define without depending on someone s subjective judgment or discretion in determining partnership needs for cash. The partner in control of the computation of Distributable Cash may be comfortable with having broad discretion in determining Distributable Cash. A short, general definition of Distributable Cash may meet his needs. A minority partner who does not have control over determining Distributable Cash may be less trusting. This minority partner may want a more objective definition of Distributable Cash. Partnership agreements sometime provide for separate provisions that distribute cash from liquidation, cash from refinancings, and cash from sale of capital assets. This is an example of a definition of Distribution Cash that takes cash from liquidation, cash from refinancings, and cash from sale of capital assets into account: Clause 7. Section x.x. Distributable Cash at any time means that portion of the cash then on hand or in bank accounts of the Company which the Members, in their Discretion, deem available for distribution to the Members. Distributable Cash shall be reduced by (a) The amount of cash required for the payment of all current expenses, liabilities and obligations of the Company (whether for expense items, capital expenditures, improvements, retirement of indebtedness or otherwise), (b) The amount of cash that the Members, in their Discretion, deem necessary to establish prudent reserves for the payment of future capital expenditures, improvements, retirements of indebtedness, operations and contingencies; these items may include, without prejudice to generality, reserves for contingencies known or unknown, liquidated or nonliquidated, and liabilities that may be incurred in litigation and liabilities undertaken under the indemnification provisions of this Agreement, (c) (d) All Distributable Cash from Financing or Refinacing, and All Distributable Cash from Capital Events. 4

5 Make sure to provide in your partnership agreement who makes the determination of Distributable Cash and when. There is no right way to do this. The determination might be made by a manager, managing member, or general partner. The determination might be made by majority vote of the partners. The determination might be made by unanimous vote of the partners. The determination might be made by the partnership s accountants or the partnership s chief financial officer. Make sure to consider the optimal way to determine Distributable Cash for each partnership. In any event, your partnership agreement should clarify: Who determines Distributable Cash? What is the standard of discretionary on discretionary items (such as establishing reserves)? Consider what should happen if you use a provision requiring agreement of the partners to determine Distributable Cash and the partners are unable to reach agreement. Most partnership agreements that require partner agreement to determine Distributable Cash do not distribute cash until the partners reach agreement on the calculation of Distributable Cash. A custom agreement might provide for minimum distributions of Distributable Cash if the partners cannot agree on the calculation of Distributable Cash. An agreement, for example, might provide for each partner to designate its estimate of Distributable Cash and the partnership could make a provisional distribution of the minimum estimate of Distributable Cash (or a percentage of the minimum estimate) until the partners are able to agree on Distributable Cash. The partnership agreement for Fred and Don Optometric might provide: Clause 8. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be distributed 70% to Fred and 30% to Don. That is not a difficult provision to draft. It unambiguously states how Distributable Cash will be divided between Fred and Don. This provision may work satisfactorily for many partnerships. The provision fails to determine how often distributions are made. This alternative takes time of distribution into account: Clause 9. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be distributed 70% to Fred and 30% to Don. Distributions of Distributable Cash shall be made monthly, within five (5) business days after the end of the immediately previous calendar month, of the Distributable Cash for that immediately previous calendar month. This provision takes time of distribution into account: 5

6 Clause 10. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be distributed 70% to Fred and 30% to Don. Distributions of Distributable Cash shall be made annually, within sixty (60) business days after the end of the immediately previous calendar year.. This provision provides for quarterly distributions: Clause 11. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be distributed 70% to Fred and 30% to Don. Distributions of Distributable Cash shall be made quarterly, within thirty (30) business days after the end of the immediately previous calendar quarter. Distribution provisions often provide for a series of successive tiered distributions. This is a typical tiered distribution provision: Clause 12. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be distributed in this order: (a) First, to Fred and Don (between them in accordance with the ratio of their Net Unrecovered Capital Contribution) until distributions of Distributable Cash have returned Fred and Don s Net Unrecovered Capital Contribution, and then (b) Second, the next seventy-five thousand dollars of Distributable Cash shall be distributed 70% to Fred and 30% to Don, and then (c) 50% to Don. Third, all remaining Distributable Cash shall be distributed 50% to Fred and The amounts distributable under each of the tiers of this Section x.x shall be measured cumulatively from the formation of the Company. Distributions of Distributable Cash shall be made annually, within thirty (30) business days after the end of the immediately previous calendar year. Net Unrecovered Capital Contribution of a Member means the excess of (a) (b) All Capital Contributions by the Partner to the Partnership over All distributions of Distributable Cash to the Partner under Section x.x(a). Several features of this distribution provision are worth noting: Each tier states how much Distributable Cash is distributed under the tier. Each tier clarifies that the ratio of distributions between the two partners under that tier. The provision clarifies that tiers are applied on a cumulative basis from the formation of the partnership. 6

7 Preferred Return Partnership distribution provisions often provide for an interest-like preferred return on capital. This preferred return operates like interest on a bank account. The preferred return is paid prior to distributions by Percentage Interests. This section concerns principles of drafting a simple preferred return. The simple preferred return, however, may turn out to be somewhat less simple to draft than you may imagine. Most partnership agreements are deficient in their provisions for even the simplest preferred return. Reading further, you may discover that your own form provisions are deficient. Rather than plunging into drafting the distribution provision, let us examine how interest is computed. Computing interest can be more complicated than some of us imagine. Draftsmen often feel that computing interest should be left to the partnership accountants. Have a little patience. Understanding how to compute interest is vital to drafting preferred returns. Engagement with the numbers in partnership allocation and distribution provisions will help you to be able to draft properly. This is the basic formula for computing the amount in a bank account at a future date if an initial deposit is invested at i percent interest for n compounding periods: Future Amount = ( Initial Deposit (1 + i) ^ n ) where Future Amount = total amount in account at the end of term Initial Deposit = amount deposited at beginning to term n = number of compounding periods during the term i = interest rate per compounding period This is the basic formula for computing compound interest that accrues over a term: Interest where Interest Initial Deposit n i n = ( Initial Deposit (1 + i) ^ ) Initial Deposit = interest accrual during term = amount deposited at beginning to term = number of compounding periods during the term = interest rate per compounding period 7

8 This formula can compute the interest that accrues during the calendar year if the initial deposit is made on December 31 of the immediately previous year. Assume that The Initial Deposit is $10,000. There is a single compounding period (annual compounding). Interest accrues at a rate of 10% per year (compounded annually). Interest, by convention, normally accrues on the day of deposit. Interest normally does not accrue on the day of payment. (This convention can be altered by agreement.) Thus, Initial Deposit = $10,000 n = 1 i = interest rate per compounding period The interest formula Interest n = ( Initial Deposit (1 + i) ^ ) Initial Deposit becomes Interest = ($10,000 (1 + 10%)^ ) 1 $10,000. This formula becomes Interest = $ 11,000 $10,000 = $1,000. This is a simple case. This formula does not work well, without adjustment, when interest is computed with daily compounding based on a calendar year that may be either 365 or 366 days (366 days in the case of leap year) and that has months of different lengths. Computations are more complex when additional amounts are contributed or amounts are paid during the year. Imagine that $10,000 is deposited on January 30, Compute interest at a 10% annual rate (compounded annually on January 1) from January 30, 2008, through December 31, Try to make this computation yourself before reading any farther. Do not do the computation approximately. Try to do the computation precisely. That is the task that an accountant will have if he tries to follow your partnership agreement. The draftsman should understand the accountant s task in interpreting the partnership agreement. 8

9 We cannot just apply the formula set forth above and directly arrive at the correct result. Months have different numbers of days. Years have different numbers of days. By convention, interest typically accrues on the day of deposit. (This convention may be limited by agreement so that interest accrues only if the deposit is made by a specified time of day.) By convention, interest typically does not accrue on the day of withdrawal or payment. (These conventions can be and sometimes are altered by the terms of the promissory note.) Interest begins to accrue on January 30, This is the day of deposit. Interest accrues ratably on that day and on every successive day through and including December 31, There are 337 days of interest accrual out of 366 days during the calendar year. The daily accrual of interest is at this rate: Daily Interest Accrual The daily interest accrual is %. There are 337 days of interest accrual at the daily accrual rate of % (uncompounded). The total interest accrual is: % = %. = 10 % have Applying this interest accrual over the year to the $10,000 initial principal, we % $10,000 = $9, We likely will want to round this number to the nearest whole cent ($9,207.65) or just round this number up to the closest higher whole cent ($9,207.66). The computation differs if the deposit was made on January 30, The calendar year 2009 has 365 days. We are asked to compute interest at a 10% annual rate (compounded annually on January 1) from January 30, 2009, through December 31, There are 365 days in The first day of interest accrual is January 30, There are 336 days of interest accrual inclusive of December 31, The daily interest accrual is 1/365 10% = %. There are 336 days of interest accrual at the daily accrual rate of % (uncompounded). The total interest accrual is 9

10 have % = %. Applying this interest accrual over the year to the $10,000 initial principal, we % $10,000 = $9, We likely will want to round this to the nearest whole cent ($9,205.47). We might just round this up to the closest higher whole cent ($9,205.48). The amount of interest that accrues from January 31 to December 31 in 2008 ($9, ) is more than the interest that accrues from January 31 to December 31 during 2009 ($9, ). How do we draft this simple preferred return? We might come up with something like this (which is not such a simple provision at all): Clause 13. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be distributed in this order: (a) First, Distributable Cash shall be distributed to Fred and Don (between them in accordance with the ratio of their Unpaid Returns) until Fred and Don each have received distributions of Distributable Cash under this Section x.x(a) that shall have reduced their Unpaid Returns to no greater than zero. (b) Second, Distributable Cash shall be distributed to Fred and Don (between them in accordance with their Unrecovered Investments) until Fred and Don each have received distributions of Distributable Cash under this Section x.x(b) that shall have reduced their Unrecovered Investments to no greater than zero. (c) 50% to Don. Third, all remaining Distributable Cash shall be distributed 50% to Fred and The tests of the tiers of this Section x.x shall be reapplied whenever Section x.x is applied. The possibility that the test in a tier has been satisfied in a prior year shall have no effect on the satisfaction of that test in a subsequent year. These tests shall be applied based by taking into account cumulative distributions of Distributable Cash from the formation of the Company. Distributions of Distributable Cash shall be made annually, to the extent of available Distributable Cash, within thirty (30) Business Days after the end of the immediately previous calendar year. For purposes of determining whether the conditions of Section x.x(a) have been met, the Unpaid Return shall be rounded to the nearest one cent (1 ). Fractional amounts of one-half of one cent (½ ) or more shall be increased to one cent (1 ). Fractional amounts greater than zero cents (0 ) and less than one-half of one cent (½ ) shall be dropped and ignored. An example of the computation of the distributions of Distributable Cash is attached as Exhibit X. The partnership agreement defines Unrecovered Investment: 10

11 Clause 14. Unrecovered Investment. Unrecovered Investment of a Member means the excess of (a) (b) All Capital Contributions by the Member to the Company, over All distributions of Distributable Cash to the Member under Section x.x(b). The partnership agreement defines Unpaid Return: Clause 15. Unpaid Return. Unpaid Return of a Member is equal to the excess of (a) the accrued Return to the Member, over (b) all distributions to the Member of Distributable Cash under Section x.x(a). These observations may be useful: Each tier states how much Distributable Cash is distributed under the tier. Each tier clarifies that the ratio of distributions between the two partners under that tier. The provision clarifies that tiers are applied on a cumulative basis from the formation of the partnership. The provision clarifies which tier of distributions returns Unrecovered Investment. Paragraph (a) and (c) distributions do not reduce Unrecovered Investment. The preferred return is paid before recovery of Unrecovered Investment. Distributions under Paragraph (b) and (c) are not treated as payments of the preferred return. If the Unrecovered Investment is completely returned but a subsequent capital contribution creates a new Unrecovered Investment, distributions under Paragraph (c) are not treated as distributions of the preferred return. Partnership distribution provisions frequently reduce Unrecovered Investment by all distributions of Distributable Cash. That often does not make much sense. Distributions of the preferred return should not reduce Unrecovered Investment. Distributions under Section x.x(c) should not reduce the Unrecovered Investment. Partnership agreements frequently provide a structure like this: (a) First, Distributable Cash shall be distributed to Fred and Don (between them in accordance with the ratio of their Unpaid Returns) 11

12 until Fred and Don each have received distributions of Distributable Cash equal to their Preferred Returns. (b) Second, Distributable Cash shall be distributed to Fred and Don (between them in accordance with their Unrecovered Investments) until Fred and Don each have received distributions of Distributable Cash equal to their Unrecovered Investments. (c) Third, all remaining Distributable Cash shall be distributed 50% to Fred and 50% to Don. Agreements like this are dangerously ambiguous. The accrued Preferred Return can have been fully distributed in year 1. Further distributions in year 1 may have been made under Paragraphs (b) and (c). This creates the interpretative challenge of determining whether distributions under Paragraphs (b) and (c) should be counted in year 2 in determining whether Fred and Don have received distributions of Distributable Cash equal to their Preferred Returns in year 2. Conventional practice suggests that distributions under paragraphs (b) and (c) should not be treated as distributions of the preferred return. As this provision is drafted, the matter at best is left in doubt. Similarly, a distribution under Paragraph (a) might be considered in determining whether Fred and Don each have received distributions of Distributable Cash equal to their Unrecovered Investments. Conventional practice teaches that distributions of the Preferred Return should not recover Unrecovered Investments. As the provision is drafted, at best, there is doubt. Some partnership agreements provide something like this: First, Distributable Cash shall be distributed to Fred and Don until Fred and Don each have received distributions of Distributable Cash under this Section x.x(a) equal to their Preferred Returns. The technical problem is that a distribution rarely is precisely equal to the amount necessary to give a partner a 14% Preferred Return. At some point, the return to a partner normally will go from slightly under a 14% return to something slightly over 14%. The partners may never receive distributions of Distributable Cash equal to their Preferred Returns. The test never may be satisfied. A provision like that in the first sentence of the immediately previous paragraph is ambiguous. This provision creates interpretative difficulties. The Return should be drafted with care. We might draft the Return like this: Clause 16. Section x.x. Return. Return of a Member equals a 10% return on the daily balance of the Member s Unrecovered Investment (and on the compounded Unpaid Return, as provided below). These rules shall apply in computing the Return: 12

13 (a) Amounts shall be credited to the Unrecovered Investment of the Member on the day on which a wire transfer of Federal funds transmitting those amounts to the Company is actually received by the Company, provided that those amounts are received by the Company and actually credited to its bank account no later than noon (Atlantic time). Amounts received by the Company and credited to its bank account later than noon (Atlantic time) shall be credited to the Unrecovered Investment of the Member on the immediately following Business Day. (b) Amounts shall be treated as distributions to the Member on the day on which those amounts are sent to the Member by wire transfer, regardless of the time of receipt. (c) The Return shall accrue with respect to amounts credited to the Unrecovered Investment on the day on which those amounts are credited by the Company to the Unrecovered Investment of the Member. (d) The Return shall not accrue on amounts distributed as Unrecovered Investment on the day of payment of those amounts to the Member. (e) For purposes of accrual, the Return shall be rounded to ten decimal places. (f) Any Unpaid Return is compounded annually at the beginning of the day on January 1 of each year. From and including January 1, the newly compounded Unpaid Return shall bear the Return as if the newly compounded Unpaid Return had been contributed to the capital of the Company on that January 1. (g ) The Return shall be computed based on a calendar year of 365 or 366 days (366 days in the case of leap year), as the case may be. (h) The Return shall accrue at a daily accrual rate of % during a calendar year of 365 days. (i) The Return shall accrue at a daily accrual rate of % during a calendar year of 366 days (366 days in the case of leap year). (j) An example of the computation of the Return is attached as Exhibit X. These observations may be useful: The provision clearly indicates when amounts bear the return and when they do not. The provision is clear about how often the return compounds. The provision is clear about the compounding date. The provision is clear about the daily accrual rate. You do not have to adopt the conventions set forth in Clause 4. You should be clear about the conventions that you do adopt. Definitions of preferred returns often are imprecise about these conventions. Few partnership agreements are careful about specifying whether the Return is paid for the date funds are contributed to the partnership or for the date on which funds are paid by the partnership. This leaves these provisions ambiguous. The accountants must guess at what the parties intended if the agreement is not explicit. A good 13

14 example attached to the partnership agreement showing how the preferred return in computed over a five to ten (or greater period) should help the partnership s accountants to understand the partnership agreement that you have drafted. Many partnership agreements provide for a preferred return to be based on the average daily balance of the partners Unrecovered Contributions. What this means is a matter of conjecture. A partner s Unrecovered Contribution can be $1 million at the beginning of the day, he can contribute an additional $10,000 at 9:15 am, and an additional $10,000 at 10:00 am, and then can withdraw $800,000 at 11:00 am. What is the partner s average daily balance of his Unrecovered Contribution for the day? One certainly could argue that the partner s average balance is ($1,000, ,010,000, + 1,020, ,000) 4 = $3,250,000 4 = $812,500. This daily average balance is computable. It makes no sense to compute the preferred return based on this average daily balance. Partnership agreements often neglect to address compounding. Most partnership agreements that do address compounding fail to specify the date on which amounts compound. If funds are contributed to the partnership and the Return compounds annually, the Return might compound on January 1 or it just as easily might compound on the anniversary of contribution. The partnership agreement should clarify the compounding convention. Partnerships agreements typically fail to deal with when funds are treated as contributed or distributed. A partnership might accept partner personal checks as contributions. Contributions might be treated as made when the partnership receives the check. Contributions might be treated as received by the partnership when the partnership deposits the check. Contributions might be treated as received by the partnership when the funds are credited to the partnership s bank account. The partnership agreement should resolve when funds are treated as received by the partnership. The partnership agreement should account for the possibility that contributions may be received from partners on different dates. Some partnership agreements assume that all contributions are made on the first day of he money, the first day of the quarter, or the first day of the year. These conventions simplify computations for the accountants. These conventions may distort the economics of the transaction. The same problem exists for distributions made by the partnership. Computing a preferred return requires knowing when distributions are treated as made. Distributions could be treated as made when the partnership writes a check, when the check is mailed, when the check is received by the partner, when the check is cashed by the partner, or when funds are credited to the partner s bank. The partnership agreement should clarify when distributions are treated as made. The provisions for Clause 15 and 16 are drafted with sufficient care that there is a reasonable probability that these provisions can be applied reliably. Less carefully drafted provisions, however, might be misinterpreted or might confuse the company accountants. Example 2. Evelyn and Gina organize the Bonemaster partnership to manufacture china dishware. Evelyn contributes $2,000,000 to the partnership. Gina 14

15 contributes $100,000. These contributions are credited to their capital accounts. Each of Evelyn and Gina makes her capital contribution on January 1, Evelyn and Gina agree that distributable net cash flow will be distributed monthly: First, Distributable Cash shall be distributed to pay the partners a 14% return (compounded annually on January 1) on their capital contributions. Second, pro rata between the partners on their Unrecovered Capital, until their Unrecovered Capital has been repaid. Third, 70% to Fred and 30% to Don. The partnership agreement provides: Clause 17. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be monthly distributed in this order: (a) First, Distributable Cash shall be distributed to Evelyn and Gina (between them in accordance with the ratio of their Unpaid Returns) until Evelyn and Gina each have received distributions of Distributable Cash under this Section x.x(a) that shall have reduced their Unpaid Returns to no greater than zero. (b) Second, Distributable Cash shall be distributed to Evelyn and Gina (between them in accordance with their Unrecovered Investments) until Evelyn and Gina each have received distributions of Distributable Cash under this Section x.x(b) that shall have reduced their Unrecovered Investments to no greater than zero. (c) 50% to Gina. Third, all remaining Distributable Cash shall be distributed 50% to Evelyn and The tests of the tiers of this Section x.x shall be reapplied whenever Section x.x is applied. The possibility that the test in a tier has been satisfied in a prior year shall have no effect on the satisfaction of that test in a subsequent year. These tests shall be applied based by taking into account cumulative distributions of Distributable Cash from the formation of the Company. Distributions of Distributable Cash shall be made monthly, to the extent of available Distributable Cash, on the first Business Day of the immediately following calendar month. For purposes of determining whether the conditions of Section x.x(a) have been met, the Unpaid Return shall be rounded to the nearest one cent (1 ). Fractional amounts of one-half of one cent (½ ) or more shall be increased to one cent (1 ). Fractional amounts greater than zero cents (0 ) and less than one-half of one cent (½ ) shall be dropped and ignored. An example of the computation of the distributions of Distributable Cash is attached as Exhibit X. The partnership agreement defines Unrecovered Investment: Clause 18. Section x.x. Unrecovered Investment. Unrecovered Investment of a Member means the excess of (a) All Capital Contributions by the Member to the Company, over 15

16 (b) All distributions of Distributable Cash to the Member under Section x.x(b). The partnership agreement defines Unpaid Return: Clause 19. Section x.x. Unpaid Return. Unpaid Return of a Member is equal to the excess of (a) (b) the accrued Return to the Member, over all distributions to the Member of Distributable Cash under Section x.x(a). The partnership agreement defines the Return: Clause 20. Section x.x. Return. Return of a Member equals a 14% per annum return on the daily balance of the Member s Unrecovered Investment (and on the compounded Unpaid Return, as provided below). These rules shall apply in computing the Return: (a) Amounts shall be credited to the Unrecovered Investment of the Member on the day on which a wire transfer of Federal funds transmitting those amounts to the Company is actually received by the Company, provided that those amounts are received by the Company and actually credited to its bank account no later than noon (Atlantic time). Amounts received by the Company and credited to its bank account later than noon (Atlantic time) shall be credited to the Unrecovered Investment of the Member at the beginning of the immediately following Business Day. (b) Amounts shall be treated as distributions to the Member on the day on which those amounts are sent to the Member by wire transfer, regardless of the time of receipt by the Member. (c) The Return shall accrue with respect to amounts credited to the Unrecovered Investment on the day on which those amounts are credited by the Company to the Unrecovered Investment of the Member. (d) The Return shall not accrue with respect to amounts distributed as Unrecovered Investment on the day of payment of those amounts to the Member. (e) For purposes of accrual, the Return shall be rounded to ten decimal places. (f) Any Unpaid Return is compounded annually on January 1 of each year. From and including January 1, the newly compounded Unpaid Return shall bear the Return as if the newly compounded Unpaid Return had been contributed to the capital of the Company on that January 1. (g ) The Return shall be computed based on a calendar year of 365 or 366 days (366 days in the case of leap year), as the case may be. (h ) The Return shall accrue at a daily accrual rate of % during a calendar year of 365 days. (h) The Return shall accrue at a daily accrual rate of % during a calendar year of 366 days (366 days in the case of leap year). 16

17 (i) An example of the computation of the Return is attached as Exhibit X. Bonemaster partnership has these amount of Distributable Cash to distribute to its partners on these days: February 2, 2009 $12,250 March 2, 2009 $12,250 April 1, 2009 $12,250 May 1, 2009 $12,250 June 1, 2009 $12,250 July 1, 2009 $12,250 August 3, 2009 $12,250 September 1, 2009 $12,250 October 1, 2009 $12,250 November 2, 2009 $12,250 December 1, 2009 $12,250 December 31, 2009 $12,250 Including a chart showing the computation of the Return over a 5 to 10 year period (or greater period) is a useful step that should aid the accountants in interpreting the computation of the Return. Common compounding conventions provide for annual, semi-annual, quarterly, monthly, daily, and continuous compounding. Compounding can make the computation of the Return significantly more complicated. The partnership agreement should carefully delineate precisely how the computation works. This includes clearly specifying when the Return compounds. A partnership agreement should clearly identify: the frequency of compounding. the compounding date. the computational year. when contributions are deemed received. when distributions are deemed made. Some partnership agreements will assume that all contributions or distributions are deemed made on the first or last day of the calendar year, the appropriate semi-annual period during the calendar year, the calendar quarter, the calendar month, the calendar week. 17

18 A careful partnership agreement might include provisions governing the effects of the receipt of funds at different times of day. Particular care concerning date and time of receipt or payment is in order if the partnership accepts deposits made by check. These conventions can simplify computations. These conventions also can change the economics of the partnership arrangement. These conventions can create incentives for contributions to be deferred until the latest possible date. Be careful to take into account the possibility that contributions are not received by partners on the same day, distributions are not made on the same day. Example 3. The facts are the same as those in Example 2, except that the Return is a 14% per annum rate of return, compounded monthly, compounded on the last day of each month. The new Unpaid Accrued Return from the immediately previous month bears the Return from and after the first day of the next month. We might draft something like this. Clause 21. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be monthly distributed in this order: (a) First, Distributable Cash shall be distributed to Evelyn and Gina (between them in accordance with the ratio of their Unpaid Returns) until Evelyn and Gina each have received distributions of Distributable Cash under this Section x.x(a) that shall have reduced their Unpaid Returns to no greater than zero. (b) Second, Distributable Cash shall be distributed to Evelyn and Gina (between them in accordance with their Unrecovered Investments) until Evelyn and Gina each have received distributions of Distributable Cash under this Section x.x(b) that shall have reduced their Unrecovered Investments to no greater than zero. (c) 50% to Gina. Third, all remaining Distributable Cash shall be distributed 50% to Evelyn and The tests of the tiers of this Section x.x shall be reapplied whenever Section x.x is applied. The possibility that the test in a tier has been satisfied in a prior year shall have no effect on the satisfaction of that test in a subsequent year. These tests shall be applied based by taking into account cumulative distributions of Distributable Cash from the formation of the Company. Distributions of Distributable Cash shall be made monthly, to the extent of available Distributable Cash, on the first Business Day of the immediately following calendar month. For purposes of determining whether the conditions of Section x.x(a) have been met, the Unpaid Return shall be rounded to the nearest one cent (1 ). Fractional amounts of one-half of one cent (½ ) or more shall be increased to one cent (1 ). Fractional amounts greater than zero cents (0 ) and less than one-half of one cent (½ ) shall be dropped and ignored. An example of the computation of the distributions of Distributable Cash is attached as Exhibit X. 18

19 Unrecovered Investment could be defined: Clause 22. Unrecovered Investment. Unrecovered Investment of a Member means the excess of (a) (b) All Capital Contributions by the Member to the Company, over All distributions of Distributable Cash to the Member under Section x.x(b). Unpaid Return could be defined: Clause 23. Section x.x. Unpaid Return. Unpaid Return of a Member is equal to the excess of (a) (b) the accrued Return to the Member, over all distributions to the Member of Distributable Cash under Section x.x(a). The partnership agreement defines the Return: Clause 24. Section x.x. Return. Return of a Member equals a 14% per annum return on the daily balance of the Member s Unrecovered Investment (and on the compounded Unpaid Return, as provided below). These rules shall apply in computing the Return: (a) Amounts shall be credited to the Unrecovered Investment of the Member on the day on which a wire transfer of Federal funds transmitting those amounts to the Company is actually received by the Company, provided that those amounts are received by the Company and actually credited to its bank account no later than noon (Atlantic time). Amounts received by the Company and credited to its bank account later than noon (Atlantic time) shall be credited to the Unrecovered Investment of the Member at the beginning of the immediately following Business Day. (b) Amounts shall be treated as distributions to the Member on the day on which those amounts are sent to the Member by wire transfer, regardless of the time of receipt by the Member. (c) The Return shall accrue with respect to amounts credited to the Unrecovered Investment on the day on which those amounts are credited by the Company to the Unrecovered Investment of the Member. (d) The Return shall not accrue with respect to amounts distributed as Unrecovered Investment on the day of payment of those amounts to the Member. (e) For purposes of accrual, the Return shall be rounded to ten decimal places. (f) Any Unpaid Return is compounded on the first day of each calendar month. From and including the first day of the calendar month, the newly compounded Unpaid Return shall bear the Return as if the newly compounded Unpaid Return had been contributed to the capital of the Company on that first day of the calendar month. (g ) The Return shall accrue at a daily accrual rate of % during a calendar year of 365 days. 19

20 (h) The Return shall accrue at a daily accrual rate of % during a calendar year of 366 days (366 days in the case of leap year). (i) An example of the computation of the Return is attached as Exhibit X. Example 4. The facts are the same as those in Example 3, except that the Return is a 14% per annum rate of return, compounded daily. The Unpaid Accrued Return that accrues each day bears the Return from the next successive day. Something like this might work for the partnership agreement: Clause 25. Section x.x. Distributions of Distributable Cash. Distributable Cash shall be monthly distributed in this order: (a) First, Distributable Cash shall be distributed to Evelyn and Gina (between them in accordance with the ratio of their Unpaid Returns) until Evelyn and Gina each have received distributions of Distributable Cash under this Section x.x(a) that shall have reduced their Unpaid Returns to no greater than zero. (b) Second, Distributable Cash shall be distributed to Evelyn and Gina (between them in accordance with their Unrecovered Investments) until Evelyn and Gina each have received distributions of Distributable Cash under this Section x.x(b) that shall have reduced their Unrecovered Investments to no greater than zero. (c) 50% to Gina. Third, all remaining Distributable Cash shall be distributed 50% to Evelyn and The tests of the tiers of this Section x.x shall be reapplied whenever Section x.x is applied. The possibility that the test in a tier has been satisfied in a prior year shall have no effect on the satisfaction of that test in a subsequent year. These tests shall be applied based by taking into account cumulative distributions of Distributable Cash from the formation of the Company. Distributions of Distributable Cash shall be made monthly, to the extent of available Distributable Cash, on the first Business Day of the immediately following calendar month. For purposes of determining whether the conditions of Section x.x(a) have been met, the Unpaid Return shall be rounded to the nearest one cent (1 ). Fractional amounts of one-half of one cent (½ ) or more shall be increased to one cent (1 ). Fractional amounts greater than zero cents (0 ) and less than one-half of one cent (½ ) shall be dropped and ignored. An example of the computation of the distributions of Distributable Cash is attached as Exhibit X. Unrecovered Investment could be defined: Clause 26. Section x.x. Unrecovered Investment. Unrecovered Investment of a Member means the excess of (a) (b) All Capital Contributions by the Member to the Company, over All distributions of Distributable Cash to the Member under Section x.x(b). 20

21 Unpaid Return could be defined: Clause 27. Section x.x. Unpaid Return. Unpaid Return of a Member is equal to the excess of (a) (b) the accrued Return to the Member, over all distributions to the Member of Distributable Cash under Section x.x(a). The partnership agreement defines the Return: Clause 28. Section x.x. Return. Return of a Member equals a 14% per annum return on the daily balance of the Member s Unrecovered Investment (and on the compounded Unpaid Return, as provided below). These rules shall apply in computing the Return: (a) Amounts shall be credited to the Unrecovered Investment of the Member on the day on which a wire transfer of Federal funds transmitting those amounts to the Company is actually received by the Company, provided that those amounts are received by the Company and actually credited to its bank account no later than noon (Atlantic time). Amounts received by the Company and credited to its bank account later than noon (Atlantic time) shall be credited to the Unrecovered Investment of the Member at the beginning of the immediately following Business Day. (b) Amounts shall be treated as distributions to the Member on the day on which those amounts are sent to the Member by wire transfer, regardless of the time of receipt by the Member. (c) The Return shall accrue with respect to amounts credited to the Unrecovered Investment on the day on which those amounts are credited by the Company to the Unrecovered Investment of the Member. (d) The Return shall not accrue with respect to amounts distributed as Unrecovered Investment on the day of payment of those amounts to the Member. (e) For purposes of accrual, the Return shall be rounded to ten decimal places. (f) Any Unpaid Return is compounded daily. From and including the next day after the day on which the daily Return has accrued, the newly compounded Unpaid Return shall bear the Return as if the newly compounded Unpaid Return had been contributed to the capital of the Company on that next day after the day on which the daily Return has accrued. (g ) The Return shall accrue at a daily accrual rate of % during a calendar year of 365 days. (h) The Return shall accrue at a daily accrual rate of % during a calendar year of 366 days (366 days in the case of leap year). (i) An example of the computation of the distributions of Distributable Cash is attached as Exhibit X. The computations need to be adjusted for a different daily accrual rate for any year of 366 days (366 days in the case of leap year). 21

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