ALI-ABA Business Law Course Materials Journal | 43

Bankruptcy Issues In Partnership And Limited Liability Company Cases

T. Randall Wrightis a partner in the Omaha, Nebraska, law firm of Baird

Holm LLP. He serves as Chairman of the Agricultural

Finance Subcommittee of the ABA’s Business Law

Section, and is a member of the American Bankruptcy

Institute. A complete set of the course materials from

which this outline was drawn may be purchased at

www.ali-aba.org.

T. Randall Wright

A. The Bankruptcy Law Environment

1. Introduction

a. Today’sbankruptcy lawsweredesigned toal-lowabusinessorindividualeithertorehabili-tate finances through a reorganization or liq-uidateassetstoobtaina“freshstart.”Chapters7and11,whicharetheonlychaptersavailabletoanon-farmingpartnershiporlimitedliabil-ity company, were established with the pas-sageof the1978BankruptcyCode (“Code”).Before 1978, the old Bankruptcy Act, passedin1898,providedthelegalstructureforinsol-vencyproceedingsintheUnitedStates.Since1978,theBankruptcyCodehasbeenamendedseveraltimes,butmostoriginalprovisionshaveremainedintact.

b. Neither the1898BankruptcyActnor today’sBankruptcy Code has dealt adequately with theissuespresentedwheneitherapartnershipor a partner files bankruptcy. And, because lim-itedliabilitycompaniesareof relativelyrecentorigin, they are not specifically mentioned in the Bankruptcy Code. There have been sev-eral efforts to revise the Bankruptcy Code toaddresstheseissues—mostrecentlybytheNa-tionalBankruptcyReviewCommission in the

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late1990s.However,despitethesesubstantialefforts,substantiverevisionof theBankruptcyCodewithrespecttopartnershipandlimitedliabilitycompanyissueshasnotoccurred.In2005,Con-gresspassedsubstantialamendmentstotheCode,includingsweepingchangesaffectingconsumerbankruptcies, but those amendments did not specifically address partnerships, partners, or limited liabilitycompanies.

2. Interaction With Partnership Laws

a. Inmostrespects,theBankruptcyCodedoesnotdistinguishpartnershipsorlimitedliabilitycompa-niesfromotherbusinessassociations.Rather,thefocusof thelawsisongivingthedebtorentitythestatutory tools it needs to recover financially, or to allow it to liquidate or wind down in a way that benefits its creditors. Few Code provisions deal with specific partnership issues. The Code currently has no specific references to limited liability companies. Unless and until the Code is amended to giveadditionalguidance,wecananticipatethatthecourtswillmakeanalogiestobothcorporationsandpartnershipswhendealingwithLLCs,dependingonthefactsandcircumstancesof thepar-ticularissue.“[A]nLLCisneitheracorporationorapartnership,asthoseconceptsarecommonlyunderstood.Instead,anLLCisahybrid.”In re ICLNDS Notes Acquisition, LLC,259B.R.289(Bankr.N.D.Ohio2001).

b. Partnershipsandlimitedliabilitycompaniesarecreatedandgovernedforthemostpartbystatelaws.Inmoststates,theUniformPartnershipAct(UPA)andtheUniformLimitedPartnershipAct(ULPA), or the revised versions of each, are the controlling statutes. LLC statutes vary significantly fromstatetostate.Inaddition,eachstatehasabodyof commonlawthathasgrownuparoundthose statutes. Although the Bankruptcy Code recognizes that state law governs property interests, becauseitisafederallaw,italsopreemptsinconsistentstatelaw.Thiscreatesuncertaintyinsomeareas.Thesometimes“tortuousinteraction”betweentheBankruptcyCodeandstatepartnershiplawhasplaguedbankruptparties,theircounsel,theircreditors,andthebenchforyears.StephenH. Case, Jennifer C. Frasier, and George H. Singer, Proposal to the National Bankruptcy Review Com-mission,May1997.Theresulthasbeeninconsistentcourtdecisionsdealingwithsomeof themostbasicissueslawyersencounterinthisarea.

c. This outline will summarize the current bankruptcy law as it relates to partnerships and LLCs, highlightcommonissuesof whichpractitionersshouldbeaware,anddiscussrecentcasesrelatedtotheseissues.(Theauthorsgratefullyacknowledgetheworkof manywhohavepreviouslywrittenextensively on these issues, and whose writings served as valuable resources, including Gerald K. Smith,whopreparedexhaustivematerialsforthisprogramformanyyearsbeforesteppingdownin1997; Robert J. Keach, Partner and Partnership Bankruptcy, A Survey and Analysis of Case Law and Proposed Amendments to the Bankruptcy Code,publishedinthe1996ABIWinterLeadershipConferencemateri-als, and Deborah L. Fletcher, Partnership and Limited Liability Entities in Bankruptcy(October1996).)

B. Key Concepts In Understanding Bankruptcy Law

1. The Bankruptcy Estate

a. Upon the filing of a petition, a bankruptcy “estate” is created, consisting of all of the equitable and legalintereststhedebtorhasorcanclaim,includingpropertyrights,contractualrights,andcauses

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of action. Included in theestatearecertainspecialcausesof action that theBankruptcyCodeprovides to augment the estate for the benefit of creditors. Because of Congress’s desire to create acentralforumforfairdistributionof assets,theCodeandthecasesarefar-reachingincharacter-izing the debtor’s assets as part of the estate. 11 U.S.C. §541.

2. The Automatic Stay

a. Once a bankruptcy petition is filed, and for the duration of the case, creditors are prohibited from takingactionagainstthedebtororitsassetstocollectdebts,enforceliens,obtaincollateral,oroth-erwiseimproveontheirpre-petitionposition,unlessthebankruptcycourtgivesitspermissionafternotice and a hearing. 11 U.S.C. §362.

3. Management Of The Estate

a. Theestateismanagedeitherbyatrusteeappointedbythecourtor,inaChapter11case,bythedebtoritself,whoisreferredtoasthe“debtorinpossession.”Themanager’sdutyistoservetheestate for the benefit of creditors. In a Chapter 11 case, management’s duty to serve the estate to benefit creditors may sometimes conflict with management’s desire to serve the partners or own-ers of the company. For example, a real estate partnership in Chapter 11 may want to continue to retainoneof thepartnersasthepropertymanager,eventhoughadifferentmanagementcompanycould provide the same quality services for less money. Creditors benefit from lower monthly ex-penses, but partners benefit from management income. The debtor’s duty in such a situation is to make decisions that benefit creditors—not partners.

4. Executory Contracts

a. “Executory contract” is an undefined term that occupies a central place in the Code. Most courts define executory contracts as contracts under which material performance by both sides remains and is required. To facilitate a fresh start or reorganization, the Code (11 U.S.C. §365) permits the trusteeordebtor inpossession toeitherassumeor rejectexecutorycontracts.“Assumption”bythe debtor requires court approval and the cure of pre-petition contract defaults. The court can approveassumptionbythedebtorortrusteeevenwithouttheothercontractingparty’sconsent,undercertaincircumstances.Adecisionbythedebtortorejectistantamounttoabreachof thecontract,resultinginapre-petitionunsecuredclaimfordamagesonthepartof theotherpartytothecontract.Rejectionmayneverthelessbeadvantageoustothedebtor,suchaswhenthecontractis no longer advantageous to the debtor as it tries to reorganize. By rejecting the contract, the debt-orcanbefreedfromburdensomecontractobligations.Whenthathappens,theotherpartytothecontractisawardedaclaimfordamages,butitmustwaitinlinewithothercreditorstobepaidonthatclaim.Typicalexecutorycontractsthatpartnershipsenterincludemanagementagreements,realorpersonalpropertyleases,servicecontracts,and,accordingtosomecourts,thepartnershipagreementitself.Theissueof whetherthepartnershipagreementisanexecutorycontractisdis-cussedbelow.

5. Ipso Facto Clauses

a. Contract clauses or state laws designed to cause a forfeiture or modification of the debtor’s rights when a bankruptcy is filed are referred to as “ipso facto clauses.” These include, for example, those

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common provisions that indicate default when a party to the contract files for bankruptcy. These clausesare rendered largelyunenforceableby theCode,which refers to them in sixplaces (11U.S.C. §§363(l), 365(e)(1) and (e)(2), 365(f)(1) and (f)(3) and, 541(c)(1)(B)). These provisions are the productof alonghistoryof theunfavorableexperiencesof debtorswithleaseprovisions,contractclauses, and state law that operated to deprive debtors of valuable rights because of the filing of a bankruptcypetition.Althoughthe“anti-ipsofacto”provisionsintheCodeclearlyrestrictfreedomto contract between parties, they are constitutionally sound and justified by the policies of the BankruptcyCode.SeeBruder v. Peaches Records & Tapes, Inc.(In re Peaches Records and Tapes), 13 C.B.C. 2d 718 (9th Cir. BAP 1985) (upholding retroactive nature of section 365 and indicating that its provisionsareacontinuationof long-standingbankruptcyprinciples.)

6. Cash Collateral

a. Cash collateral is defined by the Code as “cash, negotiable instruments, documents of title, secu-rities, deposit accounts, or other cash equivalents whenever acquired in which the estate and an entity other than the estate have an interest. . . .” 11 U.S.C. §363.

b. Typically,thetermisusedtodescribethecashproceedsof asecuredcreditor’scollateral.Cashcollateralcanincludeproceedsof leasesorrents.TheCodeprohibitsadebtororthetrusteefromusing cash collateral without the consent of affected creditors, or a court order obtained afternotice and hearing. This restriction means that one of the first issues a Chapter 11 debtor faces is obtaining consent to use cash collateral if it requires that money to pay operating expenses.

7. Avoidance Actions

a. TheCodegivesthetrusteeordebtorinpossessionseveraltoolstorecoverassetsoravoidpre-peti-tionliens.Apreferenceactionisonesuchtool.Itallowsrecoveryof moneyorpropertytransferredby the insolventdebtor forpaymentonapreviously incurreddebtwhen the transferoccurredwithin 90 days of the filing date (one year for transfers to “insiders”). Recovery for amounts paid in the “ordinary course” is not permitted, and other defenses may also apply. 11 U.S.C. §547. An “insider”of apartnerincludesthepartnershipitself,andthereverseisalsotrue—apartnerisaninsiderof apartnership.Thus,anout-of-the-ordinarytransferbyapartnershiptoapartnercanberecoveredbythebankruptpartnership,oritstrustee,evenif itwasmerelyrepaymentof law-fuldebt,aslongasitoccurredwithinoneyearof thebankruptcyandmettheotherpreferencerequirements.

b. Apartnershipisdeemedtobeinsolventwhenthesumof thepartnershipdebtsisgreaterthantheaggregateof:

allof thepartnership’sproperty,exclusiveof propertyfraudulentlytransferred,andtheamountbywhichthevalueof

eachgeneralpartner’snonpartnershipproperty—againexclusiveof fraudulentlytransferredproperty—exceedssuch

partner’s nonpartnership debts. 11 U.S.C. §101(32)(B).

Inotherwords,apartnershipwillnotbeconsideredinsolventforpurposesof bankruptcy,regard-less of the value of partnership property, if the general partners have sufficient nonpartnership assetstocoverthepartnership’sdebts.SeeIn re Union Meeting Partners, 163 B.R. 229 (Bankr. E. D. Pa. 1994).