Effect of General Partner’s or LLC Member’s Bankruptcy Filing

Treatment of a general partner’s or LLC member’s relationship to the partnership or LLC has been the source of much confusion when that person is a debtor under the Bankruptcy Code. Committees of both the National Bankruptcy Conference and the American Bar Association have spent extensive time and resources unraveling these problems and formulating proposals to clarify the treatment of these relationships and other related issues. [ FN: The statutory amendments addressing issues related to debtor partners proposed by the Ad Hoc Committee of the American Bar Association were withdrawn. Thus, the Ad Hoc Committee ’s report did not officially address any of the issues discussed in these proposals. The Partnership Committee of the National Bankruptcy Conference issued a draft report, dated September 11, 1996, that did address a number of the issues raised in these proposals.] Without these two beacons, the Commission staff’s work in this area may well have ended up on the rocky lee shore and for this we are very grateful.

The Small Business, Partnership and Single Asset Real Estate Working Group reached consensus on five principal areas in need of reform regarding a general partner’s or LLC member’s bankruptcy filing. The five areas for reform are: (i) similar treatment of partners and LLC members and managers under the Bankruptcy Code; (ii) excluding partnership and LLC agreements from the section 365 executory contract provisions; (iii) unenforceability of ipso facto provisions in bankruptcy; (iv) property of the estate, transferability and valuation; and (v) management rights. Each of the proposals is directed at clarifying current confusion over treatment of the partnership or LLC relationship when a general partner or LLC member becomes a debtor under the Bankruptcy Code.

Following the initial draft of the working group’s partner-as-debtor proposal that was circulated in April, a number of constructive comments were provided to the Commission from: Sally S. Neely for herself and on behalf of the National Bankruptcy Conference (letter dated May 5, 1997); Richard Levin of Skadden, Arps, Slate, Meagher & Flom (letter dated April 29, 1997); and ProfessorLarry E. Ribstein of George Mason University School of Law (letter dated May 27, 1997). The Commission, at its April meeting in Seattle, adopted a number of proposals to reform section 365 that clarify a number of the partnership and LLC problems. The attached proposals (i) address some of the concerns raised by these interested and helpful parties, and (ii) discuss the effect on partnerships and LLCs of the Commission’s proposals to amend the treatment of other contractual obligations under section 365.

Partnership Proposal #3

Treatment of a LLC Member under the Bankruptcy Code

Background

Limited liability companies ("LLC") combine the limited liability of the corporate form with the pass-through tax treatment of a partnership. [ FN: New Treasury regulations, effective January 1, 1997, significantly simplify the ability of an entity to obtain pass-through tax treatment. Referred to colloquially as the "check-the-box " regulations, all or most LLCs may now determine their tax treatment by election. Treas. Reg. §301.7701-2 (replaced 1996).] With the exception of Vermont and Hawaii, LLC statutes have been enacted in every state and the District of Columbia. [ FN: Sally S. Neely, Partnerships and Partners, Limited Liability Companies and Members: What Happens in Bankruptcy 18 (July 23, 1996) (unpublished manuscript, on file with the National Bankruptcy Review Commission) (citing Ribstein & Keatinge, Limited Liability Companies , §10.06 at 15-4 (Supp. Dec. 1995) (LLC statute count as of May 1, 1996)(hereinafter cited as Ribstein & Keatinge)).] Similar to corporations, LLC’s can be governed by statute, articles of organization, and an operating agreement (which is similar to a partnership agreement and delineates the business purpose and the relationship between the members, the managers (if any) and the company). Certain LLC aspects under state law may be modified by agreement between the LLC members; similar to amendment of the uniform partnership laws by agreement between the partners. [ FN: Id. at 19 (citing Ribstein & Keatinge , at §3.02 at 3-1).] LLC members are insulated from general liability for LLC debts, similar to shareholders. [ FN: Id. at 19 (citing Larry E. Ribstein , The Emergence of the Limited Liability Company , 51 Bus. Law. 1, 6 (1995)).] Certain LLC statutes, however, permit members to provide for the assumption of personal liability in the articles. [ FN: Id.] LLC’s can be managed by members or by managers; the distinction being that "members have partner-like authority to bind a member-managed LLC, managers have similar authority to bind manager-managed LLCs, and members have no authority as such to bind manager-managed LLCs." [ FN: Id. (quoting Ribstein & Keatinge , at 10). Members can, however, be given explicit limited authority, without incurring liability.] Thus, LLC members are akin to general partners in member-managed LLC’s and akin to limited partners or shareholders in manager-managed LLCs. A critical distinction between limited partners and LLC members however, is that a LLC member does not forfeit limited liability by participating in the management of the LLC, even if the LLC is manager-managed. [ FN: Id. (quoting Ribstein & Keatinge , at §1.05 at 1-4).]

Due to the relatively recent enactment of LLC statutes, the Bankruptcy Code does notspecifically refer to LLCs or LLC members. The Bankruptcy Code definition of "corporation" arguably includes an LLC "as its members have limited liability (like corporate shareholders), it appears to be an unincorporated company or association, and it is not a limited partnership." [ FN: Id. at 25-26.] However, the nature of the relationship of a member in a member-managed LLC and a manager in a manager-managed LLC is closer to that of a general partner in a partnership than an equity security holder in a corporation.

Proposal

Debtor LLC members in member-managed LLCs should be treated like general partners under the Bankruptcy Code. Similarly, debtor managers of manager-managed LLC’s should be treated like general partners under the Bankruptcy Code. This treatment should be limited to three aspects of the LLC member or LLC manager relationship: (1) rights in LLC property; (2) transferability of LLC ownership interest; and (3) management rights in the LLC.

Reasons for the Proposal

Due to the recent enactment of LLC statutes, the Bankruptcy Code does not refer to them specifically. The popularity of the LLC form mandates specific reference in the Bankruptcy Code to avoid confusion over the treatment of LLC member and LLC manager relationships in bankruptcy. The nature of the LLC member or LLC manager/LLC relationship for the most part mirrors that of a general partner to a partnership. Fiduciary duties and tax treatment all conform to those of a general partnership. [ FN: Id. at 18-21.] A major difference, however, is limited liability.

The similarities between the fiduciary and managerial roles of a general partner and a LLC member or LLC manager make uniform treatment under the Bankruptcy Code a logical choice. The principal advantage of the Proposal is that by providing similar treatment for these similar legal relationships, statutory clarification of partnership obligations will also clarify the treatment of LLC operating agreements in bankruptcy. The Proposal does not alter the overall treatment of debtor LLCs in bankruptcy, but only provides specific treatment of the LLC obligations of LLC member or LLC manager debtors. Tax-driven developments in LLC statutes, for example, make a blanket designation for LLCs under the Bankruptcy Code undesirable. [ FN: Letter from Sally S. Neely, Chair, National Bankruptcy Conference Committee on Partnerships, to Stephen H. Case et al., Advisor, National Bankruptcy Review Commission (May 5, 1997).] The Proposal thus preserves treatment of LLCs like corporations under circumstances warranting such treatment.

Competing Considerations

One could argue that an LLC member’s limited liability renders the LLC interest closer to that of an equity security than a partnership interest. LLCs are hybrid entities, incorporating certain corporate attributes and certain partnership attributes. Certain LLC issues may warrant treatment as a corporation for a debtor LLC. As stated above, however, the relationship of a LLC member in a member-managed LLC and the relationship of a LLC manager in a manager-managed LLC more closely tracks the rights and obligations of a general partner than that of an equity security holder. The popularity of these vehicles ensures an increase in the appearance of LLC members and LLC managers in bankruptcy cases and necessitates specific bankruptcy treatment. The Proposal accomplishes this goal without hamstringing future flexibility as state LLC statutes evolve.