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News Room

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addressing issues related to debtor partners proposed by the Ad Hoc Committee of the American Bar Association were withdrawn.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 #4

Exclusion of a Partnership or LLC Operating Agreement from 11 U.S.C. § 365

Background

Treatment under current section 365 is dependent on a contract’s "executoriness." [ FN: Some courts have moved away from a strict executoriness requirement and take a more functional approach. See,e.g. ,In re General Dev. Corp. , 84 F.3d 1364 (11th Cir. 1996) (affirming determination that executoriness definition has been expanded);In re Drexel Burnham Lambert Group Inc. , 138 B.R. 687 (Bankr. S.D.N.Y. 1992). Expansion of this definition has been criticized by some courts as going against the fundamental purpose of section 365. See, e.g., In re Riodizio , 204 B.R. 417, 421 (Bankr. S.D.N.Y. 1997) (functional analysis is more efficient, but "ignoring executoriness rewrites statute in a fundamental way ");In re Child World Inc. , 147 B.R. 841, 851 (Bankr. S.D.N.Y. 1992) ( "manifestly, [functional] approach ignores statutory requirement that the contract to be assumed or rejected must be executory ").] Partnership agreements are generally treated in the case law as "executory" and are, therefore, subject to assumption or rejection under section 365. [ FN: See Summit Investment & Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608 (1st Cir. 1995); Breeden v. Catron (In re Catron), 25 F.3d 1038 (4th Cir. 1994); Calvin v. Siegal , 190 B.R. 638, 643 (Bankr. D. Ariz. 1996);In re Cutler , 165 B.R. 275, 278 (Bankr. D. Ariz. 1994);In re Clinton Court , 160 B.R. 57, 60 (Bankr. E.D. Pa. 1993);In re Priestley , 93 B.R. 253, 258 (Bankr. D.N.M. 1988);In re Corky Foods Corp. , 85 B.R. 903, 904 (Bankr. S.D. Fla. 1988). Compare Phillips v. First City, Texas-Tyler, N.A. (In re Phillips), 966 F.2d 926 (5th Cir. 1992) (partnership agreement not executory following dissolution triggered by sole general partner ’s chapter 11 petition).] Section 365(c) limits a trustee’s power to assume certain contracts depending on the nature of the agreement and whether the other party to the agreement could refuse performance from one other than the debtor or debtor in possession under applicable nonbankruptcy law.

Treatment of partnership relationships under this provision of section 365 is unclear. Section 365(c) links assumption and assignment and does not distinguish between contractual obligations and terms of a relationship. A partnership relationship is much more than a contract, it is a business relationship that combines economic obligations and individual performance. Consistent with this view, the Uniform Partnership Act, the Revised Uniform Partnership Act, and the Uniform Limited Liability Company Act all preclude the assignment of noneconomic rights, in the absence of a contrary provision in the partnership or LLC agreement. Limitations on assignment therefore cloud the issue of assumption. Conflicting precedent exists regarding whether a trustee or debtor in possession can assume a partnership agreement or LLC operating agreement under section 365(c)(1)(A). [ FN: For conflicting cases addressing the partnership issues, see Summit Investment & Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608 (1st Cir. 1995) (permitting debtor in possession to assume partnership agreement); Breeden v. Catron (In re Catron), 25 F.3d 1038 (4th Cir. 1994) (prohibiting debtor in possession from assuming partnership agreement). Fewer cases have been decided in the LLC context, but at least two have arrived at opposite results on this issue. See In re Daugherty Construction Inc. , 188 B.R. 607 (Bankr. D. Neb. 1995) (debtor in possession permitted to assume the LLC agreements in question; attempts by nondebtor LLC members to enforce state dissolution provisions violated anti- ipso facto provisions of section 365(e)); Broyhill v. DeLuca (In re DeLuca), 194 B.R. 65 (Bankr. E.D. Va. 1996) (LLC dissolved upon member ’s bankruptcy filing; ipso facto provisions of section 365(e) do not apply to personal services agreement) .] Because of limitations in underlying agreements and applicable nonbankruptcy law,some courts have determined that the partnership or LLC agreement cannot be assumed, even by the debtor in possession. [ FN: See, e.g., Breeden , 25 F.3d at 1040; Broyhill , 194 B.R. at 68.]

Proposal

The Bankruptcy Code should be amended to exclude partnership and LLC governing documents from treatment under 11 U.S.C. § 365. A new section concerning partnership or LLC governing documents should be added to the Bankruptcy Code. [ The ABA Ad Hoc Committee proposed (but later withdrew) a separate subchapter to chapter 5 as well as ten substantive sections within that subchapter to address the problems of both partnership as debtor and partner as debtor. Morris W. Macey and Frank R. Kennedy, Partnership Bankruptcy and Reorganization: Proposals for Reform , 50 Bus. Law. 879, 881 (1995)( "The Committee ’s proposed solution is a series of amendments to the Bankruptcy Code that would add a subchapter IV to chapter 5 entitled Cases of Partnerships and Partners, with new Code sections running from 561 to 570. ")]

Reasons for the Change

The proposal would greatly simplify the analysis of partnership and LLC management rights in bankruptcy. Fashioning special statutory provisions to meet the needs of partnerships is consistent with the withdrawn Ad Hoc Committee proposal. Provisions that are specifically tailored to the needs of partnership and LLC relationships will have more equitable bankruptcy results for both debtors and creditors.

The Proposal assumes that section 365 remains unchanged. As interpreted, section 365 creates problems for partnership and LLC agreements for two principal reasons: (1) it links assumption by the debtor in possession or the trustee with assignment to a third party; [ FN: See 11 U.S.C. §365(f)(1) (1994) (providing that a trustee may assign an executory contract "[e]xcept as provided in subsection (c) of this section "), and 11 U.S.C. §365(c)(1)(A) (providing that a "trustee may not assume or assign any executory contract . . . if applicable law excuses a party, other than the debtor, . . . from accepting performance from or rendering performance to an entity other than the debtor or debtor in possession . . . . ") ] and (2) it exempts certain agreements from application of the anti-ipso facto provisions. [ FN: See 11 U.S.C. §365(e)(2) (1994) (providing that the anti- ipso facto provisions of section 365(e)(1) do not apply if applicable nonbankruptcy law excuses a party from accepting performance from the trustee or assignee of such contract).] By taking partnership and LLC governing documents out of section 365 and providing specially tailored treatment, theseproblems can be solved. As discussed below and in Partnership Proposal # 5, the Commission’s proposals to amend section 365 cure a number of the existing problems for partnership and LLC relationships in bankruptcy. Consequently, it may not be necessary to excise partnership and LLC relationships from section 365; special rules regarding management rights may be sufficient.

Effect of Commission’s Proposals to Amend Section 365. The Commission’s proposals to amend section 365 will solve a number of the problems for partnership and LLC relationships under current section 365. For example, under the section 365 proposals, "executoriness" will no longer be a prerequisite for a debtor in possession or trustee to assume or reject a prepetition contract; assumption will become an election to perform; and rejection will become an election to breach. Particularly with regard to the election to perform, the Commission’s section 365 proposal clarifies that postpetition performance by the debtor in possession is not a "transfer" or assignment under section 365. [ FN: See, e.g., Institut Pasteur v. Cambridge Biotech Corp. , 104 F.3d 489, 493 (1st Cir. 1997) (assumption not dependent on whether contract is assignable).] By separating the act of assumption from the act of assignment, election by a debtor in possession to perform a partnership or LLC operating agreement will not trigger the same underlying state law impediments to the assignment of management rights.

Competing Considerations

It has been argued that partnerships and LLCs do not require a separate section of the Bankruptcy Code, but rather only those problematic sections should be amended. [ FN: Letter from Richard Levin to Stephen H. Case, Advisor, National Bankruptcy Review Commission (April 29, 1997).] As discussed above, the Commission section 365 proposals have already solved a number of the partnership and LLC problems. No longer requiring "executoriness" and separating assumption from assignment will significantly alleviate the confusion surrounding partnership agreements. In the remaining areas, minor tinkering with existing provisions may adequately resolve these issues without a wholesale rewriting of the law governing partnerships and LLCs in bankruptcy.

To the extent partnership and LLC problems can actually be solved with discrete amendments to the Code without further confusing the issues, nothing precludes the Commission from recommending these changes to existing statutory provisions.

 

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