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

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 #5

Ipso Facto Provisions Rendered Unenforceable in General Partner’s or LLC Member’sBankruptcy Case

Background

Ipso facto provisions purport to alter the rights of a party based upon that party’s insolvency, financial condition, commencement of a voluntary or involuntary case under Title 11, or appointment of a trustee or custodian. Except in limited circumstances, these provisions (whether contractual or statutory) are unenforceable in cases under the Bankruptcy Code. [ FN: There are five specific anti- ipso facto provisions in the Bankruptcy Code. See 11 U.S.C. §363(l) (providing that the trustee may use, sell, or lease property notwithstanding an otherwise applicable ipso facto provision that would divest the debtor ’s interest in the property); 11 U.S.C. §365(e)(1) (providing that an executory contract or unexpired lease can not be altered or modified after the commencement of the case solely because of an ipso facto provision); 11 U.S.C. §365(f)(1) (empowering the trustee to assign an executory contract or lease regardless of a provision that would restrict, prohibit, or condition such assignment); 11 U.S.C. §365(f)(3) (prohibiting termination or modification of an agreement due to its assumption and assignment); 11 U.S.C. §541(c)(1)(B) (providing that an interest of the debtor in property becomes property of the estate notwithstanding an ipso facto clause in the underlying agreement or applicable nonbankruptcy law that restricts or conditions such transfer).] Ipso facto provisions play an important partnership role outside of bankruptcy, effecting, among others, a dissolution of the partnership or LLC, a forfeiture of management rights, or a transformation of a general partnership interest to a limited partnership interest. For example, the Uniform Partnership Act ("UPA") provides that the bankruptcy of a general partner dissolves the partnership. [ FN: UPA §31(5). Morris W. Macey and Professor Frank R. Kennedy note that when the Uniform Partnership Act was first promulgated, bankruptcy meant that a petition seeking liquidation had been filed and did not include reorganization under the Bankruptcy Act. Morris W. Macey and Frank R. Kennedy, Partnership Bankruptcy and Reorganization: Proposals for Reform , 50 Bus. Law. 879, 901 (1995).] Similarly, the Revised Uniform Partnership Act provides that a bankrupt general partner is dissociated from the partnership. [ FN: RUPA §601(6)(i).] The same dissociation occurs under the Uniform Limited Liability Company Act when a LLC member files for bankruptcy protection. [ FN: ULLCA §601(7).]

Difficulty reconciling these two opposite results arises, for the most part, under two subsections of section 365. Section 365(c)(1) provides that a trustee is unable to assume or assign an agreement if applicable nonbankruptcy law excuses the nondebtor party(s) from accepting performance from an "entity other than the debtor or debtor in possession." [ FN: 11 U.S.C. §365(c)(1)(A) (1994).] The threshold issueunder this section is whether the debtor in possession is a distinct entity from the prepetition debtor. If yes, then the debtor in possession is precluded from assuming the agreement if applicable nonbankruptcy law excuses the nondebtor party(s) from accepting the debtor in possession’s performance.

Difficulty also arises under the ipso facto carve-out provisions of section 365(e)(2). Section 365(e)(2) provides that ipso facto provisions (otherwise unenforceable under section 365(e)(1)) are enforceable under applicable nonbankruptcy law if the nondebtor party(s) to the contract could refuse performance from the trustee or from an assignee, regardless of the agreement between the parties. [ FN: 11 U.S.C. §365(e)(2) (1994). Some confusion over the interpretation of section 365(e)(2) arose when section 365(c)(1)(A) was amended in 1984. Prior to 1984, section 365(c)(1)(A) prohibited assumption by the trustee if the nondebtor party could refuse performance from an entity other than "the trustee. " This language was deleted and "an entity other than the debtor or debtor in possession " was inserted, emphasizing that the debtor in possession was not to be treated as a separate entity from the debtor for purposes of assumption. Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub. L. No. 98-353 (1984). Section 365(e)(2) was not similarly amended, leaving some question as to whether enforcement of ipso facto provisions should be treated differently from anti-assumption provisions. Some commentators conclude that ipso facto provisions should only be enforced under section 365(e)(2) when substituted performance would occur. 2 Collier on Bankruptcy ¶ 365.06, 365-60 (Lawrence P. King et al. eds. 15th ed. 1994)( "The wording of section 365(e)(2) is perhaps unnecessarily broad and suggests that a bankruptcy termination clause might be asserted against a debtor in possession when the contract is one for personal services, although it seems clear that the intent was to permit termination only when substituted performance would occur. ") ] Confusion arises over whether the nondebtor party is permitted to refuse performance from the debtor in possession under applicable nonbankruptcy law, thereby preserving the effect of the ipso facto clauses in the agreement. [ FN: A perfect example of this confusion is the case of Breeden v. Catron (In re Catron), 158 B.R. 629 (E.D. Va. 1993), aff ’d mem. , 25 F.3d 1038, 1994 WL 258400 (4th Cir. 1994). In Catron , the debtor in possession was one of three general partners engaged in the development of a shopping center. Catron contributed the undeveloped land and another partner was to develop and manage the shopping center. Catron filed a chapter 11 petition and the other partners sought relief from the stay in order to exercise a buyout option in the partnership agreement, triggered by the bankruptcy filing. The bankruptcy court granted relief from the stay and Catron appealed. Catron argued that the bankruptcy court erred in finding that as a debtor in possession he was a distinct legal entity from the prepetition debtor and therefore could not assume the partnership agreement. The district court affirmed as did the 4^th Circuit (by memorandum decision) on the grounds that because the debtor in possession stands in the shoes of the trustee, "Catron ’s status as a debtor in possession subjects him to the restrictions imposed by §365(c). " Id. , 158 B.R. at 633. Thus, Catron, as debtor in possession, was precluded from assuming the prepetition partnership agreement on the grounds that he was a separate legal entity. ] By contrast, some courts enforce the non-ipso facto provisions of the Code. Under this reasoning, the debtor in possession is not a separate entity from the prepetition debtor and therefore (i) the other party(s) to the agreement can not refuse performance under section 365(e)(2); and (ii) the debtor in possession can assume the agreementunder section 365(b). [ FN: See, e.g., Summit Investment and Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608 (1st Cir. 1995) (prepetition debtor is the same entity as the debtor in possession; ipso facto exception under section 365(e)(2) did not apply).]

Proposal

Ipso facto provisions relating to partnerships, LLCs, and the rights or interests of partners or LLC members or managers should not be enforceable under the Bankruptcy Code. Ipso facto provisions include any provision in a partnership agreement, LLC operating agreement, or applicable nonbankruptcy law that operates to terminate or modify the rights of a partner or LLC member based on insolvency, financial condition, commencement of a voluntary or involuntary case under Title 11, or appointment of a trustee or custodian. Nonipso facto provisions that limit a partner’s or LLC member’s rights, relationship, interest, or permit expulsion on the basis of something other than insolvency, financial condition, commencement of a voluntary or involuntary case under title 11, or the appointment of a receiver would still be enforceable.

Reasons for the Change

The case law is divided on the effect of ipso facto provisions in general partner bankruptcy cases. [ FN: Compare Breeden v. Catron (In re Catron), 158 B.R. 629 (E.D. Va. 1993), aff ’d mem. , 25 F.3d 1038, 1994 WL 258400 (4th Cir. 1994) (applicable nonbankruptcy law (the UPA) precluded assumption under section 365(c)(1) thus precluding nullification of ipso facto provisions under section 365(E)(1); buy-out provision was enforceable due to debtor in possession ’s inability to assume partnership agreement); with Summit Investment & Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608 (1st Cir. 1995) (invalidating RULPA provisions divesting a debtor general partner from the partnership as ipso facto clause; court refused to treat debtor in possession as separate entity); and In re Antonelli , 148 B.R. 443 (D. Md. 1992), aff ’d mem. , 4 F.3d 984, 1993 WL 321584 (4th Cir. 1993) (anti-assignment provisions of UPA overridden by anti- ipso facto provisions of section 365(f)(1); court permitted assignment of management rights to committee in violation of applicable nonbankruptcy law).] The Proposal adopts the view that, as a matter of public policy, ipso facto provisions in partnership or LLC operating agreements or applicable nonbankruptcy law should not be enforceable in bankruptcy. This position is consistent with the Bankruptcy Code treatment of ipso facto provisions in other types of property interests. [ FN: See, e.g., 11 U.S.C. §§363(l) & 541(c)(1) (1994).] Just because a partner or LLC member has sought relief under the Bankruptcy Code, there is no compelling interest served by mandating an automatic dissolution of the partnership or buyout of the debtor partner’s interest. The anti-forfeiture considerations preserved by the Proposal maintain the debtor’s status quo while balancing the interests of all creditors and parties in interest without preferring certain creditors or parties in interest over others.

It is important to remember that an ipso facto provision purports to alter a party’s rights on the basis of bankruptcy, insolvency or other financial straits. Other provisions in a partnership agreement that limit or otherwise regulate a party’s rights under the agreement will still be enforceable unless they contravene some other Bankruptcy Code provisions. For example, generally-applicable, bankruptcy-neutral provisions in an agreement that limit an individual’s management responsibilities would still be enforceable under the Proposal against both a debtor in possession and a trustee.

The Proposal is consistent with the position taken by the NBC Committee on Partnerships. The NBC Draft Report on Partnerships proposes that "[t]he commencement of a case or entry of an order for relief with respect to a general partner under title 11 (or other ipso facto condition) should not automatically cause, or provide the other partners with the option to cause, the dissolution of the partnership," and that "[t]he filing of a petition by or against a general partner under any chapter of title 11 should not result in the loss to the estate of the value of the general partner’s ‘interest in the partnership’" [ FN: NBC Draft Report on Partnerships, at 35 & 38.]

Competing Considerations

The important role that ipso facto provisions play in the partnership context outside of bankruptcy has led certain commentators to conclude that these provisions should be enforceable regardless of the bankruptcy filing. Most notably, the Ad Hoc Committee of the ABA proposed (but later withdrew) a provision that would have enforced applicable nonbankruptcy law requiring a dissolution or dissociation if a general partner was in bankruptcy. [ FN: Morris W. Macey & Frank R. Kennedy, Partnership Bankruptcy and Reorganization: Proposals for Reform, 50 Bus. Law. 905 (1995) (proposed (but later withdrawn) section 569 provided that applicable nonbankruptcy law would control the treatment of partnership agreements in bankruptcy except that a buyout price would not be determined by the agreement or applicable nonbankruptcy law if such price was conditioned on the financial straits of the debtor partner.)] Some courts have also enforced ipso facto provisions in bankruptcy. [ FN: See, e.g., Phillips v. First City, Texas-Tyler (In re Phillips), 966 F.2d 926 (5th Cir. 1992) (enforcing state partnership provision that "bankrupt " general partner did not have authority to file bankruptcy petition on behalf of partnership);In re Sunset Dev. , 69 B.R. 710 (Bankr. D. Idaho 1987) (general partner ’s filing dissolved partnership under state law notwithstanding section 365(e)).] In better-reasoned decisions that are truer to the intent and meaning of the anti-ipso facto provisions of the Bankruptcy Code, some courts find the forfeiture of a partner’s interest that would occur under state law is not enforceable in bankruptcy. [ FN: See, e.g., Summit Investment and Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608 (1st Cir. 1995)( ipso facto provisions of section 365 overruled provisions in agreement and Massachusetts limited partnership statute); Cardinal Indus. Inc. v. Buckeye Fed. Sav. & Loan Ass ’n (In re Cardinal Indus.), 105 B.R. 834, 849 (Bankr. S.D. Ohio 1989); In re Corky Foods Corp. , 85 B.R. 903, 904 (Bankr. S.D. Fla. 1988).]