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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 #6

Property of the Estate, Transferability, and Valuation of a Partnership or LLC Interest

Background

Property of the Estate. Section 541(a)(6) provides that property of the estate includes "[p]roceeds, product, offspring, rents or profits of or from property of the estate, except such as are earnings from services performed by an individual debtor after the commencement of the case." In the case of an individual partner or LLC member, the effect of this provision is that property of the estate does not include postpetition earnings for services rendered. The division of partnership income under section 541(a)(6) is between those earnings for services rendered and those earnings attributable to a return on the partnership interest. [ FN: See, e.g., Fitzsimmons v. Walsh (In re Fitzsimmons), 725 F.2d 1208, 1211 (9th Cir. 1984) (refuting contention by sole proprietor debtor in possession that all postpetition earnings were within the section 541(a)(6) exception; "the earnings exception applies only to services performed personally by an individual debtor ").] Property of the debtor becomes property of the estate regardless of an ipso facto provision that would limit the debtor’s estate’s interest in the property. [ FN: 11 U.S.C. §541(c)(1).]

Transferability of Partnership or LLC Interest. A debtor general partner’s partnership interest can be transferred by the trustee, subject to the underlying partnership agreement. [ FN: See, e.g., Rice v. Shoney ’s Inc. (In re Dean), 174 B.R. 787 (Bankr. E.D. Ark. 1994) (trustee bound by sale restrictions and option to purchase debtor ’s joint venture interest);In re Todd , 118 B.R. 432 (Bankr. D.S.C. 1989) (chapter 7 trustee bound by right of first refusal provisions in partnership agreement).] Section 363(l) provides the terms under which a trustee may use, sell or lease property of the estate. [ FN: 11 U.S.C. §363(l) (1994)(providing that the trustee, subject to section 365, may use, sell or lease property of the estate notwithstanding an ipso facto provision in the underlying agreement or applicable law).] Ipso facto provisions are not enforceable under section 363(l). However, courts have generally enforced non-ipso facto provisions in partnership agreements that restrict the alienability of the interest or otherwise give the remaining partners a right of first refusal. [ FN: This view has been countenanced by both commentators and the courts. See Gerald K. Smith, Issues in Partnership and Partner Bankruptcy Cases and Reorganization of Partnership Debtors, in course materials for ALI-ABA, Partnerships, LLCs, and LLPs: Uniform Acts, Taxation, Drafting, Securities, and Bankruptcy , at 685 ( "contractual provisions regulating who may buy partnership interests and the price, such as, Buy/Sell Agreements and Rights of First Refusal, have generally been considered enforceable. An agreement which is general, that is, a partner withdrawing or dissociating for any reason can be bought out based on a formula should be enforceable. However, if the buyout is triggered by bankruptcy it should not be enforceable unless that is compelled by §365(e)(2). " citing Calvert v. Bongards Creameries (In re Schauer), 15 C.B.C.2d 191 (Bankr. D. Minn. 1986), aff ’d 835 F.2d 1222 (8th Cir. 1987);In re Farmers Markets Inc. , 792 F.2d 1400 (9th Cir. 1986);In re Todd , 188 B.R. 432 (Bankr. D.S.C. 1989);In re Baquet , 61 B.R. 495 (Bankr. D. Mont. 1986)).]

Valuation. Both the Uniform Partnership Act and the Revised Uniform Partnership Act provide valuation formulas for partnership interests. For example, the UPA provides that partners continuing a partnership after a wrongful dissociation must pay the dissociating partner the liquidation value of the interest, less any damages resulting from the dissolution. [ FN: UPA §38(2)(b) & (2)(c)(II).] Under the RUPA, if a partner files for bankruptcy and the partnership continues, the remaining partners must buyout the bankrupt partner’s interest. The RUPA buyout price is "the amount that would have been distributable to the dissociating partner . . . if . . . the assets of the partnership were sold at a price equal to the greater of the liquidation value or the value based on a sale of the entire business as a going concern without the dissociated partner . . . . Interest must be paid from the date of dissociation to the date of payment." [ FN: RUPA §701(b).]

Proposal

"Property of the estate" for a partner or LLC member should include all rights attendant with the partnership or LLC interest, including management rights, voting rights, and economic rights (including goodwill, the right to share in profits and losses, and other any other right to payment). Except as provided below, the Proposal does not alter the effect of section 541(a)(6), to the extent it is applicable. In the case of an individual partner or LLC member who (i) continues to function as a partner or member after the order for relief, and (ii) whose estate receives or is more likely than not going to receive the "buyout price" as defined below, all partnership or LLC interest amounts arising, accruing, or are exercisable after the order for relief are deemed to be on account of personal services rendered by the partner or LLC member and do not become property of the estate. There should be a presumption, in a case of an individual debtor, that the estate is more likely than not going to receive the "buyout price," upon which presumption the parties should be entitled to rely and function until the court orders to the contrary, after notice and hearing, on motion of the trustee or any party in interest.

The court should have the power to authorize a sale under section 363 of the partnership or LLC interest and order the admission of the buyer to the partnership or LLC with all rights and duties the debtor had, except that if the governing documents preclude transfer, the anti-transfer clauses will be given effect, but only if the partnership or LLC pays the "buyout price" to the estate. The court should retain the power to fashion reasonable payment terms which balance the needs of the estate for receipt of cash as rapidly as possible with the needs of the entity for liquidity and working capital to conduct its operations in a prudent manner.

The "buyout price" means the highest price (including a calculation or appraisal method), if any, provided in the governing documents in the case of a buyout of an interest not on account of the bankruptcy, insolvency, financial condition, commencement of a voluntary or involuntary case under title 11, or appointment of a trustee or custodian, of a partner or LLC member or manager. If no such price is provided, the court should determine a fair buyout value.

Reasons for the Change

The tension that this tripartite Proposal attempts to resolve is between preserving the going concern value of the debtor’s general partner interest (i.e. the economic value) for the estate and enforcing the benefit of the nondebtor partners’ bargain. Section 541(a)(6) protects creditors by ensuring that the estate includes income attributable to estate property. [ FN: See 4 Collier on Bankruptcy ¶ 541.19, 541-94 (Lawrence P. King et al. eds. 15th ed. 1996).] Courts have grappled with the effect of this provision on an individual debtor’s postpetition earnings. [ FN: CompareIn re Powell , 187 B.R. 642 (Bankr. D. Minn. 1995) (holding that post-petition earnings under section 541(a)(6) were not property of individuals ’ chapter 11 estate; wages were derived exclusively in debtors ’ capacity as employees);In re Molina Y Vedia , 150 B.R. 393 (S.D. Tex. 1992) (100% of doctor/DIP ’s postpetition earnings within section 546(a)(1) exception); with In re Angobaldo , 160 B.R. 140 (N.D. Cal. 1993) (splitting post-petition earnings between those attributable to debtor ’s post-petition services and those attributable to profits from estate assets).] The Proposal preserves the effect of section 541(a)(6) except under a limited circumstance: (1) where the partner or LLC member continues working for the partnership or LLC; and (2) a non-ipso facto provision in the agreement or applicable nonbankruptcy law effects a buyout of the partner’s or LLC member’s interest at the buyout price.

Interpretation and enforceability of "buyout" provisions in a general partner’s bankruptcy has been the subject of a few cases. [ FN: See Connolly v. Nuthatch Hill Assoc. (In re Manning), 831 F.2d 205 (10th Cir. 1987); Cutler v. Cutler (In re Cutler), 165 B.R. 275 (Bankr. D. Ariz. 1994).] The difficult issue in these cases is whether to enforce the lower "bankruptcy" buyout price provided in the underlying agreement. [ FN: The facts in Cutler provide a good example of the different buyout alternatives in partnership agreements. In the event of bankruptcy under the Cutler agreement, the other partners could buy out the interest at book value. Cutler , 165 B.R. at 276. In the event of a voluntary withdrawal from the partnership, the agreement provided for a buy out price at 87.5% of fair market value. Id. In the event of death, disability, or incompetence of a partner, the same agreement provided for a fair market value buyout price. Id. Under the Proposal, the fair market value buy out price would apply in bankruptcy notwithstanding the alternative provision requiring book value. ] The Proposal eliminates argument over which "buyout price" is proper; under the Proposal the highest price provided is the buyout price. The buyout price provisions in the Proposal attempt to reconcile the need to maximize estate assets for creditors with the interest in enforcing the benefit of the nondebtor partners bargain. The buyout price is intended to provide a fair and predictable price to the creditors who will be cutoff under certain circumstances, as of the order for relief, from receiving income generated by an estate asset. Requiring a buyout at the highest price calculated under the agreement and if none, then at a fair price should provide as close to a predictable price as possible. Thus, creditors, debtors, and nondebtor partners and LLC members should be able to predict with a modicum of certainty what the buyout price would be in bankruptcy. The Proposal also mitigates the possible hardship suffered by an entity that must buyout a debtor member’s interest by authorizing thecourt to permit flexible payment, if necessary.

The economic interest transferability provisions of the Proposal enforce restrictive alienation provisions in partnership agreements. Enforcing a restrictive sale provision or a right of first refusal provision in a partnership agreement preserves the benefit of the nondebtor partners’ bargain during a partner’s or LLC member’s bankruptcy case. This portion of the Proposal is consistent with the withdrawn recommendation of the ABA Ad Hoc Committee that the underlying agreement and applicable state law should govern the treatment of partnership agreements 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.)] It is also consistent with the recommendation of Professor Ribstein that the treatment of partnerships be left to state law. [ FN: Letter from Professor Larry E. Ribstein, GMU Foundation Professor of Law, George Mason University to Stephen H. Case, Advisor, National Bankruptcy Review Commission (May 27, 1997).] Enforcing private agreement and underlying state law in the case of transferability of the partnership and LLC interest satisfies a number of the concerns raised by Professor Ribstein. [ FN: Id. at 3 ( "partners or LLC members should be able to expel bankrupt partners or members and to fix the buyout price regardless of the management responsibilities of the partner or member and regardless of whether the firm is an LLC or partnership or whether the bankrupt is personally liable for the firm ’s debts. ")] In preserving state law results, however, the proposal does not abandon the bankruptcy interest of maximizing estate value. If the agreement or applicable nonbankruptcy law prohibits alienation of the interest, the partnership or LLC must buy the interest at the "buyout price."

Competing Considerations

It has been argued that enforcing a contractual buyout price may lead to collusive valuation by the nondebtor and debtor partners. [ FN: Letter from Richard Levin to Stephen H. Case, Advisor, National Bankruptcy Review Commission at 4 (April 29, 1997).] The Proposal addresses this concern by providing that the highest price for an interest in the underlying agreement will be the "buyout price." This would include the price (or the calculation of a price) that a partner would receive upon voluntary withdrawal or the partner’s estate would receive upon death. While collusive price terms might be tempting in bankruptcy, undervaluing would not be tempting in the above two scenarios.