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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 #7

Treatment of Partnership and LLC Management Rights

Background

The Bankruptcy Code does not differentiate between management rights and other contract rights. Section 365(c), however, refers to applicable nonbankruptcy law to determine whether a trustee can assume an executory contract. [ FN: 11 U.S.C. §365(c) (1994). Section 365(c) provides that a trustee may not assume or assign an executory contract if applicable law excuses the nondebtor party(s) from accepting performance from someone other than the debtor or the debtor in possession.] Applicable law in the partnership context distinguishes between economic rights (the right to receive profits and losses from the partnership) and the right to participate in the management of the partnership enterprise. Only the economic rights of a partnership may be assigned without the consent of the other partners under the Uniform Partnership Act. [ FN: UPA §27(1). An assignee of the economic rights of a partnership can not exercise management rights, access partnership information, or demand an accounting without the consent of the other partner(s).] The Revised Uniform Partnership Act rule is similar, requiring the consent of all partners before admission of a partner and limiting the management rights of assignees. [ FN: RUPA §§401(i) & 503.] The transferability provisions of LLCs mirror those of partnerships. [ FN: Sally S. Neely, Partnerships and Partners, Limited Liability Companies and Members: What Happens in Bankruptcy 20 (July 23, 1996) (unpublished manuscript, on file with the National Bankruptcy Review Commission) (citations omitted).] All of these state law provisions apply only in the absence of agreement between the parties. Thus, the parties can override state law and provide that managerial rights are freely transferable.

It is expected that in most cases, where the debtor’s property includes a partnership or LLC interest, that such interest will either be (i) dealt with in a chapter 11 plan (either by being retained by the debtor or disposed of), (ii) sold or otherwise "bought out" during the pendency of the case, or (iii) abandoned to the debtor. During the "gap" period, before one of these dispositions is achieved, questions will arise about who exercises what management or voting rights which the debtor has under the applicable partnership or LLC governing documents.

Proposal

During any period when an estate being administered in a bankruptcy case includes a partnership or LLC interest, the management and voting rights of the partner or LLC member are to be exercised as follows:

·730·A debtor in possession under chapter 11 or a debtor under either chapter 12 or chapter 13 should exercise all management and voting rights, subject to the applicable non-ipso facto provisions of the partnership or LLC governingdocuments and the other applicable provisions of the Bankruptcy Code;·730

·730·Where (a) there is more than one general partner or LLC managing entity and at least one of such partners or entities is not a debtor in a case under the Bankruptcy Code, and (b) a chapter 7 or chapter 11 trustee has been appointed, then the trustee should not exercise any management rights except to the extent necessary to constitute a quorum or meet a minimum majority required by the governing documents or applicable nonbankruptcy law;·730

·730·In all other cases where a chapter 7 or chapter 11 trustee has been appointed, the trustee shall exercise all management and voting rights.·730

Regardless of the foregoing, in all cases where (i) an individual continues to function as a partner or member after the order for relief, and (ii) the estate receives or is more likely than not going to receive, the "buyout price," then the individual should have the sole power to exercise management and voting rights attributable to periods after the order for relief.

Reasons for the Change

Confusion over the treatment of management rights in bankruptcy arises where courts look to applicable nonbankruptcy law to determine under section 365(c) whether the trustee (or debtor in possession) can assume the management rights. Some courts find that the debtor in possession is unable to assume the partnership agreement because applicable nonbankruptcy law excuses the nondebtor partners from accepting performance from anyone other than the prepetition debtor. [ FN: See, e.g., Breedon 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) (UPA provisions excused nondebtor party(s) to agreement from accepting performance from debtor in possession; DIP was unable to assume agreement under section 365(c)).] Other courts find that applicable nonbankruptcy requirements are ipso facto provisions and are invalid under section 365(e). [ FN: See, e.g., Summit Invest. and Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608, 614 (1st Cir. 1995) (refuting the argument that "the postpetition ‘change ’ in contract performance is sufficiently substantial -- in and of itself -- to deprive parties . . . the full benefit of their bargain. "); In re Antonelli , 148 B.R. 443 (D. Md. 1992), aff ’d mem. , 4 F.3d 984, 1993 WL 321584 (4th Cir. 1993) (UPA restrictions on transferability invalidated under section 365(c)(1) and 365(f); certain management rights properly transferred to creditors ’ committee in chapter 11 plan).] The Proposal adopts the approach taken by the latter courts that the debtor in possession is not a separate entity from the prepetition debtor and should be able to exercise the same management rights as the prepetition debtor. [ FN: The Supreme Court adopted this position in the collective bargaining context. See NLRB v. Bildisco & Bildisco , 465 U.S. 513, 528 (1984).] chapter 12 and chapter 13 debtors should be able to exercise all postpetition management rights, despite the appointment of a trustee, due to the ongoing financial obligations of the debtor to fund the plan.

A thornier problem is the exercise of management rights by a trustee under chapter 7 or under chapter 11. The Proposal advocates that a trustee should not exercise management rights (except to establish a quorum or meet a minimum majority required by the governing documents)under the following two circumstances: (1) where there is at least one other nondebtor general partner or LLC member to operate the partnership or LLC; or (2) where an individual debtor continues to function as a partner or member after the order for relief and whose estate receives or is more likely than not going to receive the "buyout price." For example, where the debtor continues to serve the partnership or LLC after the commencement of the case, the situation is akin to a DIP and the debtor should be able to exercise all management rights subject to all non-ipso facto provisions. In the few cases where the debtor is the only general partner, the trustee should be able to exercise all management rights. [ FN: A different test for whether a trustee should exercise management rights was offered by Laurence D. Cherkis to determine this issue. Mr Cherkis proposed that a trustee should be able to exercise management rights where (i) nondebtor partners "are not relying on the professional or business reputation of the debtor or the debtor ’s particular knowledge, experience or expertise, to the exclusion of others, and (ii) the trustee or its representatives have the knowledge, expertise and experience necessary to enable the business of the partnership to continue in the ordinary course in accordance with past practice. " This test would not be satisfied in a family, a professional, or any other partnership where the relationship of the partners is an important aspect of the business. An example of the type of partnership where this test would be satisfied is a fully matured real estate development partnership.]

Factual Examples

1. Individual in an Accounting Firm

For example, consider an accounting firm with five individual partners. The partnership agreement prohibits any transfers of a partner’s interest. It has a buyout clause permitting 66 2/3% of the partners to redeem the interest of any partner at a price determined under a formula. There is a clause expelling automatically any partner who becomes a debtor under the Bankruptcy Code, but the partnership agreement (as permitted under state law) overrides automatic-dissolution-on-bankruptcy provisions of applicable state law.

One of the partners files a chapter 11 petition because of an uninsured tort liability from an auto accident. He remains as a debtor in possession. He wishes to continue as a partner. The other partners agree. Under the Proposal, the automatic expulsion is unenforceable. All of his accrued rights to distributions through the date of the order for relief are property of the estate and must be separately accounted for by the DIP. The only other amount payable to the estate for creditors is the buyout price payable under the partnership agreement. Once it is clear that the firm will probably pay this amount to the estate, then all future economics of the partnership accruing after the order for relief belong to the individual debtor. The individual debtor will exercise all of the management and voting rights that he/she did prepetition.

2. Real Estate Syndicated Limited Partnership No. 1

As a second example, consider a limited partnership owning Blackacre. There are twogeneral partners, each a corporation. There are 45 limited partners, each an individual. The partnership agreement contains no ipso facto clauses and is silent on the effect of the bankruptcy of a general partner. The governing documents permit 75% of the partners to remove a general partner at any time, for a token payment. The governing documents prohibit transfers of general partner interests without the consent of 85% of the limited partners.

General Partner No. 1 files for chapter 11 relief. A trustee is appointed. The automatic dissolution under state law is unenforceable as an ipso facto clause. Because there is a nondebtor general partner, the chapter 11 trustee is precluded from exercising management or voting rights (the trustee would exercise all of these rights if he were the sole general partner). All rights to distributions of profit and loss in the partnership belong to the trustee for as long as the estate is a member of the firm.

The limited partners act by consent to remove as a general partner -- and make the token payment -- the entity for which the trustee is appointed. The limited partners confess that they did it solely because of bankruptcy. Nonetheless, this is a valid act, in implementation of partnership democracy and (like corporate governance) cannot be stopped by a partner filing for bankruptcy.

3. Real Estate Syndicated Limited Partnership No. 2

The facts are the same as under No. 1 above, except that there is no right of the limited partners to remove the general partners.

The creditors want the value of the debtor’s general partner interest for the benefit of the estate. The creditors find a buyer for the general partnership interest and seek court approval of the sale, invoking the court’s power to override the provisions of the partnership agreement and compel the buyer’s admission as a general partner. The limited partners respond by invoking the 85% clause and refuse to approve the transfer. This triggers a duty on the part of the partnership to buy out the debtor-partner’s interest. The court determines the price and gives the partnership three years to pay it off.

Competing Considerations

Concerns with the exercise of management rights by debtors in possession focus on the shift in fiduciary duties between a solvent partner and a debtor in possession. [ FN: Larry E. Ribstein, The Federalization of Partnership Breakup: Expelling Bankrupt Partners, Law & Economics Working Paper No. 97-01, 3 (May 19, 1997) (unpublished manuscript on file with the National Bankruptcy Review Commission) (arguing that a bankrupt partner ’s fiduciary duty to creditors conflicts with those of the solvent partners).] The Proposal adopts the approach taken by the 1^st Circuit in Summit Investment that performance by the debtor in possession preserves the benefit of the bargain for the nondebtor party while maximizing assets available to other creditors by preventing a forfeiture of property of the estate. [ FN: Summit Invest. and Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608 (1st Cir. 1995).] Concerns relating to atrustee exercising management rights focus on the language of section 365(c)(1)(A) and the fact that applicable nonbankruptcy law permits refusal of a trustee’s performance. The Proposal addresses the state law concerns by permitting the trustee to exercise management rights except under two circumstances. The trustee is still subject to non-ipso facto provisions reducing the risk of harm to the nondebtor partners and LLC members. [ FN: Letter from Sally S. Neely, on behalf of herself, to Stephen H. Case et al., Advisor, National Bankruptcy Review Commission 4 (May 5, 1997) ( "the exercise of management rights [by the trustee] would be subject to non- ipso facto provisions. Therefore, the risk of harm to other partners is minimal to nonexistent, while the rewards to the estate (substantial management fees and prospect for increased value of partnership interest) are probably greater. ") ]