Issues Involving Partner and Member Bankruptcies
June 6, 2014
Prepared by:
Joli A. Lofstedt – Connolly, Rosania & Lofstedt, P.C.
and
J. Brian Fletcher – Onsager | Guyerson | Fletcher | Johnson
Presented by:
The Honorable A. Bruce Campbell – United States Bankruptcy Court for the District of Colorado
Joli. A. Lofstedt – Connolly, Rosania & Lofstedt, P.C.
J. Brian Fletcher – Onsager | Guyerson | Fletcher | Johnson
I. Issues Raised by the Bankruptcy Filing of Partner/Member
A. Partner/Member bankruptcy filings raise legal issues, including:
· Property of the Estate
· Bankruptcy and dissolution of the partnership/LLC
· Assignment of Partnership and Membership Interests
§ Transfer of Economic Interests
§ Right of First Refusal
§ Buy-out provisions
§ Ability to file Bankruptcy or Seek Dissolution
· Section 365 – Executory Contracts
§ Section 365(c)(1)
§ Section 365(e)(1) - Implication of ipso facto provisions
· Jurisdictional and Standing issues
II. Property of the Estate - Section 541 and Colorado Law
· Upon the filing of a petition in bankruptcy, a bankruptcy “estate” is created pursuant to section 541 of the Bankruptcy Code.
· Section 541(c)(1)(B) states in pertinent part that “an interest of the debtor in property becomes property of the estate. . . notwithstanding any provision in an agreement . . . that is conditioned . . . on the commencement of a case . . . .”
· The bankruptcy “estate” consists of all equitable and legal interests the debtor has, including property and contractual rights.
· Limited Liability Company – Colo. Rev. Stat. § 7-80-702: The interest of each member in a limited liability company constitutes the personal property of the member and may be transferred or assigned.
· Partnerships – Colo. Rev. Stat. § 7-64-203: Property acquired by a partnership is property of the partnership and not of the partners individually. Colo. Rev. Stat. § 7-60-108: All property originally brought into the partnership stock or subsequently acquired by purchase or otherwise on account of the partnership is partnership property.
III. Dissolution of Partnership/LLC Upon Partner or Member Bankruptcy Filing
· Applicable state law and/or the operating agreement of partnership or LLC may provide for dissolution of the partnership/LLC or that any partner or manager who files for bankruptcy withdraws from the partnership/LLC.
· Dissolution and withdrawal provisions often conflict with federal bankruptcy law principles.
· Disagreement among the courts on whether dissolution and withdrawal provisions are enforceable in bankruptcy.
A. Colorado Law
1. Partnerships –
a. Uniform Partnership Law—Colo. Rev. Stat. § 7-60-131.Causes of dissolution
(1) Dissolution is caused:
(a) Without violation of the agreement between the partners:
(I) By the termination of the definite term or particular undertaking stated in the agreement;
(II) By the express will of any partner when no definite term or particular undertaking is stated;
(III) By the express will of all the partners who have not assigned their interests or allowed them to be charged for their separate debts either before or after the termination of any stated term or particular undertaking;
(IV) By the expulsion of any partner from the business bona fide in accordance with such a power conferred by the agreement between the partners;
(b)In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time;
(c) By any event which makes it unlawful for the business of the partnership to be carried on or for the members to carry it on in partnership;
(d) By the death of any partner;
(e) By the bankruptcy of any partner or the partnership;
(f) By decree of court undersection 7-60-132.
b. Colorado Uniform Partnership Act – Colo. Rev. Stat. § 7-64-601. Events causing partner's dissociation.
(1) A partner is dissociated from a partnership upon the occurrence of any of the following events:
. . .
(f) The partner's:
(I) Becoming a debtor in bankruptcy;
(II) Executing an assignment for the benefit of creditors;
(III) Seeking, consenting to, or acquiescing in the appointment of a trustee, receiver, or liquidator of that partner or of all or substantially all of that partner's property; or
(IV) Failing, within ninety days after the appointment, to have vacated or stayed the appointment of a trustee, receiver, or liquidator of the partner or of all or substantially all of the partner's property obtained without the partner's consent or acquiescence, or failing within ninety days after the expiration of a stay to have the appointment vacated;
2. Limited Liability Companies - Dissolution – only upon agreement by the members, time or events stated in the operating agreement, after LLC ceases to have members or time set forth in operating agreement has expired.
Colo. Rev. Stat. § 7-80-801. (1) A limited liability company formed under this article is dissolved:
(a) Upon the agreement of all members;
(b) At the time or upon the occurrence of the events stated in the operating agreement; or
(c) After the limited liability company ceases to have members, on the earlier of:
(I) The ninety-first day after the limited liability company ceases to have members unless, prior to that date, a person has been admitted as a member; or
(II) The date on which a statement of dissolution of the limited liability company becomes effective pursuant tosection 7-90-304.
B. Cases re Bankruptcy and Dissolution of the Partnership or LLC
1. Connolly v. Nuthatch Hill Assocs. (In re Manning), 831 F.2d 205 (10th Cir. 1987) (“Under Colorado law, a bankruptcy filing by any partner effects an automatic dissolution of the partnership.”)
· Trustee brought an action against a debtor’s partnership and the non-bankrupt partners, seeking authority to sell partnership real estate. In the alternative, trustee sought windup of the partnership and a partnership accounting.
· Under the partnership agreement, partners entitled to buy-out the debtor partner’s interest in the partnership for a “discount” – i.e., 75% of the value of the debtors “capital account” – which was less than debtors’ share of the value of partnership. The Tenth Circuit remanded to the bankruptcy court to examine, among other things, whether there were any ipso facto provisions in the agreement related to the buy-out. According to the Tenth Circuit, if “the partners, in fact, did intend to allow a severe penalty upon dissolution by bankruptcy,” ipso facto provisions would likely be implicated. Given the “discount,” the court found that the buy-out provision may also be prohibited under sections 363(1) and 541(c) as a “modification” of estate property. The Tenth Circuit noted that “valuing the bankrupt’s interest, not at appreciated fair market value, as is typically done upon the death or incompetency of a partner, but instead at book value produces not only a modification but has the added effect of requiring [the debtor] to virtually forfeit his interest . . . .”
· Holding: trustee lacked authority under11 U.S.C.S. § 363(f)to sell the partnership property free and clear of other interests. However, the court remanded for the bankruptcy court to take extrinsic evidence as to the intent of the parties with regard to the applicability of ambiguous terms of the partnership agreement regarding dissolution by bankruptcy and for extrinsic evidence as to the intended meaning of ambiguous term “capital account.”
2. Other Jurisdictions:
A. In re Prebul, 2011 WL 2947045 (Bankr. E.D. Tenn. July 19, 2011) aff’d 2012 WL 5997927 (E.D. Tenn. Nov. 30, 2012): finding that to permit dissolution under state law “would defeat the evident purpose of §541(c)” and holding that “the statute [providing for dissolution] is rendered ineffective by §541(c)(1).”
B. In re Warner, 480 B.R. 641 ((Bankr. N.D. W. Va. 2012): holding that the bankruptcy filing of the member did not result in dissolution of the LLC.
C. In re Modanlo, 412 B.R. 715 (Bankr. D. Md. 2006): finding that the filing of bankruptcy by the sole member of the LLC dissolved the LLC by operation of law, but chapter 7 trustee “resuscitated the LLC by filing an amendment to the operating agreement.”
D. In re Clinton Court, 160 B.R. 57 (Bankr. E.D. Pa. 1993): general partner’s prior filing of a bankruptcy petition did not dissolve general partnership and, therefore, did not bar non-debtor general partner from filing subsequent bankruptcy petition on behalf of the partnership.
E. In re Sawyer, 130 B.R. 384 (Bankr. E.D.N.Y. 1991): finding that under New York law, the filing of a chapter 7 case by the general partner resulted in dissolution of the partnership.
II. Assignment of Partnership and Membership Interests
A. Factors Considered:
· Partners and members have voluntarily associated in the business.
· Partnership/LLC often formed by personal relationships.
· Partnership/LLC often a closely held entity.
· In re Harms, 10 B.R. 817 (Bankr. D. Colo. 1981): “A general partner is in a fiduciary relationship with the limited partners. It is important that he have no conflict of interest. Moreover, an agreement among partners is unique in the law. It is not only a legal relationship, but it is also a personal relation or status, somewhat as marriage is a relation or status.”
B. Colorado law.
· Colo. Rev. Stat. § 7-80-702(1). Interest in limited liability company - transferability of interest
(1) The interest of each member in a limited liability company constitutes the personal property of the member and may be assigned or transferred. Unless the assignee or transferee is admitted as a member, the assignee or transferee shall only be entitled to receive the share of profits or other compensation by way of income and the return of contributions to which that member would otherwise be entitled and shall have no right to participate in the management of the business and activities of the limited liability company or to become a member.
C. Economic rights/benefits v. management rights: Upon Chapter 7 bankruptcy filing, what rights does Chapter 7 Trustee have?
· In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003): Court held that where there are no other members in the LLC, the entire membership interest transferred to the bankruptcy estate and Chapter 7 trustee becomes a substituted member. However absent consent by the other members, trustee may only have economic rights to participate in profits and other compensation or return of contributions.
D. Other Jurisdictions:
· In re Garrison–Ashburn, L.C., 253 B.R. 700 (Bankr. E.D. Va. 2000): “[t]here is no question that the economic rights, that is the membership interest, becomes property of the estate.”
· In re Warner, 480 B.R. 641 (Bankr. N.D. W. Va. 2012): non-economic rights and economic rights (ability to receive distributions from LLC) were included in “property of the estate.”
E. Transferability of debtor’s management rights depends on a variety of factors, including:
· Nature of the operating agreement
· Whether the agreement is an executory contract
· Whether partners and members can be compelled to accept performance from a third party and whether there are any unique aspects of partnership/LLC and/or partner/manager
· Case law precedent/jurisdiction
· Whether any party objects
F. Cases Regarding Transfer of Management Rights
· In re Jundanian, 2012 WL 1098544 (Bankr. D. Md. Mar. 30, 2012): finding that the provisions in the Maryland Act providing that a person ceases to be a member of a LLC when they file bankruptcy were invalid and concluding that the management rights were estate property.
· In re Pickel, 487 B.R. 289 (Bankr. D.N.M. 2013): finding that debtor’s bankruptcy filing did not diminish debtor’s membership or management rights or interests in wholly owned LLC.
· In re First Protection, Inc., 440 B.R. 821 (9th Cir. BAP 2010): concluding debtor’s contractual rights and interests in LLC became property of the estate.
· In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003): finding that because there were no other members in the LLC, the trustee obtained all of the debtor’s rights, including the right to manage the LLC.
· In re Milford Power Company v. PDC Milford Power, 866 A.2d 738 (Del. Ch. 2004): finding clause that deprived debtor minority member of its ability to participate as a member in the governance of the LLC enforceable and discussing the policy justifications for such clauses.
· In re Modanlo, 412 B.R. 715 (Bankr. D. Md. 2006): finding trustee could continue to participate in management, but noting the result may have been different if there were other members.
III. Transfer of Economic Interests
A. General rules
1. The interest of a general partner/manager in the partnership/LLC (i.e., profits and surplus) is property of the estate under section 541 of the Bankruptcy Code.
2. The trustee generally will be authorized to transfer partner/member economic interests – e.g., interests in profits – although the transfer generally remains subject to the terms and conditions of the agreement and/or applicable non-bankruptcy law.
B. Cases
1. In re Soderstrom, 484 B.R. 874 (M.D. Fla. 2013): finding bankruptcy trustee could sell debtor’s economic interest in LLC.
2. In re A.F. Evans Co., Inc., 2009 WL 2821499 (Bankr. N.D. Cal. June 23, 2009): concluding that “there is legal authority to support the proposition that a prohibition on assignment is not enforceable in the context of a bankruptcy filing where the identity of the contracting party is not material to the contract, i.e., where only an economic interest is being assigned” (internal citations omitted).
3. Baldwin v. Wolff, 690 N.E. 2d 632 (Ill. App. 1998): finding bankruptcy trustee could assign limited partner’s right to distributions.
4. In re Dean, 174 B.R. 787 (Bankr. E.D. Ark. 1994): finding that the restrictions contained in agreement related to the transfer of interests were not invalidated by any provision of Bankruptcy Code.
IV. Right of First Refusal
A. General rules. Rights of first refusal are generally enforceable unless triggered by the bankruptcy.
B. Cases.