Bankruptcy Issues in Partnership and Limited Liability Company Cases by gregory1


									FEBRUARY 2000

Bankruptcy Issues in Partnership
and Limited Liability Company Cases
                                       by T. Randall Wright and Joyce A. Dixon

“UPA” refers to the Uniform Partnership Act (1914 Act), 6 U.L.A. 125; “ULPA,” to
the Uniform Limited Partnership Act (1916 Act); 6 U.L.A. 305; “RULPA,” to the
Revised Uniform Limited Partnership Act (1976), with 1985 Amendments, 6A
U.L.A. 1; and “LLC,” to limited liability company.

A. The Bankruptcy Law Environment

1. Introduction. Today’s bankruptcy laws were designed to allow a business or
individual to either rehabilitate its finances through a reorganization or liquidate
its assets to obtain a “fresh start.” Chapters 7 and 11, which are the only Chapters
which are available to a non-farming partnership or limited liability company,
were established with passage of the 1978 Bankruptcy Code. Before 1978, the old
Bankruptcy Act, passed in 1898, provided the legal structure for insolvency pro-
ceedings in the U.S. Since 1978, the Bankruptcy Code has been amended several
times, but most original provisions have remained intact.

T. Randall Wright is a partner in the Omaha, Nebraska, firm of Baird, Holm, McEachen, Pedersen,
Hamann & Strasheim. He is a member of the American Bankruptcy Institute. Joyce A. Dixon is a
partner in the Omaha, Nebraska, firm of Betterman & Dixon. She is a former president of the
Nebraska Women’s Foundation.
     A complete set of the course materials from which this outline was drawn may be purchased
from ALI-ABA. Call 1-800-CLE-NEWS, ext. 7000, and ask for CD83.

6 ALI-ABA Course Materials Journal                                        February 2000

2. Interaction with Partnership Laws. In most respects, the Bankruptcy Code does
   not distinguish partnerships or limited liability companies from other busi-
   ness associations. Rather, the focus of the laws is on giving the debtor entity
   the statutory tools it needs to recover financially, or to allow it to end its busi-
   ness in a way that benefits its creditors. There are, however, some provisions
   dealing with specific partnership issues. These will be dealt with later in this
   outline. The Bankruptcy Code does not currently deal with LLCs. Unless and
   until the Bankruptcy Code is amended to give additional guidance, we can
   anticipate that the courts will make analogies both to corporations and part-
   nerships when dealing with LLCs, depending upon the facts and circum-
   stances of each issue.

3. As practitioners know, partnerships and limited liability companies are creat-
   ed and governed for the most part by state laws. In most states, UPA and
   ULPA are the controlling statutes. LLC statutes vary significantly from state
   to state. In addition, each state has a body of common law that has grown up
   around those statutes. The Bankruptcy Code, however, preempts inconsistent
   state law. The sometimes “tortuous interaction” between the Bankruptcy
   Code and state partnership law has plagued bankrupt parties, their counsel,
   creditors, and the bench for years. Stephen H. Case, Jennifer C. Frasier and
   George H. Singer, Proposal to the National Bankruptcy Review Commission, May
   1997. The result has been inconsistent court decisions dealing with some of
   the most basic issues lawyers encounter in this area.

4. This outline will summarize the current bankruptcy law as it relates to part-
   nerships and LLCs, highlight common issues about which practitioners
   should be aware, and discuss recent cases that relate to these issues. The
   authors gratefully acknowledge the work of many who have previously writ-
   ten extensively on these issues, and whose writings served as valuable
   resources, including Gerald K. Smith, who prepared exhaustive materials for
   this program for many years before stepping down in 1997; Robert J. Keach,
   “Partner and Partnership Bankruptcy, a Survey and Analysis of Case Law
   and Proposed Amendments to the Bankruptcy Code,” published in the 1996
   ABI Winter Leadership Conference materials, and Deborah L. Fletcher,
   Partnership and Limited Liability Entities in Bankruptcy (October 1996).

B. Key Concepts in Understanding Bankruptcy Law

1. For those who could benefit from a brief refresher course on bankruptcy prin-
   ciples, the next few pages of this outline are devoted to the basic concepts
   needed to understand this area.
                                                                   Bankruptcy Issues 7

2. The Bankruptcy Estate. Upon the filing of a petition, a bankruptcy “estate” is
   born, consisting of all of the equitable and legal interests the debtor has or can
   claim, including property rights, contractual rights, and causes of action
   including certain special causes of action that the Bankruptcy Code gives the
   estate to help recover assets. Because of Congress’s desire to create a central
   forum for fair distribution of assets, both the Bankruptcy Code and the cases
   are far-reaching in characterizing assets as part of the estate. 11 U.S.C. §541.

3. The Automatic Stay. Once a bankruptcy petition is filed, and for the duration
   of the case, creditors are prohibited from taking action against the debtor or
   its assets to collect debts, enforce liens, obtain collateral, or otherwise improve
   on their pre-petition position, unless the bankruptcy court gives its permis-
   sion after notice and a hearing. 11 U.S.C. §362.

4. Management of the Estate. The estate is managed by either a trustee appointed
   by the court, or, in a Chapter 11 case, by the debtor itself, who is referred to as
   the “debtor in possession.” Its duty is to serve the estate for the benefit of cred-
   itors. This duty may run contrary to management’s instincts, because man-
   agement tends to want to serve the owner of the business.

5. Executory Contracts. Most courts define executory contracts (as that term is
   used in the Bankruptcy Code) as contracts under which material performance
   by both sides remains and is required. To facilitate a fresh start or reorganiza-
   tion, the Bankruptcy Code, 11 U.S.C. §365, permits the trustee or debtor in
   possession to either assume or reject executory contracts. An assumption by
   the debtor generally requires the cure of pre-petition contract defaults. The
   court can approve assumption by the debtor or trustee even without the other
   contracting party’s consent, under certain circumstances. A rejection gives the
   contracting party a pre-petition unsecured claim for damages, but may free
   the debtor from burdensome obligations under the contract. Executory con-
   tracts for a partnership may include management agreements, real or per-
   sonal property leases, service contracts, and the partnership agreement itself.

6. Ipso Facto Clauses. Contract clauses or state laws designed to effect a forfei-
   ture or modification of the debtor’s rights when a bankruptcy is filed are
   referred to as “ipso facto clauses.” These include, for example, provisions
   for automatic default when a party to the contract files for bankruptcy.
   These clauses are rendered largely unenforceable by the Bankruptcy Code,
   which refers to them in five places: 11 U.S.C. §§363(1), 365(e)(1),(2), 365(f)-
   (1),(3), and 541(c)(1)(B).

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