Partnerships

PARTNERSHIPS

Partnership as Debtor

The partnership is an ancient business form that comes in all shapes and sizes, running the gamut from a simple two-person enterprise to a huge professional partnership. ⁽⁹⁰⁰⁾ Certain partnership traits, however, are consistent regardless of a partnership's complexity. For example, under state law, general partners are liable (with certain exceptions) for the debts of the partnership. ⁽⁹⁰¹⁾ When a partnership is in bankruptcy, the estate has a claim against each general partner for some or all of the partnership debts. Due to the interlocking liability between the general partners and the partnership, encouraging consensual negotiations and exchange of information between general partners, the estate (either represented by a trustee or by the debtor in possession), and creditors inures to the benefit of all parties in interest. Clarifying and balancing the rights and liabilities between these three competing groups in a partnership bankruptcy case is the focus of the recommendations in this area.

RECOMMENDATIONS

2.3.1 Defining the term "General Partner"

A "general partner" should be defined under 11 U.S.C. § 101 as any entity that as a result of an existing or former status as an actual or purported general partner in an existing, former, predecessor, or affiliated partnership, is liable under applicable nonbankruptcy law for one or more debts of the partnership.

2.3.2 Consent of Former Partners

The Bankruptcy Code and Rules should be amended to clarify that, notwithstanding Recommendation 1 (defining "general partner"), a former general partner of a partnership is not, absent a specific court order to the contrary, required to consent to a voluntary petition by a partnership, to be served with a petition or summons in an involuntary case against a partnership, or to perform the duties of disclosure or procedural duties imposed on a general partner of a debtor partnership.

2.3.3 Bankruptcy Court Jurisdiction

The court in which a partnership case is pending should have jurisdiction under 28 U.S.C. § 1334(b) to determine who is or may be liable as a general partner for the debts of the partnership and may determine the rights among the general partners with respect to the debts of the partnership. Such matters should constitute core proceedings under 28 U.S.C. § 157(b).

2.3.4 Liability of General Partner for Deficiency in Partnership Case

If there is a deficiency of property of the partnership estate to pay in full all allowed claims in a case under title 11, the estate should have a claim against each general partner to the extent that, under applicable nonbankruptcy law, such general partner is personally liable for such deficiency. The amount of the deficiency claim should not be reduced on account of any right of contribution or indemnity among general partners. The claim should be estimated if its determination would unduly delay the administration of the case. Any action or proceeding to enforce liability under this section should be commenced no later than four years after the entry of the order for relief in the case concerning the partnership.

2.3.5 Power of the Court to Assure Payment of the Deficiency

Renumbered section 723(b) of the Bankruptcy Code should be amended to provide that the court in a partnership case may, after notice and a hearing, order any general partner that is not a debtor in a case under this title (1) to provide the estate, in such amount as the court shall determine to be appropriate under the circumstances, with indemnity for, or assurance of payment of, any deficiency recoverable from such general partner, or (2) not to incur obligations or transfer property except under specified circumstances.

2.3.6 Trustee's Recovery against the Estate of a Debtor General Partner

Renumbered section 723(c) of the Bankruptcy Code should be amended to provide that notwithstanding section 728(c), the trustee of a partnership has a claim against the estate of each general partner in such partnership that is a debtor in a case under title 11 for (1) the full amount of all claims allowed in the case concerning the partnership for which such general partner would otherwise be personally liable as a general partner under applicable nonbankruptcy law; and (2) administrative claims which have been assessed against such general partner. Notwithstanding section 502 of this title, there shall not be allowed in such partner's case a claim against the partner on which both the general partner and the partnership are liable, except to the extent that such claim is allowable and secured only by property of such general partner and not by property of such partnership.

2.3.7 Repeal of the "Jingle Rule" in All General Partner Bankruptcy Cases

Chapter 5 of the Bankruptcy Code should be amended in order to provide that the claim of a trustee of a partnership debtor, or the claim of a creditor of a nondebtor partnership, is entitled to share in the distribution in a general partner's bankruptcy case in the same manner and to the same extent as any other claim of the same class of a creditor of such general partner.

2.3.8 Allocation of Expenses of Administration of a Partnership Case

Chapter 5 of the Bankruptcy Code should be amended to provide that the expenses of administration of a partnership case under section 503 of the Bankruptcy Code may be assessed against general partners or paid from the property constituting recoveries from general partners under this section and from other property of the estate in such proportions as the court shall determine are fair and reasonable after notice and hearing.

2.3.9 Distribution of Recoveries from General Partners

Renumbered section 723 of the Bankruptcy Code should be amended to provide that notwithstanding section 726 of the Bankruptcy Code (except as provided in Recommendation 2.3.8 above), the trustee should apply any recovery obtained from a general partner or the estate of a general partner only to the payment of deficiencies on claims for which such general partner is personally liable as a general partner under applicable nonbankruptcy law. Any property constituting recoveries from general partners or the estates of general partners under this Recommendation not applied to the proper deficiencies as herein provided or to administration expenses (as provided in Recommendation 2.3.8 above), should be equitably distributed by the trustee to such general partner or to such general partners' estates as may be ordered by the court after notice and hearing.

2.3.10 Distribution of Property of the Partnership Estate

Renumbered section 723 of the Bankruptcy Code should be amended to provide that notwithstanding section 726 of the Code, and except as set forth in Recommendation 2.3.8 above (treatment of expenses of administration), the trustee should distribute property of the partnership estate which is not recovered from general partners or the estates of debtor general partners to allowed claims against the partnership in accordance with otherwise applicable provisions of this title without considering distributions of property from general partners or general partners' estates.

2.3.11 Trustee's Power to File Involuntary Cases

Section 303(b)(3) of the Bankruptcy Code should be amended to permit the trustee of a partnership in a case commenced under title 11 to file an involuntary petition against a general partner without regard to the number of creditors, nature of the claims or dollar amount of the claims otherwise required under section 303(b)(1) and (2).

2.3.12 Appointment of Committee of General Partners

Chapter 11 of the Bankruptcy Code should be amended to provide that, on request of a party in interest, the court may authorize the United States trustee to appoint a committee of general partners that is fairly representative of the interests of all general partners.

2.3.13 General Partner Liability on Nonrecourse Partnership Debt under 11 U.S.C. § 1111(b)

Section 1111(b) of the Bankruptcy Code should be amended to clarify that, except as otherwise provided in a confirmed plan of a partnership debtor or the order confirming the plan, a general partner is not liable on a nonrecourse claim against the partnership except to the extent that the general partner is personally liable on such claim under applicable nonbankruptcy law.

2.3.14 'Temporary' Injunction of Proceedings or Acts against Nondebtor General Partners

The Bankruptcy Code should be amended to permit the court for cause, upon motion of a party in interest and after notice and hearing, to temporarily enjoin actions of creditors or general partners of a debtor partnership against nondebtor general partners or their property on account of partnership obligations. No injunction should be granted under this Recommendation unless the nondebtor general partner (1) consents to the jurisdiction of the bankruptcy court; (2) makes or undertakes to make the disclosures required by Recommendation 2.3.18 below; and (3) the order granting the injunction precludes the protected general partner from incurring obligations or transfers of property except under specified circumstances.

2.3.15 Relief from the Temporary Injunction

The Bankruptcy Code should be amended to provide that the court, upon request of a party in interest and after notice and hearing, may, for cause, grant relief from the temporary injunction provided pursuant to Recommendation 2.3.14 . The relief available would include the termination, annulment, modification or conditioning a continuation of the injunction.

2.3.16 'Postconfirmation' Injunction of Proceedings or Acts against Nondebtor General Partners Who Contribute to Plans

The Bankruptcy Code should be amended to permit the court, in connection with the confirmation of a plan of reorganization in a partnership case, to enjoin partnership creditors and general partners from actions or proceedings against a general partner or its property to collect on partnership-related claims where the general partner has contributed or made an enforceable commitment to contribute an amount to the payment of debts in accordance with the plan or the order confirming the plan. The court, after notice and hearing, must determine that the plan complies with otherwise applicable requirements for confirmation in light of the personal assets of the nondebtor contributing partners and that the injunction will not discriminate unfairly or inequitably with respect to creditors of the partnership or the claims of the general partners for contribution or indemnity.

2.3.17 Revocation of Injunction

The Bankruptcy Code should be amended to provide that the injunction issued with respect to any nondebtor general partner under Recommendation 2.3.16 above should be terminated or revoked on the request of a party in interest if, after notice and hearing, the court determines (1) that the protected nondebtor general partner has failed to perform a material commitment under the plan; (2) that the order confirming the plan in which the injunction was issued is revoked under sections 1144 or 1230 of the Code; or (3) that the nondebtor general partner has procured the injunction by fraud. The Bankruptcy Code should be further amended to provide that a request for revocation for fraud under provision (3) should be made at any time within two years after the date of the entry of the confirmation order.

2.3.18 Duty of Disclosure by Nondebtor General Partners

The Bankruptcy Code should be amended to provide that, unless otherwise ordered by the court for cause, each nondebtor general partner shall, within 30 days after the entry of the order for relief in a partnership case or within such time as the court shall fix, produce information concerning such partner's financial condition and affairs similar to that provided by a debtor, together with such additional information and periodic reports as may be required by the court from time to time.

2.3.19 Access to Disclosed Information

The Bankruptcy Code should be amended to provide that the trustee, debtor in possession or other entity designated by the court in a partnership bankruptcy case should maintain and promptly provide to parties in interest in the case, on reasonable request, certain important information regarding the nondebtor general partners of the debtor partnership.

DISCUSSION

Under the Bankruptcy Act of 1898, few partnerships sought bankruptcy relief. ⁽⁹⁰²⁾ As a result, "[a]n opportunity was missed in the 1970s to do something about partners and partnerships. At that time the issues were mostly academic."⁽⁹⁰³⁾ The 1970 Commission focused on the three partnership issues that required clarification: (1) the test for filing an involuntary petition against the partnership; (2) the definition of partnership insolvency; and (3) the abolition of the "jingle rule."⁽⁹⁰⁴⁾

Since the 1978 Bankruptcy Code, the use of partnerships as well as the partnership form has changed substantially ⁽⁹⁰⁵⁾ and the Bankruptcy Code does not adequately address the complex issues that can arise when a bankruptcy petition is filed by or against a partnership. Indeed, the Code makes a few brief references aimed at issues arising in connection with the bankruptcy of a partnership. ⁽⁹⁰⁶⁾ The proposals and analysis with respect to the Recommendations adopted by the Commission are set forth below and represent a comprehensive framework to deal with partnership bankruptcies.

Three fundamental principles provide the basic framework for the Recommendations. First, it is axiomatic that under state law general partners are personally liable for some or all of the debts of the partnership. ⁽⁹⁰⁷⁾ A creditor of the partnership therefore has special recourse against a general partner transcending the relief ordinarily available to the general creditors of a corporation. It is essential for the Bankruptcy Code to recognize the obligations of general partners to the partnership creditors and to one another. Currently, the Bankruptcy Code fails to adequately address the rights and liabilities of general partners where the partnership is a debtor under Chapter 11 or 12. ⁽⁹⁰⁸⁾ With the exception of a single subsection, all of the Code provisions relating to the rights and liabilities of the partners and the partnership are generally limited to Chapter 7 cases. ⁽⁹⁰⁹⁾ A clear mechanism is needed for providing a complete resolution of the liability of general partners to partnership creditors (and the related contribution and indemnity claims of and against general partners ⁽⁹¹⁰⁾) in connection with the bankruptcy case of the partnership. Such a mechanism should provide rules that govern both liquidation and reorganization.

Second, creditors of the partnership should first look to the assets of the partnership before proceeding against general partners under certain circumstances. This is particularly true if such sequencing can be accomplished with minimal risk to the partnership creditors. While the individual liability of general partners to the partnership creditors must be recognized and protected, there are often sound reasons to sequence the rights of partnership creditors.

Third, where the general partners have sufficient resources to satisfy any portion of the deficiency of partnership assets to pay partnership obligations, providing general partners with the incentive to contribute to a plan of reorganization can provide a greater return for creditors. Thus, a collective proceeding in which the liability of nondebtor general partners can be resolved is advantageous. The alternative is that the partnership trustee and partnership creditors remain relegated under nonbankruptcy law to engage in the costly pursuit of individual general partners in an attempt to recover from nonexempt assets. The often inevitable result is the bankruptcy filing of general partners who may be located in different jurisdictions, increasing the cost of collection.

2.3.1 Defining the term "General Partner"

Rationale. Although the Bankruptcy Code declares that a partnership is a "person"⁽⁹¹¹⁾ and as such is eligible for relief, ⁽⁹¹²⁾ nowhere is the term "general partner" defined despite the Code's repeated reference to a "general partner". ⁽⁹¹³⁾ Indeed, the Bankruptcy Code, among other things, specifically authorizes an involuntary case to be commenced against a partnership by less than all of the general partners. ⁽⁹¹⁴⁾ The law is simply unclear as to whether the Code's provisions aimed at addressing the liabilities and claims by or against a general partner are applicable in specific contexts. ⁽⁹¹⁵⁾ The Commission's Recommendations for the treatment of debtor partnerships provide a comprehensive framework to establish the rights and liabilities in bankruptcy of these often complicated relationships. ⁽⁹¹⁶⁾ A necessary step to achieving this clarification is a definition of those persons to whom these provisions apply. The Recommendation is aimed at providing clarity and certainty by defining "general partner."

The term "general partner" under the Recommendation would include any entity that is liable for the debts of the partnership by virtue of applicable nonbankruptcy law. Whether an entity was a general partner at the time of the partnership's bankruptcy filing is not material. As long as an entity has general partner liability for a prepetition debt, that entity qualifies as a general partner under the Recommendation. Because the definition is a status-based definition, the term does not include an entity that may be liable solely by virtue of guaranteeing a partnership obligation. Partnership guarantors are not generally considered "partners" under state law and the Recommendation is consistent with that state law result. Included within the definition of the term "general partner," however, is any entity liable as a general partner by estoppel, ⁽⁹¹⁷⁾ as an implied general partner or otherwise under nonbankruptcy law. A limited partner, as a consequence of exercising management control or by virtue of estoppel, is also included in the definition if liability for partnership debts would attach under nonbankruptcy law. ⁽⁹¹⁸⁾

Designation under the Recommendation as a "general partner" does not alter the general partner personal liability rules under nonbankruptcy law. ⁽⁹¹⁹⁾ As a result, a person that is admitted as a general partner in an existing partnership generally would not, under nonbankruptcy law, be personally liable for partnership obligations incurred prior to admission. ⁽⁹²⁰⁾ Similarly, the personal liability of a former partner for the obligations of the partnership or any deficiency arising after withdrawal is generally limited. ⁽⁹²¹⁾

Competing Considerations. It may be argued that the Bankruptcy Code should not provide a specific definition of a "general partner" because the determination of who is liable as a general partner is governed by nonbankruptcy law. ⁽⁹²²⁾ Moreover, the authorities appear to be generally in accord with respect to such a determination. ⁽⁹²³⁾ There may be a risk that a Bankruptcy Code definition could create problems and uncertainty and that any definition of partner should, accordingly, be left up to state law.

2.3.2 Consent of Former Partners

Rule 1004(a) of the Federal Rules of Bankruptcy Procedure requires "all" general partners to consent to a voluntary petition filed by or on behalf of the partnership. Similarly, Rule 1004(b) requires a copy of an involuntary bankruptcy petition filed against a partnership under section 303 of the Bankruptcy Code and the summons to be served on "each" general partner who is not a petitioner. ⁽⁹²⁴⁾ Rule 1007(g) imposes various procedural requirements on general partners of a debtor partnership, such as preparing and filing the partnership schedules.

Rationale. This Recommendation is animated by the broad definition of a "general partner" set forth in Recommendation 1, which includes "former" partners in certain circumstances. Bankruptcy Rule 9001(5) defines a debtor for purposes of administrative responsibility to include "any or all general partners or, if designated by the court, any other person in control."⁽⁹²⁵⁾

The Recommendation clarifies that the expanded definition of "general partner" is not intended to encumber the commencement of voluntary or involuntary bankruptcy cases by or against a partnership by involving partners that have withdrawn from the partnership in the pleadings and service of process. ⁽⁹²⁶⁾ Likewise, the Recommendation does not impose disclosure duties on former partners. The Recommendation does, however, give the court the discretion to direct such former partners to comply with the procedural and disclosure requirements of the Code and Rules in appropriate circumstances.

Competing Consideration. Under state partnership law, former partners are not usually considered general partners for any purpose other than determining partnership liability. Thus, it is arguable that this Recommendation is unnecessary. However, given the general partner definition proposed in Recommendation 1 as well as the Recommendations requiring disclosure, this Recommendation clarifies the obligations of former partners.

2.3.3 Bankruptcy Court Jurisdiction

Rationale. Values are maximized by providing a single, unitary forum for resolving the obligations of the general partners to the debtor partnership, the partnership creditors, and to each other. ⁽⁹²⁷⁾ The Recommendation confers jurisdiction on the bankruptcy court in which a partnership case is pending to determine the obligations of general partners to the trustee (or the partnership as debtor in possession) and to each other by reason of contribution or indemnification in connection with partnership liabilities. The Recommendation also provides that the determination of liability of general partners for partnership debts is a core proceeding.

General partners are individually liable for the full amount of any deficiency in partnership assets to pay the claims of partnership creditors. As a result, a Chapter 7 partnership trustee has a claim against each general partner for this deficiency amount. Current law does not facilitate (and may undermine) the trustee's recovery of the deficiency amount from general partners. ⁽⁹²⁸⁾ General partners have been able to avoid liability for partnership debts for a variety of reasons, including

(1) delays inherent in the Chapter 11 process; (2) obtaining a section 105 injunction against actions against general partners on debts of or related to the partnership; (3) uncertainty regarding the ability of a partnership trustee to pursue general partners with respect to their obligations to partnership creditors; (4) failure of the partnership debtor in possession to pursue the estate's rights against its general partners; and (5) confirmation of plans which attempt (whether or not effectively) to prevent pursuit by partnership creditors of their claims against general partners by various discharge, injunction or compromise provisions. ⁽⁹²⁹⁾

The logical place to centralize determination of the rights and liabilities of partners to partnership creditors as well as to each other is in the partnership's bankruptcy case. Commentators agree that granting the bankruptcy court authority to hear and determine these issues would centralize the process in a cost-effective manner by preventing general partners from circumventing or delaying payment of their obligations to partnership creditors. ⁽⁹³⁰⁾ The Recommendation centralizes this authority in the bankruptcy court in an effort to reduce the cost of collecting deficiency amounts from general partners.

Competing Consideration. The Recommendation confers broad jurisdiction on the bankruptcy court to adjudicate claims by or against the general partnership estate as well as disputes among nondebtor general partners, by designating such matters core proceedings. Constitutional concerns may arise in the context of adjudicating contribution claims among nondebtor general partners who have not filed proofs of claim or otherwise consented to the jurisdiction of the bankruptcy court. ⁽⁹³¹⁾ This concern would, however, be substantially vitiated if Congress adopts the Commission's Recommendation with respect to reconstituting bankruptcy courts under Article III of the Constitution.

2.3.4 Liability of General Partner for Deficiency in Partnership Case

Rationale. A basic principle of partnership law is that general partners are personally liable for some or all of the debts of the partnership. ⁽⁹³²⁾ Section 723 explicitly recognizes and preserves this principle in Chapter 7 cases filed by or against a partnership. This Recommendation is an adaptation of section 723(a) and holds general partners responsible to the extent liable under nonbankruptcy law. A number of clarifications to existing law are made and the Recommendation clarifies its application to Chapters 11 and 12 of the Code. For clarity and efficiency, section 723 should be repealed in its entirety and reincorporated into Chapter 5 of the Code. ⁽⁹³³⁾

The Recommendation has four components:

a. Contribution or Indemnity Claims Not Considered

The Recommendation delineates the rights of the partnership trustee against a general partner upon the commencement of a case by or against a partnership. The first sentence of the Recommendation is virtually identical to section 723(a), except that contribution or indemnity claims by or against general partners are not to be considered in determining the partnership trustee's claim against a particular general partner. Thus, the liability of a general partner to a partnership creditor is not affected by that partner's rights against the other general partners. This is consistent with the result under nonbankruptcy law that does not limit the liability of a partner to a partnership creditor. A partner who satisfies a judgment greater than the amount of the partner's liability has a separate claim for contribution or indemnification against the other partners.

b. Estimation of Deficiency Claim of the Estate

Recovery from a general partner under section 723(a) of the Code (and this Recommendation) is limited by the amount of the deficiency of the partnership assets to pay allowed claims against the partnership estate. Thus, a final determination of that deficiency must await until an advanced stage of the case. A determination generally becomes possible only after the administration of the estate. The Recommendation therefore amends the statute and permits the court to estimate the amount of the deficiency of the estate when deferral of that determination would either unduly delay the administration of the estate or unduly prejudice the trustee's ability to recover on the claim. ⁽⁹³⁴⁾

This aspect of the Recommendation is not a foreign concept but, rather, employs the same standard used in connection with the estimation of unliquidated or contingent claims against the estate for purposes of allowance under section 502(c)(1) of the Code. ⁽⁹³⁵⁾ Estimation is used in bankruptcy cases to estimate claims for purposes of plan negotiation, voting, and distribution under a plan. The Recommendation contemplates that estimation of a partnership estate's claim would be binding on the parties to the same extent that estimation of a claim against the estate would be binding in other contexts under the Bankruptcy Code.

c. Statute of Limitations

The Recommendation resolves the conflict in the courts as to the applicable limitations period under section 723(a) of the Code. Some courts have treated the partnership trustee's claim as one asserted under section 544(a), and thus subject to the two-year limitations period provided for avoidance actions under section 546. ⁽⁹³⁶⁾ The Recommendation adopts a four-year limitations period because a claim under section 723(a) does not accrue until after the trustee has had an adequate opportunity to determine the assets of, and the claims against, the partnership's bankruptcy estate. As previously indicated, the determination of the deficiency only becomes clear in most cases at an advanced stage of the case after a considerable amount of time has elapsed. A four-year statute of limitations should allow enough time for a trustee to determine the amount of a section 723(a) claim against the general partner.

Competing Consideration. The determination of the deficiency claim generally is made at an advanced stage of the case, after all partnership assets have been distributed to creditors and the trustee is able to calculate any deficiency. It may be argued that a "four-year" statute of limitations will not encourage early resolution of claims against the partnership. The Recommendation under subsection (b) supra should limit delay as a result of a long statute of limitations.

d. Application of Section 723(a) Principles to All Chapters of the Code

The Recommendation expressly clarifies the application of section 723(a) under current law. Section 723 currently applies only in Chapter 7 partnership cases. ⁽⁹³⁷⁾ The "best interests of creditors" test embodied in sections 1129(a)(7) and 1225(a)(4), however, makes the principles embodied in section 723 relevant in Chapter 11 and 12 cases. The best interests test requires, as a condition of plan confirmation, that each holder of an impaired claim either accept the plan or "receive or retain" as much as the holder would receive had the case been liquidated under Chapter 7. If a partnership reorganization case is commenced under Chapter 7, the Chapter 7 trustee would have the authority to seek payment from the general partners on behalf of the partnership estate. As a result of this interplay, a number of courts determine the extent of recovery that would be available to a Chapter 7 trustee against the general partners and require that objecting partnership creditors actually receive at least as much or more in order to satisfy the "best interest of creditors" test. ⁽⁹³⁸⁾ Other courts have concluded that recovery under section 723(a) need not be considered if the plan preserves the right of partnership creditors to enforce their state law rights against the general partners. ⁽⁹³⁹⁾

The case law is unclear with respect to whether the debtor partnership estate (under any chapter of the Code) includes the right to enforce the obligation of general partners to contribute to the partnership in order to satisfy its liabilities. Some courts have construed the broad language of section 541(a) and the joint and several liability provisions of the uniform partnership laws to empower a debtor in possession in a partnership case to compel contributions from each general partner to satisfy the claims of the partnership. ⁽⁹⁴⁰⁾ Other courts refuse to grant relief against general partners to partnership creditors in reorganization cases. ⁽⁹⁴¹⁾

Current law is ambiguous as to whether general partners must pay partnership obligations for which they are personally responsible in connection with partnership bankruptcy cases filed under any chapter other than Chapter 7. ⁽⁹⁴²⁾ The Recommendation clarifies the present uncertainty by extending the principles embodied in section 723(a) to Chapters 11 and 12. The general partner's nonbankruptcy law liability is preserved and subject to administration in the partnership bankruptcy case.

By providing a single forum to resolve outstanding disputes, the Recommendation affords the debtor partnership, the general partners and the creditors an opportunity to effectuate a complete adjudication of their rights and responsibilities in connection with the partnership.

Competing Consideration. In a Chapter 7 proceeding, the trustee is generally required to pursue the nondebtor general partners to satisfy deficiency claims. ⁽⁹⁴³⁾ The Recommendation, although applicable in reorganization cases, is not couched in mandatory language as applied in the context of a reorganization. It can be argued that it is doubtful that a debtor in possession will diligently pursue deficiency claims against the general partners of the debtor partnership. The argument and concern is similar to that raised where avoidance actions are not pursued against insiders, affiliates or significant creditors. However, partnership creditors are afforded a number of protections. First, as noted, the Recommendation resolves the present uncertainty with respect to the "best interests of creditors" test. Second, the requirement that the plan be proposed in "good faith" can serve as a realistic check against undue self-interest. Third, creditors may seek the appointment of a trustee or seek to prosecute such actions for the benefit of the estate. Thus, objecting creditors will have the ability to force the debtor in possession to pursue claims against partners.

2.3.5 Power of the Court to Assure Payment of the Deficiency

Section 723(b) governs the determination of a deficiency claim in a partnership bankruptcy case. The statute directs the trustee first to seek recovery of any deficiency from a nondebtor general partner. The purpose of such a requirement is to direct the trustee toward nonbankrupt general partners first, to the extent that recovery is possible, prior to seeking recovery from debtor general partners. Section 723(b) requires a trustee to seek recovery against nondebtor general partners, however, only "to the extent practicable."⁽⁹⁴⁴⁾

The statute is designed to preserve the status quo. In order to preserve the value of the estate's claim against the general partner's assets, the court must be able to exercise a certain amount of control over those assets. Section 723(b) grants the court authority to order, in appropriate circumstances, any general partner to provide the estate with indemnity for, or assurance of payment of, any deficiency recoverable from the partner. Therefore, the bankruptcy court has the authority to require a nondebtor partner to post a bond or security to ensure that the rights of the partnership trustee do not materially deteriorate during the pendency of the partnership case. The section also permits the court to issue an injunction ordering the nondebtor general partner "not to dispose of property."⁽⁹⁴⁵⁾ The bankruptcy court's power to restrain a nondebtor general partner from depleting assets pending the administration of the partnership case is generally recognized. ⁽⁹⁴⁶⁾

Rationale. The Recommendation is an adaptation of current law. ⁽⁹⁴⁷⁾ The rights of a partnership trustee against nondebtor general partners for the claims of partnership creditors are preserved during the pendency of the case. ⁽⁹⁴⁸⁾ The changes to current law are essentially two-fold. First, the first sentence of section 723(b) and the requirement that the trustee must first seek recovery of any deficiency against nondebtor general partners is deleted. The remaining aspects of other Recommendations make a requirement that the trustee pursue deficiency claims against nondebtor partners first unnecessary. Second, the Recommendation expands the reach of the current statute by giving the court the authority to order nondebtor general partners not to make any "transfers," as defined under the Code, or to incur any obligations other than in the ordinary course of the partner's business or for reasonably equivalent value. For example, the court could order the nondebtor partner to post a bond or other security in order to ensure payment of the deficiency. This modifies the current statute, which grants the court the authority to enjoin unauthorized dispositions of property. The Recommendation preserves the rights of partnership creditors to recover the partnership's deficiency claim against a general partner's assets. The Recommendation also is in accord with the requirements of Recommendation 16, infra, that provides for temporary injunctive relief for nondebtor general partners under certain circumstances. The rationale is that to the extent a general partner can obtain temporary injunctive relief staying the actions of partnership creditors, partnership creditors should be able to protect their interest in the general partner's assets by preventing certain types of transfers and the occurrence of certain obligations. This is the purpose of the Recommendation.

2.3.6 Trustee's Recovery against the Estate of a Debtor General Partner

The financial condition of a general partnership and the concomitant personal liabilities of general partners for the obligations of the partnership often forces a general partner to seek personal relief under the Bankruptcy Code when the partnership fails. Section 723(c) currently provides that a trustee has a claim against the estate of each debtor general partner in the partnership for the "full amount of all claims of creditors" notwithstanding section 728(c). ⁽⁹⁴⁹⁾ The trustee's rights against the estate of a debtor general partner in bankruptcy follow from the right of a trustee to pursue a nondebtor general partner for a deficiency claim under section 723(a).

Rationale. In order to resolve the uncertainty of treatment that exists under current law, the Recommendation has three-prongs. First, section 723(a) provides that the trustee may seek recovery from a nondebtor general partner only to the extent of claims against the partnership for which a partner is personally liable under nonbankruptcy law. ⁽⁹⁵⁰⁾ Section 723(c) contains no such explicit limitation. ⁽⁹⁵¹⁾ The law is unclear and arguably provides for a dichotomous treatment of partnership claims depending upon whether or not the general partner is a debtor in bankruptcy. The limitations placed on the trustee's right to recover a deficiency claim under section 723(a) were added by Congress after the promulgation of that provision. Section 723(c) was inexplicably unaltered. There is some indication, however, in the legislative history, that the failure to amend paragraph (c) was inadvertent and that Congress intended that the limitations provided in paragraph (a) would also apply to paragraph (c). ⁽⁹⁵²⁾ The Recommendation makes the two provisions consistent as it clarifies that a claim of a partnership trustee against the estate of a debtor general partner is limited to those claims that are allowed under applicable nonbankruptcy law.

Second, the Recommendation expands the trustee's claim against the general partner's estate to include the amount of administrative expense claims for which the debtor general partner would otherwise be liable. ⁽⁹⁵³⁾ As noted above, the statute currently limits the trustee's claim to the "full amount of all claims of creditors" and therefore does not include the amount of administrative expenses incurred in the Chapter 7 case. ⁽⁹⁵⁴⁾ The Recommendation provides that the trustee has a claim against "all allowed claims" in order to include administrative expense claims.

Third, the Recommendation deletes the last sentence of section 723(c), which abrogates the "jingle rule" in Chapter 7 cases. Recommendation 2.3.7 , below, addresses this issue as a separate Proposal.

2.3.7 Repeal of the "Jingle Rule" in All General Partner Bankruptcy Cases

The "jingle rule" is a rule of priority which evolved from the common law during the nineteenth century and was codified in section 5g of the Bankruptcy Act. The jingle rule was later incorporated into the Uniform Partnership Act when promulgated in 1914, so that state partnership law would correspond to bankruptcy law. ⁽⁹⁵⁵⁾ The rule provided that the partnership assets were to be distributed first to creditors of the partnership; and the assets of an insolvent general partner were to be distributed first to the personal creditors of the general partner. ⁽⁹⁵⁶⁾ Partnership creditors would be allowed to receive a distribution only if a surplus remained. Therefore, partnership creditors were, under the jingle rule, effectively subordinated to personal creditors of the general partner.

Congress specifically abrogated the jingle rule in Chapter 7 cases in the last sentence of section 723(c). ⁽⁹⁵⁷⁾ It provides that the claim of a trustee is entitled to share equally in the bankruptcy case of the general partner under section 726(a), the same as any other claim of a kind specified in that provision. The trustee's claim in the debtor general partner's bankruptcy case is not subordinate to the claims of other creditors of the general partner but, rather, has an equal priority for purposes of distribution in a Chapter 7 case. However, section 723(c) does not effectuate a wholesale repeal of the jingle rule. The provision is only applicable in Chapter 7 cases and only becomes operative when a partnership and one of its general partners is a debtor.

Rationale. The Recommendation implements the legislative intent of the drafters of section 727(c) by extending the application of the statute to the claims of partnership creditors against a debtor general partner of a partnership that is not in bankruptcy. Eliminating the "jingle rule" in all cases results in pari passu treatment of a partnership trustee with the debtor general partner's nonpartnership creditors. The proposed Recommendation provides this same treatment to creditors of a debtor general partner of a partnership that is not in bankruptcy. The same recommendation for repeal of the "jingle rule" was made by the NBC and the ABA Ad Hoc Committee. ⁽⁹⁵⁸⁾ The Recommendation also definitively extends the application of the principles of section 727(c) and the repeal of the jingle rule to all other chapters of the Code. ⁽⁹⁵⁹⁾ It therefore simplifies the application of the "best interests of the creditors" and facilitates plan confirmation.

2.3.8 Allocation of Expenses of Administration of a Partnership Case

Rationale. Under current law, the expenses of administering a partnership estate are paid out of property of the estate prior to any distributions to creditors. The Recommendation adopts the view that it may be appropriate, in certain instances, to impose a share of the expenses of administration upon former or current general partners. It is derived largely from section 5f of the Bankruptcy Act. ⁽⁹⁶⁰⁾ Disputes over responsibility for administrative costs have arisen in several of the large professional partnership cases. Creditors argue that the partnership bankruptcy case serves as a vehicle to marshal the assets of general partners in order to satisfy the claims against the general partnership as well as an avenue for resolving claims among former and current partners. Because partners benefit from this collective proceeding, the costs of administration should be borne by those who benefit. General partners often argue that "it is unfair to increase a general partner's contribution amount in situations where creditors' committee activity has been responsible for the high cost of the case."⁽⁹⁶¹⁾ The Recommendation gives the court the discretion to apportion the expenses of administration among such nondebtor partners and creditors where appropriate. This Recommendation is supported by both the ABA Ad Hoc Committee and the NBC. ⁽⁹⁶²⁾

The power to allocate administrative expenses should also serve as a disincentive for general partners to withdraw from the partnership when the bankruptcy case of a partnership is being contemplated or commenced. By assessing administrative costs against former partners where appropriate, the Recommendation discourages partners from exiting the partnership just prior to bankruptcy and thereby avoiding those costs. The Recommendation is consistent with the bankruptcy maxim that the expenses of administration should, whenever possible, be borne by the assets administered. ⁽⁹⁶³⁾

Competing Considerations. Guidelines for the allocation of administrative expenses among nondebtor parties are difficult to pinpoint. Assessing relative benefit of the administration of the case among these parties may be difficult. Current law avoids this problem by assessing the property of the estate. The Recommendation recognizes the inequity to creditors (usually unsecured creditors) in bearing the costs of administration and reallocates some of these costs in accordance with the benefit received by the nondebtor parties.

2.3.9 Distribution of Recoveries from General Partners

Rationale. The Recommendation outlines the manner by which the trustee allocates and distributes the recoveries obtained from a nondebtor general partner in a partnership bankruptcy case. Additionally, the Recommendation further implements the policy of conforming the partnership/partner provisions of the Code to the respective rights of partnership creditors and general partners under applicable nonbankruptcy law. This Recommendation has two main features:

First, the application of recoveries on account of a deficiency by a trustee from each general partner or the partner's estate is limited to the claims supporting the right to a recovery. In other words, the Recommendation specifically limits the application of any recovery on account of a general partner's deficiency to those claims that the general partner is personally liable for under applicable nonbankruptcy law, plus a proportionate share of the expenses of administration, if any, allocated by the court. The Recommendation thus recognizes that a general partner may not be liable under applicable nonbankruptcy law for all of the obligations of the partnership.

Under section 723, recoveries from a general partner or a general partner's estate are added to the bankruptcy estate of the partnership under section 541(a)(3) and included in the distributions to creditors holding allowed claims against the partnership in accordance with section 726. ⁽⁹⁶⁴⁾ There may, however, be claims against the debtor partnership for which a particular general partner is not liable under applicable nonbankruptcy law. ⁽⁹⁶⁵⁾ In such instances, the recovery from a general partner under section 723 may be used to pay claims for which the general partner is not personally responsible. Moreover, the effect of section 1111(b) on the personal liability of a general partner for a nonrecourse deficiency claim of the partnership may effectively require the general partner to pay twice. ⁽⁹⁶⁶⁾

The Recommendation preserves the principle of equality of distribution among similarly situated creditors. As a result, however, partnership creditors may receive different distributions in the partnership bankruptcy case based upon differences in their rights against general partners. Taking into account Recommendation 2.3.10 (below), governing the distribution of property of the partnership estate, each creditor of the partnership would have the right to share in two funds upon the commencement of a case by or against a partnership under Chapter 7: (1) a pro rata share in the assets of the partnership estate based upon the priority scheme set forth in the Bankruptcy Code; and (2) a pro rata share in the recovery obtained against the general partner in proportion to the partner's liability to the specific creditor under state law. Under the second fund, only those recoveries from general partners that are personally liable to that creditor would be available to pay its claim. The disparity between a creditor's rights against a general partner under applicable nonbankruptcy law in relation to other creditors determines its right to a distribution from the recovered deficiency claim. A contrary result (embodied by present law) could effectively enable a partnership creditor to enhance its recovery in bankruptcy to the detriment of other creditors.

Second, the last sentence of the Recommendation is an adaptation of current section 723(d) of the Code. The trustee may recover more from the general partners and from the estates of debtor general partners than is necessary to pay the costs of administration and the allowed claims of the partnership creditors in full. The Recommendation therefore provides a mechanism by which the court may allocate the surplus in an equitable manner based on the relative liability of each of the general partners under the partnership agreement or applicable nonbankruptcy law. ⁽⁹⁶⁷⁾

2.3.10 Distribution of Property of the Partnership Estate

Rationale. The estate of the debtor partnership may be comprised of property resulting from the recoveries by the trustee against the general partners together with partnership assets. Recommendation 2.3.6 above sets forth the distributional rules with respect to claims against the general partners on account of a deficiency. This Recommendation contemplates that, as under current law, property of the partnership is to be distributed to the holders of allowed claims against the partnership in accordance with the distributional scheme in the Bankruptcy Code. It, however, excludes recoveries obtained from general partners or the estates of debtor general partners on account of each partner's deficiency. Consistent with Recommendation 2.3.9 , which allocates a general partner's liability to a creditor in accordance with state law, this Recommendation preserves the distribution scheme under the Bankruptcy Code for property of the partnership estate. Each partnership creditor's deficiency claim would be determined after distribution under this Recommendation. Recoveries for these deficiency claims would be in accordance with Recommendation 2.3.9 . Both the NBC and the ABA Ad Hoc Committee proposed the above Recommendation. ⁽⁹⁶⁸⁾

2.3.11 Trustee's Power to File Involuntary Cases

Section 303 of the Bankruptcy Code authorizes creditors of a general partner to commence an involuntary case under Chapter 7 or Chapter 11. ⁽⁹⁶⁹⁾ Although section 303 permits an otherwise qualified partnership creditor to file an eligible involuntary petition against a general partner, ⁽⁹⁷⁰⁾ the statute does not give standing to a trustee of a partnership to initiate such a filing. A trustee of a partnership is, by virtue of section 723, a creditor of each general partner for the full amount of all allowed claims of creditors in the partnership bankruptcy case. The trustee, therefore, may proceed against the general partners to enforce their liability for the deficiency. It may, however, be more administratively efficient and effective for the partnership trustee to administer the liabilities of general partners within the confines of the Bankruptcy Code.

The Recommendation gives the partnership trustee standing to commence an involuntary Chapter 7 or Chapter 11 case against a general partner regardless of the number of creditors, nature of the claims, or dollar amount of the claims that the trustee represents. ⁽⁹⁷¹⁾ The other requirements and safeguards otherwise applicable in involuntary cases would remain applicable, such as not paying undisputed debts as they become due. ⁽⁹⁷²⁾ Additionally, the right of partnership creditors to commence an involuntary case against a general partner remains unabridged by this Recommendation. The Recommendation provides further incentive for nondebtor general partners to voluntarily participate in the partnership's bankruptcy case.

Competing Considerations. The requirements of section 303(b) of the Code are very specific and require "three or more" creditors with noncontingent, undisputed claims which must "aggregate at least $10,000."⁽⁹⁷³⁾ The statutory requirements reflect the policy that an involuntary case should not serve as vehicle for aggressive creditors to harass an honest debtor. ⁽⁹⁷⁴⁾ It could be argued that dispensing with the number of creditors and the monetary requirements of the statute undermines the protection the Code affords debtors and gives a trustee in a partnership case too much leverage. The Recommendation would, for instance, ostensibly permit a trustee to commence an involuntary petition against an entire law firm, to the extent the other requirements of section 303 were met in each instance. The other protections in section 303 provide a certain amount of protection for nondebtor general partners. Moreover, increased leverage for the trustee to collect deficiency claims from nondebtor general partners would inure to the benefit of the partnership's creditors. Giving a trustee more leverage than creditors under these circumstances is logical because a trustee is a fiduciary and is not similar to other creditors who may have an improper agenda.

2.3.12 Appointment of Committee of General Partners

Chapter 11 authorizes the appointment of a committee of creditors and, upon the request of a party in interest, a committee of equity security holders. ⁽⁹⁷⁵⁾ The appointment of a committee of equity security holders is rare and typically authorized by the court only in the larger Chapter 11 cases involving publicly-traded corporations. A fundamental committee formation consideration is whether a particular committee is more likely to accelerate or impede the reorganization process.

The ABA Ad Hoc Committee and the NBC do not agree whether the appointment of a committee of general partners should be permitted in certain circumstances. The ABA has embraced the view that the Code should authorize the appointment of such a committee. The NBC considered a Recommendation permitting the appointment of a committee of general partners, but disapproved such a measure.

Rationale. The Bankruptcy Code does not authorize the appointment of a committee of general partners and such interests have been represented through the formation of unofficial committees. ⁽⁹⁷⁶⁾ Some of the same considerations that apply to the formation of committees of equity security holders in corporate cases are applicable in the context of large, professional partnership cases. A committee of general partners can, in certain instances, facilitate the collection of partnership receivables and other assets of the business. A partnership committee could also aid in the determination of appropriate allocations with respect to the liability of the general partners for the deficiency of partnership assets to pay partnership debts. Additionally, the uniqueness of problems arising in partnership cases which involve a large number of general partners renders a committee of general partners especially suited to facilitate the resolution of differences and disputes with the partnership, among the partners themselves, and with partnership creditors.

The Recommendation sanctions the appointment and status of a committee of general partners in a partnership case where appropriate, but does not mandate it. The court retains the discretion to determine whether the formation of a committee of general partners will facilitate or impede the reorganization process and whether the benefits of formation outweigh the concomitant expenses.

Competing Considerations. The NBC rejected a similar proposal, concluding that the self-interest of general partners will provide the necessary incentive for partners to assist the partnership trustee in marshaling partnership assets since the success of their efforts will reduce any deficiency for which the partners would be liable. The NBC also expressed the concern that the appointment of an official committee of general partners could exacerbate the conflicting interests of general partners in certain circumstances. The NBC contends that informal committees could serve the appropriate function in the large, professional partnership cases in which the perceived need for such a committee is the greatest. ⁽⁹⁷⁷⁾

2.3.13 General Partner Liability on Nonrecourse Partnership Debt under 11 U.S.C. § 1111(b)

Section 1111(b) provides that the undersecured deficiency of a nonrecourse claim secured by property of the estate shall be treated as a recourse claim. ⁽⁹⁷⁸⁾ The purpose of the provision is to assure equitable treatment for the undersecured nonrecourse lender in a Chapter 11 plan. The Bankruptcy Code is not clear on whether the transformation from nonrecourse to recourse has an effect on the personal liability of general partners, although the cases that have addressed this issue have all found that additional rights for nonrecourse creditors are not created under section 1111(b). ⁽⁹⁷⁹⁾ While all of these courts have arrived at the right result, it is unclear under the Bankruptcy Code whether the conversion of a nonrecourse claim against the property of the partnership creates a recourse claim against the individual general partners who are liable for the partnership obligations under state law. The Recommendation provides clarity and certainty with respect to desirable financing transactions. Thus, a claim remains a nonrecourse claim against the individual general partners who are not liable under nonbankruptcy law, although the claim becomes recourse against the debtor partnership by operation of section 1111(b).

2.3.14 'Temporary' Injunction of Proceedings or Acts against Nondebtor General Partners

The Bankruptcy Code should be amended to permit the court for cause, upon motion of a party in interest and after notice and hearing, to temporarily enjoin actions of creditors or general partners of a debtor partnership against nondebtor general partners or their property on account of partnership obligations. ⁽⁹⁸⁰⁾ No injunction should be granted under this Recommendation unless the nondebtor general partner (1) consents to the jurisdiction of the bankruptcy court; (2) makes or undertakes to make the disclosures required by Recommendation 2.3.18 below; and (3) the order granting the injunction precludes the protected general partner from incurring obligations or transfers of property except under specified circumstances.

The personal liability of general partners for some or all of the obligations of the partnership under nonbankruptcy law ⁽⁹⁸¹⁾ can create problems in bankruptcy cases where the debtor is a partnership. Although the automatic stay protects a debtor partnership from creditor action, the general rule is that it has no application to nondebtor partners. ⁽⁹⁸²⁾ As a result, creditors may proceed against nondebtor general partners or their assets to satisfy partnership debts. These actions may distract general partners who are attempting to reorganize the partnership to the detriment of all partnership creditors. Under these circumstances, some courts have looked beyond the literal language of the statute and extended the protection of the automatic stay to nonbankrupt general partners. ⁽⁹⁸³⁾ Other courts have resorted to section 105 in order to augment the protection of the automatic stay in certain circumstances. ⁽⁹⁸⁴⁾ Indeed, the legal relationships between a partnership and its general partners have required courts to frequently address the propriety of enjoining creditor action against nondebtor general partners. ⁽⁹⁸⁵⁾

Rationale. The Bankruptcy Code generally resolves the tension between the rights of individual creditors and creditors as a group in favor of the rights of the collective creditor body. A temporary injunction, much like the automatic stay, would serve to protect the property of nondebtor partners from the dismemberment that would otherwise occur during the formulation of the partnership plan. Plan contributions and plan formulation cooperation from general partners usually benefits all partnership creditors. Rather than permitting one creditor to recover against a nondebtor partner to the detriment of all creditors, the Recommendation promotes limited injunctive protection in order to encourage cooperation and contribution from general partners. The injunction afforded nondebtor general partners under the Recommendation would therefore halt the "race to the courthouse" under state law in favor of furthering the bankruptcy policy of equality of distribution in the partnership case. The Recommendation is designed to preserve asset values from dissipation through creditor action and provide nondebtor partners with a breathing spell in order to focus on rehabilitation or reorganization.

The injunction provided by the Recommendation, while operating to temporarily stay creditor action, does not operate automatically. Automatic relief would essentially give nondebtor partners the same protection afforded debtors under the Bankruptcy Code without requiring the general partners to file a petition and otherwise submit to the bankruptcy process. This idea was considered and rejected by the NBC. ⁽⁹⁸⁶⁾

Rather, under the Recommendation it is incumbent upon the party requesting the relief to demonstrate its entitlement to such extraordinary protection. ⁽⁹⁸⁷⁾ The discretionary nature of this protection ensures that it will only be granted under circumstances warranting such treatment. Any injunctive relief granted may also be tailored to fit the specific needs of the case. Consistent with this policy goal, the injunction is designed to operate only for a limited duration. ⁽⁹⁸⁸⁾ The Recommendation would also make explicit that the court has the authority to issue a temporary injunction, not only with respect to obligations for which a nondebtor general partner is statutorily liable under nonbankruptcy law, but also those debts that the general partner has guaranteed. ⁽⁹⁸⁹⁾ The court in all cases has, however, the discretion to balance the respective interests of the parties in light of bankruptcy policy and fashion relief (including posting a bond) as may be appropriate under the circumstances. Indeed, the court has the discretion to condition the injunction and impose constraints on the ability of a nondebtor general partner to manage assets that are subject to the debts of the partnership. ⁽⁹⁹⁰⁾

A request for injunctive relief under section 105 is governed by Part VII of the Federal Rules of Bankruptcy Procedure. ⁽⁹⁹¹⁾ The case law has been consistent in ruling that the commencement of an adversary proceeding is therefore a prerequisite to obtaining injunctive relief. ⁽⁹⁹²⁾ The Recommendation dispenses with the adversary proceeding requirement in favor of a more expeditious and less cumbersome mechanism for obtaining injunctive relief. Under the Recommendation, while injunctive relief may be limited in scope depending on the circumstances, relief by motion after appropriate notice and a hearing will reduce costs without impinging on the enjoined parties' rights.

The Recommendation would alter the current requirements with respect to standing to obtain injunctive relief under section 105. The courts have generally limited standing to commence an adversary proceeding to enjoin the actions of nondebtor third parties to the debtor, the debtor in possession or the trustee. ⁽⁹⁹³⁾ The Recommendation would permit "any party in interest," including nondebtor general partners, to request relief.

Finally, the injunctive relief authorized by the Recommendation would not impair separate creditor action against nondebtor general partners on account of their separate obligations, but would enjoin only creditor action arising in connection with partnership obligations.

Competing Consideration. An extended injunction may also afford a nondebtor general partner with the time to place assets beyond the reach of the creditors and the court. It could also increase the costs of the bankruptcy proceeding and reduce the incentive of nondebtor general partners to work toward a consensual resolution. ⁽⁹⁹⁴⁾

The ABA Recommendation providing for the termination of the temporary injunction within 60 days, subject to renewal, might obviate some of these concerns. Recommendation 2.3.15 , following, achieves the same result as the ABA proposal, but on a discretionary basis rather than a fixed statutory deadline.

2.3.15 Relief from the Temporary Injunction

Rationale. As noted in Recommendation 14 above, injunctive relief should be provided to protect nondebtor general partners under certain circumstances. This Recommendation provides the grounds to seek relief from the temporary injunction, acting like a safety valve to ensure that too much protection is not granted to nondebtor partners.

The Recommendation is an adaptation of section 362(d) of the Bankruptcy Code and recognizes that circumstances may warrant granting relief from the temporary injunction issued pursuant to Recommendation 2.3.14 above. Therefore, a court is permitted to grant appropriate relief under the Recommendation for cause. "Cause" would include the "absence of any reasonable likelihood of reorganization, inability to effectuate a plan within the time fixed by the court, denial of confirmation . . . revocation of an order of confirmation, inability to effectuate substantial consummation of a confirmed plan, material default with respect to a confirmed plan, termination of a plan by reason of the occurrence of a condition specified in the plan, or the nonpayment of fees or charges."⁽⁹⁹⁵⁾ "Cause" warranting relief from the temporary injunction would also exist if the creditor establishes that it would suffer irreparable harm or "if the reasons for the injunction or the protections afforded partnership creditors and other general partners in conjunction with the injunction do not, or cease to, exist in the case with respect to the nondebtor general partner."⁽⁹⁹⁶⁾

2.3.16 'Postconfirmation' Injunction of Proceedings or Acts against Nondebtor General Partners Who Contribute to Plans

The confirmation of a partnership's plan of reorganization generally operates to discharge all prepetition obligations of the partnership. ⁽⁹⁹⁷⁾ The discharge of a debtor in bankruptcy does not, however, operate to discharge the liability of a nondebtor liable on the same obligation. ⁽⁹⁹⁸⁾ The rationale for the rule is based on the fundamental principle that the bankruptcy laws are not intended to benefit those who have not submitted themselves or their assets to the burdens of the bankruptcy process. ⁽⁹⁹⁹⁾

Under the Bankruptcy Act, courts generally construed the narrow language of the discharge provision as barring a discharge or release in favor of third parties under a plan of reorganization. ⁽¹⁰⁰⁰⁾ A substantial number of courts under the Bankruptcy Code have adhered to the strict rule and interpret section 524(e) as prohibiting permanent injunctions and third-party releases in a plan of reorganization. ⁽¹⁰⁰¹⁾ Some courts, however, have recognized the value of a permanent injunction and have made limited exceptions. ⁽¹⁰⁰²⁾ Congress has also recently recognized the virtue of channeling injunctions to augment the discharge of debtors in Chapter 11 cases. ⁽¹⁰⁰³⁾ The Commission discusses the benefits of this type of injunction in the Report Section on Mass Future Claims. ⁽¹⁰⁰⁴⁾

The prospect of obtaining extended or permanent injunctive relief from partnership creditors and other general partners provides nondebtor general partners with the incentive to contribute substantially to a Chapter 11 or Chapter 12 plan of reorganization. The Recommendation contemplates that recoveries of partnership creditors would, in a significant number of cases, be enhanced. Since plan contributions on account of partnership obligations would often come from postpetition earnings, exempt property and other assets not otherwise available to partnership creditors, the quid pro quo of permanent injunctive relief would maximize recoveries by encouraging individual contributions. Indeed, it has been noted that:

The direct result of [a permanent injunction] is that creditors are able to receive from general partners on a consensual basis funds that would otherwise be difficult, if not impossible, for them to recover.

Without [the permanent injunction,] individual creditors would sue individual general partners, and general partners would then cross-claim against each other for contribution and sue the debtor for indemnification. The probable result would be a costly and time-consuming web of litigation replete with attendant attachments, garnishments and executions. Personal bankruptcy would be a likely consequence for many. By preventing a haphazard scramble for the assets of general partners, and by facilitating an orderly distribution scheme, the permanent injunction...ensures that general partners will be protected and that creditors' recoveries will be maximized. ⁽¹⁰⁰⁵⁾

The Recommendation would not necessarily require full payment plans in all instances. ⁽¹⁰⁰⁶⁾ It would, however, furnish partnership creditors with the protections provided in the confirmation requirements of sections 1129 and 1225 of the Code and therefore require substantial creditor agreement. Therefore, as under current law, the existence of the injunction and the required confirmation requirements would often entail a compromise of outstanding claims. The Recommendation would also clarify that the "best interests of creditors" test would require the court to assess, as part of plan confirmation, the personal assets and liabilities of nondebtor general partners.

The Recommendation (postconfirmation injunction) would not preclude the enforcement of claims of a partnership creditor against a nondebtor general partner, or against the property of a nondebtor general partner, who has not contributed or assumed a commitment to contribute to the payment of debts of the partnership in accordance with the confirmed plan. Similarly, the Recommendation would not preclude nondebtor partners from reserving the right under the plan to pursue nonparticipating general partners for their proportionate share of the distribution to the partnership creditors. The Recommendation also gives the court the discretion to impose conditions on the statutory injunction, including limitations on asset transfers ⁽¹⁰⁰⁷⁾ and the requirement of ongoing disclosure.

The policy choice in the Recommendation favors a collective proceeding maximizing the return to partnership creditors. The underlying premise is that nondebtor partners will voluntarily contribute more to ensure confirmation of the partnership plan if provided protection from future creditor claims. Encouraging a consensual resolution and plan formulation should reduce administrative costs and increase the return to creditors. The Recommendation is narrowly-tailored to provide relief only to nondebtor partners who warrant protection.

Competing Consideration. The Recommendation is carefully structured to avoid the appearance that what nondebtor partners are really getting is a discharge, though one may argue that a permanent injunction is essentially a discharge and that the difference is semantic. Moreover, the interests of creditors are protected by requiring the plan to pay claims in full before an injunction protecting nondebtor partners will issue. In the event injunctive protection is unwarranted, unwinding an injunction under the procedure in Recommendation 2.3.17 for failure to perform a material plan commitment should eliminate doubt that the injunction provided is a veiled discharge for nondebtor parties.

In addition, the court should take into account the personal assets and liabilities of the nondebtor partners. The required liquidation analysis necessitated by the best interests of creditors test would enable partners to take advantage of generous state law exemptions and prebankruptcy planning since the calculation is made with reference to the nondebtor general partner's nonexempt assets. This concern may, however, be vitiated if Congress adopts the Commission's Recommendation with respect to uniform exemptions.

2.3.17 Revocation of Injunction

The Bankruptcy Code should be amended to provide that the injunction issued with respect to any nondebtor general partner under Recommendation 2.3.16 above should be terminated or revoked on the request of a party in interest if, after notice and hearing, the court determines (1) that the protected nondebtor general partner has failed to perform a material commitment under the plan; (2) that the order confirming the plan in which the injunction was issued is revoked under sections 1144 or 1230 of the Code; or (3) that the nondebtor general partner has procured the injunction by fraud. The Bankruptcy Code should be further amended to provide that a request for revocation for fraud under provision (3) should be made at any time within two years ⁽¹⁰⁰⁸⁾ after the date of the entry of the confirmation order.

The Recommendation reflects the policy that the injunction issued pursuant to a confirmed plan is available only if the nondebtor general partner performs in accordance with the terms of the confirmed plan and has made candid disclosure to the court and to creditors. While the revocation of an injunction is within the discretion of the court under current law, the Recommendation gives the court guidance on what conditions must be met in order for injunctive relief to continue. In addition, nondebtor general partners as well as stayed creditors will know what is required for the injunction to continue.

2.3.18 Duty of Disclosure by Nondebtor General Partners

The Bankruptcy Code should be amended to provide that, unless otherwise ordered by the court for cause, each nondebtor general partner shall, within 30 days ⁽¹⁰⁰⁹⁾ after the entry of the order for relief in a partnership case or within such time as the court shall fix, produce information concerning such partner's financial condition and affairs similar to that provided by a debtor, together with such additional information and periodic reports as may be required by the court from time to time.

When a bankruptcy petition is filed by or against a general partnership, it is probable that there will be a deficiency in the assets to satisfy the claims of partnership creditors. The personal liability of nondebtor general partners for that deficiency requires that the partnership and partnership creditors be informed of the extent and location of individual partner's assets. It is imperative that creditors and other parties in interest have the same type of financial information for partners as that made available by the debtor partnership.

Bankruptcy Rule 1007(g) provides that "[t]he court may order any general partner to file a statement of personal assets and liabilities within such time as the court may fix."⁽¹⁰¹⁰⁾ Some courts construing Rule 1007 have required nondebtor general partners to file information regarding nonpartnership assets and liabilities in connection with determining whether to confirm the plan of a debtor partnership. ⁽¹⁰¹¹⁾ Rule 1007(g) is, however, discretionary. In addition, the information required to be provided under the Rule is limited.

Rationale. The Recommendation makes personal and comprehensive disclosure by nondebtor general partners the general rule, rather than the exception, when a partnership seeks relief under title 11. The disclosures contemplated by nondebtor general partners would be made under penalty of perjury and be in substantially the same form and made at substantially the same time as presently required under the Code and Rules. ⁽¹⁰¹²⁾ The court could also require the information to be supplemented on a periodic basis. Under the Recommendation, the court has the discretion, for cause, to modify the disclosure requirements and to prescribe conditions for the examination of the information provided by general partners. This provision comports with present bankruptcy law and policy.

The Recommendation strengthens the power of the partnership trustee or debtor in possession to require contributions from nondebtor general partners on account of their liability for any deficiency. ⁽¹⁰¹³⁾ A provision requiring the prompt disclosures contemplated by this Recommendation expedites the administration of the partnership estate for the benefit of partnership creditors by providing the trustee, creditors and other parties in interest with extensive, current and accurate information. The information is necessary not only to enable the partnership trustee or debtor in possession to allocate to the nondebtor partners their respective shares of the deficiency but also to prepare a plan of reorganization. Indeed, the financial information provided would serve to establish the liquidation value of the individual partner's assets. The information furnished by a nondebtor general partner under the Recommendation would also be of critical importance to the court in ascertaining whether or not to grant a temporary injunction under Recommendation 2.3.14 , above.

Competing Consideration. It may be argued that the information disclosed by nondebtor partners will be impossible to verify and will therefore be unreliable. The fact that information about the financial condition or affairs of individual partners may often be unreliable and difficult, if not impossible, to verify raises serious concerns. Requiring a general partner to submit financial information on penalty of perjury may ameliorate the problem of unreliability.

2.3.19 Access to Disclosed Information

All debtors are required to disclose all financial information and submit to the open inquiry by the court as well as all parties in interest. Recommendation 2.3.18 requires certain financial information from nondebtor general partners. This Recommendation does not require the information provided by a nondebtor partner under Recommendation 2.3.18 above to be filed with the court. If such information were required to be filed with the court, it would be of public record and "open to examination by an entity at reasonable times without charge."⁽¹⁰¹⁴⁾ During the Commission's deliberations on this issue, privacy concerns were raised about making this type of information on nondebtor partners available to the public. The Recommendation, therefore, proposes to provide this information to parties in interest in the case on request only.

The trustee, debtor in possession or other entity designated by the court in a partnership case would, under the Recommendation, be charged with the responsibility of serving as the custodian of information disclosed by nondebtor general partners and other important information. ⁽¹⁰¹⁵⁾ The information should be easily accessible to parties in interest without the need for unnecessary litigation. Such information would enable creditors to protect their interests during the partnership case. The information furnished would not, however, be made publicly available. The court should also have the discretion under the Recommendation to establish conditions for access as appropriate to protect reasonable and legitimate confidentiality concerns of nondebtor general partners.

Competing Consideration. As noted above, the Recommendation does not require any specific financial information to be filed with the court. The court, however, may direct the types of disclosures that would be appropriate. The decision of what types of information to disclose would therefore not be left entirely up to the nondebtor partner.

In addition, it may be argued that the parties seeking the benefits of a collective proceeding that provides a permanent injunction should be required to bear the burdens of compliance by filing the information required under Proposal with the bankruptcy court. The court would have the ability to protect confidential information in appropriate circumstances. The delay and problems associated with policing compliance with the disclosure provisions would also be minimized if the documents were required to be filed with the court.

Partner As Debtor

The appropriate effect of a general partner's bankruptcy filing is a hotly-debated and divisive issue. Conflict often exists between the result of a partner's bankruptcy filing under state partnership law, the result under the Bankruptcy Code, and the result under the partnership agreement itself. Courts and commentators generally acknowledge three aspects of a partner's relationship with the partnership: (1) specific rights in partnership property; (2) share of the partnership profits and surplus; and (3) the right to participate in the management of the partnership. ⁽¹⁰¹⁶⁾ Clarifying the effect of a partner's bankruptcy filing on each of these three aspects of the partner relationship is the focus of the Commission's "partner as debtor" recommendations.

RECOMMENDATIONS

2.3.20 Treatment of LLC Member or LLC Manager Under the Bankruptcy Code

Debtor LLC members in member-managed LLCs should be treated like general partners under the Bankruptcy Code. Similarly, debtor managers of manager-managed LLC's should be treated like general partners under the Bankruptcy Code. This treatment should be limited to three aspects of the LLC member or LLC manager relationship: (1) continuity of LLC after LLC member's or manager's bankruptcy filing; (2) transferability of LLC ownership interest; and (3) management rights in the LLC.

2.3.21 Exclusion of a Partnership or LLC Relationship from Treatment under 11 U.S.C. § 365

The Bankruptcy Code should be amended to exclude partnership and LLC governing documents and relationships from treatment under 11 U.S.C. § 365. A new section concerning partnership and LLC governing documents and relationships should be added to the Bankruptcy Code.

2.3.22 Ipso Facto Provisions in Partnership or LLC Governing Documents Rendered Unenforceable

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. Non-ipso 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 remain enforceable.

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

"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 any other right to payment). Except as provided below, the Recommendation 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 (1) continues employment (in whatever capacity) with the partnership or LLC after the order for relief, and (2) 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 payable 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 under a non-ipso facto provision, 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 (1) 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; and (2) ensure receipt of the buyout price by the estate.

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 of, insolvency of, financial condition of, commencement of a voluntary or involuntary case under title 11 for, or appointment of a trustee or custodian for, a partner or LLC member or manager. If no such price is provided, the court should determine a fair buyout value.

2.3.24 Treatment of Partnership and LLC Management Rights

During any period when an estate 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:

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 governing documents and applicable nonbankruptcy law, and the other applicable provisions of the Bankruptcy Code;
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 to meet a minimum majority required by the governing documents or applicable nonbankruptcy law;
In all other cases where a Chapter 7 or Chapter 11 trustee has been appointed, the trustee shall exercise all management and voting rights.

Regardless of the foregoing, in all cases where (1) an individual debtor continues to function as a partner or member after the order for relief, and (2) 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.

2.3.25 11 U.S.C. § 523 and Imputed Conduct or Liability

11 U.S.C. § 523 should be amended to provide that nothing in this section shall preclude the discharge of a general partner from a debt (otherwise nondischargeable in a copartner's or agent's bankruptcy case) arising solely as a result of imputing to the general partner the conduct or liability of a copartner or agent.

2.3.26 Subordination of Claims Arising from the Purchase or Sale of a Partnership Interest

11 U.S.C. § 510(b) should be amended to subordinate the claims "arising from the rescission of a purchase or sale" of their partnership interests or "for damages arising from the purchase or sale" of their partnership interests to all claims and interests that are senior or equal to the claim or interest represented by such security or other interest in the bankruptcy case of a general partner.

DISCUSSION

Outside bankruptcy, partnerships are governed by state law. Partnership law in virtually all states ⁽¹⁰¹⁷⁾ is governed by one of two uniform partnership acts, the Uniform Partnership Act ("UPA") or the Revised Uniform Partnership Act ("RUPA"). ⁽¹⁰¹⁸⁾ Both of these uniform laws reference the agreement between the partners as governing the partnership relationship. ⁽¹⁰¹⁹⁾ As a result, a majority of the provisions of the UPA or the RUPA apply only in the absence of agreement between the partners. In other words, the partnership agreement can alter the result under the UPA or the RUPA. Certain aspects of the partnership relationship, however, cannot be altered by agreement, including: the fiduciary duty of a partner;⁽¹⁰²⁰⁾ the right of a partner to inspect partnership books and records;⁽¹⁰²¹⁾ and the liability of a partner for partnership debts. ⁽¹⁰²²⁾

The primacy of the agreement between the partners under both the UPA and the RUPA reflects the importance of the consensual nature of the partnership relationship. "In general, a partner cannot be forced to continue as part of a partnership, nor can a partner be forced to accept a new partner."⁽¹⁰²³⁾ Under both statutory schemes, whether to continue a partnership once a partner files for bankruptcy is completely within the discretion of the nondebtor partners. ⁽¹⁰²⁴⁾ The bankruptcy of a partner triggers an automatic alteration of the relationship between the debtor partner and the partnership. ⁽¹⁰²⁵⁾ This "automatic" forfeiture of certain partnership interests under state partnership law appears to conflict with certain provisions of the Bankruptcy Code and forms the basis for the confusion over the treatment of debtor partners in bankruptcy.

Under the Bankruptcy Code, provisions in agreements that are triggered by "insolvency, financial condition, commencement of a voluntary or involuntary case under Title 11, or appointment of a trustee or custodian in bankruptcy" are not generally enforceable. ⁽¹⁰²⁶⁾ These types of provisions are commonly referred to as "ipso facto" provisions. The provisions under state partnership law, discussed above, that protect the sanctity of the partnership relationship and are triggered upon a partner's bankruptcy filing or financial condition may not be enforceable under the Bankruptcy Code.

The Commission's recommendations on the relationship between a debtor partner and the partnership attempt to reconcile the tension between the policy under state partnership law to preserve the voluntary nature of the partnership relationship and the policy under the Bankruptcy Code to prevent an automatic forfeiture of a debtor's interest in property as a result of a bankruptcy filing in order to preserve the value of the bankruptcy estate for creditors. In addition, the Commission's recommendations include specific treatment for new business organizations that are not referred to in the Bankruptcy Code, such as limited liability companies.

Both the Ad Hoc Committee on Partnerships in Bankruptcy of the Business Section of the American Bar Association and the National Bankruptcy Conference spent a great deal of time and resources studying partner and partnership-related

bankruptcy issues. ⁽¹⁰²⁷⁾ Only the National Bankruptcy Conference made specific proposals with regard to the effect of a general partner's bankruptcy filing. ⁽¹⁰²⁸⁾

2.3.20 Treatment of LLC Member or LLC Manager Under the Bankruptcy Code

A principal advantage of the partnership form over the corporate form is that partnership income is not subject to two layers of tax. Corporate income is taxed twice: as income at the corporate level; and at the shareholder level in the form of a dividend. Partnership income, on the other hand, is distributed to the partners and is taxed only at the partner level. Conversely, a principal advantage of the corporate form over the partnership form is that corporate shareholders are not personally liable for the debts of the corporation, whereas partners are personally liable to partnership creditors, with certain limitations, for the debts of the partnership.

A desire to combine the best of both of these worlds-the tax treatment of a partnership with the limited liability of a corporation-led to the enactment of the first limited liability company ("LLC") statute in Wyoming in 1977. ⁽¹⁰²⁹⁾ Commentators agree that the sudden popularity of the LLC as a business form is due to a 1988 revenue ruling by the Internal Revenue Service treating a Wyoming LLC as a partnership for tax purposes. ⁽¹⁰³⁰⁾

The importance of Revenue Ruling 88-76 to the development of LLCs is illustrated by a few statistics. By 1988, eleven years after the enactment of the Wyoming statute, only one other state (Florida) had enacted an LLC statute, and there were only twenty-six LLCs in Wyoming. By the end of 1994, forty-six additional statutes had been passed and tens of thousands of LLCs had been formed. ⁽¹⁰³¹⁾

LCCs combine the limited liability of the corporate form with the pass-through tax treatment of a partnership. ⁽¹⁰³²⁾ LLC statutes have been enacted in every state and the District of Columbia. ⁽¹⁰³³⁾ Similar to corporations, LLCs can be governed by statute, articles of organization, and an operating agreement (which is similar to a partnership agreement and delineates the business purpose and the relationship between the members, the managers (if any) and the company). Certain LLC aspects under state law may be modified by agreement between the LLC members. ⁽¹⁰³⁴⁾ LLC members are insulated from general liability for LLC debts, similar to shareholders. ⁽¹⁰³⁵⁾ LLC's can be managed by members or by managers; the distinction being that "members have partner-like authority to bind a member-managed LLC, managers have similar authority to bind manager-managed LLCs, and members have no authority as such to bind manager-managed LLCs."⁽¹⁰³⁶⁾ Thus, LLC members are akin to general partners in member-managed LLCs and LLC members that are not managers are akin to limited partners or shareholders in manager-managed LLCs. A critical distinction between limited partners and LLC members, however, is that a LLC member does not forfeit limited liability by participating in the management of the LLC, even if the LLC is manager-managed. ⁽¹⁰³⁷⁾

Due to the relatively recent enactment of LLC statutes, the Bankruptcy Code does not specifically refer to LLCs or LLC members. The Bankruptcy Code definition of "corporation" arguably includes an LLC "as its members have limited liability (like corporate shareholders), it appears to be an unincorporated company or association, and it is not a limited partnership."⁽¹⁰³⁸⁾ However, the nature of the relationship of a member in a member-managed LLC and a manager in a manager-managed LLC is closer to that of a general partner in a partnership than an equity security holder in a corporation. A few cases have addressed certain issues that arise when an LLC member or manager files for bankruptcy. ⁽¹⁰³⁹⁾ Recognizing the similarities between LLC members and managers and general partners, these courts have applied partnership-type analysis to the LLC circumstances and have arrived at differing results. ⁽¹⁰⁴⁰⁾

Rationale. Due to the recent enactment of LLC statutes, the Bankruptcy Code does not refer to them specifically. The popularity of the LLC form mandates specific reference in the Bankruptcy Code to avoid confusion over the treatment of LLC member and LLC manager relationships in bankruptcy. ⁽¹⁰⁴¹⁾ The nature of the LLC member or LLC manager/LLC relationship for the most part mirrors that of a general partner to a partnership. Fiduciary duties and tax treatment all conform to those of a general partnership. ⁽¹⁰⁴²⁾ A major difference, however, is that LLC members are protected from liability for LLC debts.

The similarities between the fiduciary and managerial roles of a general partner and a LLC member or LLC manager make uniform treatment under the Bankruptcy Code a logical choice. The principal advantage of the Recommendation is that by providing similar treatment for these similar legal relationships, statutory clarification of partnership relations will also clarify the treatment of LLC relationships in bankruptcy. The Recommendation does not alter the overall treatment of debtor LLCs in bankruptcy, but only provides specific treatment of the LLC relationship for LLC member or LLC manager debtors. Tax-driven developments in LLC statutes, for example, make a blanket designation for LLCs under the Bankruptcy Code undesirable. ⁽¹⁰⁴³⁾ The Recommendation thus preserves treatment of LLCs like corporations and their members like equity security holders under circumstances warranting such treatment. An example are the interests of LLC members of manager-managed LLCs. Members of this type of LLC generally do not have day-to-day managerial responsibility and have limited liability for the debts of the LLC. In this respect, these LLC members have interests that mirror those of equity security holders. ⁽¹⁰⁴⁴⁾ The Recommendation narrowly defines the scope of general partner treatment for LLC members and managers and preserves flexible treatment for LLC interests as equity security interests.

Competing Considerations. LLCs are hybrid entities, incorporating certain corporate attributes and certain partnership attributes. One could argue that the limited liability of an LLC member renders the LLC interest closer to that of an equity security than a general partnership interest. As stated above, however, the relationship of a LLC member in a member-managed LLC and the relationship of a LLC manager in a manager-managed LLC more closely tracks the rights and obligations of a general partner than that of an equity security holder. The popularity of these vehicles ensures an increase in the appearance of LLC members and LLC managers in bankruptcy cases and necessitates specific bankruptcy treatment. The Recommendation accomplishes this goal without hamstringing future flexibility as state LLC statutes evolve.

2.3.21 Exclusion of a Partnership or LLC Relationship from Treatment under 11 U.S.C. § 365

The three characteristics of a partnership interest and relationship-(1) specific rights in partnership property; (2) share of the partnership profits and surplus; and (3) the right to participate in the management of the partnership-are not specifically treated under the Bankruptcy Code. These interests and relationships are generally defined in a partnership or LLC operating agreement and if the applicable agreement is silent, then under state law. Partnership and LLC operating agreements are currently subject to the provisions of 11 U.S.C. § 365 governing the treatment of executory contracts.

Treatment under current section 365 is dependent on a contract's "executoriness."⁽¹⁰⁴⁵⁾ Partnership agreements are generally treated in the case law as "executory" and are, therefore, subject to the rules governing assumption or rejection under section 365. ⁽¹⁰⁴⁶⁾ Section 365(c) limits a trustee's power to assume certain contracts depending on the nature of the agreement and whether the other party to the agreement could refuse performance from one other than the debtor or debtor in possession under applicable nonbankruptcy law.

Treatment of partnership relationships under this provision of section 365 is unclear. Section 365(c) links assumption and assignment and does not distinguish between contractual obligations and other terms of a relationship. A partnership relationship is much more than a contract, it is a business relationship that combines economic obligations and individual performance. Consistent with this view, the UPA, the RUPA, and the Uniform Limited Liability Company Act ("ULLCA") all preclude the assignment of noneconomic rights, in the absence of a contrary provision in the partnership or LLC agreement. Limitations on assignment therefore cloud the issue of assumption. Conflicting precedent exists regarding whether a trustee or debtor in possession can assume a partnership agreement or LLC operating agreement under section 365(c)(1)(A). ⁽¹⁰⁴⁷⁾ Because of limitations in underlying agreements and applicable nonbankruptcy law, some courts have determined that the partnership or LLC agreement cannot be assumed, even by the debtor in possession. ⁽¹⁰⁴⁸⁾

Rationale. The Recommendation would greatly simplify the analysis of partnership and LLC management rights in bankruptcy. Provisions that are specifically tailored to the needs of partnership and LLC relationships will have more equitable bankruptcy results for both debtors and creditors. Treatment under section 365 is inadequate because it treats the entire partnership agreement like a contractual obligation and fails to adequately address the subtler aspects of the partnership relationship and economic interests. The Recommendation refers to both the governing documents as well as the overall relationship because certain partnership and LLC relationship terms are statutory and are not included in the governing documents. This is necessary because to the extent that a partnership or LLC agreement is silent, state partnership law or LLC statute will provide the default rule governing the conduct and obligations of the parties. ⁽¹⁰⁴⁹⁾

The Recommendation assumes that section 365 remains unchanged. As interpreted, section 365 creates problems for partnership and LLC agreements for two principal reasons: (1) it links assumption by the debtor in possession or the trustee with assignment to a third party;⁽¹⁰⁵⁰⁾ and (2) it exempts certain agreements from application of the anti-ipso facto provisions. ⁽¹⁰⁵¹⁾ By taking partnership and LLC governing documents and relationships out of section 365 and providing specially tailored treatment, these problems can be solved. Specially-tailored treatment would also include appropriate rules for "assumption" (or election to remain a partner or member), "rejection" (or election not to remain a partner or member), and treatment during the interim period of partnership and LLC relationships.

Effect of Commission's Proposals to Amend Section 365. The Commission's recommendations to amend section 365 will solve a number of the problems for partnership and LLC relationships under current section 365. For example, under the section 365 recommendations, "executoriness" will no longer be a prerequisite for a debtor in possession or trustee to assume or reject a prepetition contract; assumption will become an election to perform; and rejection will become an election to breach. Particularly with regard to the election to perform, the Commission's section 365 Recommendation clarifies that postpetition performance by the debtor in possession is not a "transfer" or assignment under section 365. ⁽¹⁰⁵²⁾ By separating the act of assumption from the act of assignment, election by a debtor in possession to perform a partnership or LLC operating agreement will not trigger the same underlying state law impediments to the assignment of management rights. For example, where a general partner is in Chapter 11 and seeks to "assume" the partnership agreement and continue performing all managerial obligations, the fact that the underlying agreement precludes assignment would have no bearing on whether the debtor general partner would be able to assume the agreement. ⁽¹⁰⁵³⁾

Competing Considerations. It has been argued that partnerships and LLCs do not require a separate section of the Bankruptcy Code, but rather only those problematic sections should be amended. ⁽¹⁰⁵⁴⁾ As discussed above, the Commission section 365 recommendations have already solved a number of the partnership and LLC problems. Separating assumption from assignment may alleviate the confusion surrounding partnership agreements. In the remaining areas, minor tinkering with existing provisions may adequately resolve these issues without a wholesale rewriting of the law governing partnerships and LLCs in bankruptcy.

2.3.22 Ipso Facto Provisions in Partnership or LLC Governing Documents Rendered Unenforceable

Ipso facto provisions relating to partnerships, LLCs, and the rights or interests of partners or LLC members 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. Non-ipso 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 remain enforceable.

Under the Bankruptcy Code, provisions in agreements that are triggered by "insolvency, financial condition, commencement of a voluntary or involuntary case under Title 11, or appointment of a trustee or custodian in bankruptcy" are not enforceable. ⁽¹⁰⁵⁵⁾ These types of provisions are referred to as "ipso facto" provisions. ⁽¹⁰⁵⁶⁾ The policy reason behind rendering ipso facto agreements unenforceable in bankruptcy is to prevent an automatic forfeiture of a debtor's interest in property as a result of a bankruptcy filing in order to preserve the value of the bankruptcy estate for creditors.

Generally, 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 or a right to payment. For example, the UPA provides that the bankruptcy of a general partner dissolves the partnership. ⁽¹⁰⁵⁷⁾ Similarly, the RUPA provides that a bankrupt general partner is dissociated from the partnership. ⁽¹⁰⁵⁸⁾ The same dissociation occurs under the ULLCA when a LLC member files for bankruptcy protection. ⁽¹⁰⁵⁹⁾

Problems arise when the nondebtor partner(s) or LLC member(s) do not want to continue in business with the debtor partner or LLC member. Provisions in the underlying agreement or state law accomplishing this result are generally unenforceable as ipso facto provisions. The Bankruptcy Code, however, provides an important exception designed to protect the interests of a nondebtor party who entered the prepetition agreement i