The Bankruptcy Code does not satisfactorily address the issues arising from partnership or limited liability company (LLC) bankruptcies. Thus, I applaud the Commission's efforts to lend stability and sense to this currently muddled area of bankruptcy law. I applaud those proposals that would treat members or managers of LLCs consistently with partners in partnerships and that would exclude partnership, LLC and analogous relationships from 11 U.S.C. § 365; partnerships and LLCs are not properly governed by the "executory contract" provisions of the Code. Unfortunately, I think other changes adopted by the Commission will adversely affect the development of partnership law outside the bankruptcy area and will impose higher transactional costs on the vast majority of partnerships that will not go bankrupt. I must respectfully dissent from those other proposals.

My criticisms of the partnership proposals are friendly ones. The proposals clearly attempt to accommodate state law and pre-existing partnership agreements to a great degree; my only objection is that they ought to go further in that direction. I have been persuaded by the response of Professor Ribstein ⁽²⁷⁷³⁾ to these proposals, and my comments largely parallel those he and others in the transactional field have expressed.

Before proceeding further, it is useful to summarize the alternate proposals that I believe Congress ought to consider for adapting bankruptcy law to members of partnerships, LLCs and analogous firms. First, 11 U.S.C. § 365 (executory contracts) should not apply to such entities. Second, the law should clarify the enforceability of partnership and analogous agreements regarding rights of bankrupt partners. Third, neither 11 U.S.C. § 362 (the automatic stay) nor any other Code provision should interfere with the effectuation of these agreements. Fourth, a bankrupt member's rights in a partnership or analogous firm and whether these rights are property of the estate under section 541 and subject to control and disposition under section 363 should be governed by state law.

Several general principles inform these recommendations.⁽²⁷⁷⁴⁾ First, partnerships and LLCs are important, extremely flexible investment vehicles and reflect detailed and costly planning. Ribstein Letter, at 2. Mandatory bankruptcy rules, added to the federal, state and tax laws that appertain, increase the complexity of what is already a daunting drafting task. Id.

Second, "state competition and experimentation are more likely to produce rules that efficiently balance partner and creditor interests than imposing a single federal law." Id. The uniformity of federal law, stated as a justification for displacing state laws, is in doubt, because the Commission's proposals -- particularly regarding the definition of "ipso facto" clauses -- are just as likely to produce divergent caselaw as have the precedents applying section 365 to partner bankruptcies. Professor Ribstein adds that where uniformity is necessary to reduce creditors' costs, his research demonstrates that "states move in this direction on their own." Id.

Third, "state partnership law is better able than federal law to take into account rapidly changing circumstances affecting business organizations." Id. Tax law provides a particular source of uncertainty. Bankruptcy law should free states and firms to deal with regulatory changes.

Fourth, as Professor Ribstein notes, "by trumping state law rights, bankruptcy law may give partners and creditors perverse incentives to initiate costly and unnecessary bankruptcy proceedings." Id. If bankruptcy law provides parties a potential recovery or right that does not exist under the partnership agreement or state law, opportunities exist for forum-shopping. For instance, a partner might initiate a personal bankruptcy in order to utilize the no-ipso facto rule advanced by this Commission's proposal. Id. A partner with a cash-flow problem but whose assets exceed liabilities could obtain a benefit for himself while imposing bankruptcy costs on creditors and non-debtor partners. Id. As another example, an undersecured creditor might be able to use a bankruptcy proceeding to avoid a low buyout provision under the debtor's partnership agreement, if federal bankruptcy law creates a more favorable buyout formula. Id.

Fifth, the experience of lawyers in transactional practices suggests that creditors who deal with partners as borrowers generally realize the risks they are taking in relying on the partnership interest for repayment and can adjust to those risks legally and economically. If lenders are unable to protect themselves adequately, by requesting more security or higher interest rates or shorter payout periods, that is their oversight and not a general problem with which bankruptcy should be concerned. Insofar as the Commission's proposals imply that a partner's creditors need special protection, the assumption is counter-intuitive. Moreover, what bankruptcy law appears to give with one hand -- in attempting to increase the value of a partner's interest for the benefit of creditors -- it probably takes away with the other hand by fostering litigation and bankruptcy's high transactional costs.

Finally, to the extent that these proposals might allow debtors to remain as active partners/LLCs contrary to state law or ipso facto clauses, and would authorize the forced substitution of a new partner/LLC member in a partnership/LLC, they might create value for the debtor's estate where none would have existed under state law. Bankruptcy law should not, however, be in the business of creating value, but only in fairly distributing the debtor's property among creditors according to standards determined by extrinsic law. Butner v. United States, 440 U.S. 48 (1979). I recognize that the proposals attempt to interfere with state and contract rights as little as possible, but the provisions to which I refer will inevitably be over-utilized because of their potential for creating value that parties to the proceeding would not otherwise enjoy.

With this background, I have particular objections to three specific parts of the partnership bankruptcy proposals.

A. Ipso Facto Clauses

Although ipso facto clauses that have the effect of terminating or modifying parties' rights to a contract based on insolvency, financial condition, commencement of a bankruptcy case or appointment of a trustee are not ordinarily enforceable in bankruptcy, I believe a distinction must be drawn between their enforceability in contractual relationships and in partnership or LLC agreements. Invalidating ipso facto clauses in contracts is essentially different from interfering with the complete business organization. Contractual ipso facto clauses may be viewed as bilateral solutions to damage and performance questions that would otherwise arise during a bankruptcy. Partnership and LLC agreements, however, are the constitutional documents for business organizations. Breach of such agreements does not have a simple bilateral effect, as would a contract breach. Rather, the effects of breach ripple throughout the organization. Further, the business organization documents, or state law by default, represent a carefully bargained-for multilateral assessment of the rights and interests of the affected members of the organization. Ipso facto clauses founded on bankruptcy or insolvency provide a cleancut way to identify a threat to the organization and supply its solution by, for instance, automatically expelling a bankrupt partner.

The Commission's proposals would result in a world without ipso facto clauses to protect partnerships/LLCs in the event of a member's bankruptcy. In such a world, considerably more adroit legal drafting would be required to solve the problems that arise on bankruptcy of a partner or LLC member without referring to the member's bankruptcy or financial condition. Moreover, it is not clear that creditors are better off in such a world, for their optimal remedy is probably to share in the expelled member's buyout from the firm.

Consider an example. The general partner of a real estate partnership falls seriously in arrears in his financial contributions. On filing bankruptcy, however, with the ipso facto clause invalidated, and no other clause permitting expulsion, that partner would continue to make decisions concerning the running of the partnership.⁽²⁷⁷⁵⁾ But is it not intuitively obvious that the bankrupt partner will be participating in the firm with much different goals in mind than those of other partners? The partner is in no position to contribute credit to the organization (in the form of vicarious liability); the partner may not fully bear his load of the firm's debt during the bankruptcy; and the partner's perspective on future earnings, which may go to creditors, may well diverge from the firm's interests. See Ribstein, Expelling Bankrupt Partners. The essential community of interest among the organization's members has been severed by the bankruptcy.

Professor Ribstein's letter makes additional points. He advises that members should be allowed to provide for automatic expulsion of a bankrupt partner and to fix a price in the agreement that is triggered by bankruptcy. Ribstein Letter, at 3. First, ipso facto provisions are efficient state law rules, which the Commission's proposal invalidates. Id. State law "recognizes that non-debtor partners and LLC members often need to sever their relationship with bankrupt partners because of their different incentives and interest in the firm following bankruptcy". Id. Professor Ribstein continues:

Accordingly, state law provides by default for the expulsion of bankrupt partners and LLC members and for payment for their interests in the firm. State law also permits enforcement of partnership and LLC agreement provisions for payment of less than the market value of the bankrupt partner's interest. This accommodates the partners' cash-flow and other problems that could result when a partner's bankruptcy triggers a sudden buyout obligation.

Second, the [Commission] proposal undoubtedly will give rise to litigation over whether a buyout price or expulsion is an "ipso facto" provision. For example, is a buyout price enforceable if it applies only to partner bankruptcy and partner divorce? This hardly "fosters predictability" as the Proposal asserts.

Third, as discussed in my working paper, [Expelling Bankrupt Partners] there is no compelling bankruptcy interest at stake. There is clearly no problem with expulsion of bankrupt partners, and indeed this may be in creditors' interests if it is the best way to ensure a buyout of the bankrupt partner. Even if the bankruptcy estate is denied some value by reason of the "ipso facto" provision, this is no different from the effect of secured creditors' priority. Such state law rights have been upheld for good reasons and . . . there are equally good reasons to apply state partnership law and partnership agreements in bankruptcy. [One may] recognize the potential concern that partners may create "spendthrift trusts" for themselves by making investments in partnerships that creditors cannot reach. But because this tactic also hurts solvent partners, it is mainly a problem in the sort of eve-of-bankruptcy context that is covered by fraudulent conveyance law. Thus, per se invalidation of such provisions is unnecessary.

B. Management Rights

Both Professor Ribstein and Richard Levin⁽²⁷⁷⁶⁾ forcefully criticize the novel proposal to include a partner's management rights as part of the "property of the estate," contrary to state law. Creditors are entitled under state partnership law only to the debtor's "economic" interests in the firm. Only a few rogue bankruptcy cases have held otherwise. Including management rights as part of the debtor's estate raises a Pandora's box of complex questions concerning valuation, transfer, the debtor's rights and a trustee's role that obscure rather than clarify creditors' entitlements. I agree with these experts' conclusion that the debtor's management rights should not become part of the debtor's bankruptcy estate. If they do not, then there is no need to provide, as the proposal attempts to do, for exercise of management rights by a trustee. Mr. Levin draws a helpful analogy to illuminate the proposal's lack of conceptual coherence:

In the corporate context, the trustee cannot take over the debtor's role as an officer or director of a corporation just by virtue of becoming trustee of the debtor's estate. To be sure, the trustee as a shareholder may elect a new board and take over the corporation that way, but that is different from stepping into the shoes of an individual for employment or management purposes.

Mr. Levin further points out:

A disputing partner should not be able to use the bankruptcy laws to prevent his ouster from the partnership/LLC, anymore than a corporate officer should be able to retain his position by filing a bankruptcy petition.

If ipso facto clauses are permitted, in most cases, the partnership/LLC agreements, or by default state law, would permit expulsion and buying out the bankrupt partner. No management rights would remain to be dickered about.

C. Transferability and Valuation of a Partnership or LLC Interest

Given the history of partnership law and the reality of the unique relationships that exist among partners, it is incredible to contemplate the Commission's proposal, the first of its kind in my understanding, that would allow a partnership interest to be sold and the purchaser forced upon unwilling non-debtor partners. To enunciate this recommendation, it seems to me, is to refute it. The Commission proposal would, however, change the law and under certain circumstances permit the court to order either the sale of the bankrupt partner's interest and admission of the buyer into the firm or the buyout of the bankrupt partner or member.

Professor Ribstein summarizes the reasons for questioning this proposal:

Under state partnership law, a partner's creditor is entitled to a charging order and, under some statutes and case law, to judicial foreclosure of this charging order that would make the creditor essentially the assignee of the partner's interest. However, even foreclosure would not necessarily entitle the creditor to a buyout, and as assignees creditors may not be able to dissolve the firm or otherwise obtain the value of the partner's or member's interest. These rules involve a complex adjustment of the rights of creditors and non-debtor partners worked out on a statute-by-statute and case-by-case basis under state law. For the general policy reasons discussed above, it is inappropriate to supplant this state law development with a federal provision. Moreover, special federal rules would give partners' creditors a perverse incentive to put partners into bankruptcy so that they can realize more on the partners' interests than they could under state law. This would trigger substantial bankruptcy costs merely to satisfy the selfish objectives of a few creditors.

Ribstein Letter, at 4.

The Commission's proposal on forced buyout of a partner interest, though somewhat less troubling than forced substitution, attempts to defer to state law and partnership/LLC agreements. The proposal allows enforcement of (non-ipso facto) partnership/LLC governing documents that restrict transfers of membership, but "only if" the partnership/LLC pays the "buyout price"; the "buyout price" is defined as the highest non-bankruptcy-related value provided in the documents, or if there is none, a "fair price". The forced buyout provision permits the court to fix reasonable payment terms, balancing the needs of the debtor's estate and the firm. It is not the buyout I object to so much as the court's authority to fix a price for it.

The perceived evil that this proposal seeks to avert is sub-market buyout valuations that would unfairly penalize creditors of a partner/LLC debtor. Professor Ribstein questions the utility of this proposal:

The problem of sub-market-value buyouts is not normally a serious one, however. Partnership buyout provisions typically are triggered by any partner dissociation, including those resulting other than from bankruptcy. If the partners were willing to deny market value to themselves on retirement or to their estates on death without knowing in advance whether they would be the surviving or remaining partners then the price presumably reflects both the costs and benefits of sub-market-value buyout even if a particular buyout ultimately is triggered by bankruptcy. Creditors' interests do not justify invalidating such a clause.

Ribstein, Expelling Bankrupt Partners, at 14.

The Commission's "fair price" provision ignores the ability of a partner's creditors to ascertain the partnership's buyout terms and adjust their credit decisions accordingly. The provision also affords redundant creditor protection. If the partner's buyout provision has been set at zero or unrealistically low to hinder, defraud or delay creditors, fraudulent conveyance and other laws already address the problem.

Finally, the Commission's proposal invites distracting litigation over whether a buyout provision was "on account of" bankruptcy if the provision also covers other events, such as partner divorce. Clever drafters could make the interpretation of this provision difficult. Enforcing state law and thereby the partnership/LLC agreements offers on balance a clear, efficient, fair and inexpensive means to distribute the debtor/partner's interest among the creditors.

CONCLUSION

Before Congress enacts these provisions, which change the rights that partners have among themselves and with regard to creditors of a bankrupt partner, it should look closely at the consequences for partnership/LLC law development generally and consider whether an additional layer of regulation of these extremely inventive types of business organizations is really needed. The bankruptcy tail should not wag the formidable investment dog that has been created by modern partnership/LLC law.

Notes:

²⁷⁷³  Professor Larry E. Ribstein, GMU Foundation Professor of law, George Mason University, Co-author of Allen R. Bromberg and Larry E. Ribstein, Bromberg & Ribstein on Partnership (1988); Ribstein and Keatinge, Limited Liability Companies. Return to text

²⁷⁷⁴  These comments draw heavily upon Professor Ribstein's Letter to Stephen H. Case concerning NBRC Partnership Proposals, May 27, 1997 ("Ribstein Letter"); my conversations with transactional lawyers; and Professor Ribstein's article, The Federalization of Partnership Breakup: Expelling Bankrupt Partners, George Mason University School of Law, Law and Economics Working Paper No. 97-01 (May 19, 1997) [hereinafter Expelling Bankrupt Partners]. Return to text

²⁷⁷⁵  A previous version of these proposals limited the application of the automatic stay to certain kinds of intra-partnership actions. The final version of the proposals does not do so, and I infer that the partners would be prevented from expelling this partner without first gaining approval of the bankruptcy court. Return to text

²⁷⁷⁶  Mr. Levin is now a partner at Skadden, Arps and was a principal legislative aide when the 1978 Bankruptcy Code was enacted. His view of the Commission's partnership proposal appears in a letter to Ms. Liz Holland, Commission staff member, June 13, 1997. Return to text