by John C. Murray
© 2001. All rights reserved.
Because limited liability companies ("LLCs") are still relatively new state-law creations, the treatment of these entities in bankruptcy is uncertain, i.e., will they be treated as partnerships or corporations for bankruptcy purposes? Also, because LLCs are neither partnerships nor corporations - though they have characteristics of both - can a member or manager file a bankruptcy petition on behalf of the LLC without engaging in the unauthorized practice of law?
These questions were both recently addressed and answered in In re ICLNDS Notes Acquisition, LLC, 259 B.R. 289 (Bankr. N.D. Ohio 2001). In this case the court held that the debtor, ICLNDS Notes Acquisition ("ICLNDS"), an Ohio LLC, was not eligible under the Bankruptcy Code ("Code") to file a pro se Chapter 7 bankruptcy petition, and that ICLNDS's manager engaged in the unauthorized practice of law by filing the petition. (It is not certain from the court's decision whether the manager was a member of the LLC, or an independent manager. Under Ohio law, an LLC may be managed by a manager who is not a member. Ohio Rev. Code Ann. § 1705.25).
ICLNDS's voluntary bankruptcy petition (with attached schedules) was signed by David Bruno both as "Manager" of ICLNDS and as the non-attorney petition preparer under § 110 of the Bankruptcy Code ("Code"). (Section 110 regulates the activities of non-lawyers who prepare bankruptcy petitions for compensation, and permits a lay person to assist another person with ministerial acts such as typing a petition). ICLNDS did not file an application to employ an attorney in connection with the filing.
The United States trustee brought an action to dismiss ICLNDS's bankruptcy petition, arguing that an LLC could not appear in court pro se, and that Mr. Bruno had engaged in the unauthorized practice of law by filing the petition. ICLNDS and Mr. Bruno neither responded to the trustee's motion nor appeared at the hearing on the motion.
The court agreed with the trustee's arguments, and granted the trustee's motion to dismiss the case. The court first addressed the issue of whether an LLC constituted an entity eligible to file a bankruptcy petition under the Code. The court noted that, under §§ 109(a) and 101(13) of the Code, the debtor must be a person or a municipality, and that § 101(41) of the Code defines "person" as including individuals, corporations, and partnerships. The court then stated that although there is no specific reference in the Code to LLCs, "[u]nder the rules of construction applicable to the Code . . . the use of the term 'includes' is not limiting (citation omitted). In other words, individuals, corporations and partnerships are clearly eligible for relief, but other similar entities are as well"). Id. at 292.
The court determined that under Ohio law (as in other states), an LLC is neither a partnership nor a corporation, but a "hybrid" that has features of both a corporation and a partnership. Therefore, the court held, "[a]s corporations and partnerships are eligible to be debtors, and because an LLC draws its character from both of those forms of doing business, an LLC is similar enough to those entities that it also comes within the definition of 'person' and is eligible for protection under the Code". Id. at 293.
The court then turned to the issue -- which appeared to the court to be one of first impression -- of whether ICLNDS could make a pro se appearance in court through its manager (who was not an attorney), or could only be represented by counsel.
The court stated that although, under 28 U.S.C. § 1654, individuals have the right to represent themselves without a lawyer in federal proceedings, "[t]hat right does not extend to permit them to represent other people or entities because by doing so they would be engaging in the unauthorized practice of law. The general rule is that corporations, which are artificial entities, may only appear in court through an attorney." Id. The court noted that the Ohio Supreme Court had adopted a similar rule. The court also noted that this same general rule, supported by the vast majority of case law, applied to partnerships as well, i.e., partnerships must be represented by counsel in legal proceedings. Accordingly, the court ruled that whether an LLC is viewed as a corporation, a partnership, or a hybrid, it could only appear in court through an attorney.
The court noted that had ICLNDS so requested, it ordinarily would have granted an additional period of time for it to obtain legal counsel. However, the court granted the trustee's motion to dismiss the case because ICLNDS, despite being on notice, did not respond to the motion to dismiss or file an application to employ counsel.
Finally the court cited, as an additional reason to dismiss the case, the fact that Mr. Bruno's actions in preparing and filing the bankruptcy petition and schedules constituted the unauthorized practice of law. The court stated that under Ohio law, the practice of law "includes commencing an action or proceeding in which the person is not a party (citation omitted)." Id. at 294. Therefore, the court held, an individual who prepares and signs a bankruptcy petition (which commences the case) other than in the individual's own name, is commencing the case for another and has engaged in the unauthorized practice of law. (The court also noted that the unauthorized practice of law would include counseling another individual or entity on financial matters in connection with bankruptcy). The court found that the fact that Mr. Bruno signed the petition as a non-lawyer bankruptcy petition preparer did not protect him because § 110 of the Code "does not authorize a non-lawyer to give substantive advice and counsel about the bankruptcy process or otherwise to engage in the practice of law (citations omitted)." Id. at 295. The court noted that while Bankruptcy Rule 9010 authorizes a debtor's agent, attorney in fact, or proxy to appear in court and act in the debtor's behalf, this Rule expressly states that such representative may only "perform any act not constituting the unauthorized practice of law." Id. at n.2 and n.3.
DISCUSSION:
1. The court's holding in ICLNDS Notes Acquisition, supra, that an LLC, though not defined in the Code, is eligible to file (or have filed against it) a bankruptcy proceeding is welcome, though not surprising. The uncertainty of whether an LLC is eligible to be a debtor under the Code has been especially troublesome with respect to single-member LLCs. This is because if an LLC is treated as a partnership, it could dissolve upon the bankruptcy of its sole member and its assets distributed to creditors and the bankrupt member. If, on the other hand, the LLC were treated as a corporation, it would not dissolve upon the bankruptcy of the last remaining member, although the member's ownership interest could be transferred. Some commentators believe that, at least under the Delaware Limited Liability Company Act, Del. Code Ann. tit. 6, § 18-101 et seq. ("DLCC Act"), an LLC should be treated as a corporation because the LLC operating agreement is similar to a certificate of incorporation and a member's interest is analogous to a share of stock in a corporation. See Larry E. Ribstein and Robert R. Keatings, Limited Liability Companies, § 14.04, at 14-18 (2000) ("[F]rom a policy standpoint, LLCs probably should be considered corporations for bankruptcy purposes because the special bankruptcy provisions that apply to partnerships primarily relate to the general partner's duty to contribute to payment of the firm's debts"); Carter G. Bishop and Daniel S. Kleinberger, Limited Liability Companies Tax and Business Law, § 1.04 (2)(a) (1999).
Bankruptcy courts generally look to state law to determine whether dissolution occurs upon the bankruptcy of the sole member. Under the DLLC Act, for example, an LLC whose member is in bankruptcy would be treated as if it were a corporation with a bankrupt shareholder and the bankruptcy would not cause a dissolution. If a Delaware LLC agreement is properly drafted, under Delaware law even the bankruptcy of the last remaining member will not, by itself, cause the dissolution of the LLC. Furthermore, under the DLLC Act, it is permissible to admit "springing members," i.e., a person may be admitted as a member (including as the sole member) without acquiring an interest in the LLC or being required to make a capital contribution. See Del. Code Ann. tit. 6, §§ 18-801(a)(4) and (b); James G. Leyden Jr., A Key State's Approach to LLCs: Delaware Can Be Different, 9-MAY Bus. L. Today 51, 63 (2000).
There are no specific provisions in the Code or Bankruptcy Rules that deal with LLCs, and the application of bankruptcy law and specific Code provisions is uncertain. The Code does not include an LLC within the definition of a debtor that is eligible for relief. However, it is likely that a bankruptcy court would conclude that an LLC would qualify as a debtor under the Code. See In re ICLNDS Notes Acquisition, supra, 259 B.R. at 292 ("There is no specific reference in the Code to a limited liability company. Under the rules of construction applicable to the Code, however, the use of the term "includes" is not limiting . . . . . In other words, individuals, corporations and partnerships are clearly eligible for relief, but other similar entities are as well"); Committee on Bankruptcy and Corporate Reorganization of the Association of the Bar of the City of New York, Limited Liability Companies in Bankruptcy, in The Best Entity for Doing the Deal, at 747, 763-64 (PLI Corp. Law and Practice Course Handbook Series No. 747 (1996)). Case law is just beginning to develop in this area. Does an LLC qualify as a "corporation" (which includes an "association having a power or privilege that a private corporation, but not an individual or a partnership, possesses" and a "partnership association organized under a law that makes only the capital subscribed responsible for the debts of such association") as defined in sec. 101(9) of the Code, or does it qualify as a "person" (which includes an "individual, partnership and corporation") as defined in sec. 101(41) of the Code? As noted above, the Code currently does not recognize an LLC as a distinct or separately defined entity. However, a court may find that an LLC has significant similarities to both partnership and corporate entities to qualify as a "person" entitled to protection under the Code. See In re ICLNDS Notes Acquisition, supra, 259 B.R. at 293 ("[a]s corporations and partnerships are eligible to be debtors, and because an LLC draws its character from both of those forms of doing business, an LLC is similar enough to those entities that it also comes within the definition of "person" and is eligible for protection under the Code").
Where and whether an LLC files a bankruptcy petition can be different depending on whether corporate or partnership characteristics are deemed to apply. Proper authorization for the filing of a voluntary bankruptcy petition will depend on whether the LLC is treated as a partnership or a corporation, and such determination may be different depending on whether the LLC is member-managed or manager-managed. If the LLC is member-managed and is treated as a partnership under the Code, all of the members would be required to consent to a bankruptcy filing. If the LLC is managed by one or more designated managers, it is unclear (absent specific provisions in the LLC's operating agreement) whether the manager(s) alone may determine whether to file a bankruptcy proceeding, or whether the filing of a bankruptcy petition is such an extraordinary event that all members would be required to consent. An LLC's operating agreement should expressly address who is authorized to file a bankruptcy petition on behalf of the LLC. See Thomas F. Blakemore, Limited Liability Companies and the Bankruptcy Code, 13 Am. Bankr. Inst. J. 12 (June 1994); Federal Rule of Bankruptcy Procedure 1004 (which requires the consent of all partners to the filing of a voluntary petition on behalf of a partnership and requires service of an involuntary petition on all non-petitioning general partners).
It is also unclear whether an LLC could contest the filing of an involuntary Chapter 7 or Chapter 11 bankruptcy petition against it on the basis that it is not a "person" under sec. 101(41) of the Code, or whether an LLC could convert a Chapter 11 proceeding to a Chapter 7 proceeding. Section 303(a) of the Code states that an involuntary bankruptcy proceeding may be filed only against "a person, except a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial corporation, that may be a debtor under the chapter under which such case is commenced." Under sec. 303(d) of the Code, a general partner in a partnership debtor that did not join in the filing of an involuntary bankruptcy petition may challenge the petition and seek to have it denied. This provision would apply to an LLC only if it is treated the same as a partnership in bankruptcy. If an LLC is treated as a corporation in bankruptcy, only creditors would be permitted to file an involuntary petition against the LLC, and individual members could not file an involuntary proceeding against the LLC. (The operating agreement could even expressly prohibit such a filing).
Under most state LLC statutes, if a member files a bankruptcy case the LLC automatically dissolves (unless otherwise specified in the operating agreement). Is this provision of a state LLC statute overridden by the Code because it constitutes an ipso facto clause (i.e., a clause that modifies or eliminates a party's contractual rights solely because of a bankruptcy filing) which is unenforceable under sections 541(c)(1), 363(l) and 365(e) of the Code? The answer may depend on whether the articles of organization and operating agreement are regarded as executory contracts (i.e., contracts on which performance remains due to some extent on both sides). The question then becomes whether these documents are "organic" governing documents (as opposed to executory contracts) and whether a bankruptcy court, even if it held the documents to be executory, would enforce the documents with the sole exception of the bankruptcy-remote provisions if the agreements were rejected, or permit such rejection to cause a dissolution of the LLC without providing at least a "winding down" period.
If the LLC cannot be dissolved because of the bankruptcy, will this have an adverse impact on characterization of the entity for tax purposes because it will then have continuity of life? Will such a determination depend on whether a member of an LLC files a Chapter 7 proceeding or a Chapter 11 proceeding? Can the bankrupt member assign some or all of his, her or its LLC interest, despite statutory or contractual provisions that prevent such a transfer? If the bankrupt member is also a manager, is the distraction of the bankruptcy and the lack of an on-going financial interest in the entity likely to affect his or her actions on behalf of the LLC? (Under recently enacted amendments to the Illinois LLC act, a member who becomes a debtor in bankruptcy, executes an assignment for the benefit of creditors, etc., becomes a "dissociating member" and such a member's right to participate in the management of the LLC thereupon terminates). See James M. Jorissen, Member Bankruptcy Under the New Minnesota Limited Liability Company Act: An Executory Contract Analysis, 77 Minn. L. Rev. 953 (1993).
In In Re Daugherty Construction, Inc., 188 B.R. 607 (Bankr. D. Neb. 1995), the court held that the LLC articles of organization and operating agreements of the two LLCs of which the debtor was a member were executory contracts that the debtor could assume or reject. The court also found that the state LLC statute providing for dissolution of an LLC upon a bankruptcy filing by a member violates the Code, and therefore was not enforceable against the debtor-member upon commencement of the debtor-member's bankruptcy case. The court further held that the actions of the other members of the two LLCs upon commencement of the debtor-member's Chapter 11 bankruptcy petition, including holding meetings in the debtor's absence, voting to continue the LLCs' construction business, and actually continuing and controlling the LLCs' business under new membership, violated the automatic stay provisions of sec. 362(a) of the Code and would be set aside to the extent that they impaired, modified, or terminated the member-debtor's interest in the limited liability companies. However, because this was a case of first impression and the court determined that the acts of the other members appeared to be good faith attempts to protect their interests in the LLCs under the operating agreement and the state LLC statute, the court concluded that sanctions against the other members were not appropriate. See also In the Matter of GP Express Airlines, Inc., 200 B.R. 222, 232 (Bankr. D. Neb. 1996) (the court, citing In re Daugherty, stated that "the Bankruptcy Code will not enforce provisions in private agreements or under nonbankruptcy law which terminate a debtor's interest in property or an executory contract merely because of a bankruptcy filing"); In re Sandman Associates, L.L.C., 251 B.R. 473, 482-43 (W.D.Va. 2000) (holding that where debtor LLC filed Chapter 11 bankruptcy petition solely for purpose of rejecting alleged executory contract to admit new member, new member's failure to execute LLC operating agreement as provided in the contract was not material breach that would create executory contract that debtor could reject); Anthony Michael Sabino, Litigating the Limited Liability Company, Part II: A Tale of Two Bankruptcy Courts, 69-APR N.Y. St. B.J. 22 (1997); Limited Liability Companies and Bankruptcy, Report by the Committee on Bankruptcy and Corporate Reorganization of the Association of the Bar of the City of New York, 937 PLI/Corp. 747, 800-05 (1996).
However, in Broyhill v. DeLuca (In Re DeLuca), 194 B.R. 65 (Bankr. E.D. Va. 1996), the court held that an operating agreement is an executory contract, but that because the object of the agreement (the development of a real estate project) had been started but not yet completed and the parties had on-going duties and responsibilities with respect to the successful conclusion of the project, the nature of those duties and responsibilities constituted a contract for personal services under applicable state law because the identity of the managers was material to the existence of the LLC. The court noted that such a contract for personal services cannot be forced on an unwilling party and is not subject to the Code prohibition on the enforceability of ipso facto clauses. The court further noted that "for the purpose of analyzing the effect of a member's bankruptcy upon the continued exercise of membership rights, it seems most appropriate to treat the relationship among members of a limited liability company as analogous to that of that [sic] among the partners of a partnership." Id. at 74. The court also stated that an LLC "is a form of legal entity that has attributes of both a corporation and a partnership but is not formally characterized as either one. Generally, an LLC offers all of its members, including any member-manager, limited liability as if they were shareholders of a corporation but treats the entity and its members as a partnership for tax purposes." Id. at 71. (The court in In re ICLNDS Notes Acquisition, supra, cited this passage from DeLuca in support of its holding that an LLC was eligible to file a bankruptcy petition).
In a companion case, JTB Enterprises, L.C. v. D & B Venture, L.C. (In Re DeLuca), 194 B.R. 79 (Bankr. E.D. Va. 1996), the court concluded that because the LLC operating agreement provided that each of the members had an equal vote, the holder of a 50 per cent membership interest could not cast "a majority vote of the members," as required by the operating agreement, to remove the managing member notwithstanding that the holder of the 50 per cent interest may have had the larger capital account, and the court held that the decision of the member holding such 50% interest to file a Chapter 11 petition on behalf of the LLC was a "major decision" under the operating agreement that required the vote of all the members. The court noted that it was aware that its holdings in the two related DeLuca decisions were contrary to the ruling of the court in In Re Daugherty, supra, but that it believed its holdings were consistent with the controlling authority in the district.
In In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr. E.D.Va. 2000), the court held that both before and after the enactment of amendments to the applicable LLC statute providing for the continued existence of an LLC, the bankruptcy of a member effected an assignment of that member's interest, whereby the assignee would retain his or her right to share in the LLC profits, losses and distributions but would forfeit any right to participate in management of the LLC. The court also ruled that the operating agreement was not an executory contract because it "merely provides the structure for the management of the company" and "imposes no additional duties or responsibilities on the parties" and the economic interest of the bankrupt member was not impaired nor did it affect the ability of the LLC to continue in business. Id. at 704. The court distinguished In re DeLuca, supra, by finding that, as opposed to DeLuca, "[t]his case does not concern an entity whose organic documents or enabling statute dissolves the entity on the filing of a member's petition in bankruptcy." Id. at 703.
As a result of their negative experiences in recent years involving bankruptcy filings by and against borrowers, real estate lenders have learned that if a borrowing entity with very few creditors is created, such as a bankruptcy-remote LLC, it will be much more difficult for the borrower to file, or have filed against it, a bankruptcy proceeding or avoid early dismissal. See, e.g., Barakat v. Life Ins. Co. of Virginia, 99 F. 3d 1520, 1526 (9th Cir. 1996) (holding that where the only bona fide, impaired claim in the bankruptcy case was the claim of the mortgage lender, the debtor "should [not] be able to cramdown a plan that disadvantages the largest creditor"); John C. Murray, The Lender's Guide to Single-Asset Real Estate Bankruptcies, 31 Real Prop. Prob. & Tr. J. 393, 461-471 (Fall 1996); James R. Stillman, Real Estate Mezzanine Financing in Bankruptcy, Finance Topics, American College of Real Estate Lawyers, Midyear Meeting, Scottsdale, Arizona, April 4-5, 1997, Tab 24, at 3; Varallo and Finkelstein, Fiduciary Obligations of Directors of the Financially Troubled Company, 48 Bus. Law. 239 (1992).
A desirable alternative for a lender seeking to protect its interests without opening itself up to unwanted liability may be to require the LLC to appoint an "independent director," i.e., a reputable individual or entity with no prior or current affiliation or relationship with either the lender or the LLC, as an additional member of the LLC. However, several courts have held that as an entity approaches insolvency, i.e., becomes unable to pay its debts as they become due in the ordinary course of business, the directors owe a fiduciary duty to all the creditors of the company. See, e.g., Geyer v. Ingersoll Pub. Co., 621 A.2d 784, 787-89 (1992); Credit Lyonnais Bank, Nederland, N.V. v. Pathe Comm. Corp., No. 12150, 1991 WL 277613, (Del. Ch. Dec 30, 1991); In re Andreuccetti, 975 F. 2d 413, 421 (7th Cir. 1992). In In re Kingston Square Assocs., 214 B.R. 713, 735 (Bankr. S.D.N.Y. 1997), the principal of the debtor orchestrated, with the help of unsecured creditors and the debtor's limited partners, an involuntary bankruptcy petition against the debtor. The court held such actions were not taken in bad faith and were necessary because the "independent director" had abdicated his fiduciary duty to the debtors, creditors and limited partners in favor of the interests of the mortgage lender. See also In re Cumberland Farms, Inc., 249 B.R. 341, 349-51 (Bankr. D. Mass. 2000) (finding clear breach of duty where director caused cash flow from property to be used to repay loans from "his" company to detriment of debtor's finances generally, and noting that directors must act "with absolute fidelity and must place their duties to the corporation above every other financial or business obligation . . . They cannot be permitted to serve two masters whose interests are antagonistic"); Committee on Bankruptcy and Corporate Reorganization of the Association of the Bar of the City of New York, New Developments in Structural Finance: Report by the Committee on Bankruptcy and Corporate Reorganization of the Association of the Bar of the City of New York, 56 Bus. Law. 95, 162-66 (2000) (discussing fiduciary duties of directors and impact of Kingston Square Associates, supra).
With respect to bankruptcy issues affecting LLCs it is uncertain whether, in the absence of clear-cut case law, the Code will eventually be amended to specifically define and deal with LLCs. At a 1997 meeting of the National Bankruptcy Review Commission, which considered proposed amendments to the Code, the Small Business, Partnership and Single Asset Real Estate Working Group submitted a Memorandum suggesting that the Code be amended to provide for similar treatment of partners and LLC members under the Code, the exclusion of partnership and LLC agreements from the executory contract provisions of Section 365, and the unenforceability of ipso facto clauses. The Memorandum did not suggest altering the overall treatment of debtor LLCs in bankruptcy, but only provided for specific treatment of the LLC relationship for LLC member or LLC manager debtors. The Memorandum stated that LLC members are similar to general partners in member-managed LLCs and similar to limited partners or shareholders in manager-managed LLCs. See Sally S. Neely, Partnerships and Partners and Limited Liability Companies and Members in Bankruptcy: Proposals for Reform, 71 Am. Bankr. L.J. 271, 311 (1997). No further action has been taken on this proposal and a legislative solution does not appear imminent, as the proposed revisions to the Code being considered by Congress as of the date of this article do not include any provisions addressing LLC issues.
2. The court's ruling in ICLNDS Notes Acquisition that an LLC can only appear in court through an attorney, and that a non-lawyer who prepares and files a bankruptcy petition on behalf of an LLC is engaged in the unauthorized practice of law (whether an LLC is regarded as a corporation, partnership, or hybrid entity), brings some much-needed guidance to what had heretofore been an unanswered question. The court's analysis of this issue is sound and well reasoned, and should encourage LLCs to retain and consult counsel before making the decision to file a bankruptcy petition.
