A creditor seeking to enforce state law collection remedies against an owner of an unincorporated business owner faces a unique difficulty unknown in the corporate world: statutory restrictions on the transfer of an ownership interest. Unlike corporate stock that bundles management and economic rights in a transferable stock ownership interest, an ownership interest in an unincorporated business entity uniquely unbundles these two fundamentals for the purpose of imposing two different transfer rules: only economic rights are freely transferable, while management rights may only be transferred with the consent of the remaining owners. Understanding this dynamic is critical, because both the corporate and unincorporated rules are merely default rules. A shareholder agreement can make stock nontransferable or subject a transfer to a right of first refusal. Similarly, a partnership or operating agreement of an unincorporated entity can make the management rights freely transferrable or preclude transfer of the economic rights or subject a transfer to a right of first refusal.
Because of these dramatically different transfer paradigms, the collection remedies of an owner’s personal creditors are uniquely tailored to respect the statutory transfer restriction imposed on unincorporated entity management rights. As a direct result, the exclusive collection remedy is a combination of a court imposed charging order lien that may be foreclosed if the lien is not satisfied with a reasonable time. A creditor can never, in either case, obtain the management rights without the consent of the remaining owners. When an owner enters bankruptcy however, the rules change because federal bankruptcy law preempts state entity law and state law agreements. But a creditor of a corporate shareholder can usually obtain the bundled management rights both in and outside bankruptcy. This singular and historic transfer paradigm thus creates unique challenges for creditors of an owner, which this article explores and illustrates.
In 2013, the Uniform Law Commission completed an effort to harmonize the language in various unincorporated business entity laws. This article explores the rights of an owner’s creditors in the context of three specific acts including the Uniform Partnership Act (1997) (last amended 2013) (UPA (2013)), the Uniform Limited Partnership Act (2001) (last amended 2013) (ULPA (2013)), and the Uniform Limited Liability Company Act (2006) (last amended 2013) (ULLCA (2013)). More specifically, this article explores the impact of the harmonized language in these acts with respect to (1) a charging order against an owner and foreclosure of the charging order lien, (2) fraudulent conveyances and entity clawback of illegal distributions, and (3) the effect on the entity of the bankruptcy of an owner.
Charging Orders and Foreclosure
The English Partnership Act (1895) provided that a judgment creditor of a partner was entitled to a charging order directing the partnership to pay the partner’s distributions directly to the judgment creditor. The charging order was a unique collection remedy specifically designed to preclude a partner’s personal creditors from gaining any access to the partnerships assets to satisfy the personal debts of a partner. Brown, Janson & Co. v. A. Hutchinson & Co., 1895 Q.B. 737 (Eng. C.A.). Early American partnership law adopted the same approach and obliquely provided that the judgment creditor could foreclose its charging order lien if not satisfied within a reasonable time. UPA (1914) § 28. However, the purchaser at a foreclosure sale never acquired the partner’s management rights but rather only the partner’s economic interest. Then existing statutory language made this perfectly clear as the purchase of the interest, whether by assignment or conveyance, did not “entitle the assignee, during the continuance of the partnership, to interfere in the management or administration of the partnership business or affairs, or to require any information or account of partnership transactions, or to inspect the partnership books; but it merely entitles the assignee to receive in accordance with his contract the profits to which the assigning partner would otherwise be entitled.” UPA (1914) § 27(1).
So, from the earliest annals of American partnership law, a partner’s personal creditors could not acquire a partner’s management rights without the consent of the remaining partners. Over time, this “pick-your-partner” principle became the central hallmark feature of American unincorporated business entity law. The harmonized unincorporated acts now make clear that a judgment creditor with a charging order holds a lien only entitling the creditor to receive distributions that would otherwise be paid to the partner or limited liability company (LLC) member. UPA (2013) § 504(a), ULPA (2013) § 703(a), and ULLCA (2013) § 503(a). Moreover, the harmonized acts make clear that the purchaser at a foreclosure sale obtains only the ownership of economic rights and does not become a partner or member and thus does not acquire any management rights. UPA (2013) § 504(c), ULPA (2013) § 703(c), and ULLCA (2013) § 503(c).
The right to foreclose is not a uniform statutory rule as many states expressly preclude foreclosure. C. Bishop, “Fifty State Series: LLC Charging Order Statute Table,” http://ssrn.com/abstract=1542244. This lack of uniformity creates “conflict of laws” problems among the states. For example, which state law applies when a person resident in State A (foreclosure permitted) is a member of an LLC formed in State B (foreclosure precluded)? Which state law applies when a judgment creditor seeks collection remedies in State A (since the LLC interest usually travels with the owner)? Two views have developed and both must be considered “under development” as none are opinions issued by the highest state court. One view, based on the definitions of domestic and foreign LLCs, suggests that the State A charging order limitations only apply to a domestic LLC and since the debtor is a member of a foreign LLC, the local rules and limitations are not available. This view applies the law of the foreign jurisdiction (State B). See Hanna v. Baier, No. 20-C-12-007903 (Md. Cir. Ct. Jan. 30, 2013) and Fannie Mae v. Heather Apartments Ltd. Partnership, Not Reported in N.W.2d, 2013 WL 6223564 (Minn. Ct. App., Dec. 2, 2013) (No. A13-0562). The other view applies local State A LLC law under a conflicts analysis suggesting that foreclosure is an important legislative policy directive and so the local State A will not defer to the foreign State B jurisdiction law. Wells Fargo Bank, N.A. v. Barber, 2015 WL 470589 (M.D. Fla. 2015). The issue must await resolution from a state supreme court and then see if other state supreme courts agree. See e.g., Advanced Bionics Corp. v. Medtronic, Inc., 59 P.3d 231 (Cal. 2002).
Thus, under no ordinary circumstances may a judgment creditor acquire a judgment debtor partner or member’s management rights without the consent of the remaining partners or members. One quite special circumstance remained elusive and was judicially explored in a famous Florida case that permitted a judgment creditor of the only member of a single member LLC (SMLLC) to access all the assets of the LLC itself. Olmstead v. Federal Trade Commission, 44 So. 3d 76 (Fla. 2010). The case triggered a flurry of statutory amendments across the country with some states expressly following the Olmstead result and some not. C. Bishop, “Fifty State Series: LLC Charging Order Statute Table,” http://ssrn.com/abstract=1542244. After extensive discussion, the harmonized uniform laws followed the Olmstead result by granting the judgment creditor of the only member of a SMLLC a right to acquire the member’s entire interest, including management rights. ULLCA (2013) § 503(f). This grants the judgment creditor total power over the entity and its assets so the creditor can acquire the assets and sell or sell the entire entity intact with goodwill by selling the sole member’s interest acquired by foreclosure. States adopting a contrary rule usually do so preferring the use of a SMLLC as an asset protection device. If the judgment creditor can only acquire the sole member’s economic right upon foreclosure, the sole member retain management control over the entity and will usually simply make no distributions, thereby frustrating the foreclosing creditor or forcing the creditor to resell the interest to the member at a discount. However, notwithstanding these statutes, a frustrated judgment creditor may nevertheless seek an equitable remedy in the form of a “reverse piercing” of the liability shield to impose the sole owner’s debt on the entity itself. See generally C. Bishop, “Reverse Piercing: A Single Member LLC Paradox,” 54 S.D. L. Rev. 199 (2009) (cited by the Olmstead dissent).
The original American partnership laws permitted a court issuing a charging order to further “then or later appoint a receiver of his share of the profits, and of any other money due or to fall due to him in respect of the partnership, and all other orders, directions, accounts and inquiries which the debtor partner might have made, or which the circumstances of the case may require.” UPA (1914) § 28(1). The power of a court to appoint a receiver or issue “other orders” as circumstances may require has largely been retained in the harmonized acts. UPA (2013) § 504(b), ULPA (2013) § 703(b), and ULLCA (2013) § 503(b). While these provisions may create concern that the accompanying orders may open up the charging order process to serious creditor abuse and interference in the internal affairs of the business, case law has generally not supported this conclusion. In general, courts have concluded that under these provisions a judgment creditor is not entitled to any more information than an actual purchaser of economic rights. See Wells Fargo Bank, NA v. Continuous Control Solutions, Inc., 821 N.W.2d 777 (Iowa Ct. App 2012) and C. Bishop, “Fifty State Series: LLC Charging Order Case Table,” http://ssrn.com/abstract=1565595.
Fraudulent Transfers and Illegal Distributions
Distributions to owners when an entity is insolvent may unfairly reduce assets otherwise available to pay entity creditors. Entity creditors blocked by an entity’s liability shield protecting owners from entity liabilities must have some method to clawback improper distributions to the entity so that its debts may be fairly paid. While large entity creditors may seek contractual protections by precluding distributions in loan documents, unless all the entity owners guarantee the loan, the covenant merely creates entity liability when it is breached. The creditors remain blocked by the entity’s liability shield protecting owners from status liability for entity debts. Of course, there is no need for these protections when owners are liable for entity debts by operation of law. For example, general partners in a general partnership that is not a limited liability partnership (LLP) are already liable for all partnership obligations. UPA (2013) § 306(a). There is no point for a separate provision creating liability for improper distributions to protect partnership creditors since the partners are liable for the entire partnership debt.
However, once a general partnership becomes an LLP, partners are immune from personal liability for entity liabilities. UPA (2013) § 306(c). Consequently, a clawback provision for improper distributions is necessary to protect entity creditors. The harmonized partnership act makes this clear by harmonizing the LLP clawback provisions with the other acts. UPA (2013) §§ 406–407, ULPA (2013) §§ 504–505, and ULLCA (2013) §§ 405–406.
This is a vast improvement over states that still follow the original 1914 Uniform Partnership Act, subsequently amended that law to add provisions allowing a general partnership to become an LLP, but failed to include a distribution clawback provision. In these circumstances, the more general fraudulent transfer or conveyances acts will apply. For example, an important New York case determined that distributions to partners when the firm was arguably insolvent allowed the partnership trustee in bankruptcy to recapture nearly all partner payments since partnership law provided that partners were not entitled to payments for services rendered. In re Dewey & LeBoeuf, LLP, 518 B.R. 766 (Bankr. S.D. NY 2014) and UPA (1914) § 18(f). The court applied the bankruptcy insolvency provision that allows a trustee to avoid a constructively fraudulent transfer because New York partnership law negated a reasonable equivalent value defense. 11 U.S.C. § 548(a)(1)(B). Arguably, the harmonized partnership act fixes the statutory problem. Like the original 1914 act, the 2013 harmonized act provides that a partner is not entitled to remuneration for services as a default rule. Compare UPA (1914) § 18(f) with UPA (2013) § 401(j). However, unlike the 1914 act, the 2013 act defines the term “distribution” to exclude amounts constituting reasonable compensation for present or past services. UPA (2103) § 102(4)(B). As a result, the outcome of In re Dewey & LeBoeuf would not be the same and the trustee could not clawback partner distributions.
The harmonized laws universally include provisions expressly governing distributions to owners when a shielded entity is insolvent. UPA (2013) §§ 406-407, ULPA (2013) §§ 504–505, and ULLCA (2013) §§ 405–406. Since distribution liability is specifically addressed in the statute, presumably the common law “fraudulent” transfer rules do not apply. See Uniform Voidable Transactions Act (2014).
The drafting paradigm separates the definition of an improper distribution from liability for a distribution that is defined as improper. For example, an LLC distribution is “improper” if after the distribution the LLC would not be able to pay debts due in the ordinary course or LLC assets are less than the sum of liabilities if the LLC liquidates. ULLCA (2013) § 405(a)(1)–(2). There are rules for what information the LLC may rely upon as well as when the effect of the distribution is measured. ULLCA (2013) § 405(b)–(c). Once a distribution is “improper” under these standards, liability attaches to those who decided to make the distribution as well as those who received it. Any member with management authority who consented to an improper distribution in violation of standards of conduct, is personally liable for an amount by which the improper distribution exceeds the proper distribution amount. ULLCA (2013) § 406(a). However, a person who merely receives such a distribution is liable for the same excess only if that person knew the distribution was improper. ULLCA (2013) § 406(c). Any person who is liable may seek contribution from other persons also liable. ULLCA (2013) § 406(d). Any action seeking liability must be commenced within two years after the distribution. ULLCA (2013) § 406(e).
Bankruptcy of Managing Owners
The bankruptcy of an entity owner may be problematic for the entity itself and the remaining owners. In general, statutory and entity agreement provisions triggered by bankruptcy are invalid ipso facto clauses and hence cannot preclude the bankrupt debtor’s entity ownership from becoming part of the bankruptcy estate. 11 U.S.C. § 541(c)(1)(B). Indeed, bankruptcy law trumps and preempts all inconsistent state law under the Supremacy Clause. U.S. Const. art. VI, cl. 2. Once the debtor’s interest becomes part of the bankruptcy estate, the lingering concern is whether the bankruptcy trustee will step into the debtor’s shoes so that the estate owns not only the debtor’s economic rights, but also whether the trustee has the right to exercise the debtor’s management rights. If so, this is highly problematic for both the entity and its remaining members. Unlike the remaining members, the trustee’s sole interest is to realize the full economic value of the ownership interest either through a sale of the interest or voting to liquidate the entity to sell its assets. As the discussion below indicates, the outcome of the trustee’s goals depends upon a difficult interpretation of a few complex bankruptcy statutes that directly conflict with state law that attempts to maintain management rights under the exclusive control of the now bankrupt member. Specifically, since the trustee may usually sell to a third party only what the debtor could sell, the trustee may not transfer the debtor’s management rights to a third party without the consent of the remaining members. 11 U.S.C. § 363(f)(1) (respecting applicable non-bankruptcy law). This returns the principal focus and question as to whether the trustee may assume the debtor’s management rights in order to vote the interest in the best interest of the estate. This extraordinarily complex question depends on whether the partnership or operating agreement is considered an “executory contract” and, if so, whether the debtor’s duties are in the nature of unique personal services thereby precluding the trustee from assuming these duties to impose the trustee’s services on those who bargained for the debtor. 11 U.S.C. § 365(c).
The first issue is whether any statutory or contractual provision can preclude an unincorporated entity ownership interest from becoming part of the bankruptcy estate, including both the debtor’s economic rights as well as the management rights. The answer is no, but perhaps oddly, the result does not preclude efforts to make certain the debtor’s management rights do not enter the estate. For example, all harmonized acts “dissociate” a member with management rights upon filing bankruptcy. UPA (2013) § 601(6)(A), ULPA (2013) § 603(7)(A), and ULLCA (2013) § 602(8)(A). The effect of dissociation terminates am owner’s management rights. UPA (2013) § 603(b), ULPA (2013) § 605(a), and ULLCA (2013) § 603(a). So, it is clear that state law attempts to terminate a debtor’s management rights and thereby devalue the interest to the estate. However, bankruptcy law provides that when a person becomes a debtor in bankruptcy the estate includes “all” the debtor’s legal or equitable property interests. 11 U.S.C. § 541(a)(1). Further, bankruptcy law invalidates state law provisions triggered by a bankruptcy filing. 11 U.S.C. § 541(c)(1)(B). So, under the Supremacy Clause, these state law provisions are all unenforceable in bankruptcy. Moreover, these “applicable nonbankruptcy law” provisions are not enforceable because they operate as a forfeiture, modification, or termination of the debtor’s interest in property. 11 U.S.C. § 541(c)(1)(B). Case law supports the understanding that stripping management rights is a forfeiture, modification, or termination. See, e.g., In re Warner, 480 BR 641, 656 (Bankr. N.D. WV 2012).
Once it becomes clear the entire unincorporated entity ownership, both economic and management rights, become part of the bankruptcy estate by operation of law (not by way of a transfer), the focus turns to the use of the management rights by the trustee. Obviously, the intent of unincorporated entity law is to require the consent of all remaining members for any person other than the owner to exercise that owner’s management rights.
The first step in the analysis requires a determination of whether the applicable partnership or operating agreement is an “executory contract.” If executory, the trustee may “assume or reject” the agreement. 11 U.S.C. § 365(a). If assumed, the estate becomes a party to the agreement. While the estate is entitled to the benefits of the contract, if it later rejects or otherwise breaches the obligations, the injured parties breach claim is elevated to an administrative expense priority. 11 U.S.C. §§ 503(b), 507(a)(2) and In re Klein Sleep Prods., Inc., 78 F.3d 18 (2nd Cir. 1996). However, if rejected the breach claim is relegated to a low-level priority pre-petition unsecured claim for damages. 11 U.S.C. § 365(g)(1). However, if the agreement is not executory, the trustee may not reject it, and the contract by operation of law becomes property of the estate. 11 U.S.C. § 541(a), In re Excide Technologies, 607 F.3d 957 (3rd Cir. 2012). However, a trustee may simply abandon the agreement if no net value exists. 11 U.S.C. § 544(a).
Given the ongoing nature of every unincorporated entity, one would think this analysis routine and that the agreement would always have the requisite degree of unperformed duties making it executory by nature. The primary touchstone of executory analysis is the Countryman test stating that a “contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.” V. Countryman, “Executory Contracts in Bankruptcy,” 57 Minn. L. Rev. 439, 460 (1973) (material breach standard). But case law has not always followed such a simplistic analysis. For example, one recent case determined an LLC operating agreement was not executory per se because a breach by the debtor did not discharge the obligations of the other members under the material breach standard. In re Denman, 513 B.R. 720 (Bankr. W.D. Tenn 2014). While most cases reject a per se analysis, several still reject executory characterization. Compare In re Tsiaoushis, 383 B.R. 616, 620 (Bankr. E.D. Va. 2007) (per se rule rejected) with In re Allentown Ambassadors, Inc., 361 B.R. 422 (Bankr. E.D. Pa. 2007) (executory status determined under a factor analysis).
The executory characterization is quite important because bankruptcy law carefully constructs limitations on a trustee assuming a debtor’s position in an executory contract that requires the debtor to render personal services. Specifically, a trustee may not assume or assign a debtor’s position in an executory agreement if “applicable law” excuses another party from accepting performance from any person other than the debtor without the other party’s consent. Without the consent of the remaining owners, an owner may only transfer the economic rights and not the right to participate in management. UPA (2013) § 503(a), ULPA (2013) § 702(a), and ULLCA (2013) § 502(a). So, if a partnership agreement or operating agreement is an “executory contract,” state law transfer restrictions are protected. The trustee cannot assume and assign. 11 U.S.C. § 365(c)(1)(A).
Finally, the bankruptcy of the only member of a SMLLC presents special issues in bankruptcy law just as discussed earlier when a judgment creditor seeks a charging order-foreclosure action against the only member. In both cases, the “pick-your-partner” principle is not in play because there are no other members to object to the trustee exercising dominion and control of the entity. As with a multi-member entity, the bankruptcy estate of the only member of a SMLLC will be included in the bankruptcy estate, both economic and management rights. 11 U.S.C § 541(a).
So, unless constrained by executory contract limitations imposed by state law, the trustee may exercise the debtor’s full membership rights. This would include the right to liquidate the LLC and sell its assets for the benefit of the estate. Some case law exists determining that an operating agreement is per se not an executory contract because there is only one party to the agreement. In re First Protection, Inc., 440 B.R. 821 (9th Cir. BAP Ariz. 2010).
But some early decisions bypass the executory contract analysis because there is only one member and the absence of other members leaves the pick-your-partner rule intact. In re Albright, 291 B.R. 538 (Bankr. D. Col. 2003). As a consequence, the trustee was able to liquidate the SMLLC and gain access to the entity assets.