LLP: When Is A Partnership Not a Partnership (And Who Cares)?

In re Beltway Law Group, LLP, 514 B.R. 341 (Bankr. D. D.C. 2014) –

A managing partner filed an involuntary chapter 7 petition against a professional limited liability partnership. The bankruptcy court denied the petition and dismissed the case based on its interpretation that the entity was a corporation and not a partnership for purposes of the Bankruptcy Code.

Under Section 303(b)(3) of the Bankruptcy Code, if an entity is a partnership then an involuntary petition may be filed by “fewer than all of the general partners in such partnership.” The key question for the court was whether a limited liability partnership (LLP) should be classified as a partnership or as a corporation.

Although the Bankruptcy Code does not define “partnership,” it does define “corporation;” and the definition of corporation includes “partnership associations organized under a law that makes only the capital subscribed responsible for the debts of such association.” The court found that under applicable state law only the capital contributed by an LLP partner is at risk and partners are not liable for debts of the LLP by reason of their status as a partner. Thus, the LLP came within the definition of corporation.

The court found support for this view from additional sections of the Bankruptcy Code. It noted Section 723(a) provides that in a chapter 7 bankruptcy, if a “partnership” is insolvent, the chapter 7 trustee has a claim against general partners for the deficiency to the extent that general partners are personally liable under non-bankruptcy law.  Since the partners were not liable for an LLP’s debts, this section would not be applicable.

Along the same lines, Section 502(a) provides that in the case of a partnership that is a debtor in a chapter 7 bankruptcy, the creditor of a general partner has standing to object to claims against the partnership. The court viewed this as recognition that those creditors have an interest since reducing claims against the partnership reduces the potential exposure of the general partner dollar for dollar (on account of the claims that can be made against the general partner if the partnership is insolvent).

The court contrasted an LLP to a limited partnership, which is expressly excluded from the definition of “corporation.” Under applicable state law, a limited partnership was required to have at least one limited partner and one general partner, and a general partner is liable for the debts of the limited partnership by virtue of its status as a general partner.

The court also considered the history of this debtor. In particular, it was originally formed as a limited liability company and then converted to a limited liability partnership. Since the converted entity was still liable for all liabilities of the converting entity, the court reviewed whether there were any carryover liabilities.

However, members of a limited liability company are not liable for the debts of the LLC by virtue of being a member. Thus even in the prior incarnation the debtor was a corporation. The court acknowledged that a member of a professional LLC can be liable for the negligent or wrongful acts and misconduct of individuals under the member’s supervision and control, but found that this liability was imposed by reason of the supervision and control, and was not based on status as a member.

Consequently, in this case the limited liability partnership was classified as a corporation, and thus the managing general partner could not file an involuntary petition under Section 303(b)(3).

Note that this case should not be read to mean that all limited liability partnerships will be classified as corporations. Under the original LLP statutes, partners were protected only from vicarious liability for the negligent or wrongful acts of other partners or employees of the LLP, and remained liable for the LLP’s contractual obligations. This type has been referred to as a “partial shield” LLP. Later some states gave broader protection, granting limited liability to LLP partners similar to that of a shareholder in a corporation. This type has been referred to as a “full shield” LLP.

Although there is a trend towards full shield LLP statutes, there are still states with partial shield statutes. Under the court’s reasoning, it seems likely that a “partial shield” LLP would not be considered a corporation.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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