Proof of Claim: Foreign Qualification Requirements May Be More Important Than You Thought

In re Flex Fin. Holding Co., 518 B.R. 891 (Bankr. D. Kan. 2014) –

A landlord filed a proof of claim for ~$1.34 million for a debtor’s prepetition breach of its lease.  The debtor objected based on the landlord’s failure to qualify to do business in the state where the leased property was located – arguing that this provided a defense to the claim under nonbankruptcy law and the landlord lacked the capacity to file the claim.

In 2013 a landlord sued a tenant in state court for delinquent rent.  In mid‑2013, the tenant filed bankruptcy.  The court set a bar date for claims in early 2014.  Shortly before the bar date the landlord filed its proof of claim.

The landlord was a limited liability company organized in Missouri.  The leased property was located in Kansas.  At the time it filed its proof of claim it had not qualified to do business in Kansas.  The landlord did ultimately register in Kansas.  However, this occurred after it filed the proof of claim and after expiration of the claims bar date.

Kansas has what the court described as a “closed-door” statute:  A foreign limited liability company (i.e., an LLC organized in another state) could not “maintain any action, suit or proceeding in the State of Kansas until it… registered in the state and… paid to the state all fees and penalties for the years, or parts thereof, during which it did business in the state without having registered.”

The debtor argued that the landlord was required to register to do business in Kansas since it owned income producing property and was doing business in Kansas.  And since the landlord was not authorized to do business prior to the claims bar date, the debtor asserted that it had defenses to the claim under Sections 502(b)(1) and 558 of the Bankruptcy Code.

In determining the impact of the failure to register, the court began by considering a case regarding the relationship between a claim asserted while a foreign corporation was not registered and the statute of limitations.  A state court held that the corporation could not maintain a claim while it was in non-compliance with the registration requirements.  The state court viewed the failure to register as affecting the corporation’s capacity to sue, which could be cured by registration.

However, in the state court’s view, the proper course of action was to dismiss the claim without prejudice and then allow the claim to be refiled after the corporation had registered.  The corporation would not be precluded from pursuing its claim, but it would be out of luck if the statute of limitations expired before it was able to register.

Section 502(b)(1) provides that a claim should be disallowed to the extent that “such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law for a reason other than because such claim is contingent or unmatured.”  Thus, the debtor argued that the landlord could not have pursued its claim under state law, so it should be disallowed in the bankruptcy court.  However, the bankruptcy court noted that if the state court litigation had not been stayed, the landlord would have been able to pursue its claim after it registered (since the statute of limitations had not expired).  Consequently the failure to register did not cause the claim to be unenforceable.

Alternatively, the debtor argued that under state law the landlord lacked the capacity to act as a result of its failure to register, which was a defense available to the debtor that could be asserted on behalf of the bankruptcy estate under Section 558.  The court rejected this argument because the Federal Rules of Civil Procedure, not state law, govern the capacity of entities to engage in bankruptcy claim litigation.

Turning to FRCP 17, for a corporation the capacity to sue is determined by the law of the state under which it is organized, and for other entities capacity is determined under the law of the state where the court is located, with certain exceptions.  In particular, “a partnership or other unincorporated association” that does not have capacity under state law is still entitled to sue to enforce a substantive right under federal law.

The court determined that a limited liability company should not be classified as a corporation, but rather as one of the other types of entities.  Although this meant that the law of Kansas (as opposed to Missouri) determined the landlord’s capacity, the court also concluded that the exception applied.  Thus, it had no difficulty reaching a conclusion that the landlord had capacity to file a proof of claim, since asserting a claim in bankruptcy was enforcing a substantive right under the laws of the United States.

Consequently, the court determined that the landlord’s failure to register to do business in Kansas did not provide a defense to the landlord’s claim under applicable law, nor did it provide a basis to disallow the proof of claim for lack of capacity.

It is easy to forget that state statutes requiring registration of foreign entities may have significant consequences.  Typically statutes allow non-compliance to be remedied retroactively, and most provide that the failure to qualify does not affect the validity of contracts executed by the entity.  However, in a few states the validity of a contract executed by an unqualified corporation could be called into question, or officers, directors and other agents of a foreign corporation that failed to register when required could be liable for fines or guilty of a misdemeanor.

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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