Partner Liability: Choice of Law Could Make More of a Difference Than You Might Expect

Residential Liquidating Trust v. Mortgage Investors Group, Inc. (In re Residential Capital, LLC), 527 B.R. 590 (Bankr. S.D.N.Y. 2015) –

A liquidating trust sued the general partners of a partnership for claims of contractual breach by the partnership.  The partners argued that Federal Rule of Civil Procedure 17 required the court to apply New York law, and under New York law the complaint should be dismissed.  The trust argued that Tennessee or Minnesota law applied so that the general partners were jointly and severally liable with the partnership.

The defendants were a Tennessee general partnership together with the Tennessee corporations that were its general partners; the lawsuit was filed in a New York bankruptcy court; and the claim was for breaches of a contract governed by Minnesota law.  Thus, the choices for governing law included:  the forum state (New York), the state where the general partners were organized (Tennessee), and the contractual choice of law state (Minnesota).

The defendants argued that this case was a question of the capacity to sue or be sued governed by FRCP 17(b), which provides that capacity is determined (1) for a corporation by the law under which it is organized, and (2) by the law of the forum state for other entities (except that a partnership with no capacity under that law may sue or be sued in its common name).  The defendants argued that their capacity to be sued should be governed by New York law under the provision applicable to partnerships.

The trust countered that the defendants confused the issue of whether they had the capacity to be sued with the question of whether they could be liable.  It contended the first issue was procedural, and since the defendants were Tennessee corporations that required application of Tennessee law.  However, the second issue of liability was substantive, so New York choice of law rules should be applied – with the result that either Tennessee or Minnesota law governed.

The court began its analysis by noting that both sides assumed that the Tennessee partnership would be treated as a partnership under New York law.  However, under the New York partnership statute the definition of “partnership” states that “any association formed under any other statute of this state or any statute adopted by authority other than the authority of this state, is not a partnership under this chapter…”  Thus a Tennessee partnership does not come within the definition of the New York partnership statute.

The court reviewed another case that held that the liability of foreign partnerships was governed by the law of the state where the partnership is organized.  The bankruptcy court agreed with the conclusion that FRCP 17(b) requires that a partnership’s capacity to be sued be determined under the forum state to the extent that it relates to partnerships.  However, in this case foreign partnerships fell outside the New York partnership statute and instead were governed by rules of law and equity.  As a result courts generally apply the law of the state of organization to the question of liability of foreign partnerships.  In this case, that meant Tennessee law.

But even if the FRCP provision applicable to corporations (since the general partners were corporations) was the relevant section – which would mean that the partners’ capacity to be sued would be determined under Tennessee law – the question was not capacity to be sued but rather which law applied to determine liability for a breach of contract.

In considering the issue, a threshold question was whether there was really any “actual conflict” between Tennessee and Minnesota as opposed to New York law.  It appears that the parties agreed that the general partners would be jointly and severally liable with the partnership for a contract breach under Tennessee and Minnesota law.  So the only issue was whether a different result would be reached under New York law.

The defendants contended that under New York law it was necessary to allege that the partnership was insolvent or unable to pay its debts in order to avoid dismissal of claims against the partners.  However, the court pointed out that this rule was not applicable where the partnership itself was also a named defendant.

Consequently, the court determined that the general partners could be sued for contract breach claims against the partnership.

The liability of general partners for partnership debts is not an academic question in bankruptcy.  In a partnership’s chapter 7 liquidation proceeding, if its assets are insufficient to satisfy the claims, under Section 723 of the Bankruptcy Code the trustee has a claim against the partnership’s general partners “to the extent that under applicable non-bankruptcy law such general partners are personally liable for such deficiency.”

This also has a cascading effect on a chapter 11 reorganization because under Section 1129(a)(7)(A)(ii) of the Bankruptcy Code, in order to be confirmed a plan of reorganization must meet the “best interests of creditors” test – meaning that any holder of a claim or interest that does not accept the plan must receive at least as much as it would in a chapter 7 proceeding.  Since distributions in a chapter 7 proceeding will take into account potential recoveries from general partners, a general partner’s liability for partnership debts will increase the amount required to satisfy this confirmation test.

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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