Both a limited liability company and its sole member filed chapter 7 bankruptcy cases. The chapter 7 trustee for the sole member filed a proof of claim in the LLC’s case for claims of the sole member’s creditors. The bankruptcy court disallowed the claim and the trustee appealed to the district court.
The amount at stake was not trivial. The trustee filed a claim for more than $8 million. Although the initial proof of claim did not include any documentation or provide any basis for the claim, in response to an objection the trustee filed an amendment that argued that (1) “there was a unity of interest and/or ownership among [the member and the LLC] such… that adhering to the fiction of the separate entities’ existence would promote  injustice or inequity,” and (2) they were “mere instrumentalities of each other and each was used to commit wrongdoing and caused unjust loss or injury to creditors” so that (3) the LLC was an alter ego of its member and its “separate existence should be disregarded” for the benefit of the member’s creditors.
The bankruptcy court rejected this argument holding, among other things, that a claim may be filed only by a “creditor” of a debtor, and the member’s trustee did not come within that definition with respect to the LLC: Although the trustee clearly could have filed a claim in the LLC case for amounts owed by the LLC to the member, the bankruptcy court found no basis for giving the trustee some sort of derivative standing to collect money otherwise owed to the member’s creditors.
On appeal, the district court addressed the threshold question of whether the trustee had standing to appeal the bankruptcy order. Under applicable federal law “‘Only when the order directly diminishes a person’s property, increases his burdens, or impairs his rights will he have standing to appeal.'” The bankruptcy court noted that ~$7.5 million of the ~$8 million were duplicative of claims already filed like creditors. Under the circumstances, neither the trustee nor the estate was adversely affected. Because there was no adverse effect and because the trustee did not seek the bankruptcy court’s permission to appeal, the district court concluded that the member’s trustee did not have standing.
There was a related issue of whether the creditor that objected to the trustee’s proof of claim was entitled to object in the first place. The issue was whether a creditor has standing to object to a proof of claim filed by another creditor. However, the general analysis is that a creditor is a “party in interest” and thus may object pursuant to Section 502(a) of the Bankruptcy Code.
The member’s trustee also attempted to find authority for the claim based on prior rulings that certain types of claims could not be pursued by creditors and the trustee was the proper party to pursue them. However, the district court distinguished suing completely separate third parties from an alter ego claim against the member’s LLC – which the court characterized as “not only prohibited, it is nonsensical in the context of basic concepts of the law governing the separate identities of business forms. Under applicable law a claimant cannot sue an entity that wholly owns or is owned by claimant based on an argument that the entity is the claimant’s own alter ego. “The general rule is that the corporate veil is pierced only for the benefit of third parties, and never for the benefit of the Corporation or its shareholders.”
Ultimately the district court agreed with the bankruptcy court’s comment that the remedy where financial affairs of a debtor are inextricably intertwined with those of another is substantive consolidation. (In effect the assets and liabilities of individual debtors are aggregated and they are treated as though they are a single debtor.) However, this is an unusual equitable remedy that requires a showing that “the interrelationships of the debtors are hopelessly obscured” and the time and expense necessary to unscramble them is substantial, and that the practical necessity of consolidation to protect the possible realization of a recovery for unsecured creditors outweighs the harm to any particular creditor. The court noted that the trustee did not seek substantive consolidation, and even if he had there were no facts suggesting that it would be justified.
Consequently, the district court affirmed the bankruptcy court’s denial of the claim filed by the member’s trustee in the LLC case.
This case illustrates a practical problem faced by a debtor when it has joint and several liability with another debtor. In effect the creditor has an opportunity to double dip by asserting its full claim in both bankruptcies. Although a creditor cannot receive more than 100% of its claim, it may be able to improve its recovery by collecting in both cases since generally there is no consideration given in one case to the additional recovery that may be available in a separate parallel case. So, for example, if there is a 30% distribution in each case, the creditor will probably have a better recovery than creditors with claims against only one debtor.
Substantive consolidation avoids this result, but will not be an option as a matter of course. Thus the alternate strategy of debtors trying to file cross claims.
Vicki R Harding, Esq.