What Partners and Shareholders Should Know about Personal Exposure When Putting Their Business in Chapter 11

In many small and medium-sized businesses, one or more of the partners or shareholders—also called equity security or equity interest holders—manage the day-to-day operations of the business. In this capacity, the partner is an acting principal of the business and, as such, often incurs personal liability for some—but rarely all—of the business debts by way of personally guaranteed security and loan agreements, personally guaranteed SBA notes or co-signed leases. A partner can also be held personally liable for some business debts usually owing to government and taxing authorities by way of statute, for example personal assessment for business taxes and even employee wages in some instances.

When a business files chapter 11, the question naturally arises what happens to the partner’s liability for business debts and what exposure does the partner face when his/her business files chapter 11. This articles attempts to address some of those concerns in the context of a privately held (i.e., not publicly traded) small or medium-sized business that files a chapter 11 reorganization proceeding. The term ‘partner’ is used interchangeably in this article with the concepts of equity ownership, whether that persona be a partner, principal or shareholder of the business depending on how it was formed or organized.

The Automatic Stay Protects the Business from Collection but Not Necessarily a Partner-Guarantor

Most people know that filing a bankruptcy proceeding invokes the sweeping protections of the “automatic stay”, which stays (i.e., legally stops) further collection efforts and pending lawsuits from proceeding. The automatic stay is one of the core principles of bankruptcy relief, as it affords the necessary time and relief from levies, repossession, evictions, expensive and burdensome lawsuits and other collection efforts in order for the business to come forward with a plan of reorganization. The automatic stay remains in place for the duration of any bankruptcy proceeding until such time the case is either dismissed or the plan of reorganization is confirmed or until the time that a party in interest, usually a creditor or landlord, successfully ‘lifts’ the automatic stay for cause granted by an order of the bankruptcy court. The grounds for relief from the automatic stay are not addressed in this article.

From a partner’s perspective, it is important to understand that there is no co-debtor automatic stay in chapter 11 proceedings. This means, for example, that a pre-bankruptcy lawsuit pending against both a business and its partner as co-defendants will be automatically stayed once the business files chapter 11. However the plaintiffs may still proceed against just the partner if they dismiss the lawsuit as to the business. Also this means that a partner can still be personally collected upon for existing judgments and still be personally assessed for business taxes in spite of the business bankruptcy proceeding. While personal collection efforts are often voluntarily put on hold by creditors when the business files chapter 11, the automatic stay nevertheless only applies to the business. For this reason, partners with significant personal guarantees may themselves need to file an individual bankruptcy proceeding.

The Chapter 11 Attorney Represents the Business, Not the Partners

It is a conflict of interest for the business chapter 11 attorney to render legal advice or formally represent the partners or equity security holders while representing the business. This can seem like an inconsistency when the partner maintains a primary, close and constant relationship with the business counsel. While it can be difficult for a partner of a closely held company to distinguish between the interests of the company and their own personal interests, occasionally events occur that could give rise to a conflict between what is best for the company and what is best for the partner. In all instances, however, the partner has a fiduciary duty to act in the best interests of the company and not himself, and the chapter 11 likewise has an obligation to represent the interests of the business alone. Due to this conflict of interest, partners may wish to consult with independent counsel on how their rights may be impacted by the business chapter 11 proceeding.

Personal Guarantees and Liabilities are Rarely Extinguished by the Chapter 11 Plan

The majority of chapter 11 plans do not allow for third-party releases or injunctions to protect guarantors, insiders and other non-debtor parties from lawsuits, collection efforts or otherwise. While there are exceptions to this general rule, partners and guarantors will need to find a resolution outside of the business chapter 11 proceeding.

Partners May Need to Contribute New Capital to the Plan Funding

Also called the Absolute Priority Rule, the general idea is that if creditors are going to take a financial hit, so should the partners.  The rule of thumb is that unless the plan proposes to repay all creditors in full, the partners must contribute new value in a reasonably equivalent amount to the value of the ownership interests retained. There are deviations on this rule, including that a partner may contribute new capital, cash or letters of credit to the business. The rule is not always enforced and

Other Risks: Preference Payments to Partners and Other Avoidance Actions

 Article V avoidance actions are fairly common in all chapters of bankruptcy, and particularly so in chapter 11 proceedings. Both partners and creditors alike can be subject to actions to avoid transfers of funds or assets so that those funds can be recovered for the benefit of the bankruptcy estate and unsecured creditors. While a reasonable salary paid to a partner for managing the business won’t necessarily be avoided, partner distributions and withdrawals made while the business was insolvent may be subject to avoidance. The general look back for avoidance actions is 90 days for non-insider creditors/other parties and up to one year for insiders such as partners, related companies and others having a close relationship with the debtor business. There are specific rules and limitations as well as affirmative defenses for preferences actions and transactions need to be evaluated on a case by case basis. Future compensation and salary to be paid to partners must also be disclosed in the chapter 11 plan and will need to reasonable and necessary or otherwise the plan could draw an objection.