A Bankruptcy Litigation Framework for Series Llc Eligibility, Property of the Estate and Substantive Consolidation

• Publication year: 2019

A Bankruptcy Litigation Framework for Series LLC Eligibility, Property of the Estate and Substantive Consolidation

Thomas J. McElhinney

A BANKRUPTCY LITIGATION FRAMEWORK FOR SERIES LLC ELIGIBILITY, PROPERTY OF THE ESTATE, AND SUBSTANTIVE CONSOLIDATION

ABSTRACT

The Series LLC is one of the more novel business entities available to entrepreneurs. Not only does it limit the liability of its members, but it also limits the liability between different business endeavors. Such multi-directional liability protection was previously only afforded to the creative business owner who formed a family of individual limited liability entities.

While the Series LLC sounds appealing in theory, there are several concerns. The first concern is whether the Series LLC is eligible for bankruptcy. The second concern stems from the fact that the limited liability protecting different business endeavors is untested in bankruptcy courts. A final concern is that the multi-directional limited liability of the Series LLC may frustrate the federal bankruptcy policy seeking to distribute assets to creditors promptly and equitably.

This Comment responds to these concerns by presenting a bankruptcy litigation framework that answers the question of bankruptcy eligibility and describes how parties in interest may skillfully evade some of the limited liability that entrepreneurs exploit with the Series LLC; thus, leveling the playing field and furthering federal bankruptcy policy.

INTRODUCTION

In America's infancy, states recognized the corporate instrument with a heightened level of suspicion and fear.¹ Much of this fear could be attributed to the corporation's perpetual life and its ability to absorb vast amounts of capital.² As such, states generally only granted individual corporate charters when they were necessary to achieve an otherwise unattainable community need.³ But as states' desires for business expansion grew, general corporate laws emerged to satisfy the insatiable appetite for more corporate charters.⁴ Even after the creation of general corporate laws, fears of the corporate structure remained

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prevalent and charters were severely limited.⁵ For many years, general corporate laws restricted the amount of capital a corporation could raise, the amount of debt a corporation could undertake, and the scope of activities a corporation could perform.⁶ At the turn of the twentieth century, however, lesser developed states began jockeying for new revenue by removing safeguards from their general corporate laws in an effort to invite persons from other states to incorporate.⁷

Jump ahead 100 years, and the consequences of state jockeying are clear: corporate restrictions have drastically diminished across America. Even industrialized states, such as New York, lost bargaining power since requiring a higher bar was futile when foreign incorporation was able to circumvent local restrictions.⁸ Following the decay of corporate restrictions, states had to come up with new, creative mechanisms to attract business formation. The first, and most notable, innovation in business entity law was the creation of the Limited Liability Company ("LLC"), which combined limited liability, previously only afforded to corporations, and flow-through taxation, historically reserved for partnerships.⁹

Since the genesis of the LLC, one of the more recent developments has been the creation of the Series Limited Liability Company ("Series LLC" or "SLLC"). The Series LLC offers its members dynamic, multi-directional liability protection in a single, neat and tidy package. Members benefit from the administrative convenience of owning one company and the liability protections only achievable by owning a family of separate business entities, while minimizing tax obligations. With such increased protection afforded to business owners, one cannot help but wonder whether the states' interest in attracting business is on a collision course with federal bankruptcy policies.

Federal bankruptcy law has two overarching principles.¹⁰ The first is to promote the prompt and equal distribution of assets among similarly situated creditors.¹¹ The second is to grant a fresh start to the honest but unfortunate

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debtor.¹² These overarching principles are commonly referred to as the "twin pillars" of bankruptcy law.¹³

The twin pillars of bankruptcy law, however, are not infallible. State law may have the capacity to frustrate the aims of the twin pillars when federal bankruptcy law does not displace state law.¹⁴ This is the conundrum presented by the relatively new business entity: the Series LLC.

The Series LLC offers more liability protection in one business entity than any entity ever before created. Because the Series LLC is an adaptation of the limited liability company, its members benefit from both flow-through taxation and limited liability. Limited liability in this context refers to the managers' protection from business liability, which can be thought of as the "vertical limited liability shield."¹⁵ But the Series LLC's protections do not stop there. It also provides "horizontal limited liability shields,"¹⁶ which separate individual business ventures, called "protected series," from one another,¹⁷ and consequently impede liability from flowing amongst the various ventures. The manager of a Series LLC may create as many protected series under its operating agreement as it sees fit, each with its own business purpose.¹⁸ Thus, a Series LLC can stop liability from flowing both horizontally across the company and vertically to the members. Before the inception of the Series LLC, the only way to achieve such a complex limited liability scheme was to create multiple, individual corporations or LLCs. In essence, the Series LLC allows risk averse entrepreneurs to maximize protections and minimize administrative time and costs.

Despite the prospect of limiting liability even further, two primary uncertainties surrounding Series LLCs have frustrated entrepreneurs and business owners from embracing the Series LLC as a preferred business entity.¹⁹ The first is the uncertainty of whether the state-promised limited liability afforded by a protected series will survive in a federal bankruptcy

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case.²⁰ This uncertainty exists because states conceived the Series LLC and its protected series after the Bankruptcy Code (the "Code") was enacted,²¹ consequently, commentators disagree over whether the Series LLC, the protected series or either may qualify as a debtor under the Code.²² The second uncertainty is judiciary in nature: courts have yet to adjudicate whether the horizontal limited liability shields are robust enough to withstand an attack from creditors in a bankruptcy proceeding.

This Comment addresses bankruptcy concerns surrounding the Series LLCs by providing a bankruptcy litigation framework. While commentators have appropriately raised concerns and questions about the Series LLC,²³ none have offered answers. For three reasons, now is the ideal time to confront these bankruptcy concerns. First, Series LLC adoption is becoming sufficiently widespread for the question to be relevant—evidence suggests there are at least 1,500 protected series filed in Delaware and over 26,000 filed in Illinois.²⁴ Second, the adoption of the Uniform Limited Liability Company Protected Series Act in July 2017 ("ULLCPSA" or "UPS A")²⁵ offers the hope of a consistent Series LLC legal landscape that will make a uniform analytical framework more plausible. And finally, the Series LLC entity has been in existence long enough to increase the likelihood that bankruptcy courts will begin adjudicating the issues previously raised.

Before delving into the proposed bankruptcy framework, it is important to briefly mention that American litigation is fundamentally adversarial in nature.²⁶ As such, judges are generally reactive and will rarely intervene without request

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by the parties.²⁷ Thus, a bankruptcy court will generally not decide sua sponte on whether the debtor is eligible or whether limited liability can be circumvented. Indeed, the responsibility is on the parties in interest to take action. The Federal Rules of Bankruptcy Procedure govern all procedural aspects of a bankruptcy case.²⁸ Litigation proceedings in a bankruptcy case can be divided into two categories: (i) contested matters; and (ii) adversary proceedings.²⁹ Contested matters are initiated by filing a motion, whereas adversary proceedings are initiated by filing a complaint.³⁰ The matter being disputed will generally dictate which type of proceeding is initiated. Because the Series LLC presents novel issues, this Comment adds value by not merely providing the substantive standards necessary to address the issues, but also by putting them in context of the most effective procedural posture.

The bankruptcy litigation framework introduced by this Comment identifies the procedural posture and the substantive standards for a party in interest to: (i) dispute either a Series LLC's or a protected series' eligibility; and (ii) evade horizontal limited liability shields by expanding the reach of property of the estate.

For a party in interest to dispute a Series LLC's or a protected series' bankruptcy eligibility, the party must move to dismiss in accordance with Federal Bankruptcy Rule 9014.³¹ The moving party must predicate the dismissal under the substantive "for cause" standard.³² Although the Code does not define "cause," section III.A of this Comment asserts that failing to satisfy the eligibility requirements under Code § 109 constitutes sufficient "cause" to dismiss a Series LLC or protected series bankruptcy case. On the one hand, a court will likely hold that a Series LLC categorically satisfies the Code's threshold eligibility requirement. On the other hand, however, an interested party may find success in moving to dismiss a protected series. This Comment asserts that the determinative question is...