Business Startup

Series LLCs: Exploring the Rise (and Risks) of a New Limited Liability Entity | Post 2

To follow up last week’s post that detailed the background of series LLCs, I wanted to bring to light one of the major risks related to starting a series LLC. Today’s post takes a look at the issues presented by unanswered questions pertaining to treatment of series LLCs and bankruptcy. Over the course of the next few weeks, we’ll discuss four possible options for how bankruptcy could (and perhaps, should) handle series liability during bankruptcy proceedings. Today’s post explores option one: impenetrable boundaries between series.

Are individual series able to file for Bankruptcy?
If an insolvent series (or cell) is to protect the other cells from its liabilities, it would make sense that the individual cell could file for bankruptcy. Right? Unfortunately, it’s not as cut and dry as it would seem. For a series to be able to file for bankruptcy, it must be a “person” under the Bankruptcy Code (the “Code”). The Code does not mention LLCs or series LLCs in the definition of “person,” which leaves it up to the courts to interpret the Code’s definition. The Code states “the term ‘person’ includes individual(s), partnership(s), and corporation(s)” (this list is not exhaustive). Typically, LLCs are treated as a “person” by bankruptcy courts even though they aren’t mentioned in the definition in the Code. At this point, no court has determined a cell’s “personhood” for bankruptcy purposes.

Treated as a “person” at the state-level
For the most part, Delaware, Illinois, and Iowa state statutes treat individual series as “persons.” In 2006, Delaware amended its statute to define a series as a “person.” This allows the series to act as a separate legal entity in many respects, including the ability to sue and be sued, enter into contracts, and buy, sell, and own property. Illinois and Iowa have taken a similar approach, treating each series as a “separate legal entity to the extent set forth in the articles of incorporation.”

The problem lies in the fact that bankruptcy courts are not bound by those state statute definitions. Under the supremacy doctrine, once a bankruptcy process is initiated, federal law trumps state law in determining the rights of the parties.

How will bankruptcy courts treat series LLCs?
Whether a bankruptcy court will recognize series liability shields depends on choice of law and equitable issues.

First, choice of law in bankruptcy is messy. While bankruptcy laws are federal, state laws typically govern business entities, including structure and collection remedies. According to the Supremacy Clause, federal law preempts state law in bankruptcy proceedings where the two laws are inconsistent. Bankruptcy courts, for the most part, will try and preserve the rights, remedies, and expectations of creditors according to pre-bankruptcy rights. Since pre-bankruptcy rights for creditors are governed (largely) by state law, bankruptcy courts attempt to uphold state corporation law to preserve pre-bankruptcy rights.

Second, bankruptcy courts have a wide range of legal and equitable remedies available to use. In general, bankruptcy law is rooted in equity, i.e. bankruptcy law attempts to achieve fair treatment for creditors. To carry out this goal, the Code permits a bankruptcy court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Code]…”

The lack of precedent for series LLCs and bankruptcy create a serious risk for any individual looking to form a series LLC. Below is one way bankruptcy courts could deal with series liability shields.

One Approach: The Impenetrable Boundaries Between Series
Bankruptcy courts may treat boundaries between each series as impenetrable by creditors of other series (“sister series”) within the series LLC. This idea is based on pure limited liability, i.e. no veil-piercing remedies. It’s far-fetched to believe that a bankruptcy courts will elect to uphold impenetrable series boundaries in every situation. Traditional corporations do not have impenetrable liability boundaries, so there’s no reason why this elevated limited liability would be afforded to series LLCs.

Scholars have advocated for impenetrable boundaries for certain entities. For example, the famous Judge Posner once suggested that limited liability allows for the most efficient allocation of resources. Keep in mind though, it is important that creditors have the ability to cross liability boundaries in some situations. Even Judge Posner, an avid advocate for limited liability, permits consolidation when a creditor reasonably relies on the appearance of the greater capitalization and stronger financials than actually existed.

While this approach, allowing for impenetrable boundaries, is unlikely to be employed by bankruptcy courts, it’s important to understand when analyzing the treatment of series LLCs in bankruptcy proceedings.

Stay tuned for next week’s post that will detail three additional ways a bankruptcy court may treat series liability.

If you’re interested in learning more about series LLCs or limited liability entities in general, please contact us or submit your question to our free, confidential Q & A service.

        


Gavin Johnson

Gavin enjoys craft beer and is learning the art of brewing.


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