When Fund Partners Go Bankrupt

As the aftermath of the recession continues to spawn restructuring disputes and related litigation, the next potential battles could be triggered by the insolvency of general or limited partners.

For limited partners, insolvency or bankruptcy can have very severe consequences.

“In many fund agreements, limited partners that fail to make payments or meet obligations are classified as defaulting investors,” says Jonathan W. Young, a partner in the Restructuring and Insolvency practice at Wildman, Harrold, Allen & Dixon LLP (Chicago).  “This gives the fund’s general partner not only the right to pursue collection of the outstanding funds, but to buy the limited partner out at disadvantageous terms.  The general partner may decide, for example, to devalue a limited partner’s interest by half or more.”

In the case of a bankrupt limited fund partner, however, these fund agreements are problematic as they conflict with the Bankruptcy Code, says Young.

“The Bankruptcy Code bars the automatic forfeiture of property interests as a result of a bankruptcy filing,” he says.  “Although the fund agreement may allow general partners to devalue the limited partner’s interest, a bankruptcy court may hold this unenforceable because its goal is to obtain the highest and best price for the debtor’s property.  Some courts have enforced fund agreement provisions, while others have not, so there is a significant amount of uncertainty.”

Young says there is the same conflict with the Bankruptcy Code for how default provisions treat insolvent general partners.

“A well drafted fund agreement will impose limitations on the defaulting general partner's ability to delegate its duties, or to assign its rights under the agreement,” he says.  “However, a bankruptcy court might well override these provisions, in an effort to create greater value for the general partner's creditors, and to assist the general partner in monetizing its rights in the fund.  And a bankruptcy might also limit the rights of the fund or the limited partners to recapture unearned or excess distributions to the insolvent general partner.”

Young says there is likely to be an increase in litigation testing the validity of these fund agreement default provisions as the recession leads to more fund partners  confronting insolvency or seeking bankruptcy protection.  He is available for interviews. [05/24/2010]