Insolvency Issues and Partnerships

Transcription

1 WORKING WITH PARTNERSHIPS PAPER 7.1 Insolvency Issues and Partnerships These materials were prepared by Peter Rubin and Jeff Langlois, both of Blake, Cassels & Graydon LLP, Vancouver, BC, for the Continuing Legal Education Society of British Columbia, June Peter Rubin and Jeff Langlois

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3 7.1.1 INSOLVENCY ISSUES AND PARTNERSHIPS 1 I. Introduction... 1 II. Overview of Canada s Insolvency Regime... 2 A. Liquidations Bankruptcy Receivership Priorities in Liquidation... 4 B. Reorganizations... 5 III. Partnerships... 6 A. Types of Partnership General Partnerships Limited Partnerships Limited Liability Partnerships Distinction from Joint Ventures... 9 IV. Partnerships and Bankruptcy A. Liquidation How Does a Partnership Go Bankrupt? a. Voluntary Assignment b. Failure of a Proposal c. Involuntary Bankruptcy Order What is the Effect of a Partnership Becoming Bankrupt? How is the Property of the Partnership Distributed in Bankruptcy? a. Distribution of Limited Partner s Contribution Upon Bankruptcy b. Distribution Wrinkles in Limited Liability Partnerships B. Reorganizations CCAA Rehabilitations BIA Proposals I. Introduction In the past six months the deterioration of the global economy has resulted in a significant increase in the number of insolvencies in the commercial context. Unfortunately, there is a dearth of judicial authority in matters relating to insolvent partnerships. This may partially stem from the increased use of partnership structures in recent times in combination with economic circumstances. The goal of this paper is to familiarize practitioners with the issues and special considerations involved when partnerships approach and enter into insolvent circumstances. 1 Peter Rubin is a Partner with Blake, Cassels & Graydon LLP and practices in the areas of commercial litigation and insolvency. Jeff Langlois is an Articled Student with Blake, Cassels & Graydon.

4 7.1.2 Some commentators have said that perhaps the one truly practical bit of advice one can offer is that there are a number of questions about the bankruptcy or insolvent reorganization of partnerships for which there are no fully confident answers. 2 However, for practitioners advising clients on how to best structure their affairs or what steps to take in difficult economic times, it is important to understand certain basics concerning bankruptcy and insolvency and how they can affect partnerships. This paper begins with a general overview of Canada s insolvency regime and key statutes which guide the course of insolvency proceedings. Next the various ways in which partnerships may be organized will be considered, as the organization of a partnership can lead to substantial differences in the way its solvency is dealt with. Finally, the issue of how partnerships can be subject to insolvency proceedings, and how such proceedings differ from insolvency of individuals or corporations, will be explored. II. Overview of Canada s Insolvency Regime Commercial insolvency proceedings in Canada take a variety of forms. The assets of a business may be liquidated or sold on a going-concern basis by a trustee in bankruptcy proceedings, by a court or privately appointed receiver, by the exercise of private remedies held by a secured creditor under its security agreement, or by a combination of these arrangements. The insolvent business may also be rehabilitated through a restructuring of the business and its debts under various statutory mechanisms. The key statutes to the practice of insolvency in Canada are: The Bankruptcy and Insolvency Act ( BIA ): A federal statute that includes provisions to facilitate both the liquidation and reorganization of insolvent debtors. The reorganization provisions, generally known as the proposal provisions, are more commonly used for smaller and less complicated reorganizations than those that take place under the CCAA. The threshold debt requirement is only $1,000 and the BIA may be used by individuals as well as corporations that face insolvency. The Companies Creditor s Arrangement Act ( CCAA ): This is the principal statute for the reorganization of large insolvent corporations that have more than $5 million of claims against them. This is the preferred statute for undertaking a reorganization of a business because it provides more flexibility than other statutory means of reorganization. The Personal Property and Security Act ( PPSA ): This statute governs the priorities, rights and obligations of secured creditors, including a secured creditor s right to enforce his/her security and dispose of assets subject to that security, following a default by a debtor. The BC Rules of Court are also relevant to the context of insolvency, as they provide the court with the power to appoint a receiver and/or a receiver and manager who may in turn be granted the right to take possession of, and sell, the assets subject to the receivership. Interim receivers may also be appointed under the BIA, and receivers may also be appointed privately if a security agreement provides a secured creditor with this remedy. 2 Donald E. Milner and Sheryl E. Seigel, Bankruptcy or Insolvency of Partners and Partnerships, prepared for Toronto Insight 2002.

5 A. Liquidations The two most common ways to liquidate an insolvent company in Canada are either through a bankruptcy proceeding under the BIA, or by way of an appointment of a receiver. 1. Bankruptcy The BIA is intended to facilitate the financial rehabilitation of individuals, partnerships and corporations that are unable to satisfy their debt obligations. The BIA provides for an orderly distribution of assets to a bankrupts creditors in accordance with the relevant statutory priority scheme. A proceeding in bankruptcy can be commenced in one of three ways: involuntarily, by the filing of a bankruptcy application by one or more of the debtor s creditors; voluntarily, by the debtor making an assignment in bankruptcy for the general benefit of its creditors; or on the failure of a proposal by the debtor to its creditors, due to a rejection by the creditors or by the court, or due to a default under the proposal. When a corporate debtor becomes bankrupt, the debtor ceases to have legal capacity to dispose of its assets or otherwise deal with its property and a trustee in bankruptcy is appointed over all the debtor s assets, subject to the rights of secured creditors to those assets. A trustee is an officer of the court and must represent the interests of creditors impartially. It is the trustee s duty to collect the debtor s property, realize upon it and distribute the proceeds of realization according to a priority scheme set out in the BIA. Upon the commencement of bankruptcy proceedings, unsecured creditors will be stayed from exercising any remedy against the bankrupt or the bankrupt s property and may not commence or continue any action for the recovery of a claim without leave of the court. Instead, a creditor can assert its claim against the debtor by submitting a proof of claim to the trustee, who may challenge the legitimacy or quantum of the claim before it is accepted. Secured creditors on the other hand, are not subject to the stay of proceedings. Instead, the rights of secured creditors are not affected by the bankruptcy proceeding, although a trustee will obtain an independent opinion as to the validity and enforceability of the secured creditor s security against the trustee and the bankrupt s property. The rights of a trustee in bankruptcy are subject to the rights of secured creditors. To the extent that the amount of a secured creditor s debt exceeds the value of the collateral subject to its security, a secured creditor may participate in the bankruptcy process and file a proof of claim with respect to the unsecured portion of its claim. One of the primary responsibilities of a trustee, upon assuming control of the debtor s property, is to scrutinize the actions of the bankrupt debtor in the period preceding the commencement of bankruptcy proceedings for any transactions that may be attacked as a preference, fraudulent conveyance or reviewable transaction. Attempts to prefer certain creditors over the creditors of the bankrupt debtor may be challenged pursuant to the BIA. If a challenge is successful, the transaction may be voided and the property or the value of the property must be returned to the bankrupt estate and made available for liquidation to satisfy proven claims by creditors. 2. Receivership A receiver or receiver and manager, which is typically a firm composed of licensed insolvency professionals and chartered accountants, may be given the authority to deal with the debtor company s

6 7.1.4 assets. This may include the authority to operate and manage the business in place of the existing management, and to shut down the business if the receiver determines that continued operations will ultimately diminish the amount available to satisfy creditors claims or that there is insufficient funding to continue the operation. Unlike a trustee, the assets of the debtor do not vest in the receiver, however the receiver may have the right in the order appointing it to take possession of assets and dispose of them for the benefit of creditors. Receivers may be appointed either privately or by the court. Secured creditors may have the right to appoint a receiver under a security agreement. A privately appointed receiver generally owes its duties to the secured creditor that appointed it and also has a general duty to act honestly, in good faith and in a commercially reasonable manner by maximizing recovery for the secured creditor. In the case of a court-appointed receiver, the receiver is appointed by a court order, typically on application by a secured creditor under Rule 47 of the BC Rules of Court. Court appointments are generally sought in more complex cases, where there are significant disputes among creditors or between creditors and the debtor. In such cases the assistance of the court may be required on an ongoing basis. A receiver appointed by the court obtains its powers from the court order and is an officer of the court, with duties to all creditors of the debtor. The receiver takes directions from the court and not the creditor who sought the appointment of the receiver. Generally, the court order gives a receiver broad powers to deal with the assets of the debtor, however, major asset sales usually require specific court approval. Interim Receivers are receivers that are appointed pursuant to the provisions of the BIA rather than the Rules of Court. Interim receivers are generally given the same mandate and powers as a courtappointed receiver and are most commonly applied for when the debtor has assets in multiple provinces as the federal nature of the BIA allows the receiver to be recognized across provincial boundaries. Upon appointment of a receiver, the court will typically issue a stay of proceedings restricting creditors from exercising any rights or remedies without leave of the court. Once a receiver has realized on the assets of the debtor (following court approval), it will seek to distribute those proceeds to creditors in accordance with their entitlements and priority (as set out in the BIA). If there are any proceeds remaining after satisfying secured creditors, the receiver may distribute those proceeds to creditors under a court sanctioned claims process, or the receiver may seek the court s approval to assign the debtor into bankruptcy to deal with the unsecured claims through the process described above. 3. Priorities in Liquidation Whether a liquidation is carried out through bankruptcy proceedings or through an appointed receiver, the distribution of realized assets will occur through a priority scheme. Secured creditors will rank ahead of unsecured creditors, however, there are a variety of statutory super-priority claims that may need to be satisfied before funds can be distributed to secured or unsecured creditors. Examples of claims that will take super-priority by operation of law include claims made by employees (excluding directors and officers) for unpaid wages up to $2,000 per employee (or claims made by governments with subrogated claims of employees under the Wage Earner Protection Program Act and unpaid regularly scheduled contributions to pension plans. These claims are secured as a charge against the debtor s assets, and therefore any payment that is made reduces the amount available to secured creditors.

7 7.1.5 Additionally, before distributions can be made to unsecured creditors in an insolvency proceeding, certain statutorily mandated priority claims, such as employee deductions (i.e., income tax withholdings, unemployment insurance premiums and Canada Pension Plan premiums) must also be paid. Other statutory liens that have priority over secured creditors outside of bankruptcy are treated as ordinary unsecured claims following bankruptcy (e.g., liens for unremitted federal and provincial sales tax). Following the satisfaction of super-priority claims, the BIA sets out the following priority scheme for distribution to unsecured creditors: (a) the costs of administration of the bankruptcy; (b) preferred claims, which include wage claims in excess of the statutory $2,000 charge, secured creditors claims in the amount equal to the difference between what they received and what they would have received but for the operation of the wage and pension super-priorities, and landlords claims up to the maximum amounts prescribed by statute; (c) ordinary unsecured claims on a pro rata basis. As discussed below, the BIA sets up a statutory priority scheme for the satisfaction of debts owed by a partnership which varies how unsecured creditors are treated, depending on whether they are creditors of the partnership or of the individual partner. B. Reorganizations Under the CCAA, an application may be made to the BC Supreme Court by an insolvent company 3 where the company satisfies the following requirements: the company must be a Canadian incorporated company or foreign incorporated company with assets in Canada or conducting business in Canada; the company must be insolvent. Jurisprudence under the CCAA has demonstrated that the court will use a contextual and purposive approach to determining whether a company is insolvent. Using this approach, companies who are meeting current obligations as they become due may nonetheless apply for CCAA relief if they can demonstrate a looming liquidity crisis; and the company must have in excess of $5 million in debt. Upon the application of an eligible debtor company, the court will issue an initial order which will generally provide for the following: a comprehensive stay of proceedings that will apply to both secured and unsecured creditors, and a stay against termination of contracts with the debtor company, generally for a 30 day period, which can be extended; the appointment of a monitor to supervise the restructuring of the debtor company on behalf of all creditors. The monitor acts as the eyes and ears of the court throughout the reorganization and will file periodic reports with the courts and creditors, especially in reference to the disposition of assets of the debtor company; the authorization of debtor-in-possession ( DIP ) financing to the debtor and the granting of super-priority charges in favour of the DIP lender, provided the court is convinced that additional financing during the restructuring is critical to the continued operations of the business; 3 While creditors may also initiate this process, such a step is uncommon under the CCAA.

8 7.1.6 the authorization of priority charges, such as an administrative charge to secure payments to the monitor and legal counsel in regards to fees and disbursements accrued during the restructuring; the granting of authority to repudiate contracts where it would be economically advantageous to the debtor company and its creditors as a whole to do so. Counterparties to repudiated agreements can assert a claim for damages on an unsecured basis; authorization and direction to the debtor company to file a plan of arrangement or compromise with its creditors. The purpose of the initial order is to give the company room to breath while it works out a plan of arrangement with its creditors which will allow the company to carry on business, although the nature and scope of that business may change dramatically under such a plan. The terms of a plan of arrangement will vary widely with the circumstances, but can include the conversion of debt into equity in the restructured company, the creation of a pool of funds to be distributed to creditors or the structuring of a plan to pay the company s debts over an extended period. However, each plan must treat all creditors of a class equally. In order for a plan of arrangement to be accepted, it must first be approved by creditors. Generally, creditors with the same type of interest in the debtor company will vote on a special resolution, with the plan of arrangement requiring support from a majority of creditors in each class, representing 66-2/3% of the total value of claims voting in each class. Once creditors have approved the plan, it must be submitted to the court for approval. Once the court sanctions the plan, it is binding on all creditors whose claims are compromised by the plan. Insolvent debtors may also seek to restructure their affairs under the BIA. The essential difference between the two statutory regimes is that a BIA procedure is primarily a statutory process with strict timelines, rules and guidelines which are set out in the BIA. A CCAA proceeding is more discretionary and judicially driven. While the BIA provides for an automatic stay of proceedings without a court application (even as against secured creditors) the CCAA remains the procedure of choice for companies that meet the minimum thresholds discussed above given the flexibility under that statute. The CCAA provides a flexible regime which allows a company to restructure its business, obligations and debt. While a company employing this statute may avoid a liquidation of its assets, the plan of arrangement must ultimately be attractive to creditors, and in many cases this will require a significant restructuring effort which may require the sale of a company s assets. While the CCAA is only available to debtors that are corporations, as will be discussed below, it has been used increasingly by partnerships where the partners are in fact corporations that would otherwise qualify for relief under the CCAA or where partnerships are used within the larger corporate organizational structure. III. Partnerships Various forms of partnerships exist under the laws of BC including standard or general partnerships ( GPs ), limited partnership ( LPs ) and limited liability partnerships ( LLPs ). The formation, rights and obligations of partnerships are governed by a combination of the Partnership Act 4 (the PA ), the common law and any relevant partnership agreement(s). A general discussion of the characteristics of each type of partnership can be found below, however readers should refer to the more in-depth discussions in B. Maclagan s What is a Partnership or When does a Partnership Exist, K. Burnett s 4 [R.S.B.C. 1996] Ch. 348.

9 7.1.7 General Partnerships, A. Oxtoby s Working with Limited Partnerships, and P. Finley s Limited Liability Partnership, all prepared for this course. An understanding of what a partnership is and the different types of partnerships is key to understanding how insolvency law treats those relationships. A. Types of Partnership 1. General Partnerships The PA defines a GP as the relation which subsists between persons carrying on business in common with a view of profit. 5 Though the PA allows for the registration of a partnership name, the existence of a GP is premised on the existence of these elements alone. As such, a GP can arise even where parties have no intention to form a partnership arrangement. Most importantly for the present discussion, GPs, and indeed any species of partnership, though they may operate under registered names, are not generally recognized as having a separate legal personality distinct from its members. Unlike a corporation, a partnership is nothing more than a group of individual legal personalities, acting together with a view to profit from an endeavour. Each member of a GP acts as the agent of every other member and has the ability to bind each member to debts and other legal obligations. As such, every partner of a GP is jointly and severally liable for all obligations incurred by the partnership, so long as that partner was a member of the firm when that obligation was incurred. 6 As there is no legal personality in a GP, all of the assets of those partners, both business and personal, are available to satisfy these obligations. Furthermore, partners will have the right to seek the contribution of other partners for their share of obligations owed to creditors of the partnership. Absent the separation provided by a separate legal entity, the law has developed terminology, which has been adopted in insolvency legislation and jurisprudence, which nonetheless recognizes the distinct character of debts incurred in the name of the partnership, and those debts incurred by an individual partner outside the course of the firm s business. Obligations incurred in the course of the firm s business are referred to as joint debts and the firm s property is referred to as joint property or the joint estate. Obligations incurred by individual partners, not in the partnership name, are referred to as separate debts and that partner s assets are referred to as the separate property or the separate estate. 2. Limited Partnerships While a GP exposes all partners to unlimited liability for obligations undertaken by the partners on behalf of the partnership, the PA creates another type of partnership which allows certain partners to limit their liability to the amount of their contribution to the partnership. Whereas GPs can be formed even in the absence of an explicit agreement, LPs require certain formalities to be met, including the filing of a certificate under s. 51 of the PA. LPs consist of one or more general partner(s) as well as a minimum of one limited partner. Limited partners are liable for partnership liabilities only to the extent of their contribution of capital or property to the partnership. The limited partner is shielded from liability beyond its contributions unless the limited partner takes part in the management of the business. 7 Moreover, s. 63 of the PA states that this liability is owed to the partnership itself, and not to creditors, meaning that a limited 5 PA, s PA, s PA, s. 64.

10 7.1.8 partner who has not taken part in the management of the partnership is not properly named in an action for obligations undertaken by the partnership, even though the limited partner s initial contribution may be implicated in any award granted in an enforcement of the obligation. Another significant difference between GPs and LPs is the manner in which capital is distributed between partners upon dissolution of the partnership. Under a GP structure, all partners are entitled to an equal division of their capital contribution, however, under a LP structure, s. 73 of the PA provides, unless otherwise agreed, that limited partners have priority over any partnership assets upon dissolution that remain after the satisfaction of the firm s creditors in respect of the limited partner s capital contributions. 3. Limited Liability Partnerships LLPs are a very recent statutory creation in BC, with the PA only being amended in January 2005 to allow the creation of such entities. As such, there has been no consideration in BC of how partners in a LLP may be affected by insolvency. This is compounded by the fact that the BC PA allows for a much greater degree of liability protection for partners of the LLP than is available in other jurisdictions, such as Ontario. There are two models of liability protection that have been created in various jurisdictions under the LLP structure. Practitioners generally refer to these models as partial shield and full shield LLPs. A partial shield LLP functions essentially the same as a GP, except that partners are protected from personal liability for another partner s wrongful acts, negligence, misconduct or acquiescence in such conduct by others. Therefore, damages awarded against the partnership for an act of negligence are the sole responsibility of the partner who committed the negligent act, and any other partners who knew of the act and did not take reasonable steps to prevent it. A full shield LLP includes this protection from liability for a partner s wrongful acts but it also extends to include protection from personal liability for any obligation incurred by the partnership. Therefore, while creditors will still have the ability to seek payment of a partnership debt from the joint estate consisting of each individual partner s capital contribution to the partnership, those creditors are not entitled to the personal assets of individual partners. In this way, a full shield LLP operates to protect partners in much the same manner that shareholders are protected by a corporate structure. Partnership assets are subject to partnership obligations, but personal assets are not. The PA defines a Partnership Obligation as any debt, obligation or liability of a partnership, other than debts, obligations or liabilities of partners among themselves or as among themselves and the partnership. Section 104(1) of the PA provides that a partner in a LLP: (a) is not personally liable for a partnership obligation merely because that person is a partner; (b) is not personally liable for an obligation under an agreement between the partnership and another person; and (c) is not personally liable to the partnership or another partner for an obligation to which the above paragraphs apply. Section 104(3) states that subsection (1) does not protect a partner s interest in the partnership property from claims against the partnership respecting a partnership obligation. The language of this section closely follows the language of the Uniform Law Conference of Canada s Model Limited Liability Partnership Act, which contains commentary that indicates that this language is intended to modify the common-law conception of partnerships, under which there is no legal distinction between a partner s personal property and the partner s share of the partnership. Without this language, it may

11 7.1.9 be argued that a partner s partnership assets should not be available for the satisfaction of partnership obligations if the partner is truly to be shielded from personal liability for such obligations. 8 Part 6 of the BC PA allows for the creation of full shield LLPs as the default model for LLPs in BC. However, it should be noted that partners may still opt to create a partial shield LLP by drafting their partnership agreement, required for the registration of an LLP, so as to provide that partners personal assets are available to satisfy partnership obligations. There are some important exceptions to these liability protections under full shield LLPs. Section 105 of the PA states that partners in a LLP may nonetheless be personally liable for a partnership obligation if and to the same extent that they would be liable for the obligation if the obligation was an obligation of a corporation and they were directors of that corporation. It is likely that the provision is intended to make partners in a full shield LLP personally liable for specific statutory obligations (such as for wages, taxes and environmental liabilities) where partnership assets are not sufficient to meet these obligations. Further, a partner will only be protected from personal liability in regards to those partnership obligations that were incurred after the partnership was registered as a full shield LLP. This may be especially relevant in BC given the recent enactment of Part 6 of the PA. Additionally, and most importantly from the insolvency perspective, partners in a full shield LLP are liable to the partnership in respect of distributions received in contravention of s. 112 of the PA, which prohibits an LLP from transferring partnership assets to partners before the partnership obligations of the partnership are satisfied. To the extent such distributions are not recovered, those partners authorizing the distribution may be liable. The consequences of such partial shield and full shield liability protections will be discussed in the context of insolvency proceedings below. 4. Distinction from Joint Ventures Though they may share similar features, partnerships should be understood to be distinct from joint ventures generally, and with respect to how insolvency proceedings operate for each entity. While both require a contractual agreement (verbal or otherwise) between individuals or corporate entities, the parties to a joint venture typically have no interest in operating a business in common. Instead, a joint venture is confined to a particular defined business undertaking which requires the temporary combination of capital, property or other resources to accomplish. A joint venture does not constitute a separate legal entity and parties to a joint venture are not necessarily jointly and severally liable for all of the obligations taken on to accomplish the venture. Instead, parties will make contractual arrangements for the provision of capital, property and labour and will not generally have the authority to bind the other party in the name of the joint venture. Upon the insolvency of one party to a joint venture, the contractual arrangements between the parties will dictate how joint property is to be divided, and what obligations the solvent joint venture party may be required to satisfy. However, in a true joint venture scenario, there is no insolvency of the venture itself, and the solvent partner is not necessarily jointly and severally liable for obligations undertaken in pursuit of the joint venture. 8 Alison Oxotoby, Understanding and Working with Limited Liability Partnerships, (Vancouver, CLE BC: 2006) at 4.

12 IV. Partnerships and Bankruptcy The remainder of this paper focuses on the interaction of Canada s insolvency regime with the various types of partnership arrangements outlined above. While most of the discussion is based on GPs, where insolvency proceedings differ for either LPs or LLPs, the differences will be noted. A. Liquidation 1. How Does a Partnership Go Bankrupt? A partnership may enter into bankruptcy under the BIA in one of three ways: Voluntary Assignment; Failure of a proposal; or Involuntary Bankruptcy Order. a. Voluntary Assignment First, a partnership may enter into bankruptcy voluntarily by making an assignment in bankruptcy under s. 49(1) of the BIA. This section states that an insolvent person may make an assignment of all of the insolvent person s property for the general benefit of the insolvent person s creditors. Despite the fact that partners are not generally considered to possess legal personhood, s. 2(1) of the BIA defines a person so as to include a partnership. For the purposes of the BIA, a partnership is a legal entity that is treated in some respects as distinct from the partners that constitute the partnership. An insolvent person is also defined in s. 2(1): insolvent person means a person who is not bankrupt and who resides, carries on business or has property in Canada, whose liabilities to creditors provable as claims under this Act amount to one thousand dollars, and (a) who is for any reason unable to meet his obligations as they generally become due, (b) who has ceased paying his current obligations in the ordinary course of business as they generally become due, or (c) the aggregate of whose property is not, at a fair valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would not be sufficient to enable payment of all his obligations, due and accruing due; Therefore, a partnership may avail itself of the BIA where the following requirements are met: (1) the partnership is not already bankrupt; (2) the partnership resides, carries on business or has property in Canada; (3) the partnership s creditors must have provable claims of at least $1,000; and (4) the partnership: (i) is unable to pay its obligations as they become due; (ii) has already ceased paying its obligations as they generally come due; or (iii) its assets at a fair valuation are insufficient to pay its liabilities. 9 9 David S. Ward and Linda Knol, Bankruptcy of General Partnerships in A Practical Guide to Canadian Partnership Law ed. Alison R. Manzer, loose-leaf (Canada Law Book, Toronto: 2008) at 11-8.

13 Whereas individuals and corporations can make the decision to initiate bankruptcy proceedings, the nature of partnership relationships, and the consequences (both to the partnership and the partners) of entering bankruptcy protection, require a partner to obtain the consent of the other partners in the partnership in order to assign the partnership into bankruptcy. It is to be recalled that the bankruptcy of a general partnership bankrupts each and every partner. A partner, absent agreement to the contrary, only has the ability to bind the partnership where the partner s actions fall within the regular course of business of the partnership. In Squires Brothers (Re), 10 the Court held, as a filing of an assignment in bankruptcy serves to dissolve the partnership (as will be discussed in more detail below), such a filing could not be considered to be within the scope of ordinary business the partnership is engaged. Therefore, any partner s unilateral filing of an assignment would be invalid. Furthermore, the effect of assigning the partnership into bankruptcy is to simultaneously bankrupt each of the individual partners of the firm. Therefore, the effect of allowing one partner, who may be insolvent, to assign the partnership unilaterally, would be to subject solvent partners to bankruptcy proceedings a situation the courts have labelled as a serious injustice. 11 Furthermore, one wonders how a partnership can be insolvent if the partners themselves are not insolvent. As such, an assignment must be unanimously approved by each partner of the firm in order for it to be valid. The exception to this rule is in the case of limited partnerships, which would only require the authorization of the general partner(s) as the general partners are able to bind the firm without the consent of limited partners. In any event, an assignment into bankruptcy of a limited partnership would only serve to assign the general, not the limited, partners into individual bankruptcy. The bankruptcy of a single partner will not operate to bankrupt the partnership and remaining partners so long as the firm and remaining partners are able to satisfy the obligations of the partnership without the contribution of the insolvent partner. However, pursuant to s. 36 of the PA, the insolvency of one partner functions to automatically dissolve a partnership consisting of only two partners (or an LP with only one general partner) and will also function to dissolve a partnership consisting of more than two partners unless the partnership agreement indicates otherwise. 12 Therefore, a partnership may remain solvent despite the insolvency of one of its partners and by operation of law, the insolvency of a partner is treated as a retirement or withdrawal of that partner. Note however, that as partners are jointly and severally liable for partnership obligations, the bankruptcy of one partner will not only drain assets from the partnership, but the remaining partners will be liable for all of the debts of the partnership going forward. Given this, while the bankruptcy of a single partner will not necessarily bankrupt the partnership or remaining partners, the practical effect of such a bankruptcy would be to put increasing and perhaps unexpected fiscal pressure on the remaining partners. In these circumstances, the solvency of the remaining partners will depend on their ability to bear these extra burdens. In the context of limited partnerships, the bankruptcy of a general partner does not operate to bankrupt the partnership as a whole, unless the insolvent partner is the only general partner of the firm. Section 85(1) of the BIA provides that upon the bankruptcy of all of the general partners of a LP all of the assets of the LP will vest in the trustee in bankruptcy. Additionally, the insolvency of a limited partner will not serve to bankrupt the partnership or the general partner, as limited partners are not responsible for the obligations of the partnership as long as it does not take part in the management or control of the partnership. 10 (1922), 68 D.L.R. 571 (Sask K.B.). 11 See Berthelot (Re) (1922), 3 C.B.R. 386 (Ont. S.C.). 12 PA, s. 36.

14 In the context of a limited liability partnership, it is likely that an assignment in bankruptcy in the name of the partnership that is a partial shield LLP would have the same effect as an assignment of a GP, namely, to assign all of the partners into bankruptcy, as all of the personal assets of such partners are available to satisfy partnership debts, exclusive of those debts incurred by the negligence of one or more partners. However, in the context of a full shield LLP, then it is likely that an assignment in bankruptcy would not serve to automatically bankrupt the partners of the LLP, as such partners are generally protected from personal liability for partnership obligations. b. Failure of a Proposal A partnership will also become bankrupt if it has made a proposal to creditors to satisfy its debts and the proposal is rejected by creditors. Pursuant to s. 57(a) of the BIA, upon a rejection of a proposal, an insolvent person is deemed to have made a voluntary assignment into bankruptcy, as described above. 13 The effect of such a failed proposal is to bankrupt the partnership as well as the partners, as outlined below. c. Involuntary Bankruptcy Order A partnership may also be involuntarily forced into bankruptcy upon the application by one or more of its creditors. Pursuant to s. 43(1)(a) of the BIA, one or more creditors with an unsecured claim of $1,000 or more may apply to the court for a bankruptcy order if the debtor has committed an act of bankruptcy within the six months prior to the making of the application. Section 42 sets out 10 actions which are deemed to be acts of bankruptcy under the BIA including the making of assignments in bankruptcy in other jurisdictions, transferring property or otherwise acting so as to defeat the claims of creditors or defaulting on a proposal made under the BIA. The most common ground upon which creditors rely is that the debtor has ceased to meet its liabilities generally as they become due. Secured creditors may also apply under s. 43(1)(a) if they are either willing to give up their secured position, or if they are owed amounts above and beyond the amount they hold security over. In the latter case they will stand as an unsecured creditor on equal footing with other creditors for the balance. 14 An application for a bankruptcy order against a partnership may be made against individual partners or against the partnership itself. Under s. 43(15) and (16) of the BIA, it is sufficient for the creditor of a partnership to name one or more partners of the firm, and where multiple orders have been sought against different partners, the court may consolidate these applications. The Supreme Court of Canada has held that an application for a bankruptcy order can also be filed in the name of the partnership, given that the definition of a debtor under the BIA includes an insolvent person, which, as previously mentioned, is defined to include partnerships. 15 However, where a bankruptcy order is sought in respect of a limited partnership, it is not proper to name the limited partners in that partnership. While limited partners are liable for the amount of their contribution to the partnership, this obligation is owed to the partnership itself (that is, to both the general and other limited partners) and not to creditors It may be arguable that a failed proposal undertaken without the authorization of all partners of a firm would not operate to assign the partnership into bankruptcy, as the crafting of a proposal to creditors is likely outside the ordinary course of business. 14 Fengar Investments Corp. (Re) (1993), 17 C.B.R. 93d) 167 (Ont. Ct. (Gen. Div.)). 15 Langille v. Toronto-Dominion Bank (1982), 131 D.L.R. (3d) PA, ss

15 Following the filing of an application for bankruptcy against either the partnership itself, or the individual partners, it is open to the partners to contest the application. If the application is contested, the burden of proof rests on the applicant creditor to demonstrate that the partnership/partners owe an obligation in excess of $1,000 to the creditor and that the partnership/partners have committed an act of bankruptcy. 17 The partnership/partners will have the standard defences available to them to contest the application, namely that the debtor is solvent, or that there is a dispute as to the obligation which is alleged, or that the debtor has not ceased paying its debts generally. However, where an individual partner is named by the creditor applicant, it may also be possible, in the right circumstances, to argue that the obligation was not incurred while that partner was a partner in the firm. In such a situation, the creditor would have no claim against either the personal assets or the partnership contribution of that partner, and an order for bankruptcy against that partner would not be warranted. Where the creditor is successful in proving these elements, or where the debtor chooses not to contest the application, the court may grant the order for bankruptcy. 2. What is the Effect of a Partnership Becoming Bankrupt? Once an assignment is filed, or a bankruptcy order issued in respect of a partnership, the partnership and each individual partner is bankrupt. The partners cease to have any capacity to dispose of or otherwise deal with the joint property (of the firm) and the separate property (of the individual partners), all of which vests in the trustee for bankruptcy. The trustee has the sole authority to administer the realization and distribution of the joint and separate estates for the benefit of the creditors of the respective estates. In Kingsberry Properties Ltd Partnership (Re), 18 the Ontario Court of Appeal, in one of the few recent partnership insolvency cases, confirmed that the bankruptcy of a partnership automatically results in the bankruptcy of all partners of the bankrupt partnership. Although the BIA treats partnerships as distinct legal entities, for certain insolvency purposes, that insolvency concept is not intended to challenge the general rule that partnerships are nonetheless merely an association of individuals each one of whom is personally bound in respect of all the obligations of the partnership. 19 Section 36 of the PA is also triggered by an assignment in bankruptcy or bankruptcy order and operates to dissolve the partnership. The result of this is that any obligations undertaken in the name of the partnership by a partner following bankruptcy are considered personal obligations of that partner for the purposes of determining the distribution of property to creditors. However, in the context of a limited partnership, as the limited partners are shielded from liability for partnership obligations above their contribution to the partnership, an assignment or bankruptcy order as against a limited partnership (or the general partner(s)) will not result in the bankruptcy of the limited partner. Instead, the property of the partnership (including the limited partners contribution) will vest in the trustee, along with the separate property of the general partner(s), who remain fully liable for the obligations of the partnership. 20 In the context of a bankruptcy of a full shield limited liability partnerships, there will likely be no assignment into bankruptcy of the partners, and therefore there will be no separate estate that vests in the trustee. However, for partial shield LLPs, the separate estates of the partners will vest in the trustee, to be made available for the satisfaction of partnership and personal obligations. 17 BIA, s. 43(6). 18 (1998), 3 C.B.R. (4 th ) 135 (Ont. C.A.). 19 Cohen v. Mahlin, [1927] 1 D.L.R. 577 (Alta. C.A.). 20 Kingsberry Properties (Re) (1997), 3 C.B.R. (4th) 124 (Ont. Ct. (Gen. Div.), aff d by Kingsberry Properties (Re), supra, at para. 10.

16 How is the Property of the Partnership Distributed in Bankruptcy? Following the vesting of joint and separate property in the trustee, and the ascertainment of the totality of the obligations owed by the partnership and the partners that have become bankrupt, the trustee will distribute the proceeds of the estate according to a statutory priority scheme contained in the BIA, as supplemented by the PA where required. After the payment of costs for the administration of the bankruptcy, the discharging of certain statutory charges and liens and the payment of secured creditors, the remainder of the estate is distributed to unsecured creditors according to s. 142 of the BIA. Section 142 sets out the rules to be followed in administering the estates of bankrupt partnerships. The distribution scheme is different than that which applies in bankruptcies involving individuals and corporate debtors, as the BIA recognizes the different character of debts owing by the partnership and by the individual partners. In general, the BIA attempts to keep the satisfaction of these obligations separate, providing that joint property is first applied to satisfy joint debts and separate property is first applied to separate debts. Section 142 states: 142(1) Where partners become bankrupt, their joint property shall be applicable in the first instance in payment of their joint debts, and the separate property of each partner shall be applicable in the first instance in payment of his separate debts. (2) Where there is a surplus of the separate properties of the partners, it shall be dealt with as part of the joint property. (3) Where there is a surplus of the joint property of the partners, it shall be dealt with as part of the respective separate properties in proportion to the right and interest of each partner in the joint property. (4) Where a bankrupt owes or owed debts both individually and as a member of one or more partnerships, the claims shall rank first on the property of the individual or partnership by which the debts they represent were contracted and shall only rank on the other estate or estates after all the creditors of the other estate or estates have been paid in full. (5) Where the joint property of any bankrupt partnership is insufficient to defray any costs properly incurred, the trustee may pay such costs as cannot be paid out of the joint property out of the separate property of the bankrupts or one or more of them in such proportion as he may determine, with the consent of the inspectors of the estates out of which the payment is intended to be made, or, if the inspectors withhold or refuse their consent, with the approval of the court. Although both joint and separate property is available to satisfy the obligations of the partnership, a creditor of the partnership cannot collect from the separate estate until all the claims of the creditors of the separate estate have been satisfied. Conversely, creditors of the separate estate cannot claim against the joint estate until all of the creditors of the partnership have been discharged. Section 142 only applies where there is a joint estate. Where there is no joint estate, the creditors of the partnership may claim against the separate estate of the partners at first instance. This bifurcation of creditor rankings highlights an important point that may not accord with common conceptions of the nature of partnerships held by creditors when transacting with such entities. While the common conception is that obligations of the partnership are backed by the personal assets of the individual partners, if the partnership should become bankrupt, a creditor of the partnership will only be able to rely on the separate property of partners to the extent that there is property in the separate estate in excess of the partner s individual separate obligations. Similarly, those relying on an individual s partnership assets as an indication of a partner s credit worthiness may not be able to easily collect from the joint estate if it should prove to be heavily leveraged by other creditors, regardless of when such obligations were incurred.

17 In order to comply with s. 142, the trustee must be able to determine what property is to be considered joint or separate property. In this respect, the trustee can apply to the court for directions pursuant to s. 34(1) of the BIA. In general, the arrangements made by the partners, and their intentions when acquiring property, will ordinarily be determinative of whether the property belongs to the joint or separate estates. 21 However, where joint and separate assets are intertwined such that it is impossible to separate them, the court may order that all of the assets be treated as consisting of one fund that will be distributed rateably to both separate and joint creditors. 22 Another important principle stipulated by the BIA is that partners cannot compete against creditors of the joint estate for amounts owing by the firm to them as partners. Similarly, other partners cannot compete with creditors of the separate estate for amounts owing to the firm by that partner. Only once all creditors of the partnership have been satisfied can such claims be considered. Such claims may arise where individual partners loan money to the partnership, or where an individual partner accepts a loan from a partnership. However, because the partnership is not legally distinct from the partners, such claims do not rank on the same level as creditors claims. 23 a. Distribution of Limited Partner s Contribution Upon Bankruptcy When a LP goes into bankruptcy, s. 85(1) of the BIA provides that the limited partnership will be treated as an ordinary partnership with respect to the distribution of property of the partnership. As limited partners are only liable for partnership obligations in respect of their contribution, the only property that will vest in a trustee upon bankruptcy will be the joint property of the partnership (inclusive of the limited partner s contributions) and the separate property of the general partner(s). The PA also modifies the priority in which certain partnership assets are distributed following the satisfaction of the creditors of the partnership. In a GP, if there is excess joint property following a satisfaction of firm creditors, then this property is distributed rateably to the partners. In a LP, pursuant to s. 73 of the PA, limited partners rank ahead of general partners in respect to the return of both the limited partners capital contribution (subject to variation by agreement) and any claims the limited partner may have to their share of profits based on that contribution. Only once these claims have been satisfied is the general partner able to collect on its contribution to the partnership from the remaining assets. b. Distribution Wrinkles in Limited Liability Partnerships It is difficult to ascertain how a bankruptcy of a LLP would function, given a dearth of authority on the subject, and this is compounded by the different forms of liability protection available under the PA and under the legislation of other jurisdictions. However, some observations are nonetheless possible. In a full shield LLP, the joint property of the partnership would be applied to satisfy the obligations of the partnership. Where the partnership has incurred a liability as a result of the negligence of a partner in that firm, such an obligation will rank as an unsecured claim first against partnership assets, with the remainder to be satisfied by the responsible partner. Of note, in a full shield LLP, those partnership obligations that cannot be satisfied by a distribution of the partnership property will remain unsatisfied, as partners are not personally liable for such obligations under s. 104 of the PA. Despite this protection, partners in a full shield LLP may be personally liable for certain statutory obligations (such as a certain amount of unpaid wages, taxes and environmental liabilities) if the joint 21 See Wolf Estate (Re) 2004), 4 C.B.R. (4 th ) 140 (Alta. Q.B.); Henderson v. Rudd, [1931] 3 W.W.R. 142 (Man. K.B.). 22 See Re Kriegel; Ex parte Trotman (1893), 10 Morr. 99, 68 L.T See General Fibre Board Syndicate (re) (1923), 4 C.B.R. 364 (Ont. S.C.).