Example of Importance of Corporate Legal Formalities

Suggested by a true story:

Suppose you are a limited partner in a properly formed Texas real estate investment limited partnership.  You, along with a general partner and all of the other limited partners, signed and delivered a written agreement of limited partnership, and the sole general partner duly  signed and filed a certificate of formation with the Texas Secretary of State.  You read Texas Business Organizations Code (TBOC) Section 3.011(a), which says: "To form a limited partnership, the partners must enter into a partnership agreement and file a certificate of formation." You feel good.

But, as with many for profit entities, times get rough, and the entity seeks protection from creditors in a Chapter 11 bankruptcy.  During the pendency of the proceeding, your limited partnership fails to file a statutorily mandated periodic report.  The Secretary of State terminates its certificate of formation.  Despite written notice from the Secretary of State that the limited partnership has been "involuntarily terminated" for failure to file the periodic report but can be reinstated by filing the delinquent report and paying modest fees (less than $250), the limited partnership's "manager" in bankruptcy fails to reinstate the entity.

Months pass.  A reorganization plan -- which involves you and the other limited partners contributing more cash to the entity and entering into a new limited partnership agreement -- is approved by the voting classes and confirmed by the court, and on the "Effective Date" of the plan an "Amended and Restated Agreement of Limited Partnership" of the entity becomes effective.

Here is the problem: Subchapter F of Chapter 11 of the TBOC ("Involuntary Termination of Filing Entity by Secretary of State") says that "[e]xcept as otherwise provided by this chapter, the existence of the filing entity is terminated on the issuance of the certificate of termination by the secretary of state."  There is a method available to reinstate the entity, and if properly done, "the entity is considered to have continued in existence without interruption from the date of termination."  However, reinstatement has NO effect on the personal liability, if any, of governing persons, officers or agents of the entity arising during the gap period from termination to reinstatement.  There is some comfort to be drawn from TBOC 153.311's statement that upon termination of a limited partnership's certificate of formation for failure to file a periodic report, the entity's status should be changed on the Secretary of State's records to "inactive" and that "change to inactive status does not affect the liability of a limited partner."

But in this situation, the problem is potentially even worse: remember that to form a limited partnership in Texas, the partners must enter into a partnership agreement and file a certificate of formation.   Your entity's certificate of formation was terminated nearly one year before the Effective Date and the entity's existence ceased at that time.  On the Effective Date, the partners entered into a partnership agreement.  Months after the Effective Date, the partners still have not reinstated the old certificate.

So a reading of the statutory language indicates that (1) prior to the filing of the Chapter 11 petition (prepretition) there was a Texas limited partnership, because there was a valid limited partnership agreement among the partners and a certificate of formation filed with the Texas Secretary of State; (2) postpetition, that certificate of formation was terminated and the entity's existence ceased; and (3) postconfirmation, the partners entered into a new limited partnership agreement but there is no certificate of formation.

So where are you, Mr. Limited Partner?  Counting on TBOC 153.311 to preserve your limited liability status not only for the entity's PAST debts, obligations and liabilities but also for its FUTURE debts, obligations and liabilities?  Remember that provision says that it is the "change to inactive status" recorded by the Secretary of State that does not affect your liability.  It says nothing about future entity transactions, obligations, debts and liabilities affecting that status, nor does it say anything about entering into a partnership agreement after the change of status.   It just means that the official action of the SOS does not make you automatically liable for the entity's existing (or past) obligations, that is, its obligations at the time its existence ceases.  It doesn't say that other subsequent actions do not affect liability.

From and after the Effective Date (when the restated partnership agreement took effect) until the certificate of formation is reinstated, you are probably not a limited partner in a limited partnership; you read TBOC Sections 152.051 and .052 and realize that you are probably in "an association of two or more persons ... [that] creates a [general] partnership, regardless of whether: (1) the persons intend to create a partnership ...."  That worries you, and when you turn to TBOC Section 152.304 your fears are confirmed as you read that "all partners are jointly and severally liable for all obligations of the partnership unless otherwise ... provided by law."  Grasping at that last phrase, you turn to TBOC Section 11.253 but your heart flutters as you read that, even if the certificate of formation is reinstated, "reinstatement shall have no effect on any issue or personal liability of the governing persons, officers, or agents if the filing entity during the period between termination and reinstatement."  Maybe you are okay, as you know you don't act as an agent for the entity and you aren't an officer, but when you turn to the definition of "governing persons" you begin to shake nervously realizing that every general partner is a governing person of a general or limited partnership.

The disclosure statement for the plan (which should function like a prospectus) didn't disclose this problem (in the securities law world outside of bankruptcy, we would call this a material omission, and the issuer and its controlling persons would face potential liabilities).  And to top it off, you and your fellow "limited" partners got to pay (by way of new cash contributions) for this opportunity!

 

 

This entry was posted in Steve's Blog and tagged , , , , , , , , , . Bookmark the permalink.

Leave a reply

Prove you are human *