Does an LLC’s Bankruptcy Discharge Apply to the LLC’s Alter Egos? | Patton Sullivan Brodehl LLP

When a debtor LLC receives a discharge order from a bankruptcy court, a creditor is prevented from enforcing any preexisting debts against the discharged LLC as a personal liability.  This is known as the “discharge injunction.”  But the discharge injunction does not extinguish the debt or protect any one else from liability on the debt.

Are “alter egos” of a bankrupt LLC entitled to the protection of the discharge injunction?

The court addressed this issue in a case recently published by the United States Bankruptcy Appellate Panel of the Ninth Circuit — In re: RS Air, LLC.

Facts: LLC obtains bankruptcy discharge order; creditor sues LLC’s “alter egos”

Debtor RS Air, LLC was a Delaware LLC.  Stephen G. Perlman was the founder and sole managing member of RS Air.  RS Air’s stated purpose was to provide aircraft transportation services to Perlman.  Perlman was the trustee of his trust, and also owned and controlled a separate company called Rearden LLC.

RS Air purchased a fractional interest in two aircraft from creditor NetJets Services Inc. and its affiliates, and also entered into multiple management agreements with NetJets regarding the aircraft.

Later, NetJets sued RS Air for breach of the agreements.  Just before trial, RS Air filed a Chapter 11 bankruptcy petition.  NetJets filed a claim in the bankruptcy proceedings in the amount of $2.133 million.  The bankruptcy court eventually confirmed a plan of reorganization under which NetJets could recover a small portion of its claim.

While the bankruptcy proceedings were pending, NetJets filed a separate lawsuit based on the same debt against Perlman (individually and as trustee of his trust) and Rearden LLC as “alter egos” of RS Air.  The complaint did not name RS Air as a defendant, but alleged facts regarding the debt incurred by RS Air.

Bankruptcy district court: alter ego lawsuit not barred by discharge injunction

After RS Air obtained its discharge order from the bankruptcy court, it filed a motion for contempt against NetJets for violation of the discharge injunction under 11 USC section 524(a)(2), arguing that the separate lawsuit sought to recover a discharged debt because under NetJets’ alter ego allegations, “the Defendants are all one and the same.”

The bankruptcy court denied the contempt motion, concluding that the separate lawsuit did not seek relief from RS Air, and section 524(e) provides that the discharge injunction does not apply to the liabilities “of any other entity,” including the alleged alter egos Perlman and Rearden LLC.

RS Air appealed.

Ninth Circuit: affirmed

The Ninth Circuit affirmed the bankruptcy court’s order, holding section 524 “plainly provides that the discharge only protects the debtor and not any other person who is liable with the debtor.”  The court noted that the alter ego lawsuit did not name RS Air as a defendant, and sought no relief against RS Air.  It mentioned RS Air’s debt, but only sought to hold non-debtors Perlman and Rearden LLC liable for the debt.

The court rejected RS Air’s argument that being subjected to the discovery process in the alter ego lawsuit violated the discharge injunction, holding: “the discharge injunction only enjoins personal collection of a discharged debt and does not relieve a discharged debtor from all forms of imposition or inconvenience. We have repeatedly held that a discharged debtor’s obligation to participate in discovery is not an effort to personally collect a debt and does not violate the discharge injunction.”

The court also clarified that a bankruptcy discharge “does not extinguish the debt; instead, it protects only the debtor from personal liability on that debt.”  The debt still exists, “and can be collected from any other entity that may be liable.”  As such, “RS Air continues to owe the full amount of the debt; the discharge injunction precludes collection of that debt from RS Air, but not from anyone else.”

The court also dismissed RS Air’s concerns regarding opening “the floodgates to post-discharge litigation on … alter ego claims, particularly concerning single-member LLCs.”  The court stated: “We do not foresee such a result. The corporate veil is a formidable obstacle, and parties that file baseless alter ego claims risk sanctions for frivolous filings.”

Lesson

Under the RS Air opinion, a bankruptcy discharge injunction under 11 USC section 542 protects the discharged debtor LLC from future efforts to collect on the discharged debt, but does not prevent litigation seeking to collect the same debt from the LLC’s alleged alter egos.

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