Partnership Bankruptcy: 6 Rules on Partner Liability Under §723

A general partnership's Chapter 7 case reaches past the partnership, and section 723 of the Bankruptcy Code is the instrument it uses. When the partnership's own property falls short of paying the allowed claims, the trustee acquires a claim against the general partners personally, measured by what state law would have made them pay anyway. The partners are not debtors in the partnership's case. They are, in a practical sense, its reserve.

The section is short, four subsections long, and each one fixes a rule about who pays, in what order, and what happens to any excess. Six rules follow from its text and from the provisions around it.

1. The Trustee's Claim Is Exactly as Large as State Law Makes It

The operative sentence of 11 U.S.C. 723(a) reads: "If there is a deficiency of property of the estate to pay in full all claims which are allowed in a case under this chapter concerning a partnership and with respect to which a general partner of the partnership is personally liable, the trustee shall have a claim against such general partner to the extent that under applicable nonbankruptcy law such general partner is personally liable for such deficiency." Bankruptcy law does not create the partner's liability. It borrows it.

The borrowed rule differs by state. In New York, Partnership Law section 26 makes all partners liable "Jointly and severally for everything chargeable to the partnership under sections twenty-four and twenty-five," which concern partners' wrongful acts and breaches of trust, and "Jointly for all other debts and obligations of the partnership." A partner in another state answers under that state's partnership statute, and the difference between joint and joint-and-several liability can matter a great deal to a partner with more assets than the others.

Take a hypothetical two-partner catering business, organized as a general partnership, that enters Chapter 7 with $400,000 in allowed claims. The trustee liquidates the vans, the kitchen equipment and the receivables and realizes $150,000. The deficiency is $250,000, and the trustee holds a claim for it against the partners, to the extent each is personally liable for it under the governing state's law, whether or not either partner signed a separate guaranty, because the liability flows from being a general partner, and a partner who signed nothing beyond the partnership agreement (and who may have believed, as many do, that the business's debts stayed with the business, because the bank account and the invoices and the lease all bore its name and none bore theirs) learns that the partnership form gave no such protection.

A funder that also holds a partner's personal guaranty has its own contract with that partner as well. The guaranty is a separate promise. Section 723 governs the trustee's claim; it does not rewrite the guaranty.

2. Partners Without Personal Liability Face No Claim at All

Because the claim exists only to the extent a partner is personally liable under nonbankruptcy law, a partner the state shields is outside it. New York's section 26(b) generally relieves partners in a registered limited liability partnership of liability for its debts, subject to stated exceptions. Whether a limited partner in a limited partnership is exposed depends on that state's limited partnership statute. And members of an LLC are not partners in this sense at all, even when the LLC is taxed as a partnership, so section 723 gives a trustee in an LLC's case no claim against them.

3. Partners Outside Bankruptcy Are Asked First

Section 723(b) directs the trustee, "to the extent practicable," to seek the deficiency first from general partners who are not themselves in bankruptcy. The court need not wait for the final figure: pending that determination, it may order such a partner to provide the estate with indemnity or assurance of payment, or "not to dispose of property." For a solvent partner, the practical consequence arrives early, in an order about the partner's own assets entered in a case the partner did not file.

4. A Partner Who Is Also in Bankruptcy Owes the Full Amount

If a general partner is also a debtor, section 723(c) gives the trustee a claim against that partner's estate "for the full amount of all claims of creditors allowed in the case concerning such partnership." The measure is the full amount of allowed partnership claims, rather than the deficiency alone.

The same subsection then prevents double counting, or, more precisely, prevents the partnership's creditors from also sharing in the partner's estate on the same debt. A claim against the partner on which both partner and partnership are liable is not allowed in the partner's case, except to the extent it is secured only by the partner's own property. The partnership trustee stands in their place, and the trustee's claim shares in the partner's estate under section 726(a) like any other claim of its kind.

The effect is a funnel, something like the way a building's gutters carry rain from every slope of an irregular roof into one downspout: partnership creditors are paid through the partnership trustee, and the partner's individual creditors are not crowded out by the same debt appearing twice. How that allocation plays out against a partner's personal guaranty, which is the partner's own obligation to the funder and not merely a partnership liability, is a question the subsection's words leave to the courts and to counsel.

5. Any Surplus Goes Back to the Partners' Estates

If recoveries from bankrupt partners' estates exceed the deficiency left unrecovered from solvent partners, section 723(d) requires the court, once creditors and partners have had notice and a chance to be heard, to determine "an equitable distribution of the surplus," which the trustee then returns to the partners' estates.

6. The Section Operates Only in Chapter 7, Within a Wider Partnership Scheme

Section 723 speaks of "a case under this chapter," which is Chapter 7. A partnership in Chapter 11 proceeds under its plan, and section 723 by its own terms does not reach that case.

But the Code treats partners as part of the partnership's finances in other places too. Under section 101(32)(B), a partnership is insolvent only if its debts exceed its own property plus the excess of each general partner's nonpartnership property over that partner's nonpartnership debts. An involuntary petition against a partnership may be filed by fewer than all of its general partners under section 303(b)(3), and the petitioner must serve the partners who did not join. Rule 1007(g) lets the court order any general partner to file a statement of personal assets and liabilities. And the partnership itself, not being an individual, receives no Chapter 7 discharge.

What a Settlement Can and Cannot Reach

A partnership still operating, with two or three funders and partners who would rather not see section 723 applied to them, may find a negotiated resolution worth pricing before any petition. Delancey Street works on that side of the problem: negotiating merchant cash advance balances, with a free and confidential first review, and as a company that is not a law firm it takes no part in the case itself. Once a Chapter 7 case is open, the trustee's claim against the partners is statutory and belongs to the estate, and partners in that position need their own bankruptcy counsel, each one separately where their interests diverge.