Debtor’s pledge of his partnership interest was unenforceable under Delaware law and the proof of secured claim filed by the Creditor was disallowed. The North Carolina court looked beyond the Security Agreement’s choice of law provision and to the local law of the state of incorporation. In re James Alexander Mason, Jr., 600 B.R. 765 (Bankr. E.D.N.C. 2019).
By: Jeff Dutson (King & Spalding)
A Debtor executed a Personal Guaranty and Security Agreement purporting to grant a Creditor a security interest in the Debtor’s partnership interests. Though the limited liability partnership is incorporated in Delaware, the Security Agreement states it shall be governed by the laws of the state of New York. The Debtor did not provide the Creditor with a copy of the Partnership Agreement and did not obtain consent from his partners to execute the Security Agreement prior to the closing date of the loan. The Debtor filed a bankruptcy petition and the Creditor asserted a secured claim. The Trustee objected, claiming the Partnership Agreement states the Debtor cannot pledge or assign his partnership interest without unanimous consent of the other partners. The Creditor argued that New York law, the choice of law in the Security Agreement, overrides these restrictions on assignment and the claim should be allowed.
North Carolina employs the “internal affairs doctrine” which is a conflict of laws principle that recognizes only one State should have the authority to regulate a corporation’s internal affairs – matters peculiar to the relationship among or between the corporation and its current officers, directors and shareholders. In these situations, courts look beyond a contract’s choice of law provisions and to the local law of the state of incorporation. This doctrine prevents parties from side-stepping an entity’s governance documents by including a choice of law provision for a state other than the state in which the entity is organized.
The Court determined that the issue of whether the claim is secured by the Debtor’s partnership interest necessarily implicates the limited liability partnership’s interest in maintaining consistency between the contributors of capital and the recipients of distributions. This interest is sufficiently related to internal affairs and requires application of the doctrine. The Partnership Agreement restricts the assignment of partnership interest in whole or in part and, under Delaware law, these provisions govern assignability. The court reasoned the other partners did not participate in drafting and executing the Security Agreement and their contractual rights deserve respect. The Court ruled that the Debtor did not have the power to transfer rights in his partnership interest when he executed the Security Agreement; therefore, the Creditor did not have an enforceable security interest.