Debtor's LLC Interest In Bankruptcy
Topic Bankruptcy TopicsBankruptcy
What happens if an LLC member (not the LLC itself) is placed into bankruptcy? The short answer is: Hilarity ensues, since our current Bankruptcy Code does not specifically treat LLC (or partnership) interests held by a debtor, and thus the courts must torture a couple of different provisions of the Code to attempt to deal with them.
The long answer is thus much more complicated and necessarily fact-specific. As with any asset, we begin with Bankruptcy Code § 541(a)(1), which provides:
(a) The commencement of a case under section 301, 302, or 303 of this title creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held:
(1) Except as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case.
So, the debtor's LLC interest comes into the debtor's bankruptcy estate under § 541(a)(1), but with one major caveat which is found in § 541(d):
(d) Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest, such as a mortgage secured by real property, or an interest in such a mortgage, sold by the debtor but as to which the debtor retains legal title to service or supervise the servicing of such mortgage or interest, becomes property of the estate under subsection (a)(1) or (2) of this section only to the extent of the debtor's legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.
The upshot of § 541(d) is that the debtor's LLC interest comes into the bankruptcy estate only to the extent that the debtor has equity in the interest. If the debtor has pledged the interest as collateral, for instance, then the debtor no longer holds an equitable interest in the LLC interest, and therefore it is excluded from the bankruptcy estate.
What about a charging order lien? A charging order lien also has the effect of transferring the debtor's equity in the LLC interest to the creditor, such that the debtor is left holding only legal title to the LLC interest, and thus a charging order has the same effect under § 541(d) as a lien on collateral, and thus excludes the debtor's interest from the bankruptcy estate. So, if the creditor has a charging order against the debtor's LLC interest, then presumably the creditor can seek relief from the bankruptcy automatic stay, and continue to receive distributions from the LLC as before, and perhaps even foreclose on the debtor's LLC interest if local law and the local court allows.
The remainder of our discussion will presume that the debtor owns the equity in his LLC interest, i.e., has not pledged the LLC interest as collateral, and no creditor had taken a charging order lien against the LLC interest as of the commencement of the bankruptcy case.
The Executory/Non-Executory Issue And § 365(a)
Once the debtor's LLC interest is in the bankruptcy estate, the next issue is to determine the character of the interest. Here, it is to be recalled that an LLC interest is fundamentally contractual in nature, i.e., a member owes contractual duties to the LLC in exchange for which the member will receive benefits in the form of distributions. The question then becomes whether (1) the debtor still owes the performance of duties to the LLC to be able to obtained benefits, i.e., the interest is said to be executory; or (2) the debtor has already performed all duties to the LLC and there is nothing of significance for the debtor to do in the future to receive benefits, i.e., the interest is said to be non-executory.
Before I tell you why this executory/non-executory issue is important, let me give a couple of examples: First, let's say that the debtor is one of five owners in a pizza store organized as an LLC, and the operating agreement contemplates that each owner will work in the store making pizzas so as to receive distributions; that is an executory interest since the debtor has to do something in the future to earn distributions. By contrast, let's say that the debtor is simply one of five investors in a hedge fund organized as an LLC, and all the debtor had to do was to put cash into the LLC (which the debtor has already done before filing for bankruptcy) in order to receive distributions in the future; that would be a non-executory interest, since there is nothing further for the debtor to do to obtain distributions.
Where this is an issue is that § 365(a) provides in relevant part that:
(a) . . . [T]he trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor.
Thus, if -- and only if -- the debtor's LLC interest is executory, i.e., in the nature of an executory contract, the Bankruptcy Trustee has the option of either assuming the LLC's operating agreement, or rejecting the LLC's operating agreement. The decision can have dramatic repercussions which will be discussed below.
Before we get there, it must be noted that personal service contracts can never be assumed by the Bankruptcy Trustee, as stated in § 365(c)(1):
(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—
(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment; . . ..
Going back to our pizza store example, if the LLC's operating agreement says that the debtor cannot assign his duty to make pizzas to others, but rather he alone can satisfy his pizza-making duties (he makes great pizzas), then the LLC is for the personal services of the debtor only, and cannot be assumed by the Bankruptcy Trustee if -- and only if -- the other LLC members give the Bankruptcy Trustee thumbs-down on making pizzas.
But let's assume that the debtor's LLC is not in the nature of a personal service contract and move on.
The Debtor's LLC Interest Is Non-Executory
If the debtor's LLC interest is non-executory, i.e., our hedge fund investor who has already made her investment and now has nothing else to do to fulfill her performance, then § 365 doesn't apply at all, and the Trustee takes the debtor's LLC interest whole, including voting rights, and can sell it off like any other asset or vote the rights to liquidate the company (if the Trustee holds a majority interest or can get enough other members to agree). Thanks for playing.
The Debtor's LLC Interest Is Executory
If the debtor's LLC interest is executory, then things get really complicated. First, the Bankruptcy Trustee only has 60 days to make the decision whether to assume the LLC's operating agreement, per § 365(d)(1), and if not then the LLC operating agreement is deemed to be rejected.
(d)(1) In a case under chapter 7 of this title, if the trustee does not assume or reject an executory contract . . . of personal property of the debtor within 60 days after the order for relief, or within such additional time as the court, for cause, within such 60-day period, fixes, then such contract . . . is deemed rejected.
If the Trustee rejects the LLC's operating agreement (including by failing to assume it timely), then under § 365(g) the effect is as if the debtor breached the LLC's operating agreement.
(g) Except as provided in subsections (h)(2) and (i)(2) of this section, the rejection of an executory contract or unexpired lease of the debtor constitutes a breach of such contract or lease . . ..
The practical effect here would presumably be that the other LLCs members could then terminate the debtor's LLC interest (they'd better ask for relief from the automatic stay first as a precaution), and terminate the debtor's LLC interest. If those other members do not do that, then the Bankruptcy Trustee ends up holding an interest in the LLC that is in breach, and which presumably would be worthless, and most likely the Bankruptcy Trustee would end up abandoning that interest back to the debtor.
Now let us consider what happens if the Bankruptcy Trustee assumes the LLC's operating agreement.
Where the Bankruptcy Trustee assumes the LLC's operating agreement, then the debtor's bankruptcy estate (via the Bankruptcy Trustee) becomes contractually obligated to perform any and all obligations as required by the LLC's operating agreement. So, let's say that the Bankruptcy Trustee assumes the LLC's operating agreement, and the next day there is a cash call under that agreement. In that case, the Bankruptcy Trustee would have to answer the cash call from the proceeds of other assets of the debtor's bankruptcy estate. In other words, to quote Prof. Carter Bishop who has lectured frequently on this very issue, if the Bankruptcy Trustee assumes the LLC's operating agreement, then the debtor's bankruptcy estate goes "whole hog with warts" as to the debtor's (now former) obligations under the LLC's operating agreement.
Although the Bankruptcy Trustee may have assumed the LLC's operating agreement, the Bankruptcy Court will want to move the case along and finally close it, which means that the Bankruptcy Trustee does not have the luxury of sitting around for years on end receiving distributions. Thus, the practical effect of the Bankruptcy Trustee assuming the LLC's operating agreement will be that the Bankruptcy Trustee will sell (assign) the debtor's LLC interest under § 365(f):
(1) Except as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection.
(2) The trustee may assign an executory contract or unexpired lease of the debtor only if—
(A) the trustee assumes such contract or lease in accordance with the provisions of this section; and
(B) adequate assurance of future performance by the assignee of such contract or lease is provided, whether or not there has been a default in such contract or lease.
Perhaps the real issue is whether the Bankruptcy Trustee will be able to realize much from the sale of the interest, since the assignee (buyer) will also take the obligations under the LLC agreement "whole hog with warts".
Ipso Facto Clauses
To attempt to avoid this entire mess, most LLC planners will almost inevitably draft into the LLC's operating agreement language to the effect that if a member declares bankruptcy then that member's interest is immediately terminated and they are expelled from the LLC. This is just so much wasted ink because of the clear text of §§ 541(c) and 365(c).
(1) Except as provided in paragraph (2) of this subsection, an interest of the debtor in property becomes property of the estate under subsection (a)(1), (a)(2), or (a)(5) of this section notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law—
(A) that restricts or conditions transfer of such interest by the debtor; or
(B) that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor's interest in property.
(1) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
In fact, if the other members attempt to enforce such a clause without first obtaining relief from the automatic stay (which would probably never be granted), it is very likely that those members would find themselves on the wrong side of a motion for contempt and sanctions for violating the automatic stay.
Court Opinions On The LLC Member In Bankruptcy
Find all of this confusing? Don't fret; you're in good company as the courts has struggled mightily with these issues, as you can read by the opinions below.
As mentioned, the real problem in this area (and so many others) is that the Bankruptcy Code is simply out-of-date when it comes to LLC and partnership interests and is in serious need of modernization. Don't hold your breath.
- 2022.02.05 ... Charging Order Lien Avoided By Bankruptcy Court In Kleynerman
- 2020.11.23 ... Charging Order Against Interest Of LLC In Bankruptcy Held Not To Violate The Automatic Stay In Nilhan
- 2016.03.26 … Trustee Frustrated In Selling Debtor/Member's LLC Interest In Talbut
- 2015.06.20 ... The LLC Member In Bankruptcy: Ehmann And Its Progeny
- 2014.12.19 ... Denman Creates Confusion For Bankrupt Debtor's Interest In LLC
- 2014.10.6 ... Albright Relief Applied To Personal Services LLC In Re Cleveland
BANKRUPTCY OPINIONS RE DEBTOR/MEMBER IN BANKRUPTCY
- In re Baldwin (Miller v. Bill and Carolyn LP), 2006 WL 2034217 (10th Cir.BAP (Okla.), 2006) (Unpublished Disposition).
- In re Cleveland, 2014 WL 4809924 (D. Nev. Sept. 29, 2014).
- In re Denman, 513 B.R. 720 (W.D.Tenn., July 24, 2014).
- In re DeVries, 2014 WL 4294540 (Bk.N.D.Tex., 2014).
- In re Dixie Mgt. & Invest., 2011 WL 1753971 (Bk.W.D.Ark., 2011).
- In re Ehmann (Movitz v. Fiesta Investments, LLC), 319 B.R. 200 (Bkrpt.D.Ariz., 2005).
- In re First Protection Inc. (Fursman v. Ulrich), ___ B.R. ____, 2010 WL 5059589 (9th Cir.BAP (Ariz.), Nov. 22, 2010).
- In re Graves Farms, 2019 WL 3407134 (Bk.D.Kan., July 26, 2019).
- In re Kleynerman, 2022 WL 243215 (E.D.Wis., Jan. 26, 2022).
- In re LaHood (LaHood v. Covey), 437 B.R. 330 (Bkrpt.C.D.Ill. 2010).
- In re Myers, 2013 WL 587311 (S.D.Miss., Feb. 14, 2013).
- In re Nilhan Developers, LLC, 2020 WL 6572235 (Bk.N.D.Ga., Nov. 9, 2020).
- In re Soderstrom (Horizons A Far, LLC v. Webber), 484 B.R. 874 (M.D.Fla., 2013).
- In re Strata Title, LLC, 2013 WL 1773619 (Bk.D.Ariz., 2013).
- In re Talbut, 2016 WL 937373 (N.D.Ohio, Slip Copy, 2016).
- In re Warner, 480 B.R. 641, 644-58 (Bankr. N.D.W.Va. 2012).
- In re Wilson, 2014 WL 3700634 (Bk.N.D. Tex., 2014).
- In re Yow, 590 B.R. 696 (Bk.E.D.N.C. 2018).
- Matter of H&W Food Mart, LLC, 461 B.R. 904 (BK N.D.Ga., 2011).
- Sullivan v. Mathew, 2015 WL 1509794 (N.D.Ill., 2015).