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:
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):
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.
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:
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):
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.
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.
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.
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.
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):
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".
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).
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.
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.