Disposition of Partial LLC Interests in Bankruptcy

Bankruptcy estates often own a partial interest (typically called a membership interest) in a limited liability company. Sometimes the LLC has been created for proper purposes well before bankruptcy was on the horizon. At other times, the LLC has been formed as an asset protection device by a debtor contemplating an insolvency proceeding and is part of a strategy to deter creditors. The most obvious and logical candidates to purchase the estate's LLC interests are the other, non-bankrupt members because the market for selling privately held LLC interests is thin, and dispositions to third parties may raise complications concerning sales of unregistered securities.

But what if the other members refuse to purchase the interest for more than a nominal amount while simultaneously treating the bankruptcy estate representatives in a hostile manner, such as by resisting efforts of the estate to sell to third parties, making unneeded capital calls, withholding distributions, burdening the estate with non-cash taxable income, or causing the LLC to engage in non-market transactions? What strategies can the estate pursue? Unfortunately, the answer usually lies in a tangle of confusing LLC statutes that vary from state to state, complicated by an overlay of imprecise provisions of the Bankruptcy Code.

Background

Ever since the adoption of the first LLC statutes in the late 1970s, one of the underlying policies of state law has been to allow members to “choose their partners” and to avoid liquidation simply because one of the members encounters financial distress. Thus, in general, state LLC statutes, whether based on partnership statutes, the Uniform Limited Liability Company Act or the Revised Uniform Limited Liability Act, make it difficult or, in some cases, virtually impossible for an LLC member (or the member's judgment creditor or bankruptcy estate) to sell an interest to a third party or to force a dissolution and winding up of the LLC.

Nevertheless, in instances where the non-debtor members have engaged in inequitable or oppressive conduct designed to prejudice the estate, bankruptcy courts have occasionally shown a willingness to consider remedies such as the appointment of a receiver for the LLC or even the dissolution and winding up of the LLC. The availability of these remedies depends on state law governing the creation of the LLC, the terms of any operating agreement, interpretations of Bankruptcy Code provisions not specifically addressing LLCs, and the conduct of the non-debtor members and managers.

One of the earliest significant cases addressing these remedies is In re Ehmann, 319 B.R. 200, 2005 Bankr. LEXIS 80 (Bankr. D. Ariz. 2005). There, the debtor, an owner of a partial membership interest in an Arizona LLC filed a Chapter 7 bankruptcy case. One of the members, also the manager, was the debtor's father. Id., 319 B.R. at 202. Other members were the debtor's siblings. Both before and during the bankruptcy, the LLC engaged in a number of suspicious insider transactions. Id. The trustee filed an action against the LLC requesting a declaration that the trustee had the powers of a member (rather than those of a judgment creditor of a member), a finding that the LLC assets were being misused and that a receiver should be appointed to operate or liquidate the LLC. Id. at 201.

The bankruptcy court denied the LLC's motion to dismiss the complaint, rejecting its contentions that the trustee was limited to the rights of a judgment creditor of the debtor (known as an “assignee” under the LLC statute). Id. at 203. The court found that the operating agreement was not an executory contract and that provisions in the operating agreement that would otherwise restrict or condition the debtor's transfer were inapplicable in bankruptcy, nullified by 11 U.S.C. ' 541(c)(1). Id. at 206. (In a later opinion, the court granted summary judgment to the trustee and ordered the appointment of a receiver to operate the LLC in accordance with the operating agreement or, if not practical, to seek authority to liquidate, but the court ultimately withdrew that opinion upon a settlement by the parties. In re Ehmann, 334 B.R. 437, 2005 Bankr. LEXIS 2382 (Bankr. D. Arizona 2005) opinion withdrawn, 337 B.R. 228 (Bankr. D. Ariz. 2006).)

Other Rulings

A second case of interest, In re Klingerman, 388 B.R. 677, 2008 Bankr. LEXIS 1117 (Bankr. E.D. N.C. 2008), involved the Chapter 11 case of an individual who was one of two founding members of a North Carolina LLC. The Chapter 11 debtor filed an adversary proceeding to wind up the LLC. The defendant LLC and its other founding member filed a motion to dismiss, arguing in part that the debtor lacked standing to bring the action because, under the operating agreement and the North Carolina statute, the debtor's bankruptcy caused an automatic termination of his membership status, leaving him the holder only of an economic interest. Adopting the views expressed in In re Ehmann and rejecting certain contrary views expressed by the court in In re Garrison-Ashburn, 253 B.R. 700, 2000 Bankr. LEXIS 1231 (Bankr. E.D. Va. 2000), the bankruptcy judge concluded that the debtor's membership status remained in force under 11 U.S.C. ' 541(c) and further, that the estate was not restricted to distribution rights as an “assignee.” In re Klingerman, 388 B.R. at 679. The court concluded that the Chapter 11 debtor therefore had “standing” to seek dissolution, though the question of the propriety of dissolution was reserved. Id.

Another more recent case touching upon the issue of liquidating an LLC is In re Garbinski, 465 B.R. 423, 2012 Bankr. LEXIS 515 (Bankr. W.D. Pa. 2012). In that case, the Chapter 7 trustee proposed to sell the debtor's 50% interests in two Pennsylvania LLCs to the other 50% non-debtor member. The court denied the motion on the grounds that it could not determine on the record whether the sale price was adequate under Bankruptcy Code standards, particularly in light of the buyer's insider status and his contention that any purchaser seeking to outbid him must receive his consent to become a member. Id., 465 B.R. at 425-26. In considering the trustee's motion, the court observed, almost as if it were leveraging the buyer, that ' 541(c)(1) and Pennsylvania law provisions “would seem to give the Trustee the ability to seek judicially supervised dissolution and winding up.” Id., 465 B.R. at 427.

The latest reported decision we found confronting the winding up of an LLC partially owned by the estate is In re Warner, 480 B.R. 641, 2012 Bankr. LEXIS 4496 (Bankr. N.D. W.V. 2012). The debtor, an individual who filed a Chapter 7 case, owned approximately 16% of the membership interests in a West Virginia LLC that, in turn, owned valuable real estate in West Virginia. After the court found that the debtor's purported pre-bankruptcy transfer of his interest to his brother was ineffective, the trustee in bankruptcy filed an action and then moved for summary judgment, seeking a declaration that the LLC was dissolved automatically under a provision of the operating agreement upon a member's (the debtor's) bankruptcy filing; the trustee sought either the appointment of a receiver to liquidate the LLC or a writ of mandamus requiring the manager to proceed with liquidation. Id., 480 at 646.

Initially, the bankruptcy judge found that the operating agreement was not an executory contract because it did not impose any material obligations on the debtor. Id., 651-52. The court next held that the prohibition under 11 U.S.C. ' 541(c)(1) of “ipso-facto” modifications of a debtor's property interests, precluded the automatic dissolution provisions of the operating agreement from taking effect, rejecting the trustee's contention that he had the option of enforcing that provision. Id., 480 B.R. at 655-56. However, the court stated that its holding was without prejudice to the Trustee later establishing, as an LLC member, some factual basis under the West Virginia LLC statute for the judicial appointment of a receiver or for liquidation of the LLC. Id. at 657.

Even if a court determines that the bankruptcy estate does not acquire the debtor's rights as an LLC member, including conditional liquidation rights, and instead has only the rights of an “assignee,” some LLC statutes appear to grant even an assignee the right to request a winding up of the LLC if it is “equitable.” See, e.g., the Revised Uniform Limited Liability Company Act, ' 701(4) and (5) (1996).

Conclusion

Although we have not located a reported decision compelling the winding up of a multi-member LLC, at the request of a bankruptcy estate holding a membership interest in it, these cases appear to make that remedy available, at least theoretically. The statutory provisions and cases discussed in this article demonstrate that, faced with appropriate circumstances, especially where non-debtor members attempt to take unfair advantage of the estate or frustrate the purpose of the LLC, bankruptcy courts will be empowered to force a liquidation of an LLC and enable the estate to realize a fair value for its interest.

Richard J. Mason and Patricia K. Smoots concentrate on commercial bankruptcy and related litigation out of the Chicago office of McGuireWoods LLP. Mr. Mason and Ms. Smoots can be reached at [email protected] and [email protected], respectively. The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.

Bankruptcy estates often own a partial interest (typically called a membership interest) in a limited liability company. Sometimes the LLC has been created for proper purposes well before bankruptcy was on the horizon. At other times, the LLC has been formed as an asset protection device by a debtor contemplating an insolvency proceeding and is part of a strategy to deter creditors. The most obvious and logical candidates to purchase the estate's LLC interests are the other, non-bankrupt members because the market for selling privately held LLC interests is thin, and dispositions to third parties may raise complications concerning sales of unregistered securities.

But what if the other members refuse to purchase the interest for more than a nominal amount while simultaneously treating the bankruptcy estate representatives in a hostile manner, such as by resisting efforts of the estate to sell to third parties, making unneeded capital calls, withholding distributions, burdening the estate with non-cash taxable income, or causing the LLC to engage in non-market transactions? What strategies can the estate pursue? Unfortunately, the answer usually lies in a tangle of confusing LLC statutes that vary from state to state, complicated by an overlay of imprecise provisions of the Bankruptcy Code.

Background

Ever since the adoption of the first LLC statutes in the late 1970s, one of the underlying policies of state law has been to allow members to “choose their partners” and to avoid liquidation simply because one of the members encounters financial distress. Thus, in general, state LLC statutes, whether based on partnership statutes, the Uniform Limited Liability Company Act or the Revised Uniform Limited Liability Act, make it difficult or, in some cases, virtually impossible for an LLC member (or the member's judgment creditor or bankruptcy estate) to sell an interest to a third party or to force a dissolution and winding up of the LLC.

Nevertheless, in instances where the non-debtor members have engaged in inequitable or oppressive conduct designed to prejudice the estate, bankruptcy courts have occasionally shown a willingness to consider remedies such as the appointment of a receiver for the LLC or even the dissolution and winding up of the LLC. The availability of these remedies depends on state law governing the creation of the LLC, the terms of any operating agreement, interpretations of Bankruptcy Code provisions not specifically addressing LLCs, and the conduct of the non-debtor members and managers.

One of the earliest significant cases addressing these remedies is In re Ehmann, 319 B.R. 200, 2005 Bankr. LEXIS 80 (Bankr. D. Ariz. 2005). There, the debtor, an owner of a partial membership interest in an Arizona LLC filed a Chapter 7 bankruptcy case. One of the members, also the manager, was the debtor's father. Id., 319 B.R. at 202. Other members were the debtor's siblings. Both before and during the bankruptcy, the LLC engaged in a number of suspicious insider transactions. Id. The trustee filed an action against the LLC requesting a declaration that the trustee had the powers of a member (rather than those of a judgment creditor of a member), a finding that the LLC assets were being misused and that a receiver should be appointed to operate or liquidate the LLC. Id. at 201.

The bankruptcy court denied the LLC's motion to dismiss the complaint, rejecting its contentions that the trustee was limited to the rights of a judgment creditor of the debtor (known as an “assignee” under the LLC statute). Id. at 203. The court found that the operating agreement was not an executory contract and that provisions in the operating agreement that would otherwise restrict or condition the debtor's transfer were inapplicable in bankruptcy, nullified by 11 U.S.C. ' 541(c)(1). Id. at 206. (In a later opinion, the court granted summary judgment to the trustee and ordered the appointment of a receiver to operate the LLC in accordance with the operating agreement or, if not practical, to seek authority to liquidate, but the court ultimately withdrew that opinion upon a settlement by the parties. In re Ehmann, 334 B.R. 437, 2005 Bankr. LEXIS 2382 (Bankr. D. Arizona 2005) opinion withdrawn, 337 B.R. 228 (Bankr. D. Ariz. 2006).)

Other Rulings

A second case of interest, In re Klingerman, 388 B.R. 677, 2008 Bankr. LEXIS 1117 (Bankr. E.D. N.C. 2008), involved the Chapter 11 case of an individual who was one of two founding members of a North Carolina LLC. The Chapter 11 debtor filed an adversary proceeding to wind up the LLC. The defendant LLC and its other founding member filed a motion to dismiss, arguing in part that the debtor lacked standing to bring the action because, under the operating agreement and the North Carolina statute, the debtor's bankruptcy caused an automatic termination of his membership status, leaving him the holder only of an economic interest. Adopting the views expressed in In re Ehmann and rejecting certain contrary views expressed by the court in In re Garrison-Ashburn, 253 B.R. 700, 2000 Bankr. LEXIS 1231 (Bankr. E.D. Va. 2000), the bankruptcy judge concluded that the debtor's membership status remained in force under 11 U.S.C. ' 541(c) and further, that the estate was not restricted to distribution rights as an “assignee.” In re Klingerman, 388 B.R. at 679. The court concluded that the Chapter 11 debtor therefore had “standing” to seek dissolution, though the question of the propriety of dissolution was reserved. Id.

Another more recent case touching upon the issue of liquidating an LLC is In re Garbinski, 465 B.R. 423, 2012 Bankr. LEXIS 515 (Bankr. W.D. Pa. 2012). In that case, the Chapter 7 trustee proposed to sell the debtor's 50% interests in two Pennsylvania LLCs to the other 50% non-debtor member. The court denied the motion on the grounds that it could not determine on the record whether the sale price was adequate under Bankruptcy Code standards, particularly in light of the buyer's insider status and his contention that any purchaser seeking to outbid him must receive his consent to become a member. Id., 465 B.R. at 425-26. In considering the trustee's motion, the court observed, almost as if it were leveraging the buyer, that ' 541(c)(1) and Pennsylvania law provisions “would seem to give the Trustee the ability to seek judicially supervised dissolution and winding up.” Id., 465 B.R. at 427.

The latest reported decision we found confronting the winding up of an LLC partially owned by the estate is In re Warner, 480 B.R. 641, 2012 Bankr. LEXIS 4496 (Bankr. N.D. W.V. 2012). The debtor, an individual who filed a Chapter 7 case, owned approximately 16% of the membership interests in a West Virginia LLC that, in turn, owned valuable real estate in West Virginia. After the court found that the debtor's purported pre-bankruptcy transfer of his interest to his brother was ineffective, the trustee in bankruptcy filed an action and then moved for summary judgment, seeking a declaration that the LLC was dissolved automatically under a provision of the operating agreement upon a member's (the debtor's) bankruptcy filing; the trustee sought either the appointment of a receiver to liquidate the LLC or a writ of mandamus requiring the manager to proceed with liquidation. Id., 480 at 646.

Initially, the bankruptcy judge found that the operating agreement was not an executory contract because it did not impose any material obligations on the debtor. Id., 651-52. The court next held that the prohibition under 11 U.S.C. ' 541(c)(1) of “ipso-facto” modifications of a debtor's property interests, precluded the automatic dissolution provisions of the operating agreement from taking effect, rejecting the trustee's contention that he had the option of enforcing that provision. Id., 480 B.R. at 655-56. However, the court stated that its holding was without prejudice to the Trustee later establishing, as an LLC member, some factual basis under the West Virginia LLC statute for the judicial appointment of a receiver or for liquidation of the LLC. Id. at 657.

Even if a court determines that the bankruptcy estate does not acquire the debtor's rights as an LLC member, including conditional liquidation rights, and instead has only the rights of an “assignee,” some LLC statutes appear to grant even an assignee the right to request a winding up of the LLC if it is “equitable.” See, e.g., the Revised Uniform Limited Liability Company Act, ' 701(4) and (5) (1996).

Conclusion

Although we have not located a reported decision compelling the winding up of a multi-member LLC, at the request of a bankruptcy estate holding a membership interest in it, these cases appear to make that remedy available, at least theoretically. The statutory provisions and cases discussed in this article demonstrate that, faced with appropriate circumstances, especially where non-debtor members attempt to take unfair advantage of the estate or frustrate the purpose of the LLC, bankruptcy courts will be empowered to force a liquidation of an LLC and enable the estate to realize a fair value for its interest.

Richard J. Mason and Patricia K. Smoots concentrate on commercial bankruptcy and related litigation out of the Chicago office of McGuireWoods LLP. Mr. Mason and Ms. Smoots can be reached at [email protected] and [email protected], respectively. The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.