The popularity of limited liability companies (LLCs) in the United States has grown dramatically since the adoption of the first LLC statutes in the late 1970s. If you’ve opted to run your business as LLC, it’s probably because you recognize that this form of entity combines the limited legal liability protection of a corporation with the pass-through tax treatment of a traditional partnership. Though it’s not pleasant to contemplate, you may also know that, like a corporation, a struggling LLC can file for protection from its creditors under federal bankruptcy law, called the bankruptcy “code”.
But what happens if one member of an LLC declares bankruptcy?
Let’s consider the story of a fictitious Mexican restaurant owner we’ll call “Joe”. Actually, Tres Hombres, LLC, a limited liability company, owns the restaurant, and our Joe, along with his two childhood friends Bob and Ray, are the LLC’s sole members. The LLC operating agreement gives each member equal management rights and an equal share of distributions. All three members work hard, business has been good, and the LLC has made a nice, steady profit.
Unfortunately, however, Joe is not very good at managing his personal finances. He’s run up a fairly large mountain of credit card and gambling debts and is considering filing a personal bankruptcy petition. If he does, what happens to his interest in Tres Hombres?
First, there are a couple of things that won’t occur. Like many other LLC agreements. Tres Hombres LLC’s contains boilerplate language which says that Bob and Ray can declare Joe in default and kick him out of the company if he files for bankruptcy. However, these so-called “ípso facto” clauses offer false comfort, as they are legally unenforceable.
The agreement also says Bob and Ray can buy out his interest at fair market value. Because doing so would allow them to circumvent the bankruptcy process, this clause is also a non-starter.
Now, back to the question at hand, namely what happens to the bankrupt Joe’s LLC interest? To find an answer, we need to first determine what Joe actually owns. Because he receives profits and also has an equal say in the how the business is run, Joe has both economic and managerial interests in Tres Hombres. Upon his filing of a personal bankruptcy petition these coexisting interests, just like most of Joe’s other property rights, become assets of his bankruptcy estate.
Like those other assets, the subsequent disposition of Joe’s interest in Tres Hombres is governed by the bankruptcy code. Those assets include rights under contracts to which the debtor is a party. Because each member has rights and duties under the LLC operating agreement, that agreement is treated as a contract among the members. So far so good.
What happens next depends in large measure upon how the bankruptcy trustee and court interpret the agreement’s language.
The bankruptcy code distinguishes between contracts which, without any additional action on the debtor’s part, entitle him to receive a payment and those which require him to first complete some action. This latter type of agreement is called an “executory” contract. A common example is an agreement by the debtor for the sale of property that’s still pending when the debtor files. It is an executory contract because the debtor isn’t entitled to payment until he conveys title.
Non-executory contracts automatically become assets of the estate, regardless of their value. However, the code allows the trustee to decide whether completing the debtor’s obligations under an executory contract will benefit creditors. If he concludes that it will, the trustee may “assume” the contract, perform the debtor’s duties and receive payment on behalf of the estate (and, eventually, creditors). If it won’t, the trustee can reject the contract, and the debtor will retain both his rights and duties under it.
If he assumes the executory operating agreement, the trustee must also perform any required duties. For example, the trustee may have to use estate assets to respond to a cash call by the LLC’s other members. The trustee can generally exercise all management rights, unless they require the unique talents of the debtor.
Pretty simple, right? Well, unfortunately, no.
Interpreting a particular LLC operating agreement is hardly ever as easy as I’ve made it sound, and trustees routinely struggle with it. As you may recall from reading our blog, most decisions by a trustee can be appealed to the court. However, the relevant provisions of the bankruptcy code predate the advent of LLCs, and offer no clear guidance, and bankruptcy judges have also routinely wrestled with the proper interpretation. The resulting decisions have often been inconsistent, confusing or just plain incorrect.
Bankruptcy law is constantly evolving and changing, and significant new court decisions are issued almost daily. We follow these developments closely in order to provide advice based on the most up to date precedent available. If you are a member of a limited liability company and are considering personal bankruptcy (or believe another member is doing so), please give us a call. We can analyze the LLC operating agreement and advise you concerning its most probable interpretation.