Source: https://www.mulveylawllc.com/articles/problems-of-dealing-with-limited-liability-company-interestsoriginally-published-in-the-fall-2011-edition-of-nabtalk-thejournal-of-the-national-association-of-bankruptcy-trustees
Timestamp: 2019-04-23 12:00:45+00:00

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Trustees are often faced with reviewing Debtors’ interests in businesses. As the tax benefits of pass-through entities became more popular, Debtors chose the Subchapter “S” Corporation (“S-Corporations”) format for their businesses. However, there were restrictions regarding the nature and number of shareholders in S-Corporations and the number of classes of stock ownership. The Limited Liability Company (“LLC”) became the answer to the S­Corporation restrictions, since LLCs did not have to conform to all such restrictions.
Unlike corporations or partnerships, LLCs present unique issues. LLCs are formed by filing Articles of Organization with the appropriate state government agency on a prescribed form. The governance of the LLC is typically set forth in an Operating Agreement. The LLC can be managed by its members or a manager. If the LLC is run by a manager, the role of a Bankruptcy Debtor Member may become just a passive activity, simply waiting for periodic distributions from the LLC, provided it is profitable.
It is important to understand the issues related to the LLC membership interests of the Debtors to determine if you have an asset with sufficient value to sell or liquidate for the benefit of the Bankruptcy Estate. As with any business interest of the Debtor, you need to obtain reliable information regarding whether the LLC’s liabilities exceed the value of its assets. You should request and obtain copies of the Articles of Organization and the Operating Agreement for the LLC. It is also important to determine how the Debtor’s membership interest compares to the total number of memberships outstanding in the LLC. If there is any other document, other than the Operating Agreement, which restricts how membership interest may be transformed, a copy of that document should also be obtained. Lastly, ask if other members’ interests have been sold in the LLC and obtain details of these transactions.
Now you are ready to review the LLC membership interest of the Debtor and see if administration of the interest can be of benefit to the estate. There have been relatively few reported decisions on the administration of LLC interests by Trustees and even fewer by Chapter 7 Trustees. There are a number of issues that are particularly relevant in determining the relationship between the Debtor’s membership interest in the LLC and a Trustee’s ability to sell that interest, protect that interest from creditors outside of the Debtor’s bankruptcy or prevent the Debtor from dissipating assets of the LLC.
Assets of the LLC or assets of the Debtor: how do exemptions and the automatic stay apply?
Taking a similar approach as the Ealy case is In re Schwab.33 Schwab differs in that, rather than determining the Debtor’s ownership in assets with respect to the LLC for purposes of the applicability of the automatic stay, the court instead determined that the Debtor rather than the LLC, owned the assets for purposes of applying certain of the Debtor’s personal exemptions to those assets.34 The policy and ultimate result, however, were ultimately the same: the Debtor rather than the LLC was considered the owner of the assets when the evidence and equities dictated such a result. Specifically, the assets at issue were tools and certain receivables.35 The Trustee argued that both should be determined to be assets of the LLC, which would then be a part of the Debtor’s ownership interest in the LLC, and would therefore qualify under the much smaller intangible asset exemption.36 The court, however, agreed with the Debtor in holding that the tools were property of the Debtor (and thus exempt as tools of the trade) because, though their depreciation had been assigned to the LLC in the Debtor’s tax return, the court found that the Debtor purchased the tools with her personal line of credit and in her own name and thus the Debtor had not intended them to be assets of the LLC.37 The court determined that the receivables were charges for the Debtor’s labor and thus constituted earnings—a portion of which were exempted by statute.38 This ruling can be differentiated from In re Rodio in that the LLC in this case was free from the interests of creditors and the tools at issue were titled in the individual’s name rather than in the name of the LLC.
It is evident how the Adams result is somewhat problematic in terms of preservation of estate assets. Had Mr. Adams tried to transfer ownership of his LLC to his son during the preference period, this would obviously have constituted an avoidable transfer. Instead, by taking the most significant asset owned by his LLC and transferring that to his son’s LLC, thereby limiting the value of the Debtor’s (and therefore the bankruptcy estate’s) interest in the LLC, Mr. Adams effectuates the same result without triggering any of the Trustee’s avoidance powers.
The court in In re First Protection further noted that § 365 relating to executory contracts was not applicable to that case because “there is no reason to prohibit a Trustee in bankruptcy from assuming all of the rights and obligations of a Debtor who is the only member of a single­ member LLC. In that case, there are no non-Debtor members whose interests could be harmed by the operation of the LLC by a Trustee or a Debtor in possession.”45 As is discussed infra, the approach that courts will take on this issue in the context of multi-member LLCs is less clear.
The situation in In re Harding presents what is probably the ideal situation when a Trustee seeks to sell the Debtor’s membership interest in a multi-member LLC.46 In that case the court affirmed the Trustee’s efforts to sell the Debtor’s 50% membership interest in two LLCs to the other 50% member of those LLCs.47 The court specifically found that because the Trustee conducted an auction of the assets which failed to yield any offer even close to that which was offered by the proposed buyer, the buyer’s offer constituted the ‘highest and best’ offer and thus it was a fair and arm’s-length transaction.48 Further, the court noted that, “[t]he Membership Interests are not readily marketable and the Trustee has not received any offers at a five figure price other than the sale described herein. In particular, any new owner, holding precisely 50% of the equity, would be limited in his/her ability to change or control existing management.”49 For a similar attempt and result, see In re Rosbottom, where the court granted the Chapter 11 Trustee’s motion for sale of the Debtor’s 50% and 25% interest in two LLCs to a remaining member of those LLCs free and clear of all encumbrances under the authority of § 363(b).50 Again, the court noted that it was an arm’s length transaction and specifically mentioned that the Trustee had rejected the initial purchase price for the 25% interest in one LLC and that the current price was based on the Trustee’s subsequent counteroffer.51 In sum, these cases stand for the proposition that the Trustee can sell the Debtor/estate’s interest in a multi-member LLC to the other members—but the courts will continue to give a hard look to those offers to reduce the prevalence of sweetheart deals that would be detrimental the estate’s creditors.
A similar, and yet divergent, categorization of the Debtor’s interest in a multi-member LLC been applied with respect to exemptions. In In re Mays, a case arising under Indiana statutes governing the formation of LLCs, the Debtors argued that any transferable interest they had was limited to ‘economic interests’ and because the revenues from the LLC were zero, the entire interest was exempt.61 The Court sustained the Trustee’s objection to the Debtor’s exemptions, holding the Debtors were limited to the $350 in available exemptions for intangible assets provided under Indiana law (rather than the 100% exemption sought by the Debtors), similar to the determination in Beane, supra.62 Additionally, in a footnote the court in Mays questioned the Trustee’s concession that he was limited to the rights of an “assignee” of a membership interest in the LLC, as §541(a) allows the Trustee to succeed to the Debtor’s ownership of the LLC interest.63 This suggests that the Court’s view was that the Trustee’s position is superior to that of a Judgment Creditor, which is generally given the status of an ‘assignee’ and therefore does not confer any management rights—leaving open the door for an extension of the reasoning in Albright and Modanlo (supra, dealing with single-member LLCs) to multi-member LLCs.
See also In re Garrison-Ashburn76, which held that the operating agreement was not an executory contract and therefore ipso facto clauses were not enforceable. The case was also important because it discusses assignment of both control and economic rights in a multi­member LLC. Similarly, the court in In re DeLuca77 held that the operating agreement was executory because it required personal services and therefore the Trustee could not assume the member’s management interests pursuant to §365(b)(1)).
[D]ebtor LLC members in member-managed LLCs should be treated like General Partners under the Bankruptcy Code. Similarly, Debtor managers of manager-managed LLCs should be treated like general partners under the Bankruptcy Code. This treatment should be limited to three aspects of the LLC member or LLC manager relationship: (1) continuity of LLC after LLC member’s or manager’s bankruptcy filing; (2) transferability of LLC ownership interest; and (3) management rights in the LLC.
Recommendation, reproduced at Bankruptcy: The Next Twenty Years, p. 424.
Another recommendation is the removal of LLCs and partnerships from consideration under § 365 dealing with executory contracts—followed by the addition of a new section to the Bankruptcy Code that would specifically govern documents and relationships in LLCs and partnerships. Id. at 428. Further, the Recommendation suggests that ipso facto provisions (those that operate to terminate or modify the rights of a member or partner based on insolvency, financial condition, or commencement of a bankruptcy case) in non-bankruptcy statutes (primarily state statutes modeled after the Uniform Limited Liability Company Act) and similar provisions in partnership or LLC governing documents should be rendered unenforceable. This directly tracks the logic from cases such as In re Allentown Ambassadors, which have held such provisions to be unenforceable.
There are a number of published decisions regarding LLC interests in bankruptcy cases. You can make arguments to administer many of these interests and their respective rights as you administer a member Debtor’s Bankruptcy Estate. Unfortunately, the multi-member LLC still presents problems for administration of anything but distributions due the Debtor, unless there is a market for that LLC’s membership interests to sell those interests to third parties.
1 In re Modanlo, 2006 U.S. Dist. LEXIS 96045 at *31 (D. MD. 2006), affirmed, Final Analysis Commun. Servs. v. Ahan (In re Modanlo), 2008 U.S. App. LEXIS 3685 (4th Cir. 2008).
2 Id. See also, In re Dwek, 2011 U.S. Dist. LEXIS 2011 (Mar. 31, 2011) (citing Modanlo in holding that a determination of whether a third party had a membership interest in certain LLCs in addition to the Debtor’s interest, thus resulting in the LLCs being multi-member LLCs, was threshold to determining whether the Trustee had authority to participate in the management of the affairs of the LLCs). 3 In re Modanlo, 412 B.R. 715, 731 (Bankr. D. Md. 2006).
4 In re Albright, 291 B.R. 538, (Bankr. D. Colo. 2003) 5 Id. at 541.
6 Id. Also, please note that Movitz v. Fiesta Investments, LLC (In Re Ehmann) 319 B.R. 200, 206 (Bankr. D. Ariz. reached the same result as Albright for multi-member LLCs, but it has been vacated due to a settlement.
7 In re A-Z Electronics, LLC, 350 B.R. 886 (Bankr. D. Id. 2006).
11 Desmond v. U.S. Asset Funding, LP (In re Desmond), 316 B.R. 593 (Bankr. D. N.H. 2004) 12 Id. at 594.
17 In re Calhoun, 312 B.R. 380 (Bankr. N.D. Iowa 2009), cited with approval by, In re Furlong, 437 B.R. 712, 721 (Bankr. D. Mass. 2010); In Re Aldape Telford Glazier, Inc., 410 B.R. 60, 64 at n. 5 (Bankr. D. Idaho 2009). 18 Furlong, 437 B.R. at 721.
19 In re Calhoun, 312 B.R. at 383.
20 In Re Aldape Telford Glazier, Inc., 410 B.R. at 66.
25 In re Penn, 2010 Bankr. LEXIS 1546 at *11 (Bankr. N.D. Ga. 2010).
33 In re Schwab, 378 B.R. 854 (Bankr. D. Minn. 2007).
39 Nossaman-Petitt v. Adams Enters. Inc. (In re Adams), 2009 Bankr. LEXIS 3164, at *8 (Bankr. D. Neb. 2009).
45 In re First Protection Mortgage, 440 B.R. at 832 (citing Modanlo, 412 B.R. at 727).
46 In re Harding, 2009 Bankr. LEXIS 4206 (Bankr. D. Mass. 2009) (also note, contained in the reported version of this case is the Trustee’s actual motion seeking approval of the sale of the LLC interests—it provides an excellent template.) 47 Id. at **14-18.
50 In re Rosbottom, 2010 Bankr LEXIS 2864 (Bankr. W.D. La. 2010) further proceedings at, 2010 Bankr LEXIS 2873 (Bankr. W.D. La. 2010).
52 See, e.g., In re McCabe, Plaintiff, v. George Panagiotou and GEDCO, LLC, Defendants., 345 B.R. 1 (D. Mass.
2006); In Re Erpenbeck, 2004 Bankr. LEXIS 739 (Bankr. E.D. KY 2009) (similar ruling where Debtor himself tried to transfer his membership interest to another entity.) 53 McCabe, 345 B.R. at 10.
59 Beane v. Beane, 2011 U.S. Dist. LEXIS 8872 at *27 (D. N.H. 2011).
60 Baker Dev. Corp. v. Mulder (In re Mulder), 307 B.R. 637, 647 (Bankr. N.D. Ill. 2004).
61 In re Jeffrey V. Mays and Edith R. Mays, U.S. Bankruptcy Court for S.D. of Indiana, Case No. 10-11132-JKC-7A, Order dated December 3, 2010. 62 Id. at *5.
63 Id. at *4, n. 1.
64 In re Allentown Ambassadors, 361 B.R. 422 (Bankr. E.D. Pa. 2007).
72 In Re Lahood, 437 B.R. 330 (D. C.D. ILL. 2010).
73 Allentown Ambassadords, 361 B.R. at 444; In re Daugherty Construction., Inc., 188 B.R. 607, 612 (Bankr. D. Neb. 1995).
79 Olmstead v. FTC, 44 So. 3d 76, 83 (Fla. 2010).
These materials are intended for general informational purposes only. Accordingly, they should not be construed as legal advice or legal opinion on any specific facts or circumstances. Instead, you are urged to consult counsel on any specific legal questions you may have concerning your situation.

References: § 365
 § 363
 §541
 §365
 § 365
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