LLC Interests - How Are They Treated in a Bankruptcy and Can the Trustee Get Their Hands on it?

Over the course of the last few years, the use of limited liability companies (“LLC”) has become more and more prevalent as businesses abandon the corporate form for the LLC format. As individuals owning LLC’s are now finding their way into Bankruptcy Court, issues have come up regarding what rights the bankruptcy estate has against the Debtor’s LLC interests. Traditionally, corporate interests were difficult for a Trustee to put his or her mitts on. Typically, the Trustee was only entitled to the debtor’s rights to receive profits and dividends but, generally, the Trustee could not force the sale of corporate stock or the debtor’s interests, especially if there were more than one shareholder. The use of LLC’s, although easier from a business standpoint, has created a bit of a “hand hold” for Trustee’s but, in the main, debtors who own LLC interests should not be deterred from filing a bankruptcy or reorganization case.

Three cases (In re Warner, 480 B.R. 641 (2012), In re Yow, 590 B.R. 696 (2018) and In re Minton, 2017 WL 354319) illustrate the problems that confront both debtors and the courts and various permutations. The threshold is whether or not the operating agreement (the agreement between the debtor and the LLC) is an “executory contract” within the meaning of 11 U.S.C. §365. That determination changes the various rights and duties of the parties. Courts have not been consistent in their analysis, although LLC operating agreements are also not consistent. Courts tend to focus on whether or not the debtor’s duties are “remote” or “hypothetical”, whether capital contributions are required and whether or not the debtor has continuing management duties, thus characterizing the debtors’ interests as either economic or non-economic.

Once that question is answered, the real issue is whether the Trustee can get at the debtor’s interests. Most of the courts have ruled that the Trustee has the right of a member and “stands in the shoes” of the debtor. Courts do draw the line with respect to so-called “buyout” issues, indicating that the Trustee is bound by the general terms of the operating agreement and members’ rights and privileges to buy out another member, sometimes at book value or at a discount, must be honored. Issues related to LLC interests do seem to revolve on contents of the operating agreement which should not simply be thrown in the file by the lawyer when a debtor owns an LLC interest.

Categories: Bankruptcy

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