Let us examine a hypothetical scenario involving the manager of an insolvent LLC, who is making hefty cash distributions to themselves and ignoring the company’s debts.

As a creditor, how can you prevent the manager from unfairly paying themselves and get paid what you are owed?

Examining An Insolvent LLC’s Cash Distributions To The Manager

Outlining the Scenario

Here is how this scenario can occur in practice. Let us suppose that a service provider with a large customer base has borrowed cash. This cash is secured by its accounts receivable and other personal property. The borrower has many unsecured creditors, and each is owed only a small amount.

These facts set the stage for a secured creditor with a powerful incentive to keep the borrower in business. After all, the business’s collateral value would evaporate otherwise, and no unsecured creditor has enough at stake to invest in monitoring the borrower or to sue it over losses.

Unfortunately, the borrower is an LLC owned and managed by a greedy principal. The borrower slowly pays its creditors, while aggressively soliciting business from its customers. At the same time, it is also making handsome distributions, paying a lavish salary, and even making assorted ‘loans’ to its principal.

You may be wondering: How is the principal able to get away with this? The answer is by devising a bankruptcy strategy for the LLC.

Using Bankruptcy To Avoid Debt Payments

The strategy works like this: First, the LLC files a Chapter 11 case. This allows it to retain control over its operations as a debtor-in-possession (DIP).

The debtor then negotiates with its secured creditor to accept a reduced payoff amount, and it conducts a section 363 sale. The sale proceeds are just enough to pay the secured creditor, priority unsecured creditors (mainly employees not paid their final paycheck before the filing), and administrative claimants (mainly professionals who worked on the Chapter 11 case). [i]

Approximately nothing is paid to unsecured creditors. The principal surmises that the secured creditor is very ready to accept the proposed payoff, especially when faced with the collapsed value of a closed business. The Chapter 11 plan would provide for a discharge of all of the LLC’s debts.

The result is this: The principal member is free to enjoy the mountain of cash they distributed to themselves, while thirsty creditors are left to settle for what little money there is remaining.

Possible Solutions for Creditors Seeking Payment from Insolvent LLCs

In this scenario, there are a few possible protections that creditors can turn to.

The Creditors’ Committee: A Check On Fraudulent Transfers

After the case is filed, a creditors’ committee can be appointed to look after the interests of the unsecured creditors. The creditors’ committee lives to look carefully at preferential and fraudulent transfers made pre-petition, especially those made to insiders of the debtor. [ii]

If a committee believes that a Chapter 11 debtor transferred assets to a third-party within one year before the bankruptcy case, it can possibly acquire standing to sue the recipient to avoid and recover the preferential transfers for the estate. Any recoveries will be distributed to unsecured creditors.

If the third-party transferee is an insider of the debtor, then instead of one year, transfers made within four years are subject to attack. [iii]

The unsecured creditors’ committee is a protection that the debtor’s principal would need to account for before they even file for bankruptcy. In the preceding four years, they would need to have toned down any distributions made to themselves to avoid being sued.

The Bankruptcy Examiner

The secured creditor, unimpressed by the amounts a section 363 sale was likely to generate, and suspicious of the principal’s possible commingling of assets, can seek the appointment of an examiner under Bankruptcy Code § 1112.

An examiner would have direct access to the books of the DIP, and all of its accounts and transaction records. A more detailed explanation of the role of an examiner can be found here.

In The Chapter 7 Trustee We Trust

The DIP may try to avoid the appointment of an examiner by making one final play: moving to convert the Chapter 11 case to a Chapter 7 case.

While doing this, they portray the secured creditor as value-killing and uncooperative for having hamstrung a going-concern section 363 sale of the business.

However, converting to a Chapter 7 case doesn’t actually allow the principal to get away with not paying creditors.

Once converted, a Chapter 7 trustee gets appointed. Most Chapter 7 trustees are lawyers or accountants who are very good at what they do.

The Chapter 7 trustee can oust the DIP and take custody of all property, books, and records of the debtor, leaving the principal with “virtually no management power.” Armed with such authority and information, the trustee can determine that large distributions were made to the principal while the LLC was insolvent. They can even pull up distributions made more than four years before the petition date, which may involve even larger sums of cash.

The trustee can sue the principal in the amount of such distributions. They can do so on the basis of state statutes that bar LLCs from making distributions while insolvent. These statutes also impose liability on LLC managers who execute such distributions and members who vote for or accede to such distributions. The ‘reach-back’ period for such suits is not limited to four years (or at all).

The trustee would only need to prove that the manager held that office, had authorized or agreed to the distributions, and that the distributions violated the LLC’s operating agreement, articles of incorporation, or state LLC laws.

As such, converting the case to Chapter 7 would only foil the manager’s strategy for evading payment. Their mountain of cash is subject to judgment and collection for the benefit of creditors. [iv]

Creditors Have Protections Against An LLC’s Managing Member

As a creditor, it’s important to remember that there are protections you can turn to when the managing member of an insolvent LLC is paying themselves instead of the company’s debts.

The formation of an unsecured creditors’ committee and the appointment of an examiner or Chapter 7 trustee are all designed to look after creditors’ interests. These protections can uncover any ill-gotten cash distributions paid to the principal, and open up the door for them to be sued.

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We think you’ll also like:

1. How Far Can the Trustee Reach to Clawback Fraudulent Transfers?
2. Dealing with Corporate Distress 11: How to Protect Your Claim In & Out of Bankruptcy
3. Dealing with Corporate Distress 02: These Are the People in Our Neighborhood: An Overview of Parties in Chapter 11

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. The Nuts & Bolts Of Chapter 11 – Series I
2. The Nuts & Bolts Of Chapter 11 – Series II
3. Chapter 11 – Industry Focus

This article was originally published on March 2, 2022. This article was most recently updated by the DailyDAC Editors.]

©2025. DailyDAC^TM, LLC. This article is subject to the disclaimers found here.

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References

[i] A Chapter 11 plan may not be confirmed unless priority unsecured claims and administrative claims are paid in full.  11 U.S.C. § 1129(a)(9)(A). Read “Demystifying Administrative Expenses in Bankruptcy” for more on administrative claims.

 

[ii] A committee in a different sort of case may help unsecured creditors by objecting to the secured position of a secured creditor, or by objecting to the terms of debtor-in-possession financing. Read more in “Dealing With Distress for Fun & Profit – Installment #17 – Overview of DIP Financing and Cash Collateral Motions.”

[iii] Section 548 of the Bankruptcy Code gives a trustee or DIP the power to avoid fraudulent transfers described therein, and section 544(b) gives the trustee or DIP the power to avoid fraudulent transfers per state fraudulent transfer statutes. The trustee may avoid transfers pursuant to section 548 that were made within two years just before the petition date; and may avoid transfers pursuant to state fraudulent transfer statutes made during some other longer look-back period, often the four years (as in Illinois) just before the petition date.

[iv] Some state laws, like those applied in Vieira v. Harris (In re JK Harris & Co. LLC), USCOURTS-scb-2_12-ap-80176-0.pdf, 512 B.R. 562 (Bankr. D. S.C. 2012), also require proof that the defendant violated its fiduciary duties of care and loyalty. That proof did not present serious obstacles in that case.