When a chapter 11 debtor holds a membership interest in an LLC, it may be permissible for them to sell their membership interest in the LLC, or even force the sale of the entire LLC, over the objections of one or more other members.
At the crux of the debate in various bankruptcy courts is whether an LLC membership is a property right or a contractual right. This distinction is essential in the context of bankruptcy. The two interpretations have divergent governing law with respect to their disposition and the rights of debtors or trustees to determine that disposition.
It is common for LLC membership agreements to contain so-called ipso facto provisions. These are clauses that could
These provisions are a primary focus of the executory contract v. property right debate. Also critical to the debate is whether the debtor can wield the hammer of section 363 to force the sale of its property, and even the co-owners’ share of the LLC, against such co-owners’ wishes.
The interpretation of an LLC agreement as an executory contract is the most favorable interpretation to the co-members. This determination depends on how the contract is worded, how the debtor and non-debtor members each regard the agreement (both in argument and by their actions), and what the applicable case law is in the given district. The executory contract distinction is a rabbit hole that can be very frustrating to go down. Vice Chancellor Strine, sitting on the Superior Court of Delaware, said “I do not have all year to peer through the muck” and study the different reasoning and fact circumstances behind the various court decisions on the matter.
Long story short, if an LLC membership agreement is executory, and the debtors assume the contract, then so-called ipso facto clauses may very well be upheld. If the debtors reject the contract, then rejection damage issue fights may get exciting. Either way, a thorough study of section 365, which governs the disposition of executory contracts in bankruptcy cases, is absolutely necessary. (And co-member contract party beware—contracts not assumed are often deemed rejected, so you might never even receive a formal rejection notice.)
In courts that view LLC memberships as property rights, it should be carefully noted that debtors can avail themselves of section 541(c)(1). The bankruptcy court could then trump pretty much any applicable state statute, even those that would take away any of the debtor’s rights and privileges in the LLC as a result of the bankruptcy filing or their general insolvency (i.e., the ipso facto clauses).
Where things can really get interesting, however, is with respect to section 363 sales. Here, the “property” interpretation of an LLC membership, can set up not just a sale of the debtor’s membership, but a sale of the entire LLC. Yes, the section 363 sale can force the sale of the co-owners’ portion as well. The general provisions in section 363(h) that govern the sale of all property in which debtors have a co-ownership stake. For most types of LLCs[i], the Trustee can sell the entire LLC so long as it can be shown to be in the best interest of the estate, based on the same tests that would control if we were talking about a co-owned automobile or Xerox machine:
a) if selling only the debtor’s portion of interest is impractical;
b) such sale of the debtor’s portion alone would net significantly less to the estate than selling the entire asset and dividing the proceeds pro-rata among the co-owners and the estate; and
c) the benefit to the estate outweighs the detriment to the co-owners.
One should be careful not to assume, however, that this means authorization to sell the LLC is pretty much guaranteed so long as these tests are met. It is important to also look at the governing agreements to the LLC membership interests, since section 363(h) also requires that the debtor have an “undivided interest” in the LLC (or any other property) as a “tenant in common, joint tenant, or tenant by the entirety with the co-owners.” The chapter 7 trustee in the Schwab v. Stroup (In Re Stroup) case was apparently not counting on that issue to be raised and found out the hard way that, at least in the Middle District of Pennsylvania, section 363(h) should be interpreted in its entirety. (Read the Court’s full opinion.)
If we had the time and space here, we could go on further discussing the finer points of whether it is economic rights or governance rights that are at stake in the LLC membership debate. Some courts have found that the two are distinct, and one might lose one and retain the other. Go figure.
So, if you happen to be in, or come in to, such a situation where you need to know how an LLC membership interest is going to be affected by a bankruptcy filing (or just planning ahead while forming an LLC), remember the time-honored television announcer’s warning: “Don’t try this at home, kids.” Make sure you talk to one of the experts’ experts. You’ll be glad you did.
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