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There Ought to Be a Law, and There Is: When the Insolvent LLC’s Manager Distributes Cash But Does Not Pay Creditors

Editor’s Note: The scenario discussed below was present in many respects in Vieira v. Harris (In re JK Harris & Co. LLC), 512 B.R. 562 (Bankr. D. S.C. 2012).

Let us suppose that a provider of tax resolution services to a large number of customers borrows cash secured by accounts receivable (the cash borrower can generate) and other personal property (and not by any land or buildings).  Let us further suppose that its unsecured creditors will be many and each individually owed only fairly small amounts.   Thus we have a secured creditor with the powerful incentive to keep borrower in business because the collateral value would evaporate otherwise.  We also have no unsecured creditors with enough at stake to invest in monitoring the borrower or even to sue it over losses.

Borrower is an LLC managed by a greedy principal (or sole) member.  Borrower slow pays the secured creditor and unsecured creditors over years (while aggressively soliciting business from other taxpayers) and its business becomes insolvent.  Relatedly, the LLC makes handsome distributions to its members, including the principal (over and above his $333k annual salary and assorted “loans” also made to him), and commingles funds with other entities owned or controlled by the member-manager.  This has been good for him, but it cannot go on forever.  Even the pinioned secured creditor will have had enough.

How to get away clean?  The principal devises a bankruptcy strategy.  The LLC can file a chapter 11 case and retain control over its operations and financial information as a debtor-in-possession (“DIP”), thus keeping prying eyes away.  The debtor could sell its assets as a going concern in a section 363 sale (regarding such sales, see here and here), having negotiated a reduced payoff amount with secured creditor that will leave just enough cash from the sale proceeds to pay off the secured creditor, priority unsecured creditors (principally employees not paid their final paycheck before the chapter 11 case began) and administrative claimants (mainly professionals that worked on the chapter 11 case).[i]  Approximately nothing would be paid to unsecured creditors.  The principal surmises that the secured creditor will be very ready to accept the proposed haircut if faced with baldness from the collapsed value of a closed business.  The chapter 11 plan would provide for a discharge for all of the LLC’s debts. Result: the principal member would sip a cuba libre in the shade, reclining atop the mountain of cash he distributed to himself, while thirsty creditors are left to seek water under a blazing sun in a strange neighborhood.

There’s a problema before the cuba libre: after the case was filed, a creditors committee was appointed.  A committee (see here for more) is appointed in some chapter 11 cases where the US Trustee and the Court agree that the interests of unsecured creditors as a body need representation.  The problem is that an unsecured creditors committee lives to look carefully at preferential and fraudulent transfers made pre-petition, especially those made to insiders of the debtor.[ii]  If the committee finds that the now-DIP transferred assets to a creditor-insider within one year before the bankruptcy case, the committee can possibly acquire standing to sue the insider recipient to avoid and recover the preferential transfers for the estate – with the proceeds of such recoveries getting distributed to unsecured creditors.  If the committee finds that the LLC made transfers within the four years just before the petition date[iii] to insiders while insolvent and without getting commensurate value in return (such as distributions to members), and the committee gets standing to prosecute such lawsuits, the committee could sue the recipients to avoid and recover the transfers as fraudulent transfers under the Bankruptcy Code and under state fraudulent transfer laws.  The mountain (of cash) could be moved to the unsecured creditors.

The principal of the LLC had foreseen this difficulty and had notwithstanding his avarice toned down its distributions over the four years just before filing the chapter 11 case.  He had not stopped collecting his $330k salary of course.  With “nothing to see here” the committee might simply throw itself into trying to help get the best sale price in the section 363 sale.

Can this really be happening?  There ought to be a law to get those ill-gotten distributions and distribute them to creditors!  We’re coming to that.

The principal’s strategy began to unravel when the secured creditor, unimpressed by the amounts a section 363 sale was likely to generate, and suspicious of the manager-member’s possible commingling of assets, moved the court for the appointment of an examiner under section 1112 of the Bankruptcy Code.  An examiner would have direct access to the books of the DIP, and all of its accounts and transaction records.  An examiner lives to find chicanery.

The DIP’s final play is to cut off the appointment of an examiner by moving to convert the chapter 11 case to a case under chapter 7, whilst portraying the secured creditor as valuing-killing and uncooperative for having hamstrung a going-concern section 363 sale of the business. The case is converted and a chapter 7 trustee is appointed.  Most chapter 7 trustees are lawyers or accountants who are very good at what they do.  Perhaps the member-manager prayed for a sleepy type. If so, his prayers were not answered.

The chapter 7 trustee ousts the DIP and takes custody of all property and books and records of the debtor.  Armed with such authority and information, the trustee determined that large distributions had been made to the member-manager while the LLC was insolvent – with the largest of those distributions having been made more than four years before the petition date.

The trustee found that law (that there ought to be!) and applied it.  The trustee sued the principal in the amount of such distributions on the basis of state statutes which (quite sensibly) bar LLCs from making distributions while insolvent, and which impose liability on LLC managers that execute such distributions, and even on members that 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 needed only to prove that the manager in fact held that office, that he authorized or agreed to the distributions, and that the distribution violated the LLC’s operating agreement, articles of incorporation, or state LLC laws.  The managing member’s strategy was foiled and his mountain of cash has been subjected to judgment and collection for the benefit of creditors.[iv]

[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).  For more on administrative claims, see here and here.

[ii]  A committee in a different sort of case may help unsecured creditors by objecting to the securred poistion of a secured creditor, or by objecting to the rterms of debto-in-possession financing, as here.

[iii]  Section 548 of the Bankruptcy Code gives a trustee or DIP the apower 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 madue during some other longer look-backperiod, 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), 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.

About Christopher M. Cahill

Mr. Cahill is partner at Sugar Felsenthal Grais & Helsinger LLP, in Chicago, Illinois.   He guides secured lenders, creditors, debtors, creditors’ committees, potential purchasers and others through bankruptcy cases, out-of-court workouts, assignments for the benefit of creditors, and receiverships.  Mr. Cahill has substantial mega-case experience at national law firms representing very large debtors, and has…

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Christopher M. Cahill