A Debtor’s Membership Interest In A Multi-Member LLC, What Does A Trustee Receive?

On behalf of Furr & Cohen, P.A. posted in News on Sunday, May 8, 2016.

A debtor’s equity interest in a business becomes property of the bankruptcy estate upon the filing of the debtor’s petition, pursuant to Section 541(a)(1) of the Bankruptcy Code.¹ Stock certificates or other security instruments, which are personal property of the debtor, generally represent the debtor’s equity interest in a business. An interest in a Limited Liability Company (“LLC”) is no different; as such, a debtor’s interest becomes property of the bankruptcy estate. The question for the Trustee is, to what extent?

Florida Revised LLC Act

In 2014 Florida enacted the Florida Revised Limited Liability Company Act (the “Revised Act”),² which made several significant changes to the structuring and operation of LLCs and the duties and obligations of the LLC’s members. Pertinent to this discussion, however, are the functions of becoming a member and dissociation. LLCs are creatures of contract, under an operating agreement,³ and governed by statute.⁴ One big advantage of the LLC form is the restrictions on the voluntary or involuntary transfer of interests by members.⁵ These restrictions are at the heart of the discussion when determining to what extent a debtor’s membership interest becomes property of the estate.

Two ways that a member’s interest may be transferred are: (i) an actual transfer or (ii) dissociation. The Revised Act requires unanimous consent for a person to become a member after formation.⁶ A transfer by a member can only transfer that member’s economic interest.⁷ A transferee is not entitled to participate in management of the LLC.⁸

Dissociation is where a member has withdrawn, or is terminated, as a member of the LLC voluntarily or upon the occurrence of a pre-determined event.⁹ Upon the dissociation of a member, that member becomes a transferee of its previous interest in the LLC.¹⁰ One event that triggers the dissociation of a member is that member’s filing for bankruptcy.¹¹

After the Florida Supreme Court’s decision in Olmstead v. Federal Trade Commission,¹² the Florida Legislature passed what is commonly referred to as the “Olmstead Patch.”¹³ The Olmstead Patch clarifies that a charging order is the sole and exclusive remedy afforded a judgment creditor of a member of a multi-member LLC.¹⁴

What Does A Trustee Receive?

It would appear that upon a member filing for bankruptcy the bankruptcy estate, trustee, is left with nothing of economic value to administer. The question becomes, whether all of the restrictive provisions in the Revised Act, and any restrictive provisions in an operating agreement are enforceable in bankruptcy.¹⁵ Section 541(c)(1) of the Bankruptcy Code provides that a debtor’s interest in property is determined without giving effect to any agreement or nonbankruptcy law that is conditioned on the bankruptcy filing or effects forfeiture, modification or termination of the debtor’s interest in that property.¹⁶

Where there is an Operating Agreement in place, this is not the end of the analysis. A determination must be made as to whether the Operating Agreement constitutes an executory contract, making Section 365(c) and (e) applicable. This gives rise to a new conflict within Section 365, wherein subsection (c) permits the enforcement of state and contract law restrictions on the trustee’s acquired rights and powers, where it affects the remaining members and requires their consent, and subsection (e) nullifying any ipso facto clause “modify[ing] or terminat[ing] any right or obligation of the debtor under the contract solely conditioned on the filing of a petition in bankruptcy.”¹⁷

Conclusion

There is sparse case law on the issue of a trustee’s interest in a multi-member LLC and the case law is non-existent under the Revised Act. Several questions remain in determining what interest a trustee receives. Among them are: (i) How does a trustee receive a debtor’s interest in property (as assignee or does a trustee “become” the debtor)? (ii) Whether the limiting provisions included in the Revised Act are preempted by the Bankruptcy Code? and (iii) whether an operating agreement constitutes an executory contract?

This article submitted by Jason S. Rigoli, Furr and Cohen, P.A., One Boca Place, Suite 337W, 2255 Glades Road, Boca Raton, FL 33431, jrigoli@furrcohen.com

¹ 11 U.S.C. §541(a)(1)
² Fla. Stat. §§ 605.0101 et seq.
³ An operating agreement need not be in the form of a writing, the definition of operating agreement under the Revised Act is extremely broad. See Fla. Stat. § 605.0102(45).
⁴ See, Revised Act, generally. See also, Fla. Stat. §605.0105.
⁵ The focus in this article will be on the statutory language because operating agreements can drafted to include any language agreed upon by the parties, subject to Fla. Stat. § 605.0105.
⁶ Fla. Stat. § 605.0401(3)(c).
⁷ Fla. Stat. § 605.0502.
⁸ Id.
⁹ See, Fla. Stat. §§ 605.0601 and 605.0602.
¹⁰ Fla. Stat. § 605.0603(1)(c).
¹¹ Fla. Stat. § 605.0602(8)(a)
¹² 44 So.3d 76 (Fla. 2010)
¹³ Subsections (4) – (9) of Fla. Stat. § 608.433(2011).
¹⁴ The Executive Committee of the Florida Bar Florida Revised LLC Act Drafting Committee, White Paper for the Florida Revised Limited Liability Company Act, p. 2.
¹⁵ See, U.S. Const. Art. VI, cl. 2 (“This Constitution, and the Laws of the United States which shall be made in Pursuance thereof … shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.”).
¹⁶ 11 U.S.C. § 541(c)(1). See,e.g. In re Ellis, 2011 WL 5147551 (Bankr. S.D.Ind. 2011); In re Lahood, 437 B.R. 330, 335-36 (Bankr C.D.Ill 2010)
17 11 U.S.C. § 365(e)(1)(B).