LLC Member: Is a Pre-Bankruptcy Expulsion Vulnerable to Attack?

Garcia v. Garcia (In re Garcia), 494 B.R. 799 (Bankr. E.D. N.Y. 2013) –

Prior to bankruptcy, a chapter 11 debtor who had been a member of two limited liability companies was expelled by the other members on the basis that he took excess distributions from the LLCs.  After filing bankruptcy, the debtor attacked his expulsions on the basis that they constituted a preference or a fraudulent transfer.

The other members alleged among other things that the debtor diverted funds for his personal benefit, breached his fiduciary duties, and falsified business records.  Initially the members resolved that the debtor was no longer authorized to sign on behalf of the LLCs and barred him from the LLCs’ offices.  Later they voted to expel him.

As background, the court noted that the preference provisions of the Bankruptcy Code are intended to (1) prevent unequal treatment of similarly situated creditors and (2)  discourage a race to the courthouse by creditors prior to bankruptcy.  In contrast, constructive fraudulent transfer provisions are intended to address situations in which a financially impaired debtor transfers property where there is a less than even exchange of value.

In this case, the critical issue for the preference action was whether there was (1) a transfer of the debtor’s interest, (2) on account of an antecedent debt.  For the fraudulent transfer actions, the issue was whether there was (1) a transfer (2) that was for less than reasonably equivalent value (or alternatively, without fair consideration).

On the threshold question of whether there was a transfer, the court framed the issue as whether there was an interest of the debtor in property that would have been part of the bankruptcy estate if it had not been transferred.  In this case, the debtor’s interests as a member of an LLC would have become property of the estate if he had not been expelled.  The effect of the expulsion was to extinguish his rights and transfer them to the remaining members so that their shares increased from 33% to 50% membership interests.  Thus, the court concluded that a transfer did take place.  (It also rejected the argument that termination of an interest upon default should not be considered a transfer as a matter of public policy.)

Turning to the question of whether the transfer was on account of an antecedent debt (as required for a preference action), the court concluded that it was not.  To be an antecedent debt, there must be a claim against the debtor at the time of the transfer that was pre-existing, as opposed to something arising simultaneously with the transfer.  Further, as a matter of common sense, the transfer must have the effect of reducing the debt.  Since the debtor’s liability for improper distributions was the same both before and after the expulsion, the expulsion was not a transfer on account of an antecedent debt.

To support a constructive fraudulent transfer claim, the debtor had to establish that the transfer was made for less than reasonably equivalent value.  The typical approach is to first determine if any value was given, and then to compare the value of what was given with what was received.  Here the debtor did not allege any facts to support this element of the claim.  In addition, the court noted that under the operating agreement upon “dissociation” of a member, the LLC was required to pay the member an amount equal to the value of the member’s interest in the LLC.  Thus, it appeared that the debtor would in fact receive value for the transfer.  Given the “mere possibility” that he would not receive reasonably equivalent value, the court concluded that the debtor failed to state a plausible claim.

Thus, the court rejected both the preference and fraudulent transfer claims.

This opinion provides food for thought:  Given the threshold determination that expelling an LLC member constitutes a transfer of interests, it is not difficult to imagine circumstances where the debtor’s claims might have succeeded.  A court could easily find that expulsion was a fraudulent transfer if a member was not entitled to receive any compensation for its interest (for example, as a result of the exercise if remedies in connection with expulsion for cause) and the other elements were met (for example, the member was insolvent) – giving rise to a right to recover either the membership interest or the value of the interest under Section 550 of the Bankruptcy Code.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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