Control Of An LLC: Who Comes Out On Top – A Bankrupt Member Or The Member’s Chapter 7 Trustee?

In re B&M Land and Livestock, LLC, 498 B.R. 262 (Bankr. D. Nev. 2013) –

A chapter 7 debtor that was the sole member and manager of a limited liability company filed a chapter 11 bankruptcy on behalf of the LLC.  The United States Trustee filed a motion to dismiss the LLC bankruptcy petition on the basis that the bankrupt member did not have standing to file bankruptcy on behalf of the LLC.

Ms. Raj and her husband filed a chapter 7 bankruptcy petition.  Ms. Raj was the sole member of B&M Land and Livestock, LLC, a member managed limited liability company.  Ms. Raj included the LLC in her personal bankruptcy schedules with a value of $0.

As of the LLC’s petition date, the LLC owed ~$1 million to a lender secured by property it valued at $550,000.  The lender had commenced foreclosure and scheduled a foreclosure sale.  So, Ms. Raj filed the LLC bankruptcy petition two days before the scheduled date to stop the sale.

The court viewed this as a simple issue:  all legal and equitable interests of a debtor (i.e. Ms. Raj) become property of the bankruptcy estate under Section 541 of the Bankruptcy Code.  If state law classifies LLC membership interests as personal property, the member interests become estate property.  Since applicable state law classified LLC membership interests as personal property, Ms. Raj’s interest became property of her bankruptcy estate.

In a chapter 7, the trustee controls property of the estate.  The court specifically found that “the trustee is not a mere assignee, but steps into a debtor’s shoes as to all rights, including the rights to control a single-member LLC.”

This is without regard to conflicting state law since Section 541(c)(1)(A) expressly provides that interests become part of the bankruptcy estate “notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law … that restricts or conditions transfer of such interest by the debtor.”  The court commented that there may be limits to this concept for LLCs involved in a professional practice or providing personal services.  However for the standard LLC, Section 541 trumps state law.

Thus, if a member of a single-member LLC files a chapter 7 petition, the chapter 7 trustee’s rights include the right to manage the LLC without regard to state law.  In the case of a single-member LLC, there is the additional argument that any provisions requiring consent of members will not affect the trustee because the entire membership interest becomes part of the bankruptcy estate.

Ms. Raj noted a state supreme court decision regarding a creditor’s collection rights which found that the creditor’s interests were limited to a share in profit and distributions and did not include a right to participate in management.  However, the bankruptcy court found that state law was relevant only to the determination of whether a membership interest was a property interest subject to the bankruptcy estate, and did not control how the interests were to be administered.  Thus, a bankruptcy trustee has additional rights and remedies, and any state limitations were trumped by the Bankruptcy Code.

Since the chapter 7 trustee in Ms. Raj’s case had not abandoned the bankruptcy estate’s interest in the LLC (and in fact eventually filed a declaration indicating that he intended to retain the membership interest as an asset of the estate), he remained in control; and consequently the court dismissed Ms. Raj’s petition on behalf of the LLC on the basis that she did not have standing.

Although the court was careful to mention repeatedly that this case involved a single-member LLC, it is hard to see how its reasoning would be limited to that circumstance.  The argument that the Bankruptcy Code trumps state law restrictions would seem to apply equally to a multi-member LLC.  It is worth remembering that if a member (or manager) of an LLC files bankruptcy, there may be some unexpected consequences for the LLC and any other members.

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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