Limited Liability Companies: Handle Bankrupt LLC Members With Care

Walro v. The Lee Group Holding Co., LLC (In re Lee), 524 B.R. 798 (Bankr. S.D. Ind. 2014) –

A chapter 7 trustee sought a court determination that (1) a debtor’s voting rights in a limited liability company (LLC) were property of the bankruptcy estate, and (2) other members of the LLC violated the automatic stay by taking action to remove the debtor as a member and terminating his voting rights.

The operating agreement for the limited liability company (Lee Group) provided that the debtor had a 0% economic interest, but held 51 out of 101 votes.  The agreement further provided that his voting rights would expire upon his death or withdrawal from the LLC.

The debtor signed the operating agreement as a member.  The debtor was also designated as the manager of the LLC, which meant that he was in control of the company’s business and affairs.  The members were entitled to vote on certain matters, including “alienation of interest of individual members.”

After the bankruptcy was filed, the trustee’s counsel wrote a letter to the LLC’s counsel contending that the debtor’s non-economic voting right interests became property of the bankruptcy estate subject to the trustee’s control.

After receipt of this letter, the members adopted a resolution accepting withdrawal of the debtor from the LLC as of December 31 of the prior year.  The resolution acknowledged termination of the debtor’s voting rights and his resignation as a manager.  The remaining members subsequently designated the debtor’s son as the new manager and reallocated voting rights based on economic interests.  They also agreed that the debtor would continue to work for the LLC as a “consultant.”

The trustee argued that the voting rights were property of the estate, and that the postpetition action taken by the other members to terminate the debtor’s membership violated the automatic stay.  The defendants responded that (1) the debtor’s voting rights were derivative of his role as a manager, (2) he had no other property interest in the LLC, and that (3) their actions did not violate the automatic stay.

The court began by noting that “property of the estate” has been “construed most generously” so that it includes “[e]very conceivable” interest of the debtor.  While determination of whether an interest is part of the bankruptcy estate is a federal question, courts look to state law to define the debtor’s interests.

Reviewing the operating agreement and applicable state law, the court concluded that the debtor was a member of the LLC and that his voting rights were incident to that membership.  In response to the defendants’ contention that the debtor was not a member because he did not have a right to any distributions, the court concluded that “interest” was broadly defined so that the debtor did have a qualifying economic right.

As the holder of a majority of the votes, he could ensure that he was not removed as a manager, and as a manager and majority member, he had “unfettered control,” including the right to award incentives and bonuses and to provide for indemnification of expenses and liability in any proceeding.  Further, under the operating agreement, if his wife divorced him he could purchase her interest for a substantial discount.

And regardless, the debtor was not required to have any economic rights in order to be a member.  The court then reviewed a series of cases in which courts held that both economic and non-economic rights in an LLC are property of the bankruptcy estate.

Once the court concluded that the debtor’s voting rights were property of the estate, it turned to whether the defendants had violated the automatic stay.  The court held that when the other LLC members voted postpetition to remove the debtor as manager and to appoint a new manager they were exercising control over property of the estate in violation of the stay.

The defendants next tried to argue that the debtor’s 51% voting rights applied only to routine management of the LLC and not actions that require a vote by a majority in interest of the members.  However, the court did not find this argument to be supported by the operating agreement.  In addition, it was irrelevant whether the debtor was entitled to a vote on his own removal.

Thus, the court granted the trustee’s motion for summary judgment and held that the debtor was a member as of the petition date, he had voting rights pursuant to the operating agreement, and actions of the other members in terminating his membership and voting rights violated the automatic stay so that those actions were invalid.

For those who firmly believe that members of an LLC, like partners in a partnership, should be able to choose whom they do business with, there is at least some solace in that the court did not go on to hold that the trustee was entitled to step into the debtor’s shoes as manager or to compel the debtor to remain as manager.  However, this does not provide a lot of comfort since this was because that the trustee did not request this type of relief and does not indicate how the court would have ruled if it had been asked to address these issues.

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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