Involuntary Transfer Considerations for Operating Agreements in Bankruptcy
By Transfer restrictions in operating agreements serve an important function in assuring that the members of limited liability companies (“LLCs”) are able to control the admission and withdrawal of their fellow members. Members view these controls as fundamental to the business relationship, as they do not want to be forced into business with an unknown party without their consent. Indeed, the right to freely choose with whom to associate is enshrined in the U.S. Constitution.[1] However, the ability of members to approve or deny membership to others can be challenged in the context of an involuntary assignment by a fellow member’s bankruptcy estate to a creditor under the Bankruptcy Code (the “Code”).
First, the North Carolina Limited Liability Company Act (the “Act”) provides that a judgment creditor of a member “may charge the economic interest of an interest owner with the payment of the unsatisfied amount of the judgment with interest.”[2] This gives the judgment creditor the right to receive distributions with respect to the member’s economic interest, but does not grant the judgment creditor with the full rights, privileges and responsibilities of the member.[3] Moreover, the Act generally requires “the unanimous approval of the members” for the admission of new members absent contrary language in the operating agreement.[4] This means that while the creditor of a member may effectively garnish such member’s distributions from an LLC, such member generally cannot transfer the member’s voting or governance interest in the LLC to the creditor and make the creditor a substitute member without the consent of the other members.
If a member declares bankruptcy, however, Section 541(a) of the Bankruptcy Code provides that a debtor’s property is transferred to the bankruptcy estate, including the debtor’s membership interest a limited liability company.[5] The bankruptcy estate, whether represented by a trustee or the debtor-in-possession, may then attempt to claim not only the economic benefits of membership, but also governance rights reserved for admitted members.[6] This can be very problematic for the non-bankrupt members of an LLC, as a trustee or debtor-in-possession is obligated to preserve the value of assets in the bankruptcy estate with a view towards liquidation or reorganization, which may or may not be consistent with the best interests of the LLC itself.[7] Furthermore, the non-bankrupt members of the LLC may now find themselves co-owners of an LLC with a bankruptcy trustee with whom they have had no prior dealings. Some debtors-in possession or trustees may even attempt to use this as a leverage to force the non-debtor members to pay more to repurchase the debtor’s interest in the LLC.
Unfortunately, there is some uncertainty regarding whether a bankruptcy estate’s claim to the non-economic rights of ownership in an LLC should be valid.[8] Some of this uncertainty stems from the question of whether an LLC’s operating agreement is or is not an executory contract, as ipso facto clauses (such as clauses terminating membership upon filing a bankruptcy petition) are generally invalidated in the context of a bankruptcy.[9] However, such clauses are enforceable under the Code if they are part of an executory contract assumed by the bankruptcy estate.[10] Thus, if the non-bankrupt members can show that the bankrupt member had substantial unperformed obligations under the operating agreement, then they are more likely to be able to bar the trustee or debtor-in-possession from exercising the bankrupt member’s non-economic rights.[11]
Furthermore, “[w]hile federal bankruptcy law determines what constitutes property of estate, whether debtor has interest in property and the nature and extent of debtor’s interest is question of state law.”[12] While the Act does not explicitly provide for assignees to take only the economic rights of an assignor without the consent of the other members, as is the case in Delaware,[13] the requirement that members consent to the admission of members in N.C. Gen. Stat. § 57D-3-01(a)(2) should have this same effect. Additionally, the separate provisions regarding transfers of economic interests in N.C. Gen. Stat. § 57D-5-02 and the additional requirements for the admission of economic interest owners to become members under N.C. Gen. Stat. § 57D-5-04(a) only make sense if an assignee does not generally take the full rights of membership. However, Bankruptcy Courts have yet to confirm this interpretation of Act in North Carolina.[14]
We should certainly continue to include restrictions on transfer in operating agreements that clearly limit the rights of assignees upon an involuntary transfer to economic rights. From a drafting perspective, we can also bolster the executory nature of operating agreements by including recitals and provisions in operating agreements that clarify the member’s ongoing obligations to the LLC and the other members. For now, however, we should also advise clients forming LLCs to consider the risks involved if a fellow member assigns an interest in the LLC in a bankruptcy.
[1]Nat’l Ass’n for Advancement of Colored People v. State of Ala. ex rel. Patterson, 357 U.S. 449, 460–61, 78 S. Ct. 1163, 1171, 2 L. Ed. 2d 1488 (1958) ([I]t is immaterial whether the beliefs sought to be advanced by association pertain to political, economic, religious or cultural matters, and state action which may have the effect of curtailing the freedom to associate is subject to the closest scrutiny. (citations omitted))
[2] N.C. Gen. Stat. § 57D-5-03(a).
[3] N.C. Gen. Stat. § 57D-5-03(a) and (d).
[4] N.C. Gen. Stat. § 57D-3-01(a)(2).
[5] 11 USC § 541(a)(1); N.C. Gen. Stat. § 57D-5-01 (“An ownership interest [in a limited liability company] is personal property.”).
[6] See In re Klingerman, 388 B.R. 677, 679 (Bankr. E.D.N.C. 2008) (“Mr. Klingerman’s rights and interest in the LLC, economic and non-economic, became property of the estate upon the filing of his petition. As a member of the LLC, the estate has standing to ask for dissolution of ExecuCorp. Whether or not the debtor will prevail in his request for dissolution is another question that is reserved for another day.”)
[7] For example, a bankruptcy trustee or debtor-in-possession may be reluctant to make a capital contribution or consent to certain transactions.
[8] See, e.g., Nw. Wholesale, Inc. v. Pac Organic Fruit, LLC, 184 Wash. 2d 176, 200, 357 P.3d 650, 662–63 (2015). (Holding that the debtor-in-possession could not maintain a suit against the LLC because the debtor-in-possession had ceased to be a member upon filing a bankruptcy petition); but see, Klingerman 388 B.R. at 679.
[9] 11 U.S.C. § 541(c)(1).
[10] 11.U.S.C. § 365(c) and 11.U.S.C. § 365(e). See In re Yow, No. 11-06011-5-SWH, 2018 WL 3524582, at *2 (Bankr. E.D.N.C. July 19, 2018) (“If the LLC Operating Agreements are executory in nature, then ‘the panoply of rules in § 365 apply to affect or alter a trustee’s rights and powers.’ (citing In re Warner, 480 B.R. 641, 649 (Bankr. E.D. Va. 2012)). On the other hand, if the agreements are not executory, then the court need not consider § 365 in evaluating the effect and enforceability of an operating agreement’s language. (citing In re First Protection, Inc., 440 B.R. 821 (9th Cir. BAP 2010)).
[11] See Nw. Wholesale, Inc. v. Pac Organic Fruit, LLC, 184 Wash. 2d 176, 195, 357 P.3d 650, 660 (2015) (“A contract is executory only when the ‘obligations of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other.’” (quoting In re First Protection, Inc., 440 B.R. 831, and also citing In re Ehmann, 319 B.R. 200, 204 (Bankr.D.Ariz.2005)).
[12] 3A Bankr. Service L. Ed. § 29:48. See also, Butner v. United States, 440 U.S. 48, 55, 99 S.Ct. 914, 59 L.Ed.2d 136 (1979) (“Property interests are created and defined by state law.”); In re Pettit, 217 F.3d 1072, 1078 (9th Cir.2000) (“Although the question whether an interest claimed by the debtor is “property of the estate” is a federal question to be decided by federal law, bankruptcy courts must look to state law to determine whether and to what extent the debtor has any legal or equitable interests in property as of the commencement of the case.”)
[13] 6 Del. Code Ann. tit. 18, § 702(b).
[14] See Klingerman 388 B.R. at 679; see also In re Yow 2018 WL 3524582, 65 Bankr. Ct. Dec. 263 (approving the transfer and sale of debtor’s economic interests and the abandonment of debtor’s non-economic interests in the LLCs).