LLC Interests and a Member’s Bankruptcy, Part VI

[The other articles in this seven-part series are here:  Part IPart II, Part III, Part IV, Part V, Part VII.]

In the last installment of this series, we discussed a few of the bankruptcy cases in which the court, faced with a question of the trustee’s right to exercise the debtor’s noneconomic rights as a member of a limited liability company, considered whether the LLC’s operating agreement was an executory contract under Section 365 of the Bankruptcy Code.  In this post we discuss bankruptcy cases that concluded that all the debtor’s membership rights, both economic and noneconomic, were automatically the property of the estate under Section 541 without considering whether the operating agreement was an executory contract.  In doing so, those courts tacitly (and erroneously, in the author’s respectful opinion) treat a member’s rights in a limited liability company as if they were equivalent to a shareholder’s rights represented by stock in a corporation.  Unlike the rights held by LLC members, the economic and noneconomic rights represented by a share of stock are essentially inseparable and both are correctly treated as in the nature of property rights, not contractual rights.

We’ve already mentioned the case that prompted this series, In re Lee, 524 B.R. 798 (Bankr. S.D. Ind. 2014), in which the court held that the trustee acquired all the debtor’s rights, both economic and noneconomic, without considering the potential applicability of Section 365, possibly because neither of the parties to the proceeding that the court argued that the operating agreement was an executory contract.  Although the Lee court cited to a number of cases to support its holding that the trustee acquired both the economic and noneconomic membership rights of the debtor, all but one them[1] reached that conclusion without addressing whether it was necessary to consider the possible applicability of Section 365.  While In re Lee is consistent with those cases, none of them actually holds that the trustee acquires the debtor’s noneconomic rights with no need to analyze the operating agreement under Section 365.

What about the one other case cited by In re Lee?  That’s In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr. E.D. Virginia 2000), which is actually inconsistent with In re Lee because the court in that case did in fact consider whether operating agreement was an executory contract before answering the question about the fate of the debtor’s membership rights.  As with other cases discussed in Part V, the court concluded that the operating agreement was not, under the facts before it, an executory contract.  Only then did it hold that the trustee acquired all the debtor’s membership rights, both economic and noneconomic.

However, one recent decision, In re Denman, Case No. 15-25701-K (Bankr. W.D. Tennessee 2014) does indeed hold that an operating agreement can never be an executory contract and thus there is no need to consider the applicability of Section 365 before concluding that the trustee acquires the debtor’s noneconomic LLC membership rights.  In doing so, the court reasoned that an operating agreement, at least for a Tennessee LLC, is of a unique nature and not the sort of contract contemplated by Section 365.  The court expressly likened an operating agreement to a corporation’s bylaws, in part because, under Tennessee law, a person who becomes a member is bound by the operating agreement without any other manifestation of an intent to be bound and an operating agreement can be amended without the unanimous consent of the members.  Unfortunately, there is no indication whether the court would have reaced a different result had the operating agreement require affirmative acceptance of the agreement as a condition to being admitted as a member and prohibited amendments without unanimous agreement of all members.

The Denman case has been criticized, and with good reason.  We noted at the outset of this series that LLC law is a blend of corporation law and partnership law.  Until Denman, all of the cases of which we are aware that considered the analogy, such as In re Ehmann and In re First Protection, treat an operating agreement the same as a partnership agreement.  The Denman case takes a sharp turn away from those decisions by treating an operating agreement the same as corporate bylaws.  Whether that rationale gains any traction among bankruptcy courts remains to be seen.

Finally, in Part VII, we’ll present some conclusions.

[1] In re Warner, 480 B.R. 641 (Bankr. N.D. West Virginia 2012); In re Virginia Broadband, LLC, 498 B.R. 90 (Bankr. W.D. Virginia); In re Klingerman, 388 B.R. 677 (Bankr. E.D. North Carolina 2008); In re Liber, Case No. 08-37046 (Bankr. N.D. Ohio 2012); In re Ellis, Case No. 10-16998-AJM-7A (S.D. Ind. 2011); and In re Hickory Ridge, LLC, Case No. 07-1251 (Bank. N.D. West Virginia 2010).


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