INDIANA BUSINESS LAW BLOG

[The last in a seve-part series. The other articles in the series are here:  Part I, Part II, Part III, Part IV, Part V, Part VI.]

With the bankruptcy courts’ inconsistent treatment of a debtor’s LLC membership rights, how should someone structure a limited liability company to maximize the possibility that, should the member file for bankruptcy protection, the member’s noneconomic rights will not end up in the hands of a bankruptcy trustee and, possibly, a subsequent acquirer?  With the current state of case law, there seems to be no sure-fire way, but the following factors may help.  Please recognize, however, that other, these factors may run counter to other goals and the decision to include them should be made cautiously with the advice of counsel.

• Avoid LLCs owned by one person or by a married couple. There appears to be no way of preventing a bankruptcy trustee from acquiring the economic and noneconomic rights in a single-member LLC or in, in the case of joint bankruptcy of a married couple, a limited liability company owned entirely by two spouses.

[The other articles in this seven-part series are here:  Part I, Part 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.

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

We are considering the nature of the economic and noneconomic rights of a member of a limited liability company and whether, if the member enters bankruptcy, the bankruptcy trustee acquires those rights.  As explained in Parts III and IV, the member’s economic rights are property rights that belong to the bankruptcy estate in accordance with Section 541 of the Bankruptcy Code, but the member’s noneconomic rights are contractual in nature and, therefore, are potentially subject to Section 365 of the Bankruptcy Code, under which the trustee must assume an executory contract and comply with its conditions in order to exercise the rights it affords. One of the leading bankruptcy cases to address the question is In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005):

While the parties disagree on several relevant legal principles, a dispute that is absolutely central to the motion to dismiss is whether the Trustee’s rights are governed by Bankruptcy Code § 541(c)(1) or by § 365(e)(2). In a very general sense, the latter provision, if applicable, permits the enforcement of state and contract law restrictions on the Trustee’s rights and powers, whereas the former provision, if applicable, would render such restrictions and conditions unenforceable as against the Trustee. Because § 541 applies generally to all property and rights that the Trustee acquires, whereas § 365 applies more specifically to executory contract rights, the answer to this question hinges on whether the Trustee is asserting a property right or an executory contract right.

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

Although a bankruptcy debtor’s contract rights are within the definition of property of the estate under Section 541 of the Bankruptcy Code, they are different than most other property of the estate because they represent both a potential asset and a potential liability. As such, they are potentially subject to Section 365, dealing with executory contracts.  An executory contract is one in which some of debtor’s obligations under the contract remain to be performed and some obligations owed to the debtor by another party remain to be performed. The unperformed obligations must be significant enough that failure to perform them would constitute a material breach of the contract.

If a contract is executory, the bankruptcy trustee has two choices under Section 365:  to assume the contract or to reject it.  In many cases, after assuming an executory contract, the trustee will assign it to a third party in exchange for consideration (i.e., payment of money that is added to the bankruptcy estate).  However, the trustee may assume and assign an executory contract only if two conditions are fulfilled:  (1) any breaches of the contract on the part of the debtor must be cured and (2) the assignee who takes over the contract must be capable of performing the debtor’s obligations.  Generally, any contract provisions that prohibit the assignment are void, but there are exceptions.  For example, if another party to the contract to whom the debtor owes obligations has the right to refuse performance by anyone other than the debtor, the contract cannot be assumed and assigned over the objection of that party.

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

The Indiana Business Flexibility Act creates two distinct categories of LLC rights:  (1) interest, or “a member’s economic rights in the limited liability company, including the member’s share of the profits and losses of the limited liability company and the right to receive distributions from the limited liability company,” I.C. 23‑18‑1‑10; and (2) other rights that are conferred upon members.  Many courts refer to the two categories as economic and noneconomic rights.  The Business Flexibility Act treats those two categories of rights very differently.[1]

It is indisputably clear that economic rights in an Indiana LLC are property rights because the Indiana statute expressly says so:

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

In re Lee, 524 B.R. 798 (Bankr. S.D.Ind. 2015) involved an Indiana limited liability company with five members, one of whom, Lester Lee, held 51 of the 101 votes allocated to the members and served as the sole manager of the LLC.  Although Lester had no right to receive distributions from the company, he was entitled to compensation for his services as manager and, like the other members, he held rights to buy the interests of other members in certain circumstances.

After Lester filed for bankruptcy protection, the trustee sought a determination from the bankruptcy court that the bankruptcy estate held all of Lester’s rights in the LLC, both economic and noneconomic, including the right to cast his 51 votes as a member. The Bankruptcy Court agreed.

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

The law of limited liability companies is a blend of concepts taken from the law of corporations and the law of partnerships. One of the differences between corporations and partnerships deals with the rights of the creditor of a shareholder of a corporation versus the rights of a creditor of a partner.

The usual rule for corporations is that a shareholder’s stock is property that, like any other property of the shareholder, can be reached by the shareholder’s creditors. For example, the shareholder’s creditor may be able to force a sale of the stock to satisfy a judgment against the shareholder, and the person who buys the stock will receive all the rights of a shareholder, including the right to receive dividends (i.e., economic rights) and to vote in elections of directors (i.e., noneconomic rights).