February 8, 2018
It is not uncommon for individual debtors in bankruptcy to own membership interests in LLCs. If a member of a multi-member limited liability company files bankruptcy, what happens to the Debtor’s membership interest in the LLC?
The debtor, bankruptcy Trustee, creditors, and the other members of the LLC are all impacted when an individual member files bankruptcy, because the membership units become property of the estate.
We begin by analyzing the Bankruptcy Code’s definition of property of the estate which is very broad. The Bankruptcy Code defines “property of the estate” as “all legal or equitable interest of the debtor in property as of the commencement of the case.” 11 U.S.C. § 541(a)(1). Federal law creates the bankruptcy estate, but state law defines the debtor’s property rights.
The individual debtor’s bankruptcy estate has no interest in the real or personal property of the LLC. However, and importantly, the bankruptcy estate does have an interest in the LLC membership units which the debtor owns at the time the bankruptcy is filed.
Under the Michigan Limited Liability Act, a “membership interest” is defined as “a member’s right in the limited liability company, including, but not limited to, any right to receive distributions of the limited liability company’s assets and any right to vote or participate in management.” In other words, a membership interest under the Michigan Limited Liability Act is defined using both “economic” and “non-economic” terms.
If a member files bankruptcy, what rights does the bankruptcy Trustee have with respect to the membership interest which is now property of the bankruptcy estate pursuant to 11 U.S.C. § 541?
Typically, the Trustee abandons property of inconsequential value or sells property whereby the Trustee can obtain proceeds for the Estate. This can be done by an Assignment of the Membership Interest from the Estate to a buyer.
The Michigan Limited Liability Act, MCL 450.4101, sets forth requirements to become a member or assignee of an LLC. The act also provides what rights, if any, the assignee or member receives as a result of a transfer. MCL 450.4102 defines a “member” as a “Person who has been admitted to a limited liability company as provided in section 501.” MCL 450.4501 defines the way that an assignee, after formation of the LLC, may become a member. This can be done by agreement. What if there is no willingness on part of the other members to admit an assignee as a member? What happens to the membership interest?
In evaluating how an assignee becomes a member, or what rights the assignee may have, if not a member, Courts must examine MCL 450.4505, which states:
(1) Except as provided in an operating agreement, a membership interest is assignable in whole or in part.
(2) An assignment of a membership interest does not of itself entitle the assignee to participate in the management and affairs of a limited liability company or to become or exercise any rights of a member. An assignment entitles the assignee to receive, to the extent assigned, only the distributions to which the assignor would be entitled.
(3) Unless otherwise provided in an operating agreement and except to the extent assumed by agreement, an assignee has no liability as a member solely as a result of the assignment.
(4) Except as provided in an operating agreement, a member ceases to be a member when the member's entire membership interest is assigned. The assignor is not released from any liability to the company under sections 302 and 308 even if the assignee becomes a member.
Is the assignment of the debtor’s membership simply an “economic” interest with rights to receive distributions, if any are made? It may be argued that under applicable state law, the bankruptcy estate is only entitled to receive the member’s share of the LLC’s profits and is not entitled to participate in management of the LLC. Therefore, are the rights of the bankruptcy estate in a multi-member LLC similar to the rights of a judgment creditor under state law, who are typically limited to placing a charging order on the judgment debtor’s membership interest in the LLC?
This is becoming an interesting area where the bankruptcy code and limited liability acts throughout the country are bumping up against one another. Bankruptcy Courts around the country are reaching different results.
When a member of a multi-member LLC files bankruptcy, corporate counsel and all interested parties need to analyze and assess what is and is not “property of the estate”, as well as the estimated market value of the debtor’s membership interests.
LLC ownership can be very difficult when one member files bankruptcy. Should members meet and discuss the impact of a member’s unanticipated future bankruptcy? Should the members meet and discuss valuation of each member’s interest yearly? If a member is going to file bankruptcy, should the other members be made aware? How does the Operating Agreement address these issues, if at all? Corporate counsel and bankruptcy counsel can work together in advance of and during a bankruptcy proceeding and begin a dialogue about what the members should expect.