Unique Aspects of LLCs in Bankruptcy

For Bankruptcy purposes, limited liability companies (“LLC’s”) are not treated as limited partnerships, but as corporations. Even a single member LLC is treated differently from an “individual” in Bankruptcy. The Bankruptcy of a member of a LLC call have a sever impact on the LLC itself. This Article is from a program recently given by Ken Samuelson, and deals with (a) some of the unique aspects of LLCs under Bankruptcy law; and (b) issues that frequently arise in Bankruptcies of LLCs, even if not unique to LLCs.

Kenneth L. Samuelson
Samuelson Law, LLC
Washington, DC
June 13, 2012
I. Classifications of an LLC and Limited Partnership for Bankruptcy Purposes; Classification of a Membership Interest in an LLC.

A. For Bankruptcy purposes, an LLC, a PLLC, and a limited liability partnership (having no general partner having unlimited personal liability) are each classified as corporations, and a limited partnership is classified as a “partnership” (if it has a general partner having broad personal liability).

11 USCS §101, provides, in relevant part:

“(9) The term “corporation”–
(A) includes–
(i) association having a power or privilege that a private corporation, but not an individual or a partnership, possesses;
(ii) partnership association organized under a law that makes only the capital subscribed responsible for the debts of such association;
(iii) joint-stock company;
(iv) unincorporated company or association; or
(v) business trust; but
(B) does not include limited partnership.”
[emphasis added]
Most state LLC, PLLC and limited liability partnership statutes fall within clause (ii) above. In re: RMAA Real Estate Holdings, LLC, 2010 Bankr. LEXIS 4580, 64 Collier Bankr. Cas. 2d (MB) 1877, 54 Bankr. Ct. Dec. 19 (E.D.VA, 2010); In re: Wyatt & McAlister, PLLC, 2010 Bankr. LEXIS 1413 (S.D. Miss., 2010); In re Promedicus Health Group, LLP (Wallach v. Douglas, et al.), 416 B.R. 389; 2009 Bankr. LEXIS 4066, appeal dismissed 2010 U.S. Dist. LEXIS 83269 (W.D.N.Y., 2010) (the degree of protection afforded owners is what matters); In re: Rambo Imaging, L.L.P., 2008 Bankr. LEXIS 2311, 50 Bankr. Ct. Dec. 95 (W.D. Texas, 2008); In re: James Giampietro (AE Restaurant Associates, LLC v. Giampietro), 317 B.R. 841, 2004 Bankr. LEXIS 2158, 53 Collier Bankr. Cas. 2d (MB) 1012 (Nevada, 2004).

B. Most state LLC statutes classify a member’s interest in an LLC as personal property, even if the LLC is a “single asset real estate” entity. Uniform Limited Liability Company Act (1995), §501; In re: A-Z Electronics, LLC, 350 B.R. 886; 2006 Bankr. LEXIS 2105 (Idaho, 2006).

II. Filings of Bankruptcy Petitions By or Against LLCs.

A. The LLC’s getting its internal authorization to file is governed by state law and the LLC’s governing articles and operating agreement. Wyatt, supra; A-Z Electronics, supra (see, however, authority of a Chapter 7 Trustee of the member of a single member LLC).

B. A LLC cannot take advantage of the broader definition of “insolvent” (available to a partnership) to qualify for, or to avoid, a bankruptcy.

11 USCS §101, provides, in relevant part:

“(32) The term “insolvent” means–
(A) with reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of–
(i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors; and
(ii) property that may be exempted from property of the estate under section 522 of this title [11 USCS § 522];
(B) with reference to a partnership, financial condition such that the sum of such partnership’s debts is greater than the aggregate of, at a fair valuation–
(i) all of such partnership’s property, exclusive of property of the kind specified in subparagraph (A)(i) of this paragraph; and
(ii) the sum of the excess of the value of each general partner’s nonpartnership property, exclusive of property of the kind specified in subparagraph (A) of this paragraph, over such partner’s nonpartnership debts; and”
C. A LLC cannot take advantage of the alternative (available to a partnership) to break a deadlock by filing an involuntary bankruptcy.

11 USCS §303, provides, in relevant part:

“(b) An involuntary case against a person is commenced by the filing with the bankruptcy court of a petition under chapter 7 or 11 of this title [11 USCS §§ 701 et seq. or 1101 et seq.]–
(1) by three or more entities, each of which is either a holder of a claim against such person that is not contingent as to liability or the subject of a bona fide dispute as to liability or amount, or an indenture trustee representing such a holder, if such noncontingent, undisputed claims aggregate at least $ 14,425 more than the value of any lien on property of the debtor securing such claims held by the holders of such claims;
(2) if there are fewer than 12 such holders, excluding any employee or insider of such person and any transferee of a transfer that is voidable under section 544, 545, 547, 548, 549, or 724(a) of this title [11 USCS § 544, 545, 547, 548, 549, or 724(a)], by one or more of such holders that hold in the aggregate at least $ 14,425 of such claims;
(3) if such person is a partnership–
(A) by fewer than all of the general partners in such partnership; or
(B) if relief has been ordered under this title [11 USCS §§ 101 et seq.] with respect to all of the general partners in such partnership, by a general partner in such partnership, the trustee of such a general partner, or a holder of a claim against such partnership;”
RMAA Real Estate Holdings and Rambo Imaging, both supra.

However, a member entitled to guaranteed payments, regardless of the LLC’s profits, may be a creditor, as well as an equity holder. In re: IDS Holding Company, LLC. IDS Holding Company, LLC v. Madsen, 292 B.R. 233, 2003 Bankr. LEXIS 400, 41 Bankr. Ct. Dec. 55 (Conn., 2003).

D. Proving that a single member LLC is an abusive filer requires a lot more evidence that the mechanical 180-day bar of 11 USCS §109(g) for an “individual”. In re: 4 WHIP, LLC, 332 B.R. 670, 2005 Bankr. LEXIS 2138, 45 Bankr. Ct. Dec. 168 (Conn., 2005).

E. If a member files for personal bankruptcy, the Courts are divided as to whether his/her Trustee gets his/her voting and management rights in the LLC and, if so, whether the Trustee can then sell those rights. Usually, State laws and LLC operating agreements permit members to assign their rights to profits and losses in connection with the member’s bankruptcy; however, they also usually prohibit the assignees from becoming members or managers or having any vote. The conflict stems from the differences between (a) 11 USCS §541(c)(1), which invalidates such ipso facto clauses; and (b) 11 USCS §365(c)(1), which makes the following exception to such an invalidation of ipso facto clauses:

“(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if–
(1) (A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment; or”
Although the decisions vary greatly, the consensus seems to be along the following lines:

(1) If the LLC has an operating agreement and it is deemed to be an “executory contract”, then §365(c)(1) governs. For the operating agreement to be an “executory contract”, both the Debtor and the LLC must have substantial unperformed or ongoing obligations toward the other. Those duties may not be merely structural or too remote or hypothetical. Courts seem to agree that continuing obligations to participate in the management of the LLC and to make additional capital contributions are executory. Some courts also require that the identity of the assignee be critical (as distinguished from the assignee’s being merely a passive investor) in order for the operating agreement to be an executory contract.

(2) Trustee has time limits to accept or reject an executory contract. 11 USCS §365. If the contract is rejected thereunder, 11 USCS §541(c)(1)(A) controls. In re: Cahillane (Gouveia v. TC Investments, LLC), 2009 Bankr. LEXIS 434 (N.D. Ind., 2009)

(3) Objections can be waived by course of conduct. In re McSwain and McSwain (Norberg v. Hawks Prairie Casino, LLC), 2011 Bankr. LEXIS 3921, 55 Bankr. Ct. Dec. 153 (Wash., 2011).

(4) A mere passive economic interest in the LLC may draw a far-lower interest from third parties. In re: Garbinski and Garbinski (Cardiello v. USA, et al.), 465 B.R. 423, 2012 Bankr. LEXIS 515 (W.D. PA., 2012). An attempt to buy the assets cheap.

(5) 11 USCS §365(c)(1) is designed to protect the rights of third parties (i.e. the other members of the LLC) by having the operating agreement performed by the person with whom those third parties contracted, not a stranger like the Trustee. Thus, in cases in which there are no such third parties (such as with respect to a single member LLC), 11 USCS §365(c)(1) does not apply. In re: First Protection, Inc. (Fursman, et al. v. Ulrich), 440 B.R. 821, 2010 Bankr. LEXIS 4336, 64 Collier Bankr. Cas. 2d (MB) 1376, 54 Bankr. Ct. Dec. 47 (9th Cir., 2010). [Note: In that case, the Court held that the good faith purchaser defense under 11 USCS §549(c) applies to a sale of real estate, not to a sale of LLC membership interests.]
In addition, see In re Jundanian (Caymus Venutures, et al. v. Jundanian), 2012 Bankr. LEXIS 1370 (Maryland, 2012); In the Matter of: H & W Food Mart, LLC, 461 B.R. 904, 2011 Bankr. LEXIS 5190 (N.D.Ga., 2011); In re: Prebul (Bensusan v. Prebul, et al.), 2011 Bankr. LEXIS 2795 (E.D.Tenn., 2011); In re: Tsiaoushis (Endeka Enterprises, LLC v. Calomiris), 2007 U.S. Dist. LEXIS 53376 (E.D. Va., 2007); In re: Allentown Ambassadors, Inc. (Allentown Ambassadors, Inc. v. Northeast American Baseball, LLC), 361 B.R. 422, 2007 Bankr. LEXIS 267, 47 Bankr. Ct. Dec. 251 (E.D. Pa., 2007)(in relation to the automatic stay).

III. A Member as an “Insider” for the Purposes of 11 USCS.

11 USCS §547 extends the period during which a Trustee in Bankruptcy may seek to avoid a transfer by the Debtor, to an “insider”, as follows:

“(b) Except as provided in subsections (c) and (i) of this section, the trustee may avoid any transfer of an interest of the debtor in property–
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;
(3) made while the debtor was insolvent;
(4) made–
(A) on or within 90 days before the date of the filing of the petition; or
(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
(5) that enables such creditor to receive more than such creditor would receive if–
(A) the case were a case under chapter 7 of this title [11 USCS §§ 701 et seq.];
(B) the transfer had not been made;
(C) such creditor received payment of such debt to the extent provided by the provisions of this title [11 USCS §§ 101 et seq.].”
[emphasis added]
Each member is likely to be held to be an “insider”, especially if the LLC is member-managed (as distinguished from manager-managed), unless the operating agreement places unusual and very substantial limits upon his/her authority and influence with the Debtor. In re: Longview Aluminum, L.L.C. (Appeal of Forte), 657 F.3d 507, 2011 U.S. App. LEXIS 18302, Bankr. L. Rep. (CCH) p.82,067, 66 Collier Bankr. Cas. 2d (MB) 577, 55 Bankr. Ct. Dec. 111 (7th Cir., 2011); In re: Lull (Kotoshirodo v. Dorland and Associates, Inc. CPAs), 2008 Bankr. LEXIS 4543 (Hawaii, 2008).

IV. Can Offer Tax Savings.

A sale of real estate, under a confirmed plan of reorganization, is exempt from State and local recordation and transfer taxes. 11 USCS §1146; In re Hechinger Investment Company of Delaware, Inc. (Baltimore County, Maryland, et. al v. Hechinger Liquidation Trust), 335 F.3d 243, 2003 U.S. App. LEXIS 14449, Bankr. L. Rep. (CCH) p.78,886, 41 Bankr. Ct. Dec. 162 (3rd Cir., 2003).