Court Holds that Bankruptcy Trustee Succeeded to Right to Control LLC

Court Holds that Bankruptcy Trustee Succeeded to Right to Control LLC

 

In a recent decision from the United States District Court for the Southern District of Indiana, it affirmed a determination of the Bankruptcy Court that when a member of an LLC with voting control thereof filed personal bankruptcy, that right to control the LLC became vested, as part of the bankruptcy estate, in the trustee. As such, going forward, the bankruptcy trustee has control of that LLC. In re Lester L. Lee, No. 4-15-cv-00009-RLY-WGH, Adv. Proc. No. 14-59011 (S.D. Ind. August 10, 2015).

The operating agreement of Lee Group Holding Company, LLC (“Lee Group”) identified a number of members, allocating to them certain economic and voting rights within the company. While Lester Lee did not enjoy any right to either interim or liquidating distributions from the LLC, he was afforded 51 votes therein; the balance of the members held, collectively, 50 votes. As such, Lester individually controlled a majority of the voting rights in the company.

 

Lester Lee then filed personal bankruptcy. After that filing, with the consequent entry of an automatic stay, the trustee’s counsel reviewed the Lee group operating agreement and wrote a letter providing in part that “this non-economic interest [in Lee Group] became property of the estate subject to control of the Trustee on the filing of the [bankruptcy] petition pursuant to 11 U.S.C. § 541.” Thereafter, the other members of the Lee Group executed documents purporting to accept Lee’s resignation from the Lee Group and the termination of his voting rights thereunder. These actions were taken in the face of a provision of the operating agreement which provides, inter alia, that decisions require the approval of 51% of the voting rights allocated amongst the various members. They also sought to adopt amendments to the operating agreement, again acting without consideration of the 51 voting units held by Lester Lee. After these actions were challenged by the trustee, the bankruptcy court “concluded that the Debtor’s voting rights were property of the estate as of the filing of the Petition and that the [actions of the other members of Lee Group] purporting to terminate his voting rights violated the automatic stay imposed by 11 U.S.C. § 362 and, therefore, had no legal effect.” In re Lester L. Lee, 524 B.R. 798 (Bankr. S.D. Ind. 2014).

 

It was from that ruling that this appeal to the District Court was taken. On appeal, the Court’s primary focus was upon whether the right to vote in an LLC constitutes “property of the estate,” defined by section 541(a)(1) of the Bankruptcy Code as “all legal or equitable interest of the Debtor in property as of the commencement of the case. After finding that Lee could be a “member” of the LLC notwithstanding the absence of any share in the company’s profits and losses or the distributions it should make, the Court was able to determine that Lee was a member. In a belt and suspenders analysis, the Court determined also that the voting rights themselves could constitute “economic rights in the company” affording him the opportunity to, for example, “ensure his continued employment as manager” thereof.

 

On that basis, the determination of the trial court to the effect that any effort to strip Lee of his right to control the LLC through the exercise of the 51 voting rights was invalid as a violation of the automatic stay. HERE IS A LINK to this decision.

 

Curiously not addressed by this opinion (it was not addressed by the trial court below) is Section 23-18-6-5(a)(3)(B) of the Indiana LLC Act, which provides that “a person ceases to be a member of a [LLC] upon the occurrence of any of the following events:… (3) the person is removed as a member:… (B)… By the affirmative vote, approval or consent of a majority in interest of the members after the member has assigned the member’s entire interest in the [LLC].” By this omission, the Court may be saying that, in effect, the assumption by the bankruptcy trustee of the voting rights within the estate is not an “assignment” as contemplated by this provision. Whether that is the Court’s thinking is, however, still unknown.

 

There have been a long series of cases that have addressed the question of whether the bankruptcy estate succeeds to a member’s right to participate in the management and affairs of an LLC. Famously, in In re Ashley Albright, it was determined that the bankruptcy court did succeed to the management rights. See also Thomas E. Rutledge and Thomas Earl Geu, The Albright Decision - Why a SMLLC is Not an Appropriate Asset Protection Vehicle, 5 Business Entities 16 (Sept./Oct., 2003).  That, however, was in the context of a single member LLC; Lee Group was a multiple-member LLC in which different concerns were present. This decision is yet another in which it was held, inter alia, that multiple-member versus single-member is not of itself a distinguishing factor (although certainly those fact changes may impact upon the executor contract analysis).  See, e.g., Matter of H&W Food Mart, LLC, 461 B.R. 904 (Bankr..N.D.Ga., 2011); Norberg v. Hawks Prairie Casino, LLC (In re McSwain), 2011 WL 4706982 (Bankr. W.D.Wa., 2011); In re Alameda Investments, LLC, 2013 WL 3216129 (Bankr.C.D.Cal., 2013).

 

 

Essentially, the members of the Lee Group vested control in Lester Lee. Now, for all effects and purposes, control of the LLC has been vested in Lester Lee’s bankruptcy trustee, and it appears there is little the members may do about that. While they may be trapped in that situation, counsel drafting LLC operating agreements (similar issues can arise under limited partnership agreements) need to carefully consider how voting control is allocated and address mechanisms by which, subject to the limitations of the automatic stay, operational control of the business venture may be properly removed from a bankruptcy trustee should that eventuality arise.

In response to a cross-posting of this review, Professor Carter Bishop observed:

The opinion is clear that for bankruptcy purposes BRC 541 sweeps into the debtor member’s bankruptcy estate “property” that includes the LLC interest and voting rights pertaining to that LLC interest, even if the member was a noneconomic member. The other members devoted their entire argument to BRC 541. They never addressed BRC 365. As long as 541 applies, any action to terminate those rights violates the automatic stay and are void and infective. The court so held.

The court did not state the trustee could exercise those voting rights.  The next step is crucial. If the operating agreement is an executory contract of a multi-member LLC, BRC 365 will normally respect LLC state law restrictions as “applicable law” and deny the trustee the right to exercise the debtor’s voting rights (similar outcome to a non-delegable personal service contract).This was a managing member of a multi-member LLC, so I assume BRC 365 blocks the trustee’s exercise.

 

So, I don’t think the opinion is quite as broad as Tom’s title suggests. It merely holds that BRC 541 requires the voting rights to be included in the estate. That does not conclude the matter which next shifts to BRC 365.

 

To which I respond:

The point you identify, namely the capacity to vote (as contrasted with hold) the voting interests is, well, interesting.

Neither this nor the prior decisions discuss the operating agreement as or not as an executory agreement - 365 has not been identified (based upon the pleadings I have reviewed) as an issue.

In In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr. E.D. Va. 2000), and I'm here working from memory, it was found that the voting rights were part of the estate, but that the estate was dissociated from the LLC; I think you are making the point that a similar outcome could follow if and when there is a later challenge to the estate's exercise of its voting control.  I would not be surprised if a court were to find “I’ve already said the voting rights are part of the estate, and (a) its too late for you to argue section 365 and/or (b) when I said the voting rights were in the estate I necessarily meant as well that the estate could exercise the voting rights.”

Whether the point has been already raised and rejected, or it simply has not been raised, is unknown.  I’ll see what more I can learn.